https://twitter.com/kanzure/status/838517545783148545

How often do you check your wallets? Have you ever looked in your wallet and found all your bitcoin gone or missing? Last summer, somebody, a friend of mine checked his wallet and found that 100,000 bitcoin was gone. What the hell, right? But that's what happened at Bitfinex last summer. Some hacker got into their hot wallet and stole 100,000 bitcoin. This was $70 million bucks. Of which 1.5 million was mine.

I spent the last 6 months trying to figure out how to... to understand it, how to manage it to minimize the chance of this happening again. What have I studied in the past 6 months to try to prevent future losses?

First some background on what happened last August 2016. On August 2nd, the Bitfinex... let's see. No slides? What's that? Ah, it's over here. Okay. Alright. How do I go back? I'm going forwards, so how do I go back? Okay. I'll leave it on there.

So last August, when Bitfinex was hacked, 36% of all their digital assets were stolen, both.. their digital assets. Bitfinex decided to not go bankrupt like MtGox did. Instead what they decided to do was try to continue and promise to pay back the people that lost the money. They did that by issuing first of all they socialized all the losses. Even though not all of the bitcoin--- as I said, 36% was stolen. None of the whitecoin was taken, none of the cash was taken, only the bitcoin. They first decided to socialize the losses. 36% of all their assets, everyone took a haircut of 36%, no matter what assets you had or who you were. And then they issued IOUs, promises to pay them back. These were in the forms of digital tokens called BFX. These tokens were freely tradeable on the exchange, they traded between $0.20 and $0.80 cents on the dollar. This was a way for the market to predict whether they would get their money back. Bitfinex offered to exchange these tokens into equity in the company, at a price of about $200 million valuation. So $70 million losses converted into a company worth $200 million roughly. So eveyrone who lost bitcoin, had the right to take 1/3rd of the company. So people would be able to get back their losses and to enjoy the cash flows of the company. We felt this was a better solution than MtGox because in MtGox only the lawyers make it out okay. And here there is at least a chance of you getting your money back.

Since then, we're a market maker and arbitrageurs. We look for price differences. We buy in the US and sell in China. Buy in Europe, sell in Japan, etc. On a second by second basis. We have to keep money on all the 15 different exchanges. Having money on an exchange is counterparty risk, which is the chance that the person you have your money with, goes under, or they are hacked, or they steal the money, or there is some loss. So we have to assess counterparty risk. What did we do to assess that?

Well over, let me see if I can get that, so uh, what we did was we first... this is a list of 16 different exchanges that we interviewed. They are located in the US, China, Japan, Europe, a few other places. They range from relatively early stage bitcoin exchanges to more mature bitcoin exchanges. They range in volume from 100 bitcoin per day to 100,000 bitcoin per day. There's a mix between the big and the small. We interviewed all the CEOs of these exchanges. We asked them some basic questions. Some of the questions are showed here. How do you protect your hot and cold wallets? How do you prevent internal fraud or collusion? If there is a loss, would you cover customer losses? Do you have those reserves? Financial health is very important. So we asked whether they... I am not used to this laptop. Are you profitable? Do you have insurance? Do you have a bitcoin or banking license? Do you have a good relationship with regulators, with your bank? Tell us about lawsuits you have against you. And what are the other securities?

We spent 3 months interviewing these CEOs, CTOs, CFOs, asking them all these questions. I am going to summarize the lessons learned from this interviewing process or survey, if you will. Integrated in this is, what we believe are the best practices. One cautionary note is that-- these results are generic to what we learned across all 16 exchanges. I'm going to avoid making comment on any one particular exchange.

We like to do business with only profitable exchanges. Ones that have financial resources to constantly invest in improving security. We like exchanges where owners have a strong stake in keeping it going. If it's not profitable, owners have less incentive to keep it going. If it's not profitable, it's harder to attract tech talent, because we know how highly paid they are. Next, we like big name VCs because they do a lot of diligence. I like exchanges that have a relatively low burn rate. A lot of this might sound common sense to you. That's one of my conclusions.

We like CEOs who are highly communicative. During the Bitfinex hack, we were speaking with the CEO and other management on an hourly basis until things settled down. We avoid exchanges where CEOs are unwilling to identify themselves or unwilling to have a phone call on a moment's notice. If you have a problem, large or small, you want the CEO to address it.

Next, we want to have CEOs that are very open aobut the inner workings of their companies. What are the financial statements? Who controls the keys to the cold wallet? Next, since bitcoin exchanges are private companies, they usually don't disclose financial statements. So we have to make common sense judgements about the people. Look at them eyeball to eyeball and ask does their story make sense? Do you trust him? Does he have a prior track record of success? How much does she have invested in this? Is she hungry, or is she fat and happy? You want to trust someone who has good jugement and will make good decisions especially in a crisis.

Will you cover my losses if there is a big loss? If not, that's a dealbreaker, we walk away. In some jurisdictions where there is a banking license, it's a requirement that they cover customer losses. The final point on this slide is that we like to do business with those who have the cash to cover the losses.

Back in... a bitcoin exchange that has a bitcoin license or banking license, is good where the regulators require that they have large cash reserves to cover customer losses. Some licenses, you have to be careful, do not require those reserves, such as those offered in Japan. Having a license is no substitute for good license. In real estate, the saying is location location location. In private equity, it's management management management. As markets evolve, we only want to do business with people who can evolve with the market and stay ahead.

We like exchanges that don't change their banks every few months, such as those in China. This can be a yellow flag. We like CEOs who put their customers ahead of their own interests. In the Bitfinex hack, their CEO would tell me that his first priority was to compensate customers for their losses before he gets his own money back. In our survey for insurance, we only found 1 bitcoin exchange that had any kind of insurance. I'm still skeptical, because insurance companies aren't in the business of giving payouts, but rather collecting premiums.

In terms of internal fraud controls, how do you guard against collusion of the top management? I just had a funny conversation the other day with a Japanese exchange CEO and asked him what prevents him and his colleagues from stealing all the bitcoin. He laughed and said I'm a shareholder I'm not going to steal your money. There's nothing to prevent the CEO of any exchange from walking out the door with all the bitcoin. You want to put your money with the CEOs that have a greater incentive to keep things running, rather than running out to Mongolia and living as a fugitive. Many of the exchange CEOs we do business with are now wealthy individuals. So why go to Siberia or Mongolia and have an awful life as a fugitive?

Here's a question that we never got a satisfactory answer to. How do you prevent against kidnapping of the top executives that hold the private keys to the cold wallet? I don't think you can protect against this unless you have a team of bodyguards. The way to prevent this is to not tell anyone who has the private keys. And then give the private keys to people across cities.

About the hot wallet, how do you prevent hacking against the hot wallet? We like exchanges that keep as little as possible in the hot wallet, for as little time as possible. I think Bitfinex's biggest mistake was keeping everything in their hot wallet, no matter how good they thought Bitgo was. Only keep the hot wallet hot for a few milliseconds. Do it in small batches, do it multiple times a day. It reminds me of an old bank robbery movie where the thiefs found that the bank truck drove past the same spot every single day at the same exact time. The idea is to avoid repeatable patterns.

How do you protect the cold wallet? Usually 90% of the bitcoin is in there. So that's where the honey pot is. Taking the multisignature, keep the keys and hardware in a vault, in different places, different cities, restrict the access to the top 3 people and have reliable backups.

If the exchange provides leverage, how much margin does it offer to its customer? Is it 3-to-1? 10-to-1? 50-to-1? 100-to-1? With the higher leverage, it could potentially be a red flag. Whta happens if they are lending money at 100:1 to buy bitcoin long, and then there's a 10% or 20% drop? This would result in negative equity. And then who takes the loss? Do socialized losses across all the exchanges as the Chinese companies do? or does the exchange absorb the loss? If the exchange absorbs the loss, does it have sufficient cash reserves?

We like jurisdictions that have favorable regulatory environments for Bitcoin, like NY state, Japan, Luxembourg, have very favorable government regulations about bitcoin. An example of an unfavorable regulatory environment would be China.

As a trader, we believe in diversification. We don't put more than 10% of our digital assets in any one exchange. We learned htis the hard way by having more than 40% of our assets in Bitfinex at the time of the hack. As traders, we take our bitcoin out immediately to our own cold wallet. Same with fiat. If the cash is not being immediately used, we wire it to our own bank. If the exchange socializes their losses, we want the assets out of their reach.

Finally, we monitor, monitor and monitor. We try to be vigilant about watching our golden eggs. We look for yellow flags, we monitor all the chatrooms, we go to the bitcoin conferences to pick up hints and clues. In conclusion, as I said earlier, running a bitcoin business is no different than running any other business with respect to its people. We want to deal with knowledgeable, competent trustworthy people who run profitable businesses. Before you put your money into any bitcoin exchange or bitcoin company, use your common sense about the perceptions of the people you're dealing with. If it smells bad, it's bad. Where there is smoke, there is usually fire. Ask good questions and expect good answers. If they avoid your questions, then avoid them. Do good due diligence. Be a healthy skeptic. Hope for the best, but plan for the worst.

The biggest danger in the bitcoin business is that you don't know what you don't know. As a fund manager, people always ask me what my biggest loss was historically. I tell them it's not exactly relevant, because you're driving through the rear-view mirror. Your worst loss is always ahead of you, not behind you. On the other hand, what doesn't kill you makes you stronger, a smart person will come out stronger. When you do suffer that future loss, I hope you will emerge stronger.

Thank you. Happy to answer any questions or comments and reactions.