Alistair Milne

NOTE:  The following was written specifically for a non-technical audience with a very superficial knowledge of Bitcoin

If Bitcoin were a company, it would have been shut down. Satoshi Nakamoto, its inventor, probably would be incarcerated or on the run.

However, Bitcoin is not a company. It is an ownerless entity, living on the Internet upon a network of computers all over the world.  This decentralised nature allows it to operate outside of government control, ignoring borders and regulations.  At this point, the only way to shut down Bitcoin would be to turn off the Internet.

This gives Bitcoin certain advantages:

• Bitcoin doesn’t care where you are so long as you are connected to the Internet (or even SMS)
• Bitcoin doesn’t care who you are (no AML/KYC, no need for a bank account, no age restrictions)
• Bitcoin can be sent person-to-person, like e-mail, globally

It also brings some disadvantages:

• Bitcoin is slow – to be sure you have received Bitcoin, you need to wait 30-60 minutes
• Bitcoin’s capacity has been limited due to the restrictions on computer power & Internet speed in developing nations
• Bitcoin’s value is volatile, as it is currently still very small ($12.5billion at the time of writing)

Bitcoin has already reached its maximum throughput of transactions due to the existing limits written in its software. The main limiting factor is the size of each block in Bitcoin’s blockchain.  Currently the limit is for each block to be only 1Mb in size, thus creating a hard ceiling on how many transactions can fit inside a block.

There is a lot of debate around how best to ‘scale’ Bitcoin so that it can accommodate far more users.

Some want to simply increase the maximum size of a block, others want to deploy an enhancement called ‘Segregated Witness’ or SegWit to increase the effective size of a block and enable ‘second layer’ solutions to enable far greater scaling.  SegWit also fixes a minor security bug.

The best way I can describe the two main spheres of thought, is to compare it to car engine design/improvement.

The obvious way to make an engine more powerful is to make it bigger … more capacity, more cylinders.  The downside to this approach is that they guzzle fuel (expensive to run) and are heavy.

This represents the more simple scaling method preferred by some Bitcoin users, simply increase Bitcoin’s block size so that more transactions can fit inside each one.

The main disadvantage of this approach is that you need to completely remove and replace the engine … and there are 1000’s of engines out there to change, and everyone needs to agree to make the upgrade.

The more European/Asian way is to optimise an engine; increase efficiency (better air filters, reduce weight & friction, new exhausts, etc.) and maybe bolt on turbos/superchargers to meet the demand for power when required.  More recently, some manufacturers have added energy recovery systems and electric motors.

The downside to seeking optimisations and bolt-ons is that the engine becomes more complex and perhaps more fragile as a result.

This approach represents the ‘Core’ development approach to Bitcoin; being very conservative with regard to increasing block size and seeking optimisations and/or bolt-ons which may result in far more ‘bang for your buck’ (more BHP per litre of engine size … or more transactions inside each Mb of block space).

Those of you with some familiarity with computers may think that 1Mb is very small these days, so why have such a low limit.  It seems logical to increase the blocksize to a more ‘modern’ amount and optimise later.

The main two reasons against the simplistic ‘bigger is better’ arguments are:

1/ If you cannot reach unanimous support for a full engine upgrade, you risk having two different cars on the road … essentially two different Bitcoin networks.  Very bad news!  It would create uncertainty and huge price volatility is likely.  If poorly managed, there is the potential for some to lose funds.  It would be a lot of extra work for Bitcoin businesses to maintain two different ‘models’ of Bitcoin.

2/ Bigger may not be better in developing nations like China, India or in Africa … thus hurting decentralisation (an absolute requirement for Bitcoin to be resilient against interference from any overbearing governments).  There is a reason they don’t drive around in 500BHP pick-up trucks in India … they can’t afford to buy or run one!  If you’ve been to India, you will know that small hatchbacks are by far the majority of cars (massively outnumbered by scooters and motorbikes!).

As I write this, the Bitcoin miners are ‘voting’ on whether to activate ‘SegWit’, an exciting new technology which I hope activates soon.  It is analogous to the second ‘optimise and bolt-on’ approach to engine design.

The new version of Bitcoin software will enable ‘second layer’ technologies to be bolted on to the ultra-resilient Bitcoin blockchain … enabling things like:

• Instant payments with zero counterparty risk, with no minimum size
  • Good for micropayments, Internet of Things, real-time settlement, high frequency trading, etc. etc.
• 10,000’s transactions per second throughput (i.e. VISA size capacity)
• ‘Sidechains’ enabling innovators to build their blockchain ideas on top of Bitcoin’s security
  • It will be possible to ‘peg’ other blockchains to Bitcoin’s in order to harness its security and immutability but have entirely different functionality. For example, Rootstock will be a sidechain which will enable smart contracts.

My view is that with this ‘SegWit’ upgrade, Bitcoin would become the go-to blockchain for any project … even for banks and governments.  It would truly become the ‘World Wide Ledger’ for any use we can imagine.

Full disclosure: I created the BFX Trust to help larger Bitfinex creditors convert to equity as I believe that adversity & misfortune often present golden investment opportunities. I do not work for, nor am I paid by Bitfinex. My actions are independent and based on my own judgement and desire to see the whole Bitcoin industry thrive.

Disclaimer: What follows are my opinions only and should not be taken as investment advice! DYOR! Taking equity holdings in private businesses is very high risk and not suitable for all investor profiles.  As they say on UK crowdfunding sites:  CAPITAL AT RISK!

Valuation

Bitfinex are valuing themselves at $120million ‘pre-money’ despite currently having a net of ~$60million in liabilities they cannot pay immediately … so in reality it is a $180million valuation assuming balance sheet = 0. They want to raise a total of up to $80million in debt conversions and new capital in return for 40% of the company.  Pre-hack Bitfinex was a cash-cow, generating $6million of net profits in the first seven months of 2016 … so an annualised run-rate of about $10.2million.  Their figures also imply a growth rate of nearly 100% vs 2015 had the hack not occurred.

Naturally, many will argue that Bitfinex is worth little/nothing while in debt and there is a risk of insolvency.  However, so far, it seems the creditors are willing to be patient … so we must also consider the possibility that the market leader in BTC/USD (and it is still the market leader post-hack) may successfully convert/raise sufficient funds to make it back to a sustainable footing. In that scenario, what could Bitfinex be worth?

If Bitfinex manage to hit their forecasts of $20million net profit in 2017, that would make a valuation of somewhere between $180-200million quite reasonable, especially given the rate of growth and future potential.

To put the valuation in perspective, Coinbase was said to be valued at $400million in January 2015 and we can be fairly sure they are loss-making given they recently hiked their pricing!

My opinion is that a $180million debt-free valuation of Bitfinex is thankfully the right side of $200million but presumes there is very rapid progress in converting a significant percentage of BFX Tokens to equity (e.g. 30-50%).  However, as we are currently able to buy BFX tokens at a discount (today trading at $0.52 or 52% of face value) … this significantly reduces the effective valuation for anyone buying BFX today.  If you were serious about converting, you should average down if you can … for example, you might buy the amount of BFX you wish to convert at sub-$1 and keep the rest.  If you buy @ $0.52 per BFX token, convert to equity and if Bitfinex do indeed achieve $20million of net profits in 2017, you will have grabbed yourself a bargain!  Lots of IF’s, so lets dig deeper …

How Bitfinex Looks Today

Margin lending

Margin lending is key to Bitfinex’s business. Not only does it permit traders to leverage their positions, it also earns the exchange 15% of all interest charged on the loans.

USD lending is somewhere between one third and one quarter of where it typically was pre-hack.  Currently ~$10.5million is lent to Bitfinex traders.  It has been steadily growing since the website came back online with no sign of peaking so far.

BTC lending is doing better, around 40-50% of the highs seen pre-hack and actually higher than the lowest level set in June this year.  Currently more than 8000 BTC is borrowed.

Visible BTC reserves

Immediately post-hack, Bitfinex had 125,424 BTC in its cold storage wallet.  More than half was quickly withdrawn when the website came back online, hitting a low of ~39,700 BTC at the end of August.  Since then, there has been a net inflow of Bitcoin into their cold storage … please see the chart below:

The balance stands at just under 60,000 BTC and currently slowly climbing.

Trading volumes

It is hard to get a realistic measure of how Bitfinex’s volumes have been affected since the hack and flight of some customers.  We are in a low-volatility period which doesn’t allow Bitfinex’s competitive advantage of margin trading to show itself.  Since the hack, Bitstamp’s 24hr volumes have typically ranged from 2000 to 4000 BTC.  In the same period, Bitfinex has achieved 3000-9500 per day.  Bitfinex’s range is far broader given volatility = more margin trades.  Leverage allows traders to profit from smaller moves in the price, so trade more often during volatile times.

If we look at mid-March to mid-April (another quiet period of trading), Bitstamp was ranging from 2000 to 5000 BTC per day.  Bitfinex’s trading volume range was approximately 3000-23,000 BTC.

It would therefore appear that while Bitfinex’s baseline volume appears roughly consistent vs pre-hack, its peak days may currently be ~50-60% lower given there is less leverage used on the exchange.  I feel reasonably confident that we can estimate Bitfinex’s future volumes by watching the amount of leverage used.  The current trends are positive with little sign of a ‘peak’ in USD lending being reached for the moment (the red line in the chart below).

You can see Bitfinex’s margin lending data here and here.

It is important to mention that Bitfinex has recently added ETH and ETC trading to its exchange, no doubt fueling some of its pre-hack growth.  Bitfinex is therefore less reliant on BTCUSD volume than it used to be.  Even the BFX token markets are helping!

Future Potential

It is easy to get caught up in the negativity of the moment.  Some of my best investments have been done when literally everyone was saying a company was doomed or I was the only person saving a business.  If we believe that Bitfinex is supported by the majority of its creditors – because they naturally want full recovery – then that may become a self-fulfilling prophecy.  If Bitfinex succeed in repaying all creditors who have not already sold their BFX tokens, it is not inconceivable that they emerge far stronger than before … a company and management who have gone through a trial by fire.  It will also be partially owned by some of its biggest customers – unique in the marketplace.

Let’s run through some of Bitfinex’s future opportunities:

Derivatives

This is an obvious one, allowing traders to trade/hedge with a known cost (i.e. no variable interest rate on USD/BTC/other).  OKCoin leads the market currently but they are a very opaque organisation.  If Bitfinex are serious about being more transparent & less mysterious they could capture a significant amount of cryptocurrency derivative trading … especially if they made contracts deliverable and not cash settled.

New Currency Pairs

Hopefully Bitfinex will continue to add major new currency/asset pairs to its exchange (for example, Zcash is coming soon).  Moving more quickly than the competition and having better liquidity in emerging markets will make Bitfinex the go-to exchange.

Similarly, allowing other fiat currencies into the mix may capture more market share.

OTC Trading

An obvious one to serve funds, family offices and similar. Or perhaps a ‘dark pool’ such as Kraken. Or both!

Merchant Processing / Remittance

Bolt on services that may add more consistent volume and play to one of Bitfinex’s strengths – their orderbook depth.

Innovation

Sidechains between exchanges, creating a decentralised marketplace for non-fiat markets, more development of peer-to-peer lending  … I think everyone familiar with Bitcoin realises that we are at the very beginning and growth potential is enormous!  Bitfinex can leverage their customer base and trading volume to give new innovations immediate critical mass.

Recovery Rights

This new token should appeal to the gamblers!  The Bitcoin stolen from Bitfinex has not moved since it happened and there is an active criminal investigation ongoing.  Should creditors convert quickly (i.e. before the end of September), they will gain so-called ‘Recovery Right Token’s representing the same face value amount as the BFX tokens they are converting to equity.  Should the Bitcoin be recovered (e.g. the hacker gets caught), once all BFX tokens are redeemed then these Recovery Right Tokens will also be redeemed … essentially meaning you could get a free investment in Bitfinex if the hacker is caught and compliant.

The chance of full or partial recovery is not zero, so this is an interesting sweetener to encourage conversion.  It will be fascinating to see how the market prices the RRT’s!

Some even think the RRT may give the hacker/s a way to profit from the stolen Bitcoin by giving it back!

Less Technical / Business-orientated Thoughts

For various reasons, Bitfinex gets a lot of hate online.  They’ve had several incidents, including prior hacks and technical issues (unexpected downtime, lag, etc.) which sends all the “armchair experts” into an explosion of typing fury.  However, it would appear that the people posting all the negativity mean relatively little in terms of actual trading volume.  The expression ‘its not the critic that counts’ appears to hold true.  People with deep pockets are still trading on Bitfinex.

I believe it isn’t until facing hard times that you can judge someone’s caliber.  Lesser men and women would have simply crawled into a cave and called in a liquidator if faced with the same situation as the Bitfinex management recently experienced.  The BFX token may be a grey area according to some who believe themselves to be legal experts, but it immediately gave all customers a way to achieve a better outcome than a liquidation.  For every seller, there is a buyer, which means there are plenty of people out there who think Bitfinex has a future.  30million BFX per month being traded says it all (total BFX issued = ~71million).

Getting back online, allowing everyone who wanted to withdraw everything, the BFX token and now the conversion … it is hard to argue Bitfinex management are doing a poor job.  I believe they deserve a lot of respect for what they’ve already achieved and what they continue to try to do for creditors.

If you like my analysis, please tip my son’s Bitcoin piggy bank he will get when he’s 18!

1AzmnauEdrTZbhrE7z3o4JPe2bTJKMXLyv

EDIT:  In the two days it took to write this blog piece, USD lending has increased ~$1.5 million to just under $12mil.  BTC deposits now exceed 61,000.