When a cryptocurrency contract isn’t a contract

When a cryptocurrency contract isn’t a contract

Last week I wrote about a funny anomaly in the crypto markets… a short-term opportunity to make some free bitcoin cash (BCH).

I won’t go into the specifics of the opportunity here (you can read the original piece here if you’re interested.) But now the window has closed, let’s see how this trade worked out.

The basic idea was this: Bifinex, a crypto exchange, had come up with a weird plan for managing the bitcoin fork. And their plan left an opening for traders to game the system.

You see, bitcoin holders were supposed to get an equal quantity of bitcoin cash for any bitcoin they owned after the fork last Wednesday.

But on the Bitfinex exchange, it’s possible to be short bitcoin (ie bet it’s going to go down), as well as long (which just means owning bitcoin outright).

That created a bit of a headache. What happens if you’re short bitcoin during the fork, at the time when everyone is getting one BCH for every bitcoin they hold? Does this mean you owe BCH, the new currency, too?

To avoid that hassle, the Bitfinex guys just decided to ignore short selling. Short sellers wouldn’t owe BCH if they were short bitcoin during the fork. The problem with that solution is that it left an opening for traders, the opening I described last week.

All you’d have to do is go short bitcoin on Bitfinex, then buy an equal amount of bitcoin on another exchange. In theory, you’re now covered no matter which direction the bitcoin price moves. And, you get a free BCH.

So how did it play out?

Well as soon as Bitfinex announced the plan, traders started gaming the system. Articles like last Wednesday’s Risk and Reward won’t have helped.

You could observe it in real time – the number of people going short bitcoin started to spike just after Bitfinex announced its BCH plan. Short positions in bitcoin jumped by more than 600% to a year-long high.

In theory this was a lovely elegant arbitrage, a risk-free way to make free BCH. But in practice, and especially in the world of cryptos, things are rarely so simple.

Bitfinex got wise to all the short selling and decided to arbitrarily change the rules. On Wednesday, it released a statement saying:

Upon careful review and analysis, we have decided to disallow any hedged BTC balances in excess of any such hedged balances that may have existed at the time of the July 27th distribution announcement. While this may be disappointing to some, it is welcome news to the many users with bona fide BTC exposure through settled wallet balances.

Or in other words: “tough luck, we’re not honouring those contracts”.

This was always a risk. As I said last week,

“The other risk is that Bitfinex spots the problem and closes this loophole before tomorrow. This wouldn’t surprise me – a look at the net short positions in bitcoin tells me that a lot of people have cottoned onto this.”

The moral of the story

For crypto fans, the beauty of blockchain technology is that it replaces flaky human institutions with clear rules and immutable contracts.

But as this short story shows, things don’t always work out that way. The crypto space is full of dicey counterparties and dubious contracts. Trust (or the lack of it) is arguably a bigger issue in crypto world than anywhere else in the financial system. It seems to me that escaping from our messy world of laws, liars, courts and counterparties is much harder than just coming up with a secure mining protocol.

That’s not to say that cryptos haven’t a use, or that they’re doomed. Heck, in the past week bitcoin smashed through the $3500 mark to new all-time highs.

It is to say that cryptos are part of the messy real world, and they always will be. There’s no computer code clever enough to stop strangers from screwing each other over.