For years, Tian Jia made the kind of returns on his money that investors in the rest of the world could only dream of.
The 29-year-old Beijing-based programmer had $440,000 on deposit at the Hong Kong bitcoin exchange Bitfinex until last week and, on good days, would wake up to find a couple thousand more dollars in his account than when he went to sleep. The earnings came from lending his dollars to traders who wanted to leverage their bets. The exchange allowed lenders like Tian to set their own rates, and he says margin traders paid as much as 700 percent annualized interest to borrow dollars. At times, he earned as much in one day as holders of U.S. Treasuries earn in a decade.
“The returns were really great,” Tian said. “Bitfinex was quite innovative and among the first to come out with products including margin lending.”
That lucrative practice came to a stunning halt last week after Bitfinex said it was hacked for 119,756 bitcoins, worth about $70 million at current prices. While his U.S. dollars were not stolen, Tian is being forced to forfeit 36 percent of his deposit—about $160,000—as part of a rescue plan the exchange is imposing on all its customers. He said that will more than wipe out the profits he made through lending money.
Bitfinex, which was the largest bitcoin exchange for U.S. dollar trading prior to the attack, says leaning on its users to cover the loss is the best way to avoid insolvency that would tie up deposits with legal proceedings for years. The exchange hopes to repay the lost money: Customers are receiving tokens that Bitfinex says will one day be redeemable for shares in its parent company, which would give its customers a stake in future profits. Zane Tackett, a director at Bitfinex, said the exchange is also offering to pay anyone who helps recover the bitcoins a reward of 5 percent of the money, a bounty that could total more than $3 million.
The episode has triggered legal consultations and soul-searching among Tian and others like him. Whether they accept the exchange’s offer or fire back with lawsuits will determine the latest chapter in bitcoin’s colorful history.
“Some users are still reaching out to lawyers to weigh their options, but going through litigation does mean a lot of risks,” Tian said. “The losses aren’t as bad as I initially expected, but there are still a lot of questions regarding the method of compensation.”
Among the unanswered questions: How did Bitfinex calculate the 36 percent haircut? Is the exchange itself shouldering any losses? What are the legal guarantees that the new tokens will be redeemable in the future? The exchange did not reply to multiple inquiries from Bloomberg. The tokens, which were issued at a total value of about $70 million, immediately fell to about $21 million in their trading debut Thursday on Bitfinex.
The discount suggests little confidence in the exchange’s future. “Bitfinex has to prove that it can survive first,” said Peter Ng, a Hong Kong-based user who is facing more than $200,000 in losses. “We need to see how transparent the company is going forward. If you lose trust, then you lose your customers.”
Still, he says he had feared even worse. In February 2014, Tokyo-based Mt. Gox—then the world’s largest bitcoin exchange—announced that $480 million was stolen by hackers and filed for bankruptcy weeks later. Its users are still waiting for liquidators to return a fraction of the deposits that did not disappear.
Litigation against Bitfinex could also drag out since Hong Kong, like most countries, has little legal infrastructure in place for regulating bitcoin exchanges or protecting owners of digital currencies. The city’s central bank has said bitcoin falls outside its authority. KC Chan, the secretary for financial services and the treasury, has said the government doesn’t yet see a need for legislation.
Bitcoin exchanges could still face legal liabilities under general anti-money laundering laws, and bitcoin transactions may be subject to rules on commodity trading, according to the law firm Kobre & Kim. Customers may also try to recover funds based on claims of negligence or manipulation on the part of the exchange, according to Jef Klazen, a New York-based partner at the firm.
“If your account wasn’t actually hacked but received this 36 percent haircut, you might be able to pursue a legal claim on the theory that Bitfinex misappropriated your funds because it made a unilateral decision to take money out of your account,” Klazen said. Still, he says a lot will depend on what kind of legal contracts users signed with Bitfinex when opening accounts. He reviewed the terms and conditions on the exchange’s website and thinks that disputes may need to be resolved using an arbitrator selected by the exchange.
“Depending on what jurisdiction you’re trying to sue in, a court might view that as foreclosing your ability to pursue a lawsuit,” said Klazen.
While security experts have stressed for years that users should minimize deposits at bitcoin exchanges—a painful lesson from Mt. Gox—many ignored that advice due to Bitfinex’s unique margin lending system. The platform allowed traders to multiply the size of their bets by borrowing money, but the practice required both lenders and borrowers to keep their funds at the exchange. That made it a prime target for hackers. About $38 million was on loan to margin traders immediately before the attack, according to bfxdata.com, a site that tracks activity on Bitfinex.
Among those who borrowed heavily is 34-year old Zhuo Shuoji. The Beijing-based trader says his annualized borrowing rates were usually less than ten percent, but would jump to extraordinary levels when bitcoin volatility rose. Despite the high cost, he says he made good profits until the hack. Now, he just wants to get back whatever money he can.
“The key is for us to get our remaining funds back first,” said Zhuo, adding that he is facing about $700,000 in potential losses. “Then we need to see that this exchange can remain in operation for the tokens to have any value.”
The risk for Bitfinex is that if too many customers like Zhou pull their money out and don’t come back, profits from trading fees and margin lending will tumble, throwing into question the exchange’s plan to earn back the loss over time. Still, Bitfinex’s ability to begin restoring operations, defend against follow-up attacks, and keep users from completely giving up hope has earned it some credibility.
“The way the whole thing was handled is already an improvement compared with older cases where either the exchange went bust or let users shoulder all the loss,” said Tian. “They found a middle way and solutions created could become a road map for the future.”