Daniel Cawrey is chief executive officer of Pactum Capital, a quantitative cryptocurrency investment firm and hedge fund. Sina Nader was a professional money manager at Morgan Stanley as well as Credit Suisse and is now head of investor relations at Pactum.

The views expressed are those of the authors and are not investment advice.

“History doesn’t repeat itself, but it often rhymes”

This quote is often attributed to Mark Twain. And while Bitfinex doesn’t exactly rhyme with Mt. Gox, there are several parallels in the stories of these two exchanges. People interested in understanding Bitfinex are well-served to understand what happened with Mt. Gox.

Bitfinex and Tether were investigated by the New York York Attorney General (NYAG). Here’s a synopsis for those unfamiliar with the story. Bitfinex is a cryptocurrency exchange, the owners of which also control Tether, issuer of the most popular stablecoin, known as tether or USDT. The NYAG accuses Bitfinex of losing over $800 million. It alleges the exchange tried to recoup those losses by dipping into the cash reserves of tether, the stablecoin its principals also control.

Problem is, taking money held by Tether would render the stablecoin more or less useless. This is because Tether is supposedly backed by cash reserves and there are people who still believe this. Yet if there are no cash reserves, or significantly less cash than believed, then the whole concept of Tether is essentially fraudulent.

This is laid out in the filing from late last week. At the end of the document, the NYAG issues an ultimatum. The office “does seek to enjoin Respondents from taking any further action to access, loan, extend credit, encumber, pledge, or make any other similar transfer or claim between Bitfinex and Tether.”

Where’s the money?

The cliff for BTC on Coinbase April 25 once the Bitfinex/Tether lawsuit dropped. Source:Tradingview

One may rightly wonder: how exactly did Bitfinex manage to lose more than $800 million? The answer is closely intertwined with the exchange’s banking relationships, or lack thereof. Crypto “OGs” and insiders may be feeling like they’ve seen this movie before.

Indeed, those feelings would be quite valid. In the early days of crypto, one of the largest bitcoin exchanges, known as Mt. Gox, also got into significant trouble due primarily to its banking relationships. It got so bad that in February of 2014, Mt. Gox stopped all trading and filed for bankruptcy protection. At the time, it claimed to have lost 624,408 BTC.

What unbanked, noncompliant cryptocurrency exchange holdings look like. Source: Wizsec

A Japanese bank that handled Mt. Gox’s cash transactions had been trying to close its account. In addition, no U.S. banks would work with Mt. Gox. This made it essentially impossible for Mt. Gox to send users’ cash back to them when they tried to withdraw their money. Users experienced delays of weeks or months until the exchange shut down unceremoniously.

In the case of Mt. Gox, the fallout lingered for a long time and still continues to this day. If history is any guide, we can expect any potential fallout from significant troubles experienced by Bitfinex to linger too. While this should give many participants in the crypto industry pause, it is an excellent opportunity to reflect on the state of crypto in general – and for the crypto space to do a little soul-searching.

Exchange implosions

At issue in 2019 is the presence of so many problematic cryptocurrency exchanges. Spectacular failures where hundreds of millions of dollars go missing, in the case of Bitfinex, are not good. The fact that this appears to be happening again in the span of five years speaks volumes.

From the Mt. Gox crisis docs. Could other failing exchanges try to follow this same playbook? Source:CoinDesk

This industry is still young, immature, and experiencing growing pains. These latest issues with Bitfinex are also a learning opportunity. It’s now clear that exchanges without normal banking relationships are the weakest link in this volatile market. Now prominent traders and funds have been pulling assets from exchanges in fairly large amounts.

Inflow/outflows on BItfinex by USD value. Activity has increased since the allegations were announced. Source: TokenAnalyst

One can understand why exchange outflow would increase in the current environment. Certain exchanges clearly cannot be trusted to safeguard cryptocurrency assets.

It is time for some of the best engineers and developers to turn their attention to the most basic of mandates: Compliance and custody for crypto. Until there is an improved layer of trust, it will be difficult for this industry to grow in ways many advocates want to see.

Lawyer Stephen Palley knows crypto folks want BTC to be worth a ton. Yet that will only happen with much stronger and more compliant exchange infrastructure. Source: Twitter

What does ‘custody’ really mean?

Cryptocurrency goes beyond just computer science at this point. Experts are needed – people who have experience in the various arts and sciences needed to safeguard large amounts of money.

This is what is meant when using the word “custody.” More security, legal, regulatory, and compliance experts are required to push this ecosystem to new frontiers. Auditors, accountants, and experienced financial operators with enough seasoning in the traditional world. These people should have a vision for the challenges and also the amazing promise of crypto. And innovations in bank-backed stablecoins such as USDC and PAX are a great start.

“History doesn’t repeat itself, but it often rhymes.” There’s certainly a familiar rhyme going around right now. It’s easy to look back at Mt. Gox and see similarities to Bitfinex and Tether. This time, though, it’s arguably even more complex given the Tether stablecoin inflows and outflows.

Yet all the same signals, like the large price spread between Bitfinex and regulated exchanges such as Coinbase, are there. And we can stop the repetitive, “Groundhog Day”-type scenarios. We can do better and not let this happen ever again.

Bill Murray is trapped in a mysterious time loop in the movie “Groundhog Day.” Crypto doesn’t always have to repeat the same mistakes over and over. Source: Moviefone

We may be trying to build a better world at the intersection of finance and technology with crypto. However, perhaps it is time to acknowledge that we can learn some things from the legacy financial systems on Wall Street we are working to upgrade.

It’s not about “teaching an old dog new tricks,” but rather about a young, promising puppy learning a few tricks from the old dogs who’ve been managing money for a couple of centuries.

Mt. Gox image via CoinDesk archives.