The weakest link
The surge in interest in cryptocurrencies from investors seeking instant returns has again exposed the worrying truth that the entire space is beholden to a narrow set of exchanges unable to guarantee a functioning service.
This should not come as a surprise. The history of cryptocurrencies is littered with money vanishing into the ether. Mt Gox is the poster child for all that is untrustworthy in the space, managing to lose an estimated $350m (at the time) of Bitcoin, ultimately leading to its bankruptcy. However, nearly every major exchange operating has suffered losses, with the likes of Poloniex (12.3% of its entire bitcoin supply lost), Bitfinex (120,000 bitcoins, then worth c. $70m, stolen), Bitstamp (19,000 bitcoins, then c. $5m) and Yapizon (3,816 bitcoins, then c. $5.5m). There have been countless others.
The situation has without question improved in the last five years, with the acceptance of a greater need of regulation such as AML and KYC processes, better access to banking services and increased investment in the area. However, events such as this week have shown that the exchanges remain the weak link in a still fragile ecosystem.
The issue begins at the start of the process, with overloaded exchanges still slow to approve new users. They are then very good at taking customer money, but remain frequently poor at allowing users to cash out. Support ranges from non-existent on some exchanges to slow and inconsistent on others. As an example, the two times I have tried to withdraw to fiat in the past year I have seen delays of 2 months (Kraken) and 3 weeks and counting with no end in sight (Coinbase) – so much for the promise of a response within 6 hours.
These are issues that will get solved over time. It is difficult to scale a business when demand is increasing so quickly. It is an annoyance, but eventually an exchange will get it right and the other exchanges will have no choice but to follow or lose customers. The biggest exchanges will get bigger; the smallest will die or offer more opaque services to cater to certain audiences.
What is of more concern is the propensity of exchanges to fall over during periods of high demand. Whilst this may seem a similar issue to the above – one that can be solved with increased scale – it is of greater importance because it could cause a panic that could eventually cause a run on the exchange.
The Ethereum flash crash in June saw prices dip from over $300 to under $1 in a matter of seconds. Prices rebounded quickly, and it largely only affected those who were margin trading in ETH with ETH as their collateral, but it showed the impact that relatively small amounts of money can have on market with billions of dollars traded each day.
Furthermore, a lot of money that has entered the crypto space has not left it, with people either selling for alternative cryptocurrencies or parked in BTC, ETH in what is known as ‘hodling’. What would happen if a large chunk of the market decided enough was enough and that they actually wanted to cash out?
Preston Byrne’s article “The Bear Case for Crypto, Part II: The Great Bank Run” tackles this issue, pointing out that pledges from exchanges to keep 100% of customer deposits is irrelevant to preventing a lack of liquidity in a sell off, because they will not be able to keep pace with the rise in prices. Anyone who bought BTC from Coinbase in January will have paid $1,000. If that same person went to sell the same BTC back now and withdraw their cash, Coinbase would have to find $10,000 to reimburse them. This is sustainable only while new funds coming in outweighs those seeking to exit. In a bull market, with investors rushing to throw their money in, this is possible. In a sustained bear market or a sudden crash it is less certain.
Coinbase at least have banking services which allows such a withdrawal. The same cannot be said for a number of exchanges, including Bitfinex, which today processed a staggering $1.3bn trades for Bitcoin alone – more than the entire market volume earlier this year.
Bitfinex, which lost their banking services in April following Wells Fargo’s refusal to process transfers from Bitfinex’s Taiwanese banking providers, are thought by many to be the most likely cause of the next crypto catastrophe owing to their use of Tether (a cryptocurrency that is notionally pegged to the dollar but which provides no audits to prove that it holds equal fiat reserves for every USDT it ‘prints’).
This usage of USDT is not confined to Bitfinex but rather has spread to a number of other exchanges. What happens if people try to cash out via Tether and there are not sufficient fiat reserves or the process would take too long? They would then be forced to move to other exchanges which do offer banking services. This, again, would lead to the slim number of exchanges being quickly overwhelmed.
The crypto market has quickly risen from being a rounding error for some corporations to seeing billions of dollars traded a day. If the market was to rise in 2018 half as much as it has done this year then the total market would be approaching somewhere in the region of $2.5 trillion. It is also susceptible to incredible levels of volatility, fear and panic. Thanks to the recent exposure, it is also now home to many people who are not professional investors, will not understand the technology and will be unprepared to hold through drops of 50%-90%.
Does that feel like a good mixture when one of the (better) exchanges has not been able to respond to a simple withdrawal query in three weeks?