With Socialized Loss Proposal, Bitfinex Enters Uncharted Waters

The Bitfinex hack appears to be forcing the exchange to consider unconventional measures as part of a bid to relaunch.

AccessTimeIconAug 5, 2016 at 7:41 p.m. UTC
Updated Mar 6, 2023 at 3:08 p.m. UTC

The Bitfinex hack appears to be forcing the exchange to consider unconventional measures as part of a bid to relaunch after last week's $60m hack.

The Hong Kong-based bitcoin exchange announced last night that it is "leaning towards" a scenario that would see it socialize losses among bitcoin users and margin traders with BTC/USD positions. While not "set in stone", the idea that users could potentially share losses equally has nonetheless prompted speculation given the perceived impact the exchange's ultimate closure could have on both the price of bitcoin, and its perception as a technology among the general public.

In the wake of the statement, market observers are attempting to assess the nature of the approach and whether it will be enough to resolve the issues at the exchange, one of the largest on the bitcoin network by volume prior to its shutdown.

Speaking to CoinDesk today, representatives of the ecosystem's trading and exchange communities agreed that this would mark one of the first times, if not the first time, a socialed loss proposal would be implemented in the wake of a hack at a major digital currency exchange.

Michael Moro, CEO of OTC trading firm Genesis Trading, told CoinDesk:

"I can’t think of another situation in which something similar has been proposed in digital currency."

While the idea appears to be in its early stages, market observers did emphasize that by taking funds from all its bitcoin users – even those whose funds are potentially still under the exchange’s control – and redistributing them, Bitfinex was moving into territory that was largely without past precedent.

Experienced market observers as diverse as Whale Club community admin BTCVIX, HaoBTC director of marketing Eric Mu and blockchain consultant Antony Lewis, for example, struggled to recall another similar instance, as did others when reached.

Still, some suggested such a scheme may be the only path forward for keeping the exchange online.

"I think it may be necessary evil to avoid a Mt Gox-style shutdown," Mu said.

Indeed, at press time, there remains a lack of clarity as to what the exchange means by "socialized loss", whether it could be legally implemented or if Bitfinex would face any potential liability should certain aggrieved parties take action if it pursues the plan.

Past precedent

Still, others noted that similar actions have been taken by smaller exchanges in the past on rare occasions, and that some, have even been successful in efforts to relaunch.

Adamant Research's Tuur Demeester noted that, while the definition was not used at the time, the situation bears a resemblance to actions taken by digital currency exchanges like Poloniex and Bitfloor in the past.

For example, Poloniex moved to pay back exchange users in 2014 after it lost 12.3% of all its bitcoins in a hacking incident. In this case, Poloniex would go on to repay customer claims in a matter of months, eventually rising from a relatively unknown platform to the largest ethereum exchange by trade volume.

Of note, is that Poloniex, however, does not offer fiat currency trading, while Bitfinex does.

Another reference point was an incident on China-based exchange Huobi’s margin trading platform, BitVC, in 2014, when it garnered criticism for socializing user losses.

But for some, this comparison doesn’t describe the current situation at Bitfinex given that, in this instance, users were opting into an agreement and accepting the risk of a socialized loss in exchange for the potential gains offered by higher margins.

"This is completely different than the high leverage socialized loss futures contracts," BTC VIX said. "[These firms] have an insurance fund that buffers those times they incur a loss and that often covers the system loss."

Legal uncertainties

Still, many market observers have questions about whether the exchange could legally implement such a measure. Legal experts suggested that, while the market may be looking for easy answers, these may be speculative at best for now.

For example, Bitfinex's terms of service state that it was formed under the law of the British Virgin Islands, meaning any lawsuits could take place in this jurisdiction. At press time, Bitfinex's terms of service were no longer available online, though a cached version can be found here.

One legal expert, speaking on background, said that while it remains to be seen whether Bitfinex or its security partner BitGo will be sued, both could face liability even if it’s not immediately clear who would sue or where the lawsuit would be filed.

"BitGo’s terms of service have a mandatory arbitration clause, Bitfinex has a class action waiver, there are all sorts of impediments to bringing claims," he said, adding:

"But, just because you have terms doesn’t mean they will be enforced."

Digital currency advocate and trial lawyer Drew Hinkes emphasized that the terms of service for the companies would be of key importance.

He noted Bitfinex's terms of service call for mandatory arbitration and feature a broad definition of loss and force majeure.

"This would create some challenges for a party wanting to bring a claim," he said.

'Wild West' return

Most respondents interviewed had a number of unresolved questions about how the situation would develop going forward, though there were some commonalities.

For instance, there was uncertainty as to whether authorities would get involved, and if they did, whether they would allow the exchange to continue operating and move forward with a repayment plan.

The exchange is said to be in contact with authorities, but at press time, representatives of Bitfinex haven't offered clarity as to which are involved.

Indeed, commentary often devolved into some of the more existential questions facing the bitcoin ecosystem, those related to the intent of the technology and its ability to succeed on the vision for finance it has popularized.

Indeed, the irony that bitcoin’s technology is facing security concerns due to the use of traditional financial models by its startups was not lost on market observers. Financial Times writer Izabella Kaminska, for example, used her particular acerbic brand of reporting to raise these pertinent questions.

However, it seems even bitcoin entrepreneurs are finding overlap with her insights.

Andrea Medri, CFO of bitcoin exchange The Rock Trading, said he is still wondering why so much bitcoin was being kept on the exchange.

"The beauty of this technology is that you can be your own bank and leave your assets with an intermediary such as an exchange for few minutes only," Medri said, concluding:

"People need to realize that they don’t need custodians any longer."

Disclaimer: CoinDesk is a subsidiary of Digital Currency Group, which owns Genesis Trading and has an ownership stake in BitGo.

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