A New Mining ContractOn Sept 15 Bitfinex launched a beta three month cloud mining contract TH1. The unique feature of the contract was that users could trade it on the margin. At first, there was relatively little information about the contract. For instance, it launched with 100 shares that each represented 1 TH/s. Bitfinex said that they would add more shares, but there was no schedule for this. In the following days, Bitfinex issued an additional 400 shares in four tranches of 100.
It was also unclear how Bitfinex was selling the shares as they did not have an issue price. They later revealed that they were selling them to a market maker (whose identity is still unknown) who could choose whether to hold or sell them.
On the first day of trading the contract price held at 2 BTC for most of the day, but on the second day it fell 45% to 1.1 BTC. This made sense as the contract's expected mining value was a lot closer to 1.1 BTC.
Over the next 27 days the strangest thing happened. Despite the fact that it was a three month contract and its mining value was decreasing, the mining contract increased in value from 1.1 BTC to 1.3 BTC. During this time the estimated mining difficulty increase was falling from 10% to as low as 0%. But towards the end of this period even with future difficulty increases of 0% for the life of the contract, the contract was over-valued by as much as 45% over its mining value.
At first as the difference between TH1's price and its mining value increased, it emboldened speculators to short it. For instance, I started with a very small short position which grew to 38 contracts.
However, after the price repeatedly failed to correct, I realized that my spreadsheet's forecast of a 20% profit in 70 days was too good to be true and I developed a theory that the price was being manipulated.
How to Manipulate the TH1The manipulator maintains a floor price for the contract (ex. 1.2 BTC) by buying as many contracts as they need to do so. This is possible because the supply of contracts is limited. This floor price exceeds the mining value of the contract by a significant margin.
As the price of the contract exceeds the mining value, it will attract speculators who want to short it. They will drive up the swap rate for lending out the TH1 contract for shorting. For instance, if the contract is priced at 1.2 BTC but only worth 1.0 BTC in mining value - the shorters will be willing to pay up to 0.2 BTC (minus a small amount for risk and the cost of using their money) in interest.
In this scenario the person maintaining the premium pays out 0.2 BTC more than the contract is worth, and then gets almost all of it back from the shorters. It isn't profitable.
However Bitfinex only lets you lend swap for 30 days. So shorters were not able to lock in a rate for the entire 90 day period. Shorters expected the contract price to decline over time, thus decreasing their interest cost. However the manipulator maintained the price causing the amount of interest to be more than expected and a spike in the interest rate.
If the manipulator had gone unchecked, they could have maintained a price of 1.2 BTC (or even a higher price) up until the last 30 day period - at which point shorters would have been willing to pay as much as 0.8 BTC to short the contract down to its expired date value of 0.
While shorters were making their profit calculation based on the assumption of fixed interest rates, the manipulator had at least two opportunities (at the expiration of each 30 day period) to greatly increase the interest rate.
Bitfinex Intervenes and Bails Out Some of the UsersI developed this theory and started to post publicly about my concerns on Bitcointalk (where some people agreed and were concerned) and Reddit (where I was ridiculed).
Bitfinex has previously intervened twice in their markets. Once during a flash crash that was specific to Bitfinex they reversed the trades. Another time, during the April 2013 BTC crash - a third party bought the Bitcoins and bailed out lenders who otherwise would have suffered from Bitfinex not being able to close positions fast enough to pay them.
My recommendation to Bitfinex was that they shut down the market and reverse all the trades. I wrote Bitfinex to express my concerns. They said that they were looking into it, but did not promise any action.
As Bitfinex failed to take action, I closed my TH1 position at a loss of approximately 8 BTC. At least one other shorter closed their position as well. On Oct 16, Bitfinex took action and announced that “Firstly, we would like to plainly state that Bitfinex will not tolerate any behavior that we deem to be manipulative.” They also added 100 shares and increased the margin requirements, but their threat to intervene against manipulation was the prime factor that caused the price to fall in the next 24 hours from 1.3 BTC to 0.9 BTC. After several days the number of swaps had fallen from 300 to 40.
Since that time, the price of the TH1 contract has had a stronger correlation with its expected mining value.
If I had held my position for several additional days, or if Bitfinex had intervened sooner then I would have made a profit of at least 4 BTC. Instead I lost 8 BTC. This money may have gone to the mainipulator (if they managed to sell some of their contracts before the price crashed). But I think it is more likely that the money went to other shorters who benefited from the price crash that I helped cause by my analysis of the manipulation and my public advocacy for Bitfinex's intervention.
I've asked Bitfinex to reimburse my losses, but they have not answered this request. I find it perplexing that they intervened in the market in a way that rewarded shorters for their inaction (and using my losses to do so) and punished those of us who took our own action. In effect, they are encouraging their users to trust Bitfinex to intervene in the market in the future - instead of doing their own analysis of the potential risks. This might be causing people to become too secure in their investments, notably in the $23 million USD swap market which would be expensive to bailout if there was a flash crash.
LinksTH1 speculation thread (fixed link)
