【Zombit】Lending transactions are hot! Taking you to understand the secrets of Bitfinex's lending process

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Before understanding Bitfinex's lending transactions, you first need to know what "margin trading" is in the traditional stock market?

When you anticipate a short-term increase in a company's stock price, you might want to buy more shares of that company so that you can sell them later at a higher price to make a profit. But what if you don't have enough funds on hand? The simplest solution is to borrow money from a bank. However, the borrowing process can be cumbersome and may require collateralizing significant assets. By the time all the paperwork is done and the money is in place, the stock price of the company may have already skyrocketed!

That's when margin trading comes into play. When the above situation occurs, investors can borrow money from a brokerage to buy stocks, requiring only a partial deposit as collateral. This allows them to buy more shares with a small amount of capital, effectively increasing leverage.

For example, if Xiao Sang has $40,000 and wants to buy 1 share of Company A's stock priced at $10, he can buy 4 shares of that company in total. However, with margin trading, he can buy 10 shares of Company A's stock because margin trading only requires him to pay 40% of the total amount as collateral. The remaining 60% is borrowed from the brokerage. So, instead of buying 4 shares of stock, he can purchase 10 shares, effectively increasing the leverage of the transaction.

Why do brokerages lend you money?

As the saying goes, there's no such thing as a free lunch. When brokerages lend money to investors, the investors need to pay related interest. The margin interest rate is usually higher than the regular bank loan interest rate. This income used to be a significant revenue source for brokerages, as margin trading is typically short-term borrowing and interest is calculated on a daily basis.

What is the relationship between margin trading and Bitfinex?

Bitfinex platform offers peer-to-peer margin trading for cryptocurrencies. Users can not only borrow USD to invest in cryptocurrencies but more importantly, Bitfinex allows users to act as traditional brokerages, creating peer-to-peer margin trading, lending money to other investors to earn stable interest returns. Bitfinex acts as a matchmaker, enabling both lenders and borrowers to complete transactions under mutually acceptable conditions, with Bitfinex charging a 15% interest fee.

This image shows the order books of lenders and borrowers. Lenders offer the amount they are willing to lend, the interest rate, and the maximum lending period, while borrowers specify their conditions. The rightmost column shows the matched transactions.

Will I lose the money I lend?

There is a possibility, but it is low. When using margin trading on Bitfinex to borrow money for cryptocurrency investment, the borrowed money can only be used on the platform and cannot be withdrawn from the exchange. Therefore, the chance of investors not repaying is only when they incur significant losses in trading, leading to an inability to repay, resulting in losses for the lenders. Hence, a mechanism has been developed to protect the lenders' funds. When an investor's position incurs losses reaching a certain percentage, the system will forcibly sell the investor's position to protect the lenders' funds. In the traditional stock market, this is known as a "margin call," which will be detailed below.

How much can you borrow at most?

Using Bitfinex as an example, the initial net position value must be at least 30%, meaning the margin loan wallet must hold funds equivalent to 30% of the position value. For example, if A has $30 in their Bitfinex account, they can borrow up to $100 through peer-to-peer margin trading to purchase cryptocurrencies. However, A cannot use the $30 in their account. Therefore, A effectively uses $30 as collateral, borrowing $100 from other market participants, which translates to a leverage of 3.3 times.

When will Bitfinex force liquidation?

According to Bitfinex's rules, when the net value reaches 22.5% of the initial position value, you will receive a margin call notice. When the net value falls below 15%, the position will be forcibly liquidated without further notice, and the margin and generated interest will be returned to the margin provider. In other words, when the borrower's losses reach 50% of the collateral assets, the position will be forcibly liquidated.

Example:

Assuming A collateralizes assets worth $30 and borrows $100 in margin trading, A uses the $100 to purchase Bitcoin when the price is $100 per coin. If Bitcoin's price falls below X, A's Bitcoin will be sold entirely.

For instance, if the price of Bitcoin drops from $100 per coin to $85 per coin, A's position will be forcibly liquidated. The system will sell all of A's Bitcoin and automatically deduct the initial $100 loan + interest from A's account, returning it to the lender.

If A incurs a 15% loss using their funds entirely today, but if leveraging 3.3 times, the loss would reach 50%.

From the examples above, it is evident that the assets of the lenders are well-protected under this mechanism unless there is a sudden drop of over 30% in cryptocurrency assets, which is highly unlikely.

For a more extreme example, if A has received a margin call notice and their net value has dropped to 15%, and at that exact moment, the cryptocurrency A purchased plummets by over 15%, creating scenarios where the system cannot immediately liquidate A's assets or even if the system sells all of A's assets, it is insufficient to repay the margin provider. Is there a possibility for these circumstances to occur?

On March 12, 2020, the cryptocurrency market experienced an unprecedented crash, with Bitcoin plummeting by 44.5% in a day, dropping from a high of $8,000 to a low of $4,410. The largest intra-minute drop was 7.46%, making it a matter of milliseconds for the system to force liquidation. A 7.46% drop in a minute is well within the system's capabilities. Thus, for borrowers, their funds are relatively safe. Furthermore, Bitfinex only allows margin trading for mainstream coins, and the probability of mainstream coins with market values in the billions plummeting by over 15% instantaneously is almost negligible.

When you become a landlord for interest, how do you profit?

As mentioned earlier, the interest income from traditional securities trading borrowed by brokerages is substantial because skilled traders can conduct short-term operations, potentially yielding profits of over 10% within a few days. Therefore, they are willing to pay high interest rates to brokerages.

What about the cryptocurrency market?

According to Bitfinex's USD lending rate data from 2016 Q3 to 2020 Q1, the quarterly lending rate in 2017 Q2 was 11.22%, which translates to an annualized return rate of up to 44.88%. Of course, interest rates cannot remain at such high levels consistently. When extended over three years from 2016 to 2020, the average annualized return rate remains around 18%.

The reason why the cryptocurrency market can offer such high borrowing rates is due to its "high volatility," allowing professional traders to accept higher borrowing costs for leverage trading.

With such high returns, is the Bitfinex platform secure?

Before we begin, let's look at the transparent asset ranking provided by Bituniverse within the platform on July 29, 2020. The ranking data is provided by PeckShield and Chain.info, meaning it is not provided by the exchange but collected and analyzed by a third-party organization based on on-chain data, including the "known" assets of the exchange and user-held assets stored on the exchange. The higher the asset value, the more it indicates several points. Firstly, if the assets belong to the exchange, it shows that the exchange has more assets, allowing them to compensate users with more assets in case of a problem. If the exchange itself is struggling to operate, it increases the risk of an exit scam and decreases the willingness to compensate in case of an issue. If many of the assets belong to users, it indicates that users trust the exchange significantly, which is why they hold substantial assets there. Wealthy individuals are more concerned about the security of their assets, so the more transparent assets there are, the more trustworthy the exchange is considered. Bitfinex ranks 4th in the list, which is quite high up. It's not surprising to see prominent exchanges like Coinbase, Huobi Global, and Binance leading the list.

Furthermore, Bitfinex, established in 2012, is a long-standing exchange registered in Hong Kong. The platform offers various services, including spot trading, margin trading, peer-to-peer margin trading, over-the-counter trading, and derivatives trading. Bitfinex holds a significant position in the crypto sphere, acting as a pioneer in the industry and one of the few exchanges from the early days that have survived. Many early exchanges closed due to theft or running off with funds, but Bitfinex's continued operation signifies a belief in sustainable business practices.

Lastly, and perhaps most importantly, Bitfinex is backed by Tether, known as the "Federal Reserve of the cryptocurrency world." Tether's stablecoin USDT is currently the most widely circulated and used stablecoin in the market, utilized by nearly all exchanges. The relationship between Bitfinex and Tether's top management can be described as "close," with many of Tether's fund flows tied to Bitfinex.

However, Tether has also faced many scandals, such as over-issuing stablecoins and misusing public funds. The risks associated with Bitfinex or Tether are undeniable. If either encounters significant issues, it would undoubtedly have a catastrophic impact on the entire cryptocurrency market.

All investments carry risks, but considering the risks and potential returns, participating in Bitfinex's lending transactions, in the author's opinion, is worth a try.

[This article is authorized for reprint from Zombit Coin Notes]