Counterparty risk of cryptocurrency exchanges is on the foremost of investors’ minds when trading digital currencies. All exchanges have the potential to be hacked or to lose customer’s digital assets. Custody services are in the making, but none have yet achieved the institutional quality of traditional financial markets. If Goldman Sachs or JPMorgan were to offer custody services for crypto, it would change the game. Until they do, we must be vigilant and diligent about constantly evaluating counterparty risks of exchanges. In this article, we focus on credit risks as a key component of this evaluation.
The evaluation of counterparty risk of digital exchanges and evaluations of private equity investments have a similar approach. Most of these companies are privately and closely held, do not disclose financial statements, are not regulated and are relatively opaque. One must consider: the quality of the management, their technology to store and safeguard their digital assets, their responsiveness and openness to customer inquiries and their financial health. In this analysis, we use four of the largest and oldest cryptocurrency exchanges to exemplify how we approach examinations of exchanges’ revenues, profitability and possible credit risks.
We have learned, the hard way, that it’s best to work with the most profitable exchanges, as they have the resources to invest in the people and technology to protect customer assets. Furthermore, in the event of a loss, highly profitable exchanges have the ability to cover customer losses out of their own pockets, as they are incentivized to keep customers happy and to keep the cash machines running.
The following are estimates of the revenues or profits of the largest Asian exchanges, which are quite impressive:
In May, 2019, the parent company of Bitfinex raised $1 billion through the sale of the LEO token.
In its Initial Exchange Offering, they presented their income statements:
Gross Profit $333.5M $418.2M
Expenses $6.8M $14M
Net Profit $326M $404M
Bitfinex has not published financial statements publicly since then. But, LEO tokens continue to trade close to their initial offering price in comparable volumes and Bitfinex exchange continues to be one of the top 10 crypto exchanges by volume. So, we believe their gross and net profits are at least the same, or greater. Bitfinex was only started in 2013; it’s very impressive to have $300- 400 million of profits after 5-6 years.
Huobi issued the Huobi Token (HT) in February 2018 as an exchange token. They planned to use 20% of its revenues to buy back and burn HT so there is a continuous decreasing supply, similar to a stock buyback program in equity markets. Huobi publishes the amount of HT purchased quarterly, from which we can estimate their annual revenues:
2018/01/01-12/31: $ 485 M
2019/01/01 – 12/31: $645 M
2020/01/01 – 11/30: $817 M
Huobi was founded in 2013 which is impressive because not many early stage companies can boast $800 million in sales after 7 years. They have 1500 employees in China with a payroll of less than $50 million which goes to prove how extremely profitable they are. Their profitability is similar to that of Bitfinex.
OKEX issued the OKB token in May 2019 as an exchange token. They promised to use 30% of its revenues to buy back and burn OKB so there is a continuous decreasing supply, similar to Huobi’s program. OKEX publishes the amount of OKB purchased monthly, from which we can estimate their annual revenues:
2019/01/01-12/31 $170 M
2020/01/01-11/30 $250 M
OKEX’s figures are not as impressive as its peers, but nevertheless, achieving $250 million in sales for a 7 year old company is no small achievement.
Binance issued the BNB token in 2017 as an exchange token. They also promised to use 20% of its revenues to buy back BNB in 2019 but later changed their minds. Subsequently, they decided to only burn the BNB held in corporate reserves, which angered holders of their token. Recently, the CEO of Binance told Bloomberg his estimate of 2020 profits in comparison to that of 2019:
2020: $800m to $ 1B
2019: $570 M
Given the huge volumes in December, my assumption is that 2020 finished closely to the high end of estimates above.
It’s amazing to me that a four year old company, formed in 2017, has profits of nearly $1 billion in 2020. Some companies have become like ‘unicorns of the market’ in a short time, but having profits of $1 billion per year is a much greater accomplishment than having investors value your company at $1 billion. These are real earnings.
Hacks Are Covered – In considering credit risks, it’s important to study the behavior of exchanges when there are hacks of losses of customer assets.
The following are examples of exchanges who have covered customer losses.
Coincheck suffered a $530 million hack of its NEM tokens in January, 2018.
During the bitcoin craze of 2017, Coincheck had revenues of over $500 million, so it used those funds to reimburse customers for their losses according to industry sources.
The hack of Bithumb of $31 million in June 2018 was refunded to customers using their own reserves.
Bithumb was capable of absorbing this loss as its 2017 revenues were $469 million.
Upbit experienced a hack of $49 million of Ether in November of 2019. They promised to cover all customer losses.
Given Upbit’s revenues and profits in 2018 of $436 million and $259 million, respectively, they had the wherewithal to absorb the losses, despite a large decline in 2019 revenues of profits of $129 million and $38 million.
Japanese exchange Zaif experienced a hack of $60 million in September 2018 and agreed to reimburse all users for their losses. Zaif had record revenues in 2017 and was among the largest exchanges in Japan at the time.
In May 2019, hackers stole $40 million of bitcoin from Asian exchange Binance.
With $550 million to $570 million of revenues in 2019, Binance was not only capable of covering the losses, but they also had a strong incentive to do so in order to stay in business and continue its profit making machine.
The biggest hacks of exchanges in 2018 and 2019 were mostly covered by the digital exchanges to ensure the return of customers. This can greatly reduce credit risks of holding your assets on these exchanges.
In closing, it is necessary to continuously and diligently evaluate the counterparty risk of the exchanges on which we trade. There are always new risks which come out of left field.
Who would have believed that the CEO of Quadriga X died keeping the passwords to the crypto accounts in his head, he truly took his crypto assets to the grave!
Who would have believed that when the CEO of OKEX was in police custody, that he was not even able to use his private keys to authorize withdrawals from the exchange.
These are all unexpected events, but at the very least, if we deal with highly profitable exchanges, there is hope that they will have the resources and incentives to best serve their customers.
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The Signitt Network
Tags: Mitchell Dong, Savvy Investor, CEO, Pythagoras Investments