If you’re the operator of a large trading platform, charged by a US prosecutor with fraud, misusing customer funds and covering up losses, what do you do? Plead guilty in response for a smaller fine? Seek protection from creditors? Or collect even more money from clients and try to trade your way out of a hole?
For a traditional financial institution, the answer is usually to settle the claim, express contrition and try to draw a line under past mistakes. If the losses and fraud are overwhelming, bankruptcy may be the only option.
But in the world of cryptocurrencies, the answer is different.
Within three weeks of being charged with fraud by the New York Attorney General, iFinex, the owner of the Bitfinex cryptocurrency exchange, announced a major new fundraising. It said it was conducting a $1bn private sale of a new utility token called ‘LEO’ in a so-called Initial Exchange Offering (IEO).
“Token holders will experience benefits across iFinex cryptocurrency exchanges and are expected to obtain benefits from future iFinex projects, products, and services,” Bitfinex said when announcing the sale.
iFinex subsequently announced that it had sold out the whole of the LEO offering in a single day, May 10, in exchange for $1bn worth of tether tokens held by clients.
Tether, which is operated by the same entities that control Bitfinex, is a so-called stablecoin, pegged one-to-one against the US dollar. Around $3.3bn of tether are in issue.
In its court order, filed on April 24, the New York Office of the Attorney General (NY OAG) produced evidence that Bitfinex, despite earlier promises, had stopped providing full backing for tether in the form of dollars set aside in bank accounts specifically for that purpose.
Instead, said the NY OAG, early in 2019 Bitfinex had started to use inter-company loans as part of tether’s backing, without disclosing that it was doing so.
On May 22, Bitfinex said that it had obtained a temporary stay in the New York Supreme Court of some of the Attorney General’s demands, arguing that the OAG lacked jurisdiction over Bitfinex and Tether, which do not do business in New York state, and that New York’s law enforcement powers in connection with securities fraud cannot be used extraterritorially.
A further hearing in the Supreme Court is scheduled for July 29.
Doubling down to escape from trouble
Legal uncertainty notwithstanding, the LEO IEO seems a remarkable success, even if Bitfinex itself provides the only measure of the token’s value: on June 11 a LEO token was worth $1.889, says Bitfinex, up 89 percent in a month.
The LEO sale is not the first time Bitfinex has doubled down to escape from trouble.
In August 2016, Bitfinex suffered a hack of 119,756 bitcoins, worth nearly $1bn at current market prices.
The exchange responded by socialising losses among affected clients. It created a new token called BFX, crediting customers with one BFX token for each dollar lost as a result of the hack.
In less than a year, Bitfinex was able to make BFX holders whole, albeit helped by a rally in cryptocurrency prices. On August 3 2016, the day after the hack was announced, the bitcoin/US dollar price was $485, but by April 2017 it had risen to over $1000.
“Within eight months of the security breach, all BFX token holders had their tokens redeemed at 100 cents on the dollar, or had exchanged their tokens, directly or indirectly, for shares of the capital stock of iFinex Inc. All BFX tokens were redeemed and destroyed through this process,” Bitfinex said in its May 2019 white paper announcing the sale of LEO.
An IEO boom?
Some cryptocurrency exchanges, mostly based in Asia, see the IEO structure used by Bitfinex as ideal to promote the next wave of token-based corporate or project fundraisings.
Specifically, they say, it addresses the shortcomings of Initial Coin Offerings (ICOs), which witnessed a boom and then a dramatic bust in 2017 and 2018.
“An IEO is a fundraising event that is administered by an exchange”, Binance, a cryptocurrency exchange, says on its website.
“In contrast to an ICO, where the project team themselves conduct the fundraising, an IEO means that the fundraising will be conducted on a well-known exchange’s fundraising platform,” Binance says.
“The ICO fever in 2017 proved to be a very high-risk environment for individuals wanting to participate in new blockchain project token releases, from accidentally sending funds to the wrong wallet, or some project teams absconding with funds,” Binance adds.
Around $518m has been raised through IEOs this year, according to data from TradeBlock, cited in a June 8 Wall Street Journal article.
ICOs raised over $20bn in 2017 and 2018, although the pace of issuance dipped sharply in the second half of last year, in response to the bear market in cryptocurrency prices and much-increased regulatory scrutiny.
Regulators are still working through a case list of ICOs they perceive as disguised securities offerings: last week the US Securities and Exchange Commission charged the issuer of a 2017 ICO, Kik Inc., with conducting an illegal $100m securities offering of digital tokens.
The exchanges conducting IEOs seem to think they have a better chance of staying one step ahead of the rules. For example, exchanges may already have procedures in place to identify customers and to ensure they are selling IEOs only to accredited investors, and they may block clients from certain jurisdictions.
Binance, for example, bars entities based in 29 countries, including the US, but also Iran and North Korea, from accessing its website.
Cryptocurrency exchanges may also say they are performing some kind of quality control on the IEOs they sponsor. Binance, for example, says that it is staking its reputation behind the projects sponsored on its IEO platform, offering a higher degree of trust in individual fundraising projects.
IEOs certainly promise a lucrative new line of business for the cryptocurrency exchanges sponsoring them: exchanges may charge up to 10 percent of the funds raised, according to one report.
An investment in regulatory arbitrage
Many remain sceptical of the whole IEO phenomenon.
“Cryptocurrency exchanges like Binance and Bitfinex are doing token offerings,” said Myles Milston, CEO of GlobaCap, a capital markets platform focused on issuing debt and equity securities in blockchain form and in full compliance with existing securities regulations.
“These tokens are not securities—they are just a means of payment. But when they eventually start conducting securities offerings in exchange for those tokens, the exchanges will still need to ensure that the appropriate know-your-customer (KYC) tests have taken place, that they have conducted the appropriate investor suitability checks and made sure the right risk warnings are in place.”
“They haven’t solved for that yet,” said Milston.
“IEOs are 100 percent marketing,” he added. “But they also help the exchanges in providing cash flow up front.”
“IEOs are just rebranded ICOs,” Nic Carter, partner at Castle Island Ventures, told New Money Review.
“People like them because they resolve the uncertainty around time to liquidity: most ICO investors had to play this game where they waited for exchange listings. And it would often take months for a new ICO to get listed. So this is is the natural conclusion,” said Carter.
“But IEOs are likely to make exchanges liable as well. They are directly underwriting these raises, which are most of the time unregistered securities,” he added.
Others see IEOs as a novel attempt to get around securities law.
“Two years ago, everyone and his cousin was launching an ICO. Now, only people that can afford the investment in regulatory arbitrage can do it. It’s a more restricted game,” said Giacomo Zucco, chief executive of BHB network.
But could IEOs still provide a new upward leg to the cryptocurrency boom? For those monitoring the phenomenon, one entity is worthy of close attention, says Zucco.
“I’d watch Bitfinex closely,” he told New Money Review. “They’ve already survived a number of black swan events. I wouldn’t be surprised if they used LEO to create an informal revenue-sharing process that can survive regulatory attempts to take it down.”
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