Quote from: Digiconomist on August 09, 2014, 03:39:45 PM

Hi everyone,

I do frequent cryptocurrency exchange reviews, and as I got to Bitfinex (BFX) my attention was immediately drawn towards their liquidity swaps. They reveal a substantial amount credit risk when using Bitfinex. In fact, the market derived probability of default for the exchange over a one year period can be determined at somewhere between 39.59% and 52.79%. This depends on whether you assume to lose 75% or 100% should the exchange actually default, but in any case a higher recovery rate would not be reasonable given ISDA standards.

For full details how I get to these numbers, check out: http://digiconomist.net/caution_advised_when_using_bitfinex/

To put it differently, the chances of losing at least 75% of your money on Bitfinex is well over 290 times larger than the chance that you will lose as much by simply holding Bitcoins in cold storage. I based that on the current 1 day volatility of Bitcoin, included in the details. Obviously, a default probability of at least 40% does not need comparisons to show that it is pretty bad.

These numbers would only be incorrect if market prices aren't "right." The problem is, markets are always right, unless there is some manipulation involved. If that would be the case, then there would be even more reason to avoid BFX. After all, it wouldn't be more than a scam-platform. I have no evidence that this (manipulation) is happening, just pointing out that it wouldn't improve the conclusion: putting money on BFX should be considered a very high-risk activity. Especially liquidity providers should be aware that by providing liquidity at BFX they are running a bigger risk than by buying into Bitcoin.

I'm sorry...I can't let this one sit here. Not because I think he is slandering a great institution, which he is, but rather that he is just so wrong on so many points. I appreciate people's ideas, but any idea should stand up to further scrutiny, this one clearly doesn't.

Here is one interesting thing which he failed to notice. IF the return is correlated to solely the risk of default of the exchange, then why would different currencies have different rates?

First off, the efficient market hypothesis was just that, a hypothesis. It has widely been viewed as a flawed model, and not actually practical in the real world. The whole purpose of markets is to discover what something is worth, if we already knew, we would never trade. But let's look at the numbers...

You pointed out that the USD return over 30 days was 2.79%. So, let us look at the BTC market. It's daily rate (according to Bitfinex.com) is 0.0055, and that works out (after their 15% fee) to .14% per 30 days.

So, as you astutely pointed out.
"After all, if the exchange suddenly defaults or disappears, then all money present on the platform might be gone as well. Since there is no counterparty risk on the traders due to the exchanges system, the full credit spread is caused by counterparty risk on the exchange itself."

So, an exchange with dollars in a bank account has a high chance of disappearing, and yet an exchange with bitcoin in its account, has a very low risk of disappearing. This seems to be pretty weird, given that they are indeed the same institution. If anything, one would imagine that bitcoin losses would be much harder to recover, but we could ask the Mt Gox customers to clarify.

So, two assets, lent by the same business, with widely different rates. It is almost as if the entirety of the rate is not explained by one cause. Perhaps there are other factors at play. Let's explore a bit.

Why would the USD rate be orders of magnitude higher than the BTC rate? Econ 101 says that prices are set by supply and demand, and based on the size of the market, it seems to fit. The USD market is much larger than the BTC market (30 million vs 2.5 million, roughly). Seems like a LOT of demand for USD, and what is that used for? To buy bitcoin. So it would seem that there are a lot of people who are bullish bitcoin, and very few people who are bearish. Perhaps that explains the big difference between the rates?

According to YOUR hypothesis, that rate=risk, if the risk carried by the lenders is ONLY a function of counterparty risk, the risk should be equal for BTC and USD. It is not, therefore I think your hypothesis is flawed.

I think that the market actually functions somewhat as follows. If you think that the price of bitcoin is going to be higher than $594, it makes a lot of sense to take out this loan. If you do not think the price will be higher than that over the next 30 days, it makes a lot of sense to offer this loan. Judging by the size of the markets, it seems a lot of people think the price will be higher than that in 30 days.

Lastly, IF there is a correlation between the risk undertaken by the lender, and the rate that they receive. It would, IMO, be relatively easy to tease that data out by looking at the interest rate on the lowest priced asset, the one in the least demand, and then figure that must be closest to the actual number. People lent that asset at that rate, and since any counterparty risk should be equal over all assets for one exchange, that rate would be, if you agree with his hypothesis, the one closest to the actual compensation for risk.