Bitcoin is now down close to 70% from the $20,000 all time high. The bear market is here. What level is the bottom, and when?

My hunch tells me that similar to the 2015 bear market, the price at which the average miner turns off their ASICs will be the local bottom.

During the last bear market that range was $200 – $250. While the price languished, various high profile miners went under. KnC and Spondoolies were two casualties. Most surprisingly, in March of 2015 the difficulty actually dropped. That was 7 months before the price ticked up, but it illustrates the amount of pain that miners faced.

Now assuming there is no positive catalyst, like an SEC approved ETF to save us, at what price do we bottom? I believe the key consideration will be when miners begin to shut off their machines; and hence the question, what is the marginal cost of a Bitcoin?

A few days ago I chatted with one of the largest mining facility operators globally. He told me that the average electricity cost of Chinese miners all-in is 6 to 7 cents kWh. At that level, he estimated that at a price of roughly $5,000 is when miners would begin altering operations and look to move machines to cheaper areas. At $3,000 to $4,000, these miners would begin to shut off machines completely.

However, these rough anecdotes assume that miners using 7nm chips either do not work efficiently well, or will not be sold until 2019. Bitmain, Dragonmint, and GMO are all racing to build such miners. The firm that successfully brings a 7nm miner to market, will absolutely lower the marginal cost of the average mining farm, and decimate the older generation mining rigs.

Price leads the hashrate and the final confirmation of the breakeven level will be whether difficulty actually drops. That would require a sustained period of price weakness to shutter enough miners for the hashrate to fall.

When in Doubt, IPO

Upside Risks – SEC Approved ETF

It all started in Feb 2017 on a beach in southern Thailand. Thailand’s king passed a few months prior, so the party atmosphere was subdued. Accompanied by a good friend of mine and one of the best shitcoin traders in the game, we headed down the beach in search of a party.

One of his big shitcoin positions at the time was Pepe Cash. This was the precursor to Crypto Kitties. For those not in the know, PepeCash is “rare pepe” memes hashed onto a blockchain. The next killer app to be sure. Pepe Cash was on a mini run, and my boy constantly monitored the market.

We didn’t find a poppin’ party, but we did find special shakes. The bartender didn’t think we were sideways enough so he went in the back to get the real stuff. Over the next few hours we walked for miles, met interesting tourists and locals, and waxed philosophical about shitcoins.

On our ride back to our hotel, I noticed something strange. Our Tuk Tuk driver was wearing a trucker hat with a Pepe the Frog logo on it. Not trusting my eyes, I nudged my friend to confirm what I saw. He concurred that our driver was sporting a Pepe hat. My friend immediately whipped out his phone to check the market. Perhaps they saw what we did. Pepe Cash was pumping and he bought some more.

We both looked at each other and knew it was a sign that something special would happen in 2017. What actually happened was far beyond what we could have ever imagined.

The real profit in 2017 was made by Ether holders, shitcoin projects, and promoters. The seed capital for many of the venerated crypto hedge funds emanated from outsized returns on holdings of Ether and token projects.

Jealous traditional VCs transformed portions of their funds into poorly designed hedge funds so that they too could punt shitcoins. Everyone piled info the same deals, all thinking they “got it”. That worked well all of 2017.

Today, Ether slides towards $200. At best, many token projects are down 50% from 2017. At worst, they are slightly above than zero.

This begs the questions:

1. Did any funds actually realise any of their outstanding 2016 profits?
2. Can VC-turned-hedge-fund-punters psychologically handle mark-to-market losses?
3. How many token projects actually sold a large or hedged portion of the Ether they raised?

Big Door In, Small Door Out

One of the first things you learn as an Asia Pacific trader: how you exit a position is more important than how you enter.

My first trading book was the Vietnam certificates book. Our desk issued USD denominated certificates on a basket of Vietnamese stocks. Calling the Vietnamese stock market “Mickey Mouse” would have been a compliment in 2009.

You could only go one way per trading day on a particular stock. If you bought, you could only continue buying intraday, you could not sell. There was a 5% limit up and down each day; any stock in the news would hit either of those limits immediately in the morning auction. That meant you had to fax your orders into the broker and make sure you got in the queue as early as possible. Unfortunately, sometimes your broker front ran you because they knew you had size to trade in a particular stock.

My boss encouraged me to take a view on the market. Given the structure of the market, if I took a position, I was stuck with it for a while. And when I wished to exit, I would have to sell into strength or buy weakness to get out of a long or short position respectively.

When I became an ETF market maker, I routinely traded other “Mickey Mouse” markets like India, Indonesia, and China just to name a few. These markets were and still are marked by snap decisions (often overnight) by regulators which adversely affect traders who aren’t politically connected. I became obsessed with how to get out of any position: a trait which serves me well in the crypto markets.

My first boss taught me that everything was my fault as the trader. Obviously there are many things outside of your control, but if you approach your profession with that mentality you attempt to quantify and mitigate all of the risks within your control.

The point of my sermon is that most VC investors do not approach their investments with this mentality. Due to the illiquidity of their investments, they can mark to fantasy, show amazing returns on paper, and get paid. The only secondary market validation of their investments is the next round of fundraising, which can easily always go up if you get your boys to go in along with you. You pump my bags, I’ll pump yours.

VC investors loved ICOs in the bull market because they could point to an objective and liquid secondary market valuation. They used these eye-popping returns to raise bigger shitcoin funds in 2017, and early 2018. However, objectivity and transparency is undesirable when your shitcoin portfolio is down by a minimum of 50%. Depending on the vintage of the fund, it might be up, however, most money was raised and invested in 2H2017 to 2H2018. That means the suckers who invested recently are most likely down.

The VC investor who has never suffered the vagaries of the market is as green as the noob who thinks he or she can go from 1 to 100 Bitcoin in a few trading days. They don’t have the mental strength to cut positions to limit further losses, or backup the truck and buy opportune dips even though they are down. More importantly, LPs can now see an objective last price for a particular token, and can’t be hoodwinked. They will attempt to be a Monday morning quarterback, and that only adds to the VC investors’ anxiety. At a certain point, they go “fuck it”, and dump everything they can.

It is this moment, that Ether goes from a 3-digit to a 2-digit shitcoin.

Concentration Risk

Before the SAFT and other private token placement monstrosities, the majority of money was raised from retail token punters. Now that projects are scared of federal pound-me-in-the-ass prison, they mostly only accept accredited investors.

Accredited investors always had a way into new technology projects due to their wealth and access. This pool of investors is also highly concentrated. The number of funds that can spray $1 to $5 million into every vapourware project that agrees with their sector thesis is limited. However, these gatekeepers control a vast ocean of institutional money. Softbank’s Vision Fund is $100 billion.

So instead of a more dispersed pool of investors, the number of token holders of projects raising serious money decreased dramatically starting in mid-2017. The liquidation preferences went from dispersed along a price curve, to very concentrated.

VCs all compete with each other for the same pools of capital. These pools of capital all employ professionals from the same schools, and who passed the same financial certification tests. Therefore they will buy together and sell together. The biggest risk in the money management game is career risk. Better to lose money with everyone else, than lose money alone. The latter will cost you your job. And there ain’t no other profession that pays as well as financial services relative to the skills needed to be a practitioner. I remember one of my besties trying to argue he had skills because he could calculate the NAV of an ETF using the sumproduct() function on his excel sheet. #Delusional.

The herd of token VC punters will all decide to sell at the same time. If you don’t sell, and the market continues falling, you lose your job. So everyone sells simultaneously but who can eat all that shit? Retail cannot because the deals would never have gotten so large without institutional money. So we gap lower, first on tokens, then on the mothership Ether.

I don’t know what that tipping point will be, but in hindsight, it will be obvious when the capitulation occurs. There are those who believe that a sustainable token economy can exist. But they won’t be buying at these levels. Sub-$100 takes us back to Spring 2017 levels. At those depressed prices, the carrion is ripe for ingestion.

One of our strengths at BitMEX is financial innovation. We created the XBTUSD perpetual swap, a truly unique product to any financial market. XBTUSD is now the most liquid crypto instrument globally by a factor of 10 and has been emulated by a half dozen crypto markets.

On the back of that success, BitMEX has created a way to replicate the same Bitcoin-margined perpetual swap but on Ether / USD via a quanto pricing model. This product is the ETHUSD perpetual swap. In just under two weeks, this product has become the most liquid Ether / USD (or USD equivalent) pair globally, and has proven to be a vital instrument in speculating or hedging on the ETH/USD price pair.

In the last 24 hours, BitMEX’s ETHUSD swap has traded the equivalent of 800,000 ETH. The next most liquid ETH/USD and ETH/USDT markets, Bitfinex and Binance, traded just under 500,000 ETH each in the same period.

If you are still unsure on the pricing or trading of this instrument, please take a look back at our newsletter from last week where we run through multiple worked examples on hedging and speculating. To aid in your understanding, we have also created a downloadable spreadsheet to work through the math.

Abstract: We examine the extent to which one miner dominated Bitcoin in 2009. We review Sergio Demian Lerner’s 2013 analysis, where he discovered that the increase in the ExtraNonce value in the block can potentially be used to link different blocks to the same miner. We build on his analysis and conclude that although the evidence is far less robust than many assume, there is reasonable evidence that a single dominant miner in 2009 could have generated around 700,000 bitcoin. Although our analysis itself is weak and there is no perfect way of approaching this problem.

Bitcoin blocks mined in 2009 – ExtraNonce vs block height

(Source: BitMEX Research, Bitcoin blockchain)

The history of the debate over the dominant miner in 2009

Towards the start of April 2013, blockchain researcher Sergio Demian Lerner attempted to argue that Satoshi had mined a million bitcoin in 2009. The logic behind this assertion was that the hashrate throughout 2009 was at a low level, around 7 million hashes per second and this was said to be consistent with one miner being highly dominant. At the same time this hashrate was around the same to that which was present in Bitcoin’s first 14 days, which Sergio assumes may be a period in which Satoshi was the only miner. Many in the community were sceptical of Sergio’s claims. The scepticism seems to be based on the following:

1. The 7 MH/second estimate is based on block timestamps and unreliable, nor is the sample size large enough
2. There is no reason to believe Satoshi mined alone in the first 14 days
3. Many individuals recalled mining themselves in the period
4. Sergio’s assumptions about hardware were incorrect

It is likely that some people could have been biased in dismissing Sergio’s claims, since if Satoshi had mined a significant proportion of the early coins, in the eyes of some that could damage the monetary integrity of the system. However, in our view, the evidence Sergio initially presented was somewhat weak.

The ExtraNonce bombshell

Just a few days later, Sergio then posted a far more persuasive argument on his blog, with much stronger evidence that a single miner was dominant. This then eventually convinced many in the community and to this day many people believe Satoshi is likely to have mined around one million bitcoin.

Sergio’s evidence centred around something called the ExtraNonce. The ExtraNonce is not part of the Bitcoin protocol, in that it is not part of the consensus rules nor is there a formal specification about how to interpret the field. The ExtraNonce is an area in the Coinbase transaction which can vary after several hashing attempts to provide extra entropy for miners, once the standard nonce in the block header has been used up. As the image below illustrates, as the ExtraNonce changes, the impact works its way up the merkle tree into the block header (although in 2009 most blocks contained only the Coinbase transaction, as the network was not used for transactions.)

(Illustrative diagram of the structure of a Bitcoin block)

Sergio published the below picture, with the ExtraNonce on the y-axis and the blockheight on the x-axis (He incorrectly labeled the x-axis as time). The image shows that the ExtraNonce increase over time, in a series of slopes. Some of the slopes (in black) are said to be of a similar gradient, not to overlap and to go back down to zero once they reach a certain height. This is said to demonstrate that all the black lines belonged to one miner (potentially Satoshi) and that this miner now controlled almost a million Bitcoin. Although the technical points about the gradient of the slopes, the height and the lack of overlap may be quite difficult to appreciate and evaluate, the image itself is clearly very powerful and persuasive, in our view.

(Source: Bitslog)

The new BitMEX Research allocation of blocks to the dominant miner

We decided to repeat Sergio’s analysis, except our objective was to count the blocks mined by the apparent single entity and allocate all the blocks. The excercise was challenging, since the slopes interact with many other points. It is therefore impossible to do an accurate allocation. As a result, our analysis is far from perfect and we used a variety of methods, including statistical analysis, random number generators and even manual review to allocate some blocks. We will have made many errors and we do not claim our methodology is robust or scientific. However, as far as we are aware, this is the first attempt to allocate every block in 2009 as belonging to the apparent single entity or not. The below high resolution image below represents our allocation for every block in 2009.

Bitcoin blocks mined in 2009 – Allocation to the dominant miner – ExtraNonce value (y-axis) vs block height (axis)

(Source: BitMEX Research, Bitcoin blockchain)

Analysis of the allocation

Up to August 2009 we agree with Sergio’s conclusion.  There are 22 slopes prior to August, which all have both similar height and gradient (Around an increase in the value of the ExtraNonce by 4 per block found). At the same time these slopes almost never overlap. (The tiny amount of apparent overlap in some instances in less than 5 blocks and therefore may just be coincidence).

After August 2009 the pattern breaks down to some extent. The gradient of the slopes varies considerably (from 1.1 nonces per block to 10 nonces per block). At the same time the height of the slopes is inconsistent and there are many large gaps between them. Therefore although the image still looks compelling, the evidence that the miner is one entity is somewhat weak, in our view. We have presented results below, which include figures both pre and post August 2009.

(Source: BitMEX Research, Bitcoin blockchain)

Debate over the strength of the analysis

Conclusion

In conclusion, although there is strong evidence of a dominant miner in 2009, we think the evidence is far less robust than many have assumed. Although a picture is worth a thousand words, sometimes pictures can be a little misleading. Even if one is convinced, the evidence only supports the claim that the dominant miner may have generated significantly less than a million bitcoin in our view. Perhaps 600,000 to 700,000 bitcoin is a better estimate.

None of the above says much about whether the dominant miner was Satoshi, although we know Satoshi mined block 9, which we have allocated to the dominant miner in our analysis. However this is in a slope of just 11 blocks, so it’s certainly not conclusive. Whoever the dominant miner was, it is of course possible the keys have been lost or discarded by now.

We will end with one famous quote from Satoshi to consider:

Why delete a wallet instead of moving it aside and keeping the old copy just in case?  You should never delete a wallet.

(Source: Bitcointalk)

Although, maybe we are giving that quote out of context…

Hedging a quanto perpetual swap is not straightforward. The added component of correlation risk between two crypto assets complicates things. I will take things from first principles, then provide a more general formula.

Assumptions:
Symbol: ETHUSD
Multiplier: 0.000001 XBT
ETHUSD Price: $500
.BETH (ETH/USD Spot Index): $500
.BXBT (XBT/USD Spot Index): $10,000

Scenario 1 – Short ETHUSD and Hedge

You are lifted for 100,000 contracts of ETHUSD.

First let’s compute your currency exposures:

XBT Value = $500 * 0.000001 XBT * -100,000 = -50 XBT
ETH Value = XBT Value / [ .BETH / .BXBT ] = -1,000 ETH

Next you hedge your ETH/USD exposure by purchasing 1,000 ETH at the spot price. Assume you can match the current .BETH Index price on your purchase.

You have hedged your underlying currency exposure. At this point your exposure is perfectly hedged. However, as the price of ETHUSD changes, your PNL on ETHUSD will be in XBT, while the PNL on your ETH hedge will be in USD.

Let’s look at two extreme examples.

Example 1: .BETH Rises and .BXBT Falls

.BETH and ETHUSD rises to $750
.BXBT falls to $5,000

ETHUSD PNL = (ETHUSD Exit Price - ETHUSD Entry Price) * Multiplier * # Contracts = -25 XBT, USD Value -$125,000

ETH Spot USD PNL = (.BETH Exit Price - .BETH Entry Price) * # ETH = $250,000

Net USD PNL = ETHUSD XBT PNL in USD + ETH Spot USD PNL = +$125,000

In this example the correlation between the USD value of XBT and ETH is -1. They moved in a perfectly negatively correlated fashion, and you made money.

Example 2: .BETH Rises and .BXBT Rises

.BETH and ETHUSD rises to $750
.BXBT rises to $15,000

ETHUSD PNL = -25 XBT, USD Value -$375,000
ETH Spot USD PNL = $250,000
Net USD PNL = -$125,000

In this example the correlation between the USD value of XBT and ETH is +1. They moved in a perfectly positively correlated fashion, and you lost money.

The short ETHUSD position + Hedge profited when correlation fell, and lost when the correlation rose. Due to the flat ETHUSD vs. .BETH basis, the entry price assumed a correlation of zero between the two cryptos.

Scenario 2: Long ETHUSD and Hedge

You are lifted for 100,000 contracts ofETHUSD.

First let’s compute your currency exposures:

XBT Value = $500 * 0.000001 XBT * 100,000 = 50 XBT
ETH Value = XBT Value / [ .BETH / .BXBT ] = 1,000 ETH

Next you hedge your ETH/USD exposure by shorting 1,000 ETH at the spot price. Assume you can match the current .BETH Index price on your purchase, and there is no cost to borrow ETH for this short sell.

You have hedged your underlying currency exposure. At this point your exposure is perfectly hedged. However, as the price of ETHUSD changes, your PNL on ETHUSD will be in XBT, while the PNL on your ETH hedge will be in USD.

Let’s look at two extreme examples.

Example 1: .BETH Rises and .BXBT Falls

.BETH and ETHUSD rises to $750
.BXBT falls to $5,000

ETHUSD PNL  = 25 XBT, USD Value $125,000
ETH Spot USD PNL = -$250,000
Net USD PNL = -$125,000

In this example the correlation between the USD value of XBT and ETH is -1. They moved in a perfectly negatively correlated fashion, and you lost money.

Example 2: .BETH Rises and .BXBT Rises

.BETH and ETHUSD rises to $750
.BXBT rises to $15,000

ETHUSD PNL = 25 XBT, USD Value $375,000
ETH Spot USD PNL = -$250,000
Net USD PNL = $125,000

In this example the correlation between the USD value of XBT and ETH is +1. They moved in a perfectly positively correlated fashion, and you made money.

The short ETHUSD position + Hedge profited when correlation rose, and lost when the correlation fell. Due to the flat ETHUSD vs. .BETH basis, the entry price assumed a correlation of zero between the two cryptos.

The below table summaries the two scenarios:

Time Horizon

The correlation between XBT and ETH is not static. The longer you hold a hedged swap position, the more chance that the correlation regime you expect based on the recent past, will change.

Unlike a futures contract, the ETHUSD swap has no expiration date. Therefore your quanto risk is specific to your time horizon. For market makers who are in and out quickly, the quanto effect is negligible. For cash and carry market makers who hold a position for an extended period of time to capture funding, the quanto effect can destroy one’s PNL.

Covariance

Many market makers will not be satisfied leaving their correlation risk unhedged. They will constantly hedge their PNL on the BitMEX and spot leg of their portfolio. Depending on the XBT and ETH volatility, and their correlation, the covariance will determine whether the hedging of PNL positively or negatively impacts your overall profits. If both assets are highly volatile and the correlation is moving in or out of your favour, your gains or losses from hedging the PNL are amplified.

We are in uncharted territory. In a few month’s time, I will observe the past data and attempt to calculate what portion of the funding is attributed to market makers pricing in a quanto risk, and what portion is due to the interest rate differentials between ETH and USD.

Speculators care about obtaining exposure to risk. How they get that exposure if they can get in and out cheaply is secondary. If BitMEX is able to create a liquid market for Bitcoin quanto’ed derivatives, speculators will flock to them.

As I previously explained in “Why Quanto?”, in order for BitMEX to offer ETH/USD risk, we had to quanto into Bitcoin. This post will explore the concepts speculators care about.

For all the below examples we will use the following assumptions:

Contract: ETHUSD
Multiplier: 0.000001 XBT per 1 USD
Contracts: 10,000

Contract Value

The most important aspect to a speculator is the contract’s payoff function. Since we are speculating on the ETH/USD price, ideally the contract’s Bitcoin value should increase and decrease in a linear fashion with respect to the ETH/USD price.

I assume the speculator denominates their profit in Bitcoin (XBT) terms. Therefore the value of Bitcoin in USD terms at a particular ETH/USD price is irrelevant. Put simply, the speculator wants to use Bitcoin as a margin to earn more Bitcoin.

The above chart illustrates that at different ETHUSD values, the XBT value of the position changes linearly. That is exactly what the speculator desires.

XBT Value = ETHUSD Price * Multiplier * # Contracts

Calculating Margin

How is the amount of Bitcoin margin calculated? The initial margin for the ETHUSD contract is 2%, or 50x leverage.

Initial Margin (IM) = 2% * XBT Value

If you enter the trade at an ETHUSD Price of $500, this is your initial margin requirement:

IM = 2% * $500 * 0.000001 XBT * 10,000 = 0.10 XBT

The next important consideration is what is your liquidation price. That is determined by the maintenance margin. The maintenance margin for the ETHUSD contract is 1%. If the underlying ETH/USD spot price declines by 1%, you will be liquidated.

Calculating Profit and Loss (PNL)

The PNL is denominated in Bitcoin. In Bitcoin terms, the PNL changes linearly with the ETHUSD price. If the contract goes up 1%, your Bitcoin PNL also goes up 1%. The chart above illustrates that.

XBT PNL = (ETHUSD Exit Price - ETHUSD Entry Price) * Multiplier * # Contracts

In the above example, if the ETHUSD price moves from $500 to $600, this is the XBT PNL:

XBT PNL = ($600 - $500) * 0.000001 XBT * 10,000 = 1 XBT

Number of Contracts

To get a certain amount of Bitcoin exposure requires a little math.

The following describes how to calculate how many contracts it takes to equal a desired Bitcoin notional.

Contracts = XBT Notional / [ ETHUSD Price * Multiplier ]

If you want 100 XBT of risk, how many contracts of ETHUSD must you trade:

Contracts = 100 XBT / [ $500 * 0.000001 XBT ] = 200,000 Contracts

The quanto structure satisfies the desires of a Bitcoin-based speculator. The major components that speculators care about all vary linearly with respect to the ETH/USD price. The relative rich or cheapness of the contract vs. the underlying is not a major concern if the contract is liquid.

The factors that govern whether the contract will be at a premium or discount will be explored in the subsequent piece. These considerations heavily depend on how to hedge a quanto derivative from first principles. The hedging of the contract is where the non-linear effects matter.

The USD is the biggest shitcoin out there. However, all assets are priced against it. Crypto is not immune. The Bitcoin / USD price is the most important cross in the crypto asset universe.

Moving into the altcoin space, the most active crosses are against the USD as well. To replicate our inverse style derivatives on an altcoin / USD cross requires us to accept the altcoin in question as collateral. The next natural altcoin BitMEX could accept is Ether. However, to fit into our multi-sig security process, it requires us to use/code an Ethereum multi-sig smart contract.

Unfortunately, due to various exploits of popular Ethereum multi-sig smart contracts, we never felt comfortable custodying Ether. Rule 1, to infinity minus 1, of operating a crypto trading platform, is don’t lose the crypto. Anything we can do to limit our risk surface area we must do. Therefore, taking Ether as collateral given the current state of the protocol is a non-starter.

Given these constraints, we cannot launch an Ether margined inverse ETHUSD contract. An inverse style contract is one where the margin and PNL currency is denominated in the home currency (ETH), the quote currency is denominated in the foreign currency (USD), and the contract value is a nominal amount of the foreign currency (USD).

Inverse Contract Example: XBTUSD Swap

Margin Currency: XBT (Bitcoin)
Quote Currency: USD
Contract Value: $1

In order to offer risk on ETH/USD where Bitcoin is used as the margin and PNL currency, the quanto derivative type is necessary.

From Wikipedia:

A quanto is a type of derivative in which the underlying is denominated in one currency, but the instrument itself is settled in another currency at some rate. Such products are attractive for speculators and investors who wish to have exposure to a foreign asset, but without the corresponding exchange rate risk.

Quantos are exotic derivatives that can move non-linearly with respect to the underlying. However, they are very beneficial for speculators and hedgers in search of liquidity, where they can post margin in a currency in which they feel comfortable. In my time as a delta one trader, we routinely traded USD quanto derivatives to get exposure to local currency futures contracts in countries that restricted the trading ability of foreigners (e.g. India and Taiwan).

The recently launched BitMEX ETHUSD Perpetual Swap is a quanto derivative. The contract pays out 0.000001 XBT per 1 USD. This means that the Bitcoin multiplier is constant regardless of the nominal USD price of ETH. This is great for speculators, the Bitcoin return varies linearly with respect to the ETHUSD price. For those using this contract to hedge the ETH/USD cross or market makers, it gets a bit trickier. I will get into the mechanics of hedging and market-making later in this newsletter.

Quanto Worked Example Spreadsheet
We have created a spreadsheet for users to download and work through some of the below use cases that can be accessed here.

From 14:29 to 15:26 UTC today, August 4, 2018, access to BitMEX.com and the BitMEX API was severely impaired.

A large spike in load caused an overload in a critical internal system used for rate limiting and sessions, creating a feedback loop in that system where data was recalculated more often then usual, exacerbating the load.

The feedback loop has been fixed and systems have returned back to normal. BitMEX engineers are working to separate these systems entirely, so that these particular non-critical operations cannot affect processing time of critical trade requests and logins.

We apologize for the disruption. BitMEX engineers have disabled the cause of the feedback loop and are working the weekend to separate these critical systems so that such an event cannot occur again.

Abstract: We look at the events surrounding the bitcoin price rally in June 2011 to $32 and the following temporary flash crash down to $0.01, on the MtGox exchange. We look at the incompetence of MtGox and examine the causes of the crash. We then look at the political battle and uncertainty which occurred in the aftermath of the crash.

Bitcoin price from May 2011 to 18 June 2011

(Source: YouTube, MtGox, BitMEX Research)

Click here to download the pdf version of this report

Overview

If one likes price volatility and scandals, the summer of 2011 was an exciting time for Bitcoin. Over the course of a few days, bitcoin plummeted in value from a peak of $32 to just $0.01 on the MtGox exchange, a trading platform based in Tokyo, which was dominant at the time. This was after a recent rally, with bitcoin trading at around $2 a couple of months earlier. The crash down to $0.01 is now a famous part of Bitcoin history.

In this piece, we look at the cause of the crash and its aftermath. Although the major exchange of the time, MtGox, was shown to the community to be largely negligent, which may not have been the best advertisement for Bitcoin. In our view the engaging nature of the events which occurred that summer, ironically made a significant contribution to the level of interest in the space.

MtGox security issues & the context of the event

There was significant uncertainty surrounding the hack at MtGox which caused the June 2011 price crash and the issues surrounding it were never fully explained. The Bitcoin community was riddled with rumours about whether MtGox was solvent and how much bitcoin was stolen.

Thanks to a report published in 2017 by Kim Nilsson, we now have a relatively strong understanding of what occurred in 2011 and the damage that this caused to MtGox.  Ironically, despite the huge impact on the market and the company’s reputation, in terms of MtGox’s solvency, this event was largely insignificant compared to other security incidents. For many however, a new window into MtGox was opened up, which illustrated a severe lack of monitoring systems, governance, controls and security measures.

The  table below lists some of the major security incidents at the MtGox exchange, with the June 2011 hack highlighted in green. This incident may have only directly cost the exchange 2,000 bitcoin, an inconsequential amount, compared to roughly 837,000 bitcoin of total losses.

List of known MtGox losses

(Source: Cracking MtGox, BitMEX Research)

Overview of the events in June 2011

In the weeks leading up to 19 June, many users of MtGox were reporting that their accounts had been hacked. At around the same time a database of MtGox users, including an MD5 hash of their passwords (with an unclear/inconsistent salt policy) was leaked and made available. Many passwords were identified. Some traders used the same credentials at the rival exchange, Tradehill, who also experienced security issues. Despite this, MtGox did not suspend trading, a decision which many traders questioned.

On 19th June 2011 (3am on 20th June Tokyo time), there were large sell orders on the exchange and the price crashed from around $17.50 to $0.01 and trading continued at this level for several minutes before recovering. This lead to a high degree of uncertainty, with some assuming there may be a problem with the Bitcoin network.

It now seems likely that what actually happened was that a hacker may have obtained access to the account of Jed McCaleb, the founder of MtGox who sold the exchange to Mark Karpeles around three months earlier. This account appears to have retained administrative rights to the database and therefore the hacker was able to manipulate account balances and grant themselves a large number of bitcoins on the MtGox system. The hacker is the likely to have begun selling some of these coins.

Due to the poor management of MtGox, in our view it is unlikely that the company were aware of this, even in the aftermath of the hack, and therefore the explanations provided at the time of the events were incomplete or inaccurate.

The withdrawal limits

At the time, MtGox had a daily withdrawal limit of US$1,000, this applied to both bitcoin and USD (via Dwolla). This meant that the hacker (or any others who benefited from the hack by buying bitcoin at low prices), would be unable to benefit by withdrawing the funds, except within the US$1,000 limit. However, the US$1,000 bitcoin limit was based on the market price of bitcoin on the platform and since the price fell to $0.01, in theory the maximum each user could withdraw was 100,000 bitcoin, certainly not a small amount.

Fortunately, however, MtGox appeared to also have a bitcoin based withdrawal limit, that many users were unaware of. As the Mark Karpeles said at the time:

2011-06-20 00:16:43 MagicalTux the btc withdrawal limit saved us

(Source: IRC, Note: MagicalTux is the CEO & owner of MtGox, Mark Karpeles)

Mark then mentioned that only 2,000 bitcoin were withdrawn in the aftermath of the event, which was a relatively positive result for MtGox.

Got about 2,000 BTC out

(Source: IRC)

There was widespread scepticism about this number at the time, with many believing much more was stolen. Ironically, this 2,000 bitcoin figure now seems about right, although MtGox had lost far more in other incidents. However, due to the price crash and suspension of trading, this incident was very public at the time and resulted in the incompetence of the MtGox platform being exposed to the community.

The rollback debate

Many trades took place at the artificially low price of around $0.01 during the crash. Some traders & investors were unhappy at missing out on the price rally from around $1 to $32, and therefore had buy orders waiting in the system, all the way down the order book to $0.01. To them, this crash is exactly what they were waiting for. To the dismay of many of these traders, in the aftermath of the incident MtGox said they would reverse the trades which occurred during the crash:

The bitcoin will be back to around 17.5$/BTC after we rollback all trades that have happened after the huge Bitcoin sale that happened on June 20th near 3:00am (JST). One account with a lot of coins was compromised and whoever stole it (using a HK based IP to login) first sold all the coins in there, to buy those again just after, and then tried to withdraw the coins. The $1000/day withdraw limit was active for this account and the hacker could only get out with $1000 worth of coins. Apart from this no account was compromised, and nothing was lost. Due to the large impact this had on the Bitcoin market, we will rollback every trade which happened since the big sale, and ensure this account is secure before opening access again.

(Source: MtGox)

After this announcement there was significant debate in the community as to whether the rollback should occur. Obviously many participants in the debate had a financial interest in the outcome and this was no doubt effecting their views. In many ways, there were some parallels between this rollback and the 2016 DAO “rollback” on the Ethereum network, with some similar arguments being made.

The community appeared to be split on this issue, with some even favouring a vote to decide.

The trader who bought 260,000 bitcoins for US$2,622

The day after the incident, a trader called “Kevin”, claims to have purchased around 260,000 bitcoins during the crash and was arguing that he should be able to keep the coins. As he explained:

I had around $3,000 USD in my MtGox account, from earlier sales I’d made. I looked at the market stats, and realized that there were tons of orders to buy BTC at $0.01 that would likely eat up any remaining bitcoins this seller had on the order. I figured if I put a buy order in for $0.0101, my order would execute first and I could buy a huge amount of bitcoins

(Source: Bitcointalk)

Kevin posted what he claimed to be the trade confirmation:

06/19/11 17:51  Bought BTC 259684.77 for 0.0101

Kevin then went on to explain the likely reason behind the price crash, which was that the seller was trying to manipulate the price down so that they could withdraw more coins within the US$1,000 limit. In our view this part of Kevin’s story is likely to be an accurate explanation for the price crash. This logic contradicts the claim from MtGox that the person who conducted the hack was also the buyer of the bitcoin.

I could place a reasonably sized sell order for $0.001, crash the market again, and withdraw probably all of the bitcoins, since they’d be valued at $0.001 each and would fit under the $1,000 USD limit. I also decided against this, when I realized that whoever placed the gigantic sell order was probably doing so for the exact same reason

However, some have doubted the accuracy of Kevin’s story, claiming the volume of trades he claims is not consistent with the MtGox feed. The feed appeared to show trading volume of only 55,000 bitcoins during the crash past $0.0101 and only 238,000 bitcoins traded in the period. Only 3,000 bitcoin seem to have been traded at the $0.0101 price. These figures are lower than those implied by Kevin, although Kevin’s trades could have been excluded from this data for a variety of reasons. The feed was also notoriously unreliable and it was not clear if there was a precise definition of some for the information in the feed. In our view, there is no reason to believe the whole truth of any of the parties involved in this incident, but Kevin’s explanation for the crash itself seems plausible to us.

MtGox price feed during the crash

(Source: BitMEX Research, MtGox. Note: Volume in bitcoin)

The proof of reserves

The MtGox exchange was down for several weeks and many users were becoming anxious about the solvency of the platform. There was uncertainty over the amount of bitcoin which were lost and users were concerned about a run on MtGox, eventually leading to the exchange going into liquidation and users losing funds. In an attempt to reduce some of these concerns, as the chat log and bitcoin transaction show below, MtGox attempted to prove it had access to a significant quantity of bitcoin, by conducting an onchain transaction on 18th July 2011.

IRC Chat log – 18 July 2011

(Source: IRC Logs)

(Source: blockchain.info)

At the time, the above action seemed to settle the nerves of many of the traders.

Conclusion

A few weeks after these events, after many false starts, trading at MtGox eventually resumed and the bulk of the trades were reversed. However, to this day, as far as we are aware, MtGox has not been able to provide a coherent explanation for what occurred. The lack of a consistent narrative from MtGox lead many to believe that MtGox had poor monitoring and controls of its systems and that the company was run negligently. Many concluded “never to trust MtGox again”.

Unfortunately, however, MtGox somehow continued to dominate the exchange ecosystem for another three years. However one views the conduct and transparency of some of the platforms and players in the ecosystem today, we can at least conclude that things have  significantly improved since 2011.

Abstract: Following our earlier research pieces on Tether, financial information from Q1 2018 has been released by the financial regulators in Puerto Rico, providing more evidence of the impact of Tether. In addition to this, a source close to Tether has confirmed to us that the speculation in our initial report is correct.

After our earlier speculation that Noble Bank in Puetro Rico was Tether’s primary reserve bank, a few months later in May 2018 Bloomberg released an article further substantiating our claims. As Bloomberg put it:

According to three people with knowledge of the matter, Noble Bank International, based in San Juan, Puerto Rico, took over banking duties for Bitfinex last year.

In addition to the above, BitMEX Research has also now spoken to people close to Tether, who have also confirmed the reliability of most of the claims in our February 2018 report. Our initial discovery was based on the disclosure of data from the financial regulator in Puerto Rico, who have recently provided the latest update, for the quarter ended March 2018. In our view, the data continues to support our initial speculation.

New Financial Data for Q1 2018

Bank deposits in the International Financial Entities (IFE) category, which includes Noble Bank, were $3.5 billion, up 6.9% in the quarter. Total assets in the category were $4.1 billion, up 7% in the quarter. This moderate growth coincides with a the moderate increase in the volume of crypto-coin trading, which has likely resulted from the continued growth of the Tether balance and crypto-coin ecosystem, moderated by crashing crypto-coin prices in the quarter. In the quarter, the value of Tether in issue increased by 62.7% to $2.3 billion.

We have updated the chart below from the version in our earlier piece, which compares the Tether balance with the deposits in the banking category in Puerto Rico which contains Noble Bank.

Puerto Rico’s IFE aggregate deposits versus the Tether balance in millions of USD. (Source: IFE Accounts, BitMEX Research, Coinmarketcap)

Cash as a percentage of total assets (an indication of full-reserve banking) also increased in the quarter, from 85.8% to 91.0%. This also indicates crypto-coin or Tether-related activity, as we explained in the previous piece.

Puerto Rico’s IFE aggregate cash balance as a percentage of total assets. (Source: IFE Accounts, BitMEX Research)

In the quarter the regulator appears to have changed the name of the Tether balance, to “Deposits, money market investments and other interest-bearing balances” from “Cash in banks“. We do not view this as suspicious.