Bitcoin Money

‘Fastest Growing Bitcoin Business’ Paying Interest On Deposits

Today Bitcoinica began testing an incentive to attract deposits to its leveraged trading service — the only one of its kind where bitcoin positions are traded.  An announcement of the incentive was posted on the BitcoinTalk forum by Zhou Tong, Bitcoinica’s founder.  Essentially, Bitcoinica has started paying interest to those holding balances in their accounts with the service and will start passing through interest rate differentials to those using leverage to hold BTC/USD positions.

Generally, those holding a long BTC/USD position (anticipating a rise in the exchange rate) will be paying interest and those with a short BTC/USD position (anticipating a drop in the exchange rate) will be receiving interest income.

Bitcoinica began operating its forex-like service in September, 2011 and has become the ‘fastest growing Bitcoin business’, according to Tong.  That claim is likely true.  Trades on Bitcoinica don’t measure the same as trades on Bitcoin exchanges as trades on Bitcoinica don’t cause bitcoins to actually trade hands.  But the volume Bitcoinica sees daily can oftentimes exceed a third or more of all the bitcoin trades occurring on all the other Bitcoin exchanges combined!

A contributing factor to Bitcoinica’s growth has been that its margin accounts are trivially easy to open and leverage is granted automatically without restrictions.  To get started a trader transfers bitcoins or USD funds even using methods convenient to bitcoiners.  Those arriving funds will then show in the balances for the trader’s currency account.

An account’s margin balance is then calculated based on the combined currency account balances — the USD balance plus the current value of the bitcoins held on deposit.  A trader can then self-manage the account’s leverage ratio, from 2.5:1 all the way up to a very risky 10:1. 

Because a long BTC/USD position can be purchased using leverage gained through a margin balance funded by bitcoins themselves, Bitcoinica uses reserves of USDs to enable that leveraged transaction to be made.  There has been more demand for these reserves than supply is available and as a result Bitcoinica has to deny new trades when reserves are insufficient — a condition that seems to have been occurring more often than not over the past several weeks.

By paying interest for deposits Bitcoinica hopes to attract additional funds.  With USD deposits earning nearly 20% APY (the current cap set by the exchange), it would seem that the exchange should find no shortage of funds arriving from depositors seeking higher yields.

But there’s the rub.

Bitcoinica is today likely operating without being in full compliance with the law in jurisdictions where it has customers, including the U.S.

Tong claims to be the official operator of Bitcoinica and CEO of xWayLabs, Inc. which is registered out of Delaware.  Unclear at this time is whether or not xWayLabs has any legal relationship with Bitcoinica other than having the same owner . [Update: re: xWayLabs of Deleware.] Tong does indicate that “there is going to be a change in the corporate status to allow financial services to be provided with full compliance, but we are unable to disclose more information”.

Tong does admit “we are holding a huge amount of customer deposits” but also expresses his intention to “make our legal information fully available to our users” in a matter of “a few weeks”.

While Tong may be confident that customer deposits will be safe and that withdrawals can be made unimpeded, his comments might indicate naivety.  Faced with a concern from a customer that withdrawal will require identification Tong responds “Currently we don’t have any KYC procedures. […] Just don’t worry about it.”

The young Zhou Tong is not the first individual to attempt to fly under the regulator’s radar while operating a business that is not yet in compliance.  Bitcoinica has already grown large enough to be noticed but the addition of 20% APY interest payments on USD deposits plus not following anti-money laundering (AML/KYC) requirements is like painting a big red target on your chest.  Even if Bitcoinica has a plan to get itself “in full compliance”, it may not have the “few more weeks” to do so.

[Update: March 1, 2012 - Following a security breach at a hosting company used by Bitcoinica, over 43K BTC (or more than $200K USD worth of bitcoins) was stolen.  Bitcoinica’s CEO claims they have sufficient reserves to cover the loss and will continue to operate the service.]

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