Business: When you own a lot of money to a crypto bank?

Posted by

Here is what’s happening with CoinFlex.

Cryptocurrency exchange CoinFlex plans to raise funds by issuing a new token that will offer a 20% annual return, in an effort to resume withdrawals after a client failed to repay a $47 million debt. 

The platform said it will start to issue $47 million of what it calls “Recovery Value USD” tokens on Tuesday. The resumption of withdrawals, targeted for June 30, will depend on the level of demand for the new tokens. …

CoinFlex paused withdrawals last Thursday after an unnamed counterparty, a high-net-worth individual with “substantial shareholdings in several unicorn private companies and a large portfolio” experienced liquidity issues and failed to repay debt.

CoinFlex is, in the loose terminology that we have been using recently, a crypto bank: It takes money (cryptocurrency, stablecoins, etc.) from “depositors” (customers) and lends money to borrowers. (More accurately, CoinFlex is an exchange/broker, which takes customer money to do trades and also lends money to customers to allow them to do trades; it is not exactly traditional banking, but it also involves holding customer money repayable on demand and providing leverage to other customers.) Here, one borrower was this “high-net-worth individual” who owes CoinFlex $47 million. CoinFlex has $166.8 million in “total value locked,” says its website, so $47 million is kind of a lot. That high-net-worth person has apparently declined to pay it back.

“The Individual is a high integrity person of significant means, experiencing temporary liquidity issues due to a credit (and price) crunch in crypto markets (and even noncrypto markets) who has significant shareholdings in several unicorn private companies and a large portfolio,” says CoinFlex. CoinFlex’s chief executive officer later clarified that (as everyone assumed) the $47 million whale is Roger Ver, who is also an investor in CoinFlex. Ver has denied owing CoinFlex the money. Awkward for everyone really.

This is Roger Ver.

Crypto banks tend to make mostly margin loans secured by cryptocurrency. Ordinarily in this scenario you might expect CoinFlex to send him a margin call and, when he doesn’t pay up, liquidate his collateral. Hilariously CoinFlex can’t do that because, while this loan is secured (now under-secured), CoinFlex has promised not to touch the collateral. It explains:

During the recent market volatility, a long-time customer of CoinFLEX’s account went into negative equity, meaning the Individual’s account currently holds a negative balance. … In normal circumstances, we would auto-liquidate a position that runs low on equity at prices prior to the zero-equity price. In this case, the Individual had a non-liquidation recourse account. This condition required the Individual to pledge stringent personal guarantees around account equity and margin calls in exchange for not being liquidated.

Not that stringent! 

The second-best choice for CoinFlex is to sell the bad debt at market prices and use the cash to pay back its remaining customers. That seems to be, roughly speaking, the plan:

As a solution toward re-enabling withdrawals, CoinFLEX is planning to monetize this personal guarantee by creating a corresponding liability in the form of a token called Recovery Value USD (“rvUSD”). The terms of the rvUSD token issuance can be found here.

We have been speaking to potential large buyers and believe there is significant interest in the terms presented. 

But there is some nuance here. In traditional finance, when you own a $47 million debt and the debtor doesn’t pay, you want to sell off that debt at whatever the market will bear, get some cash, and use it to meet your own obligations. If the market says that a bad margin loan is worth, say, 80 cents on the dollar, then you sell it for $37.6 million (80% of face value) and take a $9.4 million loss; at least you have $37.6 million to hand back to your depositors.

But in traditional finance you also have equity. You have, say, $10 billion of loans outstanding, funded with $9 billion of deposits (customer money) and $1 billion of equity (your own money). If you take a $10 million hit on one loan, then your equity goes down to $990 million — you lost money — but your customers are still protected. 

In crypto:

  1. There are no regulatory capital requirements, and crypto banks often seem quite proud to be running at roughly zero equity. Tether, the biggest crypto bank, boasts of its 0.2% capital ratio; if the value of its assets declines by more than 0.2%, depositor money is at risk. Tether also boasts of its transparency, and while that is a bit silly, it is the case that for many other crypto-bank-type entities it is harder to guess how much equity capital they have.
  2. There is no prudential supervision, and crypto banks think nothing of concentrating, like, a third of their customers’ money in a single loan. Voyager Digital Ltd., for example, is another crypto bank, which had about a 4.3% capital ratio but loaned out more than twice its total capital to one hedge fund that went bust.
  3. Also, because there is no prudential supervision, crypto banks will sometimes concentrate their money in loans to their affiliates. The fact that Ver is both an investor in CoinFlex and a big borrower from CoinFlex is pretty standard in crypto even though it would be very bad in traditional banking. It is bad because, if your big borrower is also your big backer, you might be inclined to give him a special deal like, for instance, promising not to foreclose on his collateral even if he doesn’t meet margin calls. 

These things are, you know, bad generally, but they create a particular problem when you have a $47 million bad debt. If you sell the debt for $37.6 million you could be insolvent and unable to pay back customers, if you have no equity cushion, as seems to be common in crypto. If you want to pay back your depositors, you have to sell your bad debt for $47 million. This is hard because presumably a debt that isn’t being paid back isn’t worth 100 cents on the dollar. But you have to find 100 cents on the dollar anyway.

Fortunately crypto has ways to do this, or way to do this, which is to call something a token, offer an extremely high interest rate and pay it in kind. So the CoinFlex “rvUSD” token pays a “20% APR accrued and paid daily in rvUSD.” If you buy 100 rvUSDs today, in a year you’ll have 120 rvUSDs I guess. If you can cash those all out for a dollar each then you’re in great shape. I don’t know exactly how the math for that works. Does CoinFlex’s whale owe them 20% interest? Or are they making up the extra interest out of equity? Out of future trading revenue if everything goes back to normal? Also one could ask other basic security-structuring questions — Is this thing secured by the loan? Or are holders of rvUSDs unsecured creditors of CoinFlex? Are they creditors at all? — that seem a bit silly in this context. 

Crypto is having its 2008 financial crisis, but it’s much more interesting than that, isn’t it? In 2008, (1) traditional well-understood principles of credit and collateral and seniority and bankruptcy and banking law were applied to somewhat new and aggressively structured instruments, and (2) regulators invented a few novel approaches to limit the damage. In the crypto crisis, every lender and exchange can kind of make up its own principles from scratch and see what they can sell to people. In a sense crypto is having many different tiny 2008 crises all at once; the crisis is always the same — short-term demand deposits funding risky lending — but everyone gets to invent a new way to address it.