Abstract: In this piece we review and analyse Bitmain’s financial data, which was made available (or leaked) as part of the pre-IPO process. The figures indicate Bitmain was highly profitable and cash generative in 2017, but may currently be loss making. Bitmain also spent the majority of its operating cash flow acquiring Bitcoin Cash and may have suffered mark to market losses of US$328 million as a result. We conclude that the IPO itself may go well, however going forwards the allocation of investor capital will be key and management may need to improve in this area.

The IPO process

Bitmain expects to submit IPO documents to the Hong Kong Stock Exchange at the end of August 2018, with a public listing expected towards the end of 2018. The company has just conducted a pre-IPO round, raising several hundred million dollars at a valuation of around $14 billion. Therefore we believe the company is likely to attempt to raise several billion dollars at the IPO stage, with a valuation north of $20 billion.

Documents outlining this process, which also contain Bitmain financial data, have been leaked on Twitter. We have reason to believe the authenticity of these documents, which forms the basis for this report.

Bitmain’s position in the mining industry

(Source: Bitmain pre-IPO documents, BitMEX Research)

Will there be demand for the IPO?

Bitmain has a strong or dominant position in most areas in cryptocurrency mining, as the table above illustrates. Bitmain is likely to be the largest and most profitable company in the blockchain space, which is likely to make the company attractive to many investors.

In the last few years and decades the key lesson many technology investors have learnt, rightly or wrongly, is to always invest in the number one company. The number one company typically benefits the most from network effects and as a result smaller rivals tend to fail. The below list of usual suspects illustrate this basic point:

Justified or not, the blockchain space is now regarded by many as one of the the next big internet based technologies and Bitmain is the number one player in this space. Whether this network effect type logic can apply to ASIC design and distribution is not clear to us and the benefits of being big may be limited to the more traditional economies of scale. We think it is important to not only look at cryptocurrency mining through the technology lens, but also to look at it from the angle of an energy intensive industry, like mining for natural resources. In these sectors the benefits of scale are more limited than for internet based networks. Therefore we don’t completely agree that one should blindly invest in the largest cryptocurrency mining entity, we just think than some investors, perhaps naively, may think this way.  

Bitmain’s own mining operation declines

As we alluded to above, one of the most interesting discoveries in the Bitmain pre-IPO documents was the sharp decline in Bitmain’s own mining farm business. Although the share of revenue has dramatically fallen, in absolute terms own mining revenue still grew by 250% in 2017, its just that the 948% growth in equipment sales overshadowed this.

Bitmain – share of revenue from own mining operations

(Source: Bitmain pre-IPO documents, BitMEX Research)

We believe this decline represents a smart strategic decision by Bitmain to divest (relatively speaking), from an increasingly competitive and lower margin area. In our view, as one moves down the mining supply chain, the competition is likely to increase faster and Bitmain made a sensible move by trying to focus their efforts up the chain, where an increasingly large proportion of the value from mining may accrue. In some ways this is good news for Bitcoin decentralisation, as a dominant mining player has stepped back. We believe ASIC design and distribution is less critical to network security than mining farm operation, which in theory choose the pools who construct blocks and select which blocks to build on top of. Of course Bitmain’s power and dominance in the ASIC space still remains as a significant problem for Bitcoin.

Currently Bitmain are likely to be making losses 

In the documents, Bitmain disclosed the revenue, sales and crucially gross profit margin for each of the main mining products. We have displayed the relevant data in the table below. The data shows that Bitmain sold over a million S9’s in 2017 and then over 0.7 million in Q1 2018 alone.

Financial metrics by mining product

(Source: Bitmain pre-IPO documents, BitMEX Research, Bitmain website)

Using the disclosed gross profit margin from 2017, we calculated the implied cost price of each machine. Assuming these costs remain unchanged (which may be unrealistic), we were able to calculate gross profit margins based on the latest prices on the Bitmain store. This analysis implies Bitmain are currently loss-making, with a negative profit margin of 11.6% for the main S9 product and a margin of over negative 100% on the L3 product. In reality costs are likely to have declined so the situation may not be as bad, however we think it is likely Bitmain are currently making significant losses.

These low prices are likely to be a deliberate strategy by Bitmain, to squeeze out their competition by causing them to experience lower sales and therefore financial difficulties. In our view, herein lies the key to one of the main driving forces behind the decision to IPO. A successful IPO may increase the firepower available to continue this strategy and eliminate an advantage rivals could have by doing their IPOs first.  

Another reason for these low prices and apparent losses may be that Bitmain has too much inventory on the balance sheet. As at March 2018 Bitmain had $1.2 billion of inventory on the books, equal to 52% of 2017 sales. Bitmain may therefore have had to suffer inventory write downs, which could have generated further losses in addition to the loss making sales.

Use of operating cash flow and balance sheet

The documents contain summary balance sheet data. On the positive side is that Bitmain has no debt and the company was highly cash generative in 2017. The negatives include:

1. Large prepayments to TSMC, totalling almost $866m in 2017, which weaken Bitmain’s working capital situation;
2. A large inventory balance, of around $1.2bn (over 50% of peak annual sales) illustrating overproduction;
3. A large portfolio of altcoins, with a cost base of $1.2 billion which represents the primary use of Bitmain’s cash flow.

(Source: Bitmain pre-IPO documents, BitMEX Research, Prices from Bitfinex)

(Notes: Projections based on prices as at 28 August 2018, coin holdings as at 31 March 2018)

One of the key assets of the company is its portfolio of cryptocurrencies, valued (on a cost basis) at almost $1.2bn as at March 2018. As at March 2018 this consisted of over 1 million Bitcoin Cash. The market value of the altcoin portfolio has fallen in value since Bitmain invested, with almost all the losses attributable to Bitcoin Cash, as the chart below shows.

Bitmains investment in cryptocurrency – change in value vs cost price – $ million

(Source: Bitmain pre-IPO documents, BitMEX Research, Prices from Bitfinex)

(Notes: Prices as at 28 August 2018, coin holdings as at 31 March 2018. Chart assumes coin holding do not change)

As the following chart below illustrates, the Bitcoin Cash investment itself is very significant, to the extent that the company spent around 69% of its 2017 operating cash flow on purchasing Bitcoin Cash. Although this could be an exaggeration, some of the Bitcoin Cash would have been inherited from pre-fork Bitcoin. The figures imply that around 71,560 of the 1,021,316 Bitcoin Cash coins could have been inherited in this way. 

Bitmain use of 2017 cashflow – $m

(Source: Bitmain pre-IPO documents, BitMEX Research)

The situation is even worse than the above indicates. Not only did Bitmain spend a majority of the 2017 cash flow into Bitcoin Cash, they also spent a majority of cash flow from their entire history of operations, into Bitcoin Cash. The documents show that Bitmain generated no cash flow in in 2016 and then only $25m in Q1 2018 (perhaps due to large TSMC prepayments).

Bitmain operating cashflow – $m

(Source: Bitmain pre-IPO documents, BitMEX Research)

In a sense of course none of this matters. Bitmain spent their own funds on risky assets and they knew the risks. For a public company the situation could be a different, with investors expecting the company to invest in core operations or return money to investors. Although perhaps our expectations for governance here are too high for Hong Kong.

Why are Bitmain doing the IPO?

In our view the primary motivating factor for the IPO is simply that Bitmain’s competitors are also planning on doing them and the industry is fiercely competitive, as Bitmain’s loss making prices indicate. Rival Canaan Creative are planning on an IPO and Bitmain are unlikely to let them obtain such a funding advantage. Bitmain’s IPO should deduct money from the pool of capital that could otherwise be invested in Canaan as well as the other miners and it is therefore a good complement to the strategy of lowering prices.

The other reason for the IPO may be to strengthen the balance sheet after investing the majority of the operating cash flow into Bitcoin Cash. Bitmain only had around $105 million of cash on the balance sheet as at March 2018, when this figure could have been nearer a billion dollars if the company hadn’t acquired so much Bitcoin Cash. At the same time the business does require a lot of cash, for example the large advance cash payments TSMC require, which reached a peak of $866m in 2017.

The debate over Bitmain’s technological advantage

The narrative surrounding Bitmain’s technical capabilities can be spun in either direction and as ever the truth may lie somewhere in the middle. However, one thing is clear, if these mining companies do go public, the picture should be far less murky going forwards and we think that could be a significant positive for the cryptocurrency community.

Conclusion

In a way some of Bitmain’s biggest mistakes, such as producing too many units and buying too many speculative altcoins in a bull market, are somewhat analogous to the typical behaviour of mining company management teams.  For instance gold mining firms often invest in high cost assets in bull markets and then fail to invest in quality low cost assets in bear markets. Perhaps it is not totally fair to blame these companies, the hedge funds and institutional investors who own the shares are often just as, if not more, at fault. Greed, fear and the emotions of market moves can affect us all. Therefore although Bitmain has made mistakes, in many ways they are not unusual or unexpected.

We are sure you have heard it before, but “cryptocurrency is here to stay”. In that environment we think Bitmain has the ingredients to be one of the great companies in the space. Bitmain can be a legendary crypto company, generating strong shareholder returns for decades to come, but in order to achieve this (and it’s a lot harder than it sounds) the Bitmain management team may need to improve their management of company resources. Once the company goes public, capital allocation decisions in this volatile and unpredictable market will be difficult enough, letting emotions impact too many investment decisions may not be tolerated.

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…

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.

Abstract: In this piece we look over the history of distributed stablecoins, focusing on two case studies, BitShares (BitUSD) and MakerDAO (Dai). We examine the efficacy of various design choices, such as the inclusion of price oracles and pooled collateral. We conclude that while a successful stablecoin is likely to represent the holy grail of financial technology, none of the systems we have examined so far appear robust enough to scale in a meaningful way. The coins we have looked at seem to rely on “why would it trade at any other price?” type logic, to enforce price stability to some extent, although dependence on this reasoning is decreasing as technology improves.

Overview

Distributed stablecoins aim to achieve both the characteristics of crypto-coins like Bitcoin (censorship resistant digital transactions) and the price stability of traditional financial assets, such as the US Dollar or gold. These systems are distinct from tokens such as Tether, where one entity controls a pool of US Dollar collateral, ultimately making the system centralised and thus susceptible to being shut down by the authorities.

Along with the somewhat related idea of distributed exchanges, distributed stablecoins have been referred to as the “holy grail” of financial technology, due to their very strong potential benefits. In our view the transformative nature of such a technology on society would be immense, perhaps far more significant than Bitcoin or Ethereum tokens with their floating exchange rates. Distributed stablecoins could have the advantages of Bitcoin (censorship resistance combined with the ability to transact electronically), without the difficulties of a volatile exchange rate and the challenge of encouraging users and merchants to adopt a new unknown token. Such a system is likely to be very successful and therefore it is no surprise that so many people have attempted to launch such projects:

List of stablecoin projects

The technical challenges involved in creating such systems are often underestimated. Indeed constructing a distributed stablecoin system, which is robust enough to withstand cycles or the turbulence and volatility linked to financial markets may be almost impossible. For instance perhaps most forms of fiat money, even the US Dollar itself, have not even achieved that, with credit cycles putting US Dollar bank deposits at risk. A stablecoin system which builds on top of the US Dollar is therefore never going to be more reliable than traditional banking, in our view.

In economics there is a concept of money supply, with risk and the potential inflationary impact increasing as the number of layers increase. One could add this stablecoin systems on top, as a new high risk layer:

• M0 – Notes & coins plus deposits at the central banks
• M1 – Money on deposit in a bank current account (including M0)
• M2 – Money on deposit in a bank savings account (including M1)
• M3 – Money in a money market account (including M2)
• MZM – Money in all financial assets redeemable on demand (including M3)
• MSC (Synthetic Crypto Money) – Money inside synthetic crypto stablecoin systems  (including MZM)

However advanced or sophisticated the distributed stablecoin technology is, we believe the token is likely to be less robust than the layers above it in the money supply tree.

In this piece we review some of the most prominent and interesting attempts at building these synthetic US Dollar type systems. BitUSD in 2014 and then a more recent project, MakerDAO (Dai).

Case study 1: BitShares (BitUSD) – 2014

The first stable coin we will discuss is BitUSD, a stablecoin on the BitShares platform. BitShares was a delegated proof of stake (DPOS) platform launched in 2014 by:

• Daniel Larimer (The primary architect behind EOS and Steem),
• Charles Hoskinson (the former Ethereum Foundation CEO & Cardano architect), and
• Stan Larimer (Daniel’s father).

BitShares is just one in a long line of decentralised autonomous corporation (DAC) type platforms released by Daniel Larimer, as the below image shows:

(Note: Daniel Larmier’s company Invictus Innovations launched a number of token/DAC platforms including Protoshares, Angelshares and BitShares. The black arrows represent Protoshares coin holders being granted tokens in the new chains, which Invictus Innovations promised to deliver on all new DAC platforms. Source: BitSharestalk)

BitUSD Marketing material

(Source: Introduction to BitShares Youtube video)

BitUSD System dynamics

Weaknesses

Exposure to a fall in the value of collateral – BitShares was a new, untested and low value asset, and therefore its value was volatile. If the value of the token falls by 50% sharply, in a period spanned by one of the loans used to create BitUSD, there may be insufficient collateral and the peg could fail.

Lack of a price oracle – In our view one of the most controversial aspects of this design is the absence of any price oracle mechanism, providing the system with real world exchange rates. However any price oracle system is challenging to implement and may introduce several weaknesses and avenues for manipulation. We will talk more about this in part 2. In our view, the only real way around this may be that any stablecoin system may require a price feed from a distributed exchange, which can in theory publish a distributed price feed from real world US Dollar transactions. The distributed exchange in BitShares did not allow “real USD”. A distributed exchange system like Bisq, without a central clearing could in theory allow “real USD” prices and provide a distributed price feed.   Therefore stablecoins may eventually be considered as a layer two technology on top of liquid and robust distributed exchange platforms, should these systems ever emerge.

Manipulation – Trading volume in the Bitshares vs BitUSD market on the distributed exchange platform was low, it was therefore possible for block producers to manipulate the market by causing the value of Bitshares to fall relative to BitUSD, enabling them to obtain Bitshares at a discount.

Lack of any price stability mechanism – The main weakness of the system is the lack of any mechanism to move the price towards $1, other than the “where else would it trade?” logic.

Daniel Larimer’s defence of the system

In Daniel’s view, the mechanism of BitUSD creation is analogous to how USD are created in the economy, in that financial institutions lend them into existence.

It’s the same way dollars are created in the regular banking system. Dollars are learnt into existence backed by collateral, in the case of the current banking system the collateral is your house. In the case of our system its shares in the DAC itself.

(Source: Lets talk Bitcoin episode 129)

In a way Daniel is correct here, however as we explained in the introduction to this piece, these synthetic dollars are far less reliable than those created by more traditional banks, and can be considered as a whole new layer of risk, as they are even further away from base money. In addition to this, when obtaining a bank loan, the bank typically has a legal obligation to provide the customer physical cash should they demand it. While such an outcome for BitUSD holder is possible, its not a legal obligation for the creators of BitUSD. Although obviously banks typically do not have the cash in reserve to pay back their deposits, we think the fact they have a legal obligation to do so is an important distinction to draw when comparing BitUSD to US Dollar banking deposits.

In response to the supposed weakness of a lack of a price peg, Larimer argues in favor of his “hypothesis that the price feed is unnecessary” as follows:

It implements automatic margin calls, such that if the price moves against someone who is effectively short, it forces them to cover and buy it back in the market and that creates a peg. The market peg works on the premise that all market participants buy and sell based on what they think market participants will be buying and selling in the future. The only rational choice is to assume that it’s going to trade based on the peg in the future. If you don’t believe that they you have to decide on which way it’s going to go, up or down. And if you don’t have a way of saying you abstain from the market. If you don’t think it works you sell the shares and get out, as the systems going to fail in the first place. So its a self reinforcing market peg, that causes the asset to always have the purchasing power of the dollar.

(Source: Lets talk Bitcoin episode 129)

In our view this idea that a price of $1 is the “only rational choice” is a weak argument. It is basically saying that if the price is not $1, then what will it be? This logic may hold true for some periods, but it is not sustainable and will not scale, in our view.

Conclusion

The volume of BitUSD in existence was a lot lower than many had hoped, in some periods there was only around $40,000 in issuance. At the same time liquidity was very low and the price stability was weak, as the below chart illustrates. The main architect of BitUSD went on to propose a new stablecoin SteemUSD in 2017, this time including a price feed system. Therefore we consider BitUSD as an interesting early experiment, it did not achieve what was hoped nor did it build a robust stablecoin.

(Source: Coinmarketcap)

Case Study 2: MakerDAO (Dai) – 2017

The next stablecoin we look at is Dai, which exists on the Ethereum platform. This system is highly complex, with four relevant pools of funds and six possible stability mechanisms. There are currently around $50 million worth of Dai in issuance and the peg seems to be holding up reasonably well.

System dynamics

Analysis of the core stability mechanism – Dai redemption

The primary stability mechanisms appear to be the ability of CDP owners to redeem if the price of Dai is too low and for people to create new Dai if the price is too high. For example if the price of Dai falls to 80 cent, CDP owners could purchase Dai in the market and redeem it, unlocking $1 worth of Ethereum and making a nice profit. This is how the system should work under normal circumstances.

The above appears to be a robust stability mechanism which should keep the price of Dai at or near $1. However, the theory may only work if CDP owners expect the price of Dai to correct back to $1. If the price of Dai has fallen to 80 cent, CDP owners may be reluctant to redeem if they expect the Dai price to fall further to 60 cent, as such a price would enable them to make even more profit. There is no guarantee that once the price reaches 80 cent, it won’t continue to fall.

Therefore the stability mechanism could depend somewhat on the power dynamics between two groups, Dai owners and CDP owners. These two groups are essentially trading against each other in the market, Dai owners are selling of Dai and CDP owners are the potential buyers. If the power balance shifts towards CDP owners, such that they are well capitalised, patient, collaborative and determined, this group could outmaneuver the Dai token holders, drive the price down, and then buy it back and make a large profit. This may seem unlikely, but in our view the stability mechanism may not work in all market scenarios. Although we consider Dai as superior to BitUSD, in some limited ways, the Dai peg relies on market psychology and investor expectations, in the same way as BitUSD. Therefore the Dai peg is also weak and unlikely to scale.

The global settlement system can mitigate the above risk. If CDP owners are successfully manipulating the price of Dai down too far, this could trigger global settlement. Dai holders would then get around $1 of Ethereum back. Therefore the threat of global settlement may keep the price of Dai up. However again the effectiveness of this threat depends on the determination of the various groups, the CDP owners, MakerDAO token holders and global settlement activators.

Conclusion

We consider Dai to be one of the most sophisticated and advanced stablecoins systems which has been produced so far. In our view, when digging into Dai’s stability mechanisms, there is no one powerful mechanism which ensures stability. Instead we have a complex network of systems, which to some extent reference each other and use circular logic.  One could claim this complexity was created to obfuscate the lack of a strong and clear stability mechanism, but it is more likely to be an indication of an experimental trial and error type approach to the design of the system.

Therefore the system is still reliant on investor expectations and psychology, although to a lesser extent than the BitUSD. While the stability systems in place could work, at least for a while, we think they are not robust enough to withstand market turmoil or some types of power imbalances between Dai holders and CDP owners. Therefore, the search for the holy grail continues.