Chapter 8 of the book Reckless: The Story Of Cryptocurrency Interest Rates is published below. The full book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book does provide useful commentary in the run up to the failure of FTX, which provides context for the eventual calamity.
Bitfinex
The first significant Bitcoin lending markets emerged on a cryptocurrency exchange called Bitfinex. The exchange was founded in 2013 and the lending markets reached a significant level by early 2014. Unlike many of the other cryptocurrency trading platforms, Bitfinex was run by people with Wall Street experience. Chief Strategy Officer Phil Potter, one of the most influential people in the company, had worked for Morgan Stanley and Bear Stearns in the 1990s before moving into FinTech. In contrast, the people at other cryptocurrency exchanges typically only had experience in startups or technology companies. The other major cryptocurrency exchanges which launched before Bitfinex, such as MtGox, Coinbase, Bitstamp and Kraken, only really had spot markets, Bitfinex was the real pioneer in creating lending markets.
The lending markets here were not because there was demand for Bitcoin loans, from people who wanted to withdraw Bitcoin from the Bitfinex platform to invest Bitcoin in the economy. This was absolutely not the case. The demand for loans was because Bitfinex clients wanted to speculate on cryptocurrency prices with leverage. These traders could post collateral in the form of US Dollars, Bitcoin or Ethereum and use this balance to borrow funds in a lending market on the platform. This was a peer-to-peer lending market, where traders could lend and borrow against each other, using an aggregated open order book with central clearing and settlement. These were market driven interest rates.
An example of this lending activity would be a trader posting Bitcoin collateral to borrow US Dollars and then using those funds to acquire more Bitcoin, increasing one’s exposure to Bitcoin. With many traders wanting to speculate on appreciating cryptocurrency prices, this activity became exceptionally popular. At the same time traders could earn healthy returns lending out US Dollars to these speculators. These highly innovative and transformational features benefited Bitfinex, which soon became one of the most important companies in the cryptocurrency ecosystem. Certainly the most important company with respect to price formation. Bitfinex’s Bitcoin vs US Dollar pair was the most liquid instrument in the cryptocurrency space from around mid-2014 all the way until the end of 2017, with around a 40% market share.
The features Bitfinex offered may not seem especially interesting, as many traditional brokers, such as Interactive Brokers, already provided these features in traditional markets. However, it is important to appreciate that cryptocurrency prices can be exceptionally volatile. At the same time cryptocurrency markets were open 24 hours a day, 7 days a week, 365 days a year. Very different to traditional markets with set trading hours, weekends and bank holidays. Bitfinex also had to contend with the fact that chasing customers for bad debt in the cryptocurrency space was not something that was done. Bitfinex also had to deal with other complications, for instance certain traders would borrow all the US Dollars on offer, not to trade with, but to lend out again at a higher interest rate. Bitfinex therefore had to implement extra special charges on borrowers who did not use the funds to trade within 24 hours, to deter this behaviour. Therefore, ensuring the lending markets were up and running all the time, without a major failure, was a significant technical challenge.
In some periods the annualised interest rate one could earn by lending US Dollars on Bitfinex reached as high as 700%. This was picked up by media entities such as Bloomberg and these high rates played a key role in enticing new people and new money into the space. These rates were especially attractive in an environment where interest rates in the real economy were pathetically low.
The 29-year-old Beijing-based programmer had $440,000 on deposit at the Hong Kong bitcoin exchange Bitfinex until last week and, on good days, would wake up to find a couple thousand more dollars in his account than when he went to sleep. The earnings came from lending his dollars to traders who wanted to leverage their bets. The exchange allowed lenders like Tian to set their own rates, and he says margin traders paid as much as 700 percent [annualised] interest to borrow dollars. At times, he earned as much in one day as holders of U.S. Treasuries earn in a decade. Margin traders paid as much as 700 percent [annualised] interest to borrow dollars
It should be noted that 700% was very much the exception, not the norm. Rates did spike to 700% for a few hours, however in most periods the US Dollar lending rate was in the 20% to 60% range. Although as the following chart shows, rates were extremely unstable. It should be noted that the following chart smooths out volatility, by using daily averages. If hourly data is used, the interest rates on Bitfinex look even more volatile.
In contrast to US Dollar rates, the Bitcoin lending rates were much lower, at around 10%. However, they were still volatile with the rate often spiking up to around 150%. Demand to borrow US Dollars to increase exposure to Bitcoin was high, in contrast there was not much demand to borrow Bitcoin. This characteristic of the markets continued into 2022. The main reason to borrow Bitcoin was when traders wanted to short Bitcoin. Bitfinex was one of the only places traders could short Bitcoin at the time.
Bitfinex US Dollar Lending Rates (Daily averages)
Source: bfxdata.com
Notes: Interest rate based on the daily average rate of all Bitfinex open positions, using hourly data. The right-hand axis on this chart uses a logarithmic scale, due to the strong growth in the period
The high US Dollar lending rates can be explained by several factors. The main driver was the bull market for Bitcoin in the period. Bitcoin was enjoying continued positive price momentum. This generated demand for people who wanted to borrow US Dollars to get leveraged exposure to Bitcoin. When the Bitcoin price increased further, US Dollar rates on Bitfinex sometimes rallied too. There was also a very limited supply of capital willing to lend US Dollars on Bitfinex in the 2014 to 2016 era. Not many large financial institutions were involved in the space at the time. If one wanted to lend US Dollars on Bitfinex, one had to take credit risk with the exchange. This was also not something many investors wanted to do. Who was to say the exchange wouldn’t get shut down the next day, with the management team disappearing? Or what if the exchange was secretly insolvent, like MtGox was shown to be a few years earlier? For those willing to take these risks on Bitfinex, they could earn handsome returns by lending US Dollars. The epicentre of this activity, where most of the traders were based, seemed to be Hong Kong, China, Singapore, Japan and South Korea, although of course traders were based all over the world.
The fear of taking credit risk with Bitfinex was not unfounded. On 2 August 2016, Bitfinex suffered a major hack, losing around 120,000 Bitcoin, worth around US$70 million at the time (pre-hack prices). A third-party custodian company, BitGo managed some of the private keys in Bitfinex’s multi-signature wallet solution at the time, and Bitfinex and BitGo have behind the scenes pointed the finger at each other for years, trying to attribute blame for the hack. To give an idea of the scale of the lending market, before the hack at the peak, US$45 million was outstanding in US Dollar loans on the platform. In contrast there were around US$14 million and US$5 million of Bitcoin and Ethereum loans outstanding respectively.
As a result of the hack Bitfinex was insolvent and withdrawals were suspended. Bitfinex then froze all positions and closed down and unwound the lending market. This is shown on the previous chart, as the outstanding loan balance declined to zero. The markets were shut down for around nine days before opening up again. To make the exchange solvent, Bitfinex then gave all customer accounts a 36% haircut, across all assets, whatever coins they held, even though only Bitcoin was stolen. Bitfinex considered only applying a haircut to those with Bitcoin in their wallets. However, due to the lending markets and the complex interrelationships between the coins, this would not have been possible and the company had to apply the haircut to all assets.
Customers were also issued a new Bitfinex token which represented the debt, the token had the ticker BFX. 80 million BFX tokens were issued, with a par value of US$1 each. This issuance was slightly higher than the hole, to provide some working capital to Bitfinex. On the first day of trading the BFX token reached a low of around 10 cents on the dollar, before ending the day at around 30 cents. At the time there was widespread scepticism about Bitfinex’s future in the cryptocurrency trading community.
Incredibly and against all odds, benefiting from the bull market and strong trading volumes, Bitfinex managed to eventually dig themselves out of the hole. A considerable number of BFX token holders had either redeemed their tokens at par value or converted the tokens into Bitfinex equity. Eventually, by around March 2017, the company had more in reserve than the tokens were worth and the company became solvent. Therefore, everyone was made whole. On the other hand many clients sold their BFX token at way below the par value and they may not feel they did well out of the hack. Some of Bitfinex’s largest clients, who quite legitimately had good knowledge about Bitfinex’s health and strong relationships with the Bitfinex management team, could see the strong volume going through the platform, leading to strong profits. These large clients may have acquired BFX tokens from less knowledgeable retail investors at a discount.
Amazingly, years later, in February 2022, the US Justice department indicted two individuals for possession of the stolen Bitcoin, not necessarily for actually conducting the hack itself. The funds stolen by then were worth US$3.6 billion. Ilya Lichtenstein, 34, and his wife, Heather Morgan, 31 were arrested in New York. However, exactly how the hack was conducted, or if it was even these two individuals who were responsible for the hack, remains unclear.
With Bitfinex resolving its insolvency crisis, the company continued to perform well into 2017, with total US Dollar loans on the platform breaching US$1 billion by the end of the year. Rival platform Poloniex was the first major exchange to copy the lending features implemented by Bitfinex and as a result, the platform also performed well and gained market share from the more established players like Coinbase, Kraken and Bitstamp. Poloniex’s more aggressive policy with respect to listing alternative coins also contributed to its growth, in particular Ripple and Ethereum Classic. The success of Poloniex also created the first major use case of Bitfinex’s stablecoin USD Tether (USDT). Poloniex had no banking relationships and USDT was the main corridor between Bitfinex and Poloniex. Although, in this period, Bitcoin was still the main currency in the space for sending funds between exchanges and it was the primary margin and settlement currency on the trading platforms.
Bitfinex had a monumental impact on cryptocurrency trading markets and lending markets. As a result of its innovative products and astonishing survival through a crisis, cryptocurrency lending markets were born. In some form or another, they have stayed with us ever since.
The Basis Trade
In finance, the basis is the difference between the spot price of a commodity and the futures price. A market is in contango when the futures price is higher than the spot price. In contrast, backwardation is when the futures price is lower than the spot price. Bitcoin is typically in contango, as most traders in the space want to be long and expect the price to increase. Traders can use this spread to their advantage, by buying Bitcoin in the spot market and selling the future. As time progresses, towards the future’s expiration date, this gap should close. The trader here should earn a profit, a type of yield or return. This can also be thought of as an interest rate. Basis risk is the risk that the price gap between the spot price and the futures price changes, as in the effective interest rate changes, due to a shift in the shape of the futures curve.
The first Bitcoin futures market was called ICBIT, which launched in 2011. These first Bitcoin futures products launched in 2012. The Bitcoin contract was quoted in US Dollars, settled in Bitcoin and had a duration of six months. However, this very basic platform was difficult to use and never gained significant traction. In 2012, ICBIT explained the rationale for their Bitcoin futures products as follows:
Miners, merchants who accept payment in Bitcoins, or just anyone having Bitcoins who wants independence of BTC vs USD rate. This is the most typical use case for futures. Example: Miner has mined 1000 BTC and current exchange rate is $6 for 1 BTC (so marking to market that’s $6000 value in Bitcoins). If rate decreases to $3 for 1 BTC by December, miner would effectively [lose] half of his money (because he needs to do certain payments in USD). To fix this problem the miner sells 600 December BTCUSD futures contract at 6.0000 price. Traders who want to speculate on the Bitcoin to fiat money rate. Buying/selling futures contracts is significantly cheaper than trading on the spot market. Also trader[s are] allowed to take any position he likes – long or short, without the need to own the corresponding currency (e.g. USD to go long in BTC, and BTC to sell for going short in BTC). Accessible leverage varies according to the specific instrument, however a rough estimate for BTCUSD contract would be close to 1:10.
ICBIT reached its peak popularity in around 2013, before Bitfinex took over. In that period, one could earn an annualised rate of around 200% conducting the basis trade on ICBIT. From around 2014 onwards, new players entered the market. Huobi, OkCoin, BTC China and BitMEX, all based in China or Hong Kong, launched Bitcoin futures contracts, based on ICBIT’s design. The main innovation these new players brought to the market was the socialised loss and insurance fund system. These were pools of funds, built up inside the platform, to help pay for the winning traders when losing traders went bankrupt. These systems greatly improved the reliability of the trading platforms.
From around 2018 onwards, cryptocurrency futures contracts, mostly for Bitcoin and Ethereum, finally started to gain significant traction in the market. By this time, they were available on platforms such as Binance, FTX, Bitfinex, Bybit, BitMEX and OKCoin/OKX. At the end of 2017, the world’s largest traditional derivatives exchange, the Chicago Mercantile Exchange (CME), also launched Bitcoin futures. This proved to be a very successful product.
These Bitcoin and Ethereum futures contracts were used by speculators, sophisticated proprietary trading shops and hedge funds. During periods of the retail mania there was a huge flow of retail money into the market. This occurred to an incredible extent during 2021, as a result the futures tended to trade at significant premiums to the spot markets.
In April 2021 open interest in Bitcoin futures across the major platforms reached almost US$30 billion, whilst the Ethereum peak, a few months later in November 2021, reached almost US$15 billion. Effective annualised Bitcoin basis rates of up to 35% could be earned at the peak in March 2021 on the native cryptocurrency platforms. While on the CME, at the peak in March one could earn 16%. This arbitrage trade was essentially risk free, as long as you had the capital to keep your position open, you were patient enough to wait for the futures expiration date and the exchange remained solvent. These high rates of return reflected the fact that most participants in cryptocurrency trading markets expected the underlying prices of the coins to keep on increasing. At the time of writing, in October 2022, these annualised futures basis rates are more moderate, at around 2%. However, while annualised futures basis rates were very important rates in the cryptocurrency space, they are not really interest rates, because they are not really charged to a borrower.
BitMEX
BitMEX is a cryptocurrency derivatives trading platform, founded in 2014, by Arthur Hayes, Ben Delo and Sam Reed. BitMEX developed and offered a ground breaking new product in the industry, a perpetual swap contract, which is basically a Bitcoin futures contract that did not have an expiration date.
Unlike Bitfinex, BitMEX did not have a spot exchange nor did BitMEX have lending markets. Instead, on BitMEX, traders would deposit Bitcoin and use Bitcoin as the margin and settlement currency to trade cryptocurrency derivatives. These contracts would allow traders to open large notional positions while only having a small amount of capital in the account. For example, BitMEX allows traders to achieve effective leverage of up to 100 times, in that one could deposit 1 Bitcoin and open a position in a contract with a notional size of 100 Bitcoin.
BitMEX had to ensure its rolling swap contract effectively tracked the spot price of Bitcoin, unlike a future which tends to trade at a premium. In order to achieve this there was something called a funding rate associated with the contract. Unlike futures with an expiry date and settlement, there is no basis rate. Instead, BitMEX used a funding rate, which was initially associated with the cost of borrowing the underlying asset on Bitfinex. This interest rate is charged to traders or received by traders, depending on if they are long or short. This mechanism mimics how the margin lending worked on Bitfinex, with traders exchanging interest payments between each other.
At first BitMEX used the Bitfinex Bitcoin and US Dollar lending rates to calculate the funding rate. The rate was the cost to borrow US Dollars on Bitfinex minus the cost to borrow Bitcoin. As explained above, this number was almost always positive. If a BitMEX client went long Bitcoin, they would pay this rate, while if they went short Bitcoin, they would receive this interest rate. Therefore, if demand to go long Bitcoin increased on Bitfinex, the rate would be higher and it would be more expensive to go long on BitMEX. The idea behind this seems somewhat related to a retail instrument in traditional finance, CFDs (Contract For Difference). These contracts typically have no expiry and longs pay a funding rate overnight to shorts, depending on the base rate of the currency in question. However, each CFD only has one leverage rate, while BitMEX wanted one highly liquid uniform contract across all leverage ratios.
BitMEX’s funding rate did not work particularly effectively. The issue was that Bitfinex traders were using around 3x leverage, while BitMEX supported up to 100x. Therefore, the interest rate was too low, as it reflected demand from traders using 3x, while the traders were actually using higher leverage. At the same time, the trade flow on BitMEX was more speculative. Therefore, BitMEX changed the methodology of the contract, adding a new component to the funding rate calculation. BitMEX looked at the price of the perpetual swap contract in the last period (now using 8 hour windows) and compared it to the funding rate adjusted spot price of the underlying asset over the same period, using data from the spot exchanges such as Bitfinex. If the perpetual contract was trading at a larger premium to the underlying than the funding rate, traders going long the contract would make greater payments to those going short in the next period, and vice versa. This mechanism helped ensure the price of the contract closely followed the spot price. This mechanism proved to be highly effective.
It is not clear if this rate represents a Bitcoin interest rate. It can be thought of as a special mechanism used by a trading platform to achieve a particular objective, rather than an interest rate. This was certainly less of an interest rate than even the borrow rates on Bitfinex, which were more linked to actual loans and debt. Even if the debt could only be used to speculate.
This new type of derivative contract meant that traders could achieve the desired amount of leverage without using spot margin trading and lending markets. BitMEX made the ability to obtain leveraged exposure to Bitcoin even easier than on Bitfinex. As a result of this, from mid-2017 onwards, BitMEX enjoyed strong growth. By 2018 the perpetual swap contract was doing billions of US Dollars per day in notional trading volume. This new derivative contract type eventually took over from Bitfinex’s Bitcoin market as the most liquid instrument in the space and as a result, Bitfinex’s lending market rates became slightly less significant. In around 2020 BitMEX lost its crown as having the most traded Bitcoin contract, as other exchanges like Binance and FTX became the market leaders. However, these other platforms copied BitMEX’s perpetual swap contract innovation, and the perpetual contract remains extremely popular to this day. Whether it’s an interest rate or not, the funding rate for this contract remains one of the most important quasi Bitcoin rates.
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