(Bloomberg) -- After hackers stole $69 million from Bitfinex last year, the bitcoin exchange’s fate seemed sealed: lawsuits, bankruptcy and years of liquidation proceedings.
That’s what happened to Mt. Gox, the high-profile marketplace for trading the virtual currency, which lost $480 million. There were also other smaller implosions such as Cointrader and Bitcurex.
But against the odds, Bitfinex pulled out of its spiral dive, announcing last month that all customers were repaid. The exchange posted its most profitable month and claimed its spot as the largest bitcoin venue for U.S. dollar trading. “We’ve demonstrated an alternative to bankruptcy,” said Phil Potter, 45, Bitfinex’s chief strategy officer.
Behind the turnaround, unusual in an industry with few safeguards, is a combination of an uptick in market activity that boosted fee-based income and a mostly successful effort to mollify angry customers with an innovative market-based solution to how everyone would be compensated. Assuming the strategy doesn’t unravel down the road, Bitfinex may prove to be a valuable template for how the bitcoin community deals with a crisis in the future.
On Aug. 2, as the U.S. presidential election got into full swing after the Republican and Democratic conventions, Potter got an early morning phone call at his beach home in Long Island saying hackers had breached security and were draining customer deposits. Bitfinex’s executives don’t work in a single location, but are peppered throughout the U.S., Europe and Asia. Its parent company iFinex Inc. is incorporated in the British Virgin Islands, while back office functions are done in Taiwan, technology support is concentrated in London and the compliance team is run out of Hong Kong.
While the exchange succeeded in protecting U.S. dollar and other currency deposits, by the time they could block access, thieves had walked away with about 57 percent of bitcoin deposits. Even though the virtual currency exists as software, it can be stolen and transactions are irreversible. In the aftermath, bitcoin briefly slumped 15 percent against the dollar.
“The first thought we all had was, ‘Oh my god, is this another Mt. Gox?’" said Harry Yeh, managing partner at digital currency dealer Binary Financial and a large Bitfinex customer.
A key concern was whether another large bitcoin exchange implosion would undermine the virtual currency’s ecosystem and trigger a bear market like the one that followed Mt. Gox’s demise in 2014.
As Potter, who once worked in Morgan Stanley’s wealth-management business, and other Bitfinex executives assessed the damage, they spoke to bankruptcy lawyers. After four sleepless days, they decided against shutting down the exchange and bet they could pull out of the mess.
The first step was the toughest. Bitfinex decided to ‘socialize’ losses evenly among all customers and apply a 36 percent haircut to every account. Even though some people’s bitcoin weren’t stolen, the exchange had a margin lending system that affected almost everyone. Unsurprisingly, users whose accounts weren’t breached were outraged and began rounding up allies to file class actions.
“We thought we might still have had to go in to bankruptcy, and if we did, this is likely how it would have had to work out: everyone takes an equal hit," Potter said.
On the whole, however, the community saw the benefits of avoiding a drawn out bankruptcy with their money locked up indefinitely, and were relieved to receive at least 64 percent of their money back.
Next, Bitfinex sweetened the deal by issuing IOU tokens to each customer equal to the 36 percent that was taken from their accounts. Management promised the tokens would eventually be exchanged for cash or equity in Bitfinex’s parent company.
In another clever move, Bitfinex said users could trade the tokens and let the market decide how much they were worth. Customers who wanted nothing more to do with Bitfinex could sell the instruments at a discount and walk away. Those who believed they would be repaid could gamble on a recovery by snapping up more tokens, although U.S. customers were given fewer options in order to comply with local regulations.
Initially, the price of each token plunged to around 15 cents on the dollar, indicating that traders thought there was only a one-in-eight chance the exchange would make good on its promise to pay back losses.
Then, the value of each token began to pick up as Bitfinex’s big customers started buying. Within a month, prices were at about 50 cents on the dollar. Potter said Bitfinex insiders and employees were barred from trading tokens.
Eventually, a virtuous cycle kicked in. As the tokens rose in value, confidence swelled and traders returned, boosting earnings from transaction fees and the likelihood of a successful turnaround. In mid-October, customers agreed to convert about a third of all tokens into equity. The deal valued the parent company at $200 million, underscoring the recovery in confidence.
A bitcoin rally that began last year, with prices more than doubling since August, also lifted market turnover. Bitfinex used the profits and drew down reserves to exchange more of the tokens for cash each month. The cycle continued until March when, with income at an all-time high and tokens trading at more than 90 cents on the dollar, management redeemed the remaining tokens and announced the recovery complete.
“They didn’t go into receivership, nobody lost money and now if anything they’re back and bigger and more profitable than ever,” said Binary Financial’s Yeh.
Not everyone was happy. Some smaller customers sold their tokens early, failing to recoup most of their losses. Essentially, the token market inherently favored bigger customers, whose close relationship with Bitfinex gave them a better idea of their potential. That also made it harder for disgruntled users to find allies to sue the exchange.
Still, it might be too early for Bitfinex to celebrate. Two weeks after announcing the $69 million was paid off, Bitfinex was forced to halt withdrawals and deposits of fiat currencies after its banks stopped processing payments. Potter said the situation is improving, but it remains unclear when access to fiat funding will be restored.
Meanwhile, Mt. Gox’s customers are still waiting for details on when and how much money they’ll get back. The trustee overseeing the liquidation told creditors in March that the investigation "is still on-going."
While it’s not clear whether Bitfinex’s recovery strategy is one that will be adopted for another crisis, the idea of using tradeable tokens is catching on. Used as derivatives that represent a share of future profits, equity or any other underlying asset, the tokens are gaining in popularity because they are unregulated and can be immediately bought and sold.
“Bitfinex’s recovery is an example of people starting to get creative with how to utilize tokenized systems to engineer solutions or mechanism that previously didn’t exist,” said Brian Lio, who runs research firm Smith + Crown. “Groups are going to step forward and try and come up with solutions in the absence of regulations.”
(An earlier version of this story was corrected to show that employees were barred from buying or selling tokens.)