Unchained - Teetering on the Edge: How Black Thursday Exposed the Flaws in the Crypto Markets - Ep.164

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Starting point is 00:01:09 store, all with up to 5% back. Download the crypto.com app and reserve yours now. Today's guest is Kyle Samani, managing partner at Multi-Coin Capital. Welcome, Kyle. Hey, Laura, good to be back on the show. You wrote a couple of really interesting blog posts last week that refer to some of the events on March 12th, which we'll call Black Thursday for listeners who, because we're going to be referencing events throughout that day throughout the show. And on that day, due to panic over the

Starting point is 00:01:43 coronavirus and its effect on the economy. And amid a much wider sell-off, the crypto markets crashed in two legs, as you wrote about in one of your blog posts. And you say in the first blog post that in the second leg, the market structure of the crypto markets broke. So why don't you just kind of broadly describe the events of that day in crypto? So just for clarity, so if you look at kind of the like coin market cap, you'll see a lot of the events are reported on the UTC time. And actually the first leg down happened on the 12th and the second leg down happened on the 13th. And the U.S. It was basically morning and evening. And so I'm just going to refer to the two legs as morning and evening, just for simplicity.

Starting point is 00:02:27 So the first leg down happened at about 5 a.m. central time, 6 a.m. Eastern time on the 12th. We don't know with 100% uncertainty what caused it, but definitely someone who held a lot of Bitcoin, started selling to Bitcoin. The two best theories are one that someone was derisking because they were kind of concerned about global macro and as a result of the coronavirus. And the second theory is that the plus token scammers from kind of last summer. sold off Bitcoin and presumably they wanted to do that in the guise of it kind of being aligned with the coronavirus. They had a chance to see the U.S. futures markets, you know, limit down

Starting point is 00:03:04 the night before. And so they kind of assumed that everyone would rightfully just assume that the broader markets were the cause. So those are the two best theories. It feels like a high probability that one of those is correct. There is a possible third theory. There are other possible theories, but none of them that I think make a ton of sense. And so it's very likely that one of those two things cost the first leg down on the 12th. That moves Bitcoin from about $7,500 to about $5,800 or so over the course of about an hour. So it was a very large and very fast move. And then the kind of price is stabilized throughout the day.

Starting point is 00:03:37 I can tell you from our side, you know, we work with a lot of other market participants, exchanges, market makers, desks and stuff. And obviously the day for all of those guys was really hectic. And a number of people got margin called, meaning that they had posted collateral to borrow some assets. The value of the value of the assets they borrowed, it decreased such that the value of the collateral was now higher than the

Starting point is 00:04:00 value of the assets that were borrowed. And so, assuming the value of the assets borrowed was higher than the value of the collateral. And so those lenders were trying to work with the borrowers to figure out how to either get more collateral or repay the loans. And so that kind of

Starting point is 00:04:16 back and forth went between a lot of lenders over the course of the day. And what appears to be the case is that that some number of borrowers were unable to either post more collateral or repay the loans. And so the lenders in the evening started liquidating collateral. And that's what caused the second leg down. Unfortunately, during the second leg down, then we kind of started hitting some mechanical problems in the crypto markets. And that's kind of why I said the market structure broke. Yeah. And you have a really great dissection of how the crypto markets have these

Starting point is 00:04:46 unique characteristics that kind of played into what happened there. So I don't, I don't don't know if you can remember all nine of them, but you laid out nine different ways that they, you know, are kind of distinct from traditional markets or or have their own unique characteristics. So can you at least lay out the major ones, if not all? Sure. So the most unique thing about crypto is that there are a lot of trading venues where people trade, and they all trade the same assets, you know, Bitcoin, Ethereum, right, rebel, etc. In traditional markets, by and large, you can more or less think of like, let's say equities as like there being a single exchange where equities are traded.

Starting point is 00:05:24 In FX markets, there are a handful of trading venues, like primarily a few major banks and dealers around the world, like three or four kind of major venues where people trade FX. But in crypto, there's about 10 or so major venues where people trade. And although the underlying, you know, assets are core, the same, Bitcoin, Ethereum, those things, the way they're traded is very different. So you've got spot markets, you've got futures markets, you've got perpetual swaps, which are a form of the futures market, and you've got options.

Starting point is 00:05:52 those being the major ones. And then, you know, different exchanges have different, they trade different products. So not all the exchanges trade all the products. For example, Coinbase only trade spot. They don't have any derivatives. If you look at Bitmex, Bitmex only trades futures and perps. Deribut really just dominates options trading.

Starting point is 00:06:11 And so you've got all these different venues and people trading different products. And of course, as the underlying price of Bitcoin changes, the price of these different derivatives products is also changing in real time. And so what's really, and then on top of that, you've got different kinds of traders who cannot access certain venues, right? So if you just say, like, I want to sell or buy $10 million of Bitcoin, let's just say, like, generally speaking, the not sensible thing to do would be to go to a single exchange and like just eat through the order book on that exchange. The right thing to do, and there's a lot of kind of people who formally know how to do best execution on this stuff is, you know, you look at the order books across all of these exchanges and you'd write pick off the orders off of those. off of all of those exchanges. You'd space it out over time and do those kinds of things.

Starting point is 00:06:54 But that's assuming you can access all of the order books in crypto. A substantial majority of traders in the space actually cannot access all of the order books or even some of the order books. Some people can only access one order book. For example, a lot of Chinese retail traders basically only trade on Wooby. A lot of people who don't want to KYC only trade on Bitmex. And so you've got people who structurally do not want to spread their trades across lots the venues. And so as a result of kind of all of these, you know, unique dynamics of like different

Starting point is 00:07:23 products being traded across different venues and the fact that that people are not, you know, doing quote unquote best execution and kind of taking liquidity across all different venues, you end up with pretty meaningful price deviations between those venues. 99% of the time, those price deviations are close to zero or like maybe they get a little bit beyond the make or takeer fees, but not much. And arbitrages will kind of just arbitrage those. And like, that's fine. But what happened on the 12th was that those prices started getting so out of whack. Arbitrager started having to shuttle money between the exchanges.

Starting point is 00:07:59 Because, like, let's say the price was high on one exchange and the other. But let's say the money they had on each exchange was backwards. So they had it to basically flip the positioning of like the Bitcoin, let's say the USDT that they had across those exchanges. Well, in order to do that, they have to use the blockchain and, you know, withdraw from one exchange and deposit to another exchange. And that takes time. And so on the 12th, like that started happening in such high frequency that basically the Bitcoin blockchain and the Ethereum blockchain became entirely congested. So people were using up all of the block space on both chains. And so gas fees started to go up.

Starting point is 00:08:33 The network started to become congested. Transactions started to start not going through. And so that was like a big problem, just making the whole system more difficult to use. On top of that, because the price went down, a lot of miners started turning off their mining machine. because their revenue was decreasing and the cost of electricity is fixed. And so it actually became unprofitable for them to keep on mining. And so when they do that, that means the rate at which new blocks are coming out is slowing down, which obviously decreases the overall throughput of each blockchain.

Starting point is 00:09:02 And so those two things kind of happening at once basically made it so that people could not move, you know, arbitrages could not move money between exchanges quickly enough. And so the prices started to really meaningfully deviate between those exchanges. on top of that then things got even oh i'll pause there like that was already a lot um yeah well i mean what you're describing just sounds like one of those terrible feedbacks feedback loops like it just was essentially a downward spiral you know the problem was being exacerbated at every step of the way but one thing that i wanted to ask about because it was a little bit confused when i read this in your blog post um you know one btc is one btc and whether or

Starting point is 00:09:45 or not you choose to sell it at 4,000 or 8,000 or 12,000 or whatever it is, is presumably under the miners control. So I kind of don't necessarily understand why it is that they would just turn off their mining equipment immediately at that second because, yeah, I maybe I'm, you know, I just don't understand how they run their business. But I feel like, yeah, I could see an argument for being like, oh, well, you know, they could just hang on to it until the price goes back up. Right. So they can, and certainly miners historically have very much speculated on the price of Bitcoin. As the derivatives markets have matured specifically the futures markets and the options markets, miners have become a lot of miners have gotten blown out like in 2018 as the market crashed. And so they've become a lot more, a lot less willing to take on price risk of Bitcoin. And so fortunately now they can hedge this to a large degree where they can say, hey, my cost of mining Bitcoin is $5,000. I can guarantee lock-in price of $7,000. 7,000. And so I'm going to do that. And I'm not going to take on the fact that maybe the price falls to 6,000 or 5,000 or 4,000. And so a lot of miners are becoming a lot more rational

Starting point is 00:10:53 about that. But if you're, so that has started to happen. However, there are a lot of miners who still are not hedged. And so for them, right, if you're a minor, let's say your cost of mining Bitcoin is 6,000. And as the price of Bitcoin, you hit 6,000, maybe you keep on mining. But like, maybe you say, hey, at 5,500, right, am I going to mine for 10% loss? Like, if it hits 5,000, am I going to mine for, you know, almost 20% loss, 17 or 18, you know, whatever that math comes out to be. And a lot of people start to say, hey, this just isn't worth it. Like, I'll just wait for the price to come back up before I start mining. Why would I mine now and have a guaranteed loss? And so that started happening on the 12th. And then one other thing I wanted to ask about was

Starting point is 00:11:33 you did talk about how there were obviously increased transactions plus higher gas fees and transaction fees. And so why was it that those higher fees were not enough to offset that, you know, the decline in the value of the block reward? Yeah. So I haven't looked at the, the ratio recently, but right, if you just say a minor makes 100% of revenue, I think right now is something like 90 to 95% of minor revenue kind of generically speaking comes from block rewards and only 5% to 10% comes from transaction fees. I don't remember the exact math breakdown, but it's something to that effect. And so like, fees going up like three or four X like it doesn't offset enough to like where they move the

Starting point is 00:12:14 needle right okay all right so um then uh you know in the beginning you talked about how part of the reason for the first um sell-off was perhaps you know a coronavirus or or maybe even the plus token but then um for the second one that was uh what was the cause of that again was that the miners turning off the? Yeah, so the cause of the selling was that there were lenders who had lent out assets and the borrowers became insolvent or were close to becoming insolvent. And so the lender started liquidating the collateral of the borrowers. What's interesting is there's two different types of ways to get leverage in crypto.

Starting point is 00:12:57 You can do it on exchange using Bitmax or Binance or any of the derivatives exchanges, all that you take on leverage. And if you follow any of the Twitter accounts like whale, I think one's called whale calls. I think another one is called Bitnex wrecked. There's probably other ones for the other exchanges. And basically, right, if you follow those accounts, they'll start tweeting out, you know,

Starting point is 00:13:15 this number of contracts liquidated at this price. They're just like bots that tweet that out. So those people are taking on leverage on the exchange. And those exchanges have rules and say, hey, look, if you're levered long, either you're levered long or leveraged short, if the price moves against you, there are some threshold that the exchangeers will just,

Starting point is 00:13:32 they will take your collateral and they will just start market selling your collateral right to make sure that you stay solvent. And so that happens all programmatically in the exchange, just handle that. The other way to take on leverage is to basically call someone, in this case a lender, so think people like Genesis or BlockFi or Matrix Port or those kinds of companies. And those kinds of companies say, hey, you know, if you want to get a yield on your Bitcoin, deposit on the Bitcoin with me and I'll give you a yield like a bank.

Starting point is 00:13:58 And if you want to borrow some Bitcoin, you know, call me and I'll lend you some Bitcoin. And so those guys started to, you know, the people who borrowed Bitcoin and Eith and whatever else they had borrowed, and probably dollars in this case, those people started to become insolvent. And so in those cases, the lenders don't typically programmatically market sell on the underlying exchanges. They always prefer not to liquidate people's collateral. And so they were quite literally calling up, you know, the people who borrowed and saying,

Starting point is 00:14:26 hey, Bob, hey Joe, hey, Jim, you know, you're close to being insolvent. You know, either you need to deposit more collateral or we're going to liquidate your collateral. And so it sounds like they had about 12 hours or so of, you know, back and forth in dialogue. And obviously things did not get resolved in that 12 hour period. And so the lenders, you know, contractually had to start liquidating that collateral. And so that's what caused the second leg down. Okay.

Starting point is 00:14:50 And so like on this chart that you have on your blog post, there's what does this look like, maybe a period of about 12 hours or so where there does not appear to be very many liquidations at all. it sort of flat after the first big spike in the morning. And then then it continues to go up. Is that kind of what happened there? Like, why, why was there this period where it doesn't look like there were any liquidations? Correct. So that's what happened during that 12-hour period was the lenders were reaching out to the borrower saying, hey, guys, you know, here's your balances, here's your, you know, solvency ratios and whatever, you know, you need to either deposit more collateral

Starting point is 00:15:31 or you need to return the loans. And, you know, the contracts between the lenders and the borrowers, you know, they have language saying, hey, we're going to give you this much notice. If you don't respond in six hours or four hours, then we have the right to liquidate your collateral. Once you respond, you know, there's like a whole bunch of provisions in those contracts

Starting point is 00:15:48 about these kinds of situations that very formally defined, right? Like how quickly things need to get resolved. In this case, it seems like it was about 12 hours. It was kind of about the amount of time in whichever contracts were written. and obviously things did not get resolved. And so then at that point, the lenders legally had the right to claim the collateral, and then in order to ensure that their depositors stayed solvent,

Starting point is 00:16:10 that they had to liquidate that collateral. Wow. Okay. So there was another thing here, and I was trying to, there was a lot of speculation about this online. But basically, so there was one point where, so in your blog post you said that there were only $20 million worth of bids left on the entire Bitmex order book and over $200 million in long positions that needed to be liquidated. And you say that that could have crashed the price of BTC to zero briefly. But that

Starting point is 00:16:43 would happen was that Bitmex ended up going down for maintenance. And I did see some people speculating that Bitmex had kind of gone offline to save the price of Bitcoin. Like what do you think happened there? And also how does this play into what you were saying before about the Bitcoin blockchain being backlogged? Yeah. So there's a few kind of compounding variables here. So all of this happened during the second leg down, which was in the evening in the U.S. So once the lender started liquidating collateral, the obviously the prices started Bitcoin started going down more. At that point, there were people who had leverage on Bitmax. I mean, people had leverage on all of the derivatives exchanges. But on BitMex specifically, there was more people who were levered long. And so those those, those. liquidation started to cascade. And the problem was that over the course of the day, people had already done a lot of arbitrages because of the price movements in the first half of the day.

Starting point is 00:17:36 And so a lot of market makers had already moved collateral off of Bitmex to take advantage of arbitrage on other venues. And so the amount of collateral available on Bitmex was lower than normal. On top of that, the blockchain was slowing down because the miners were turning their machines off and because there were just so many transactions that were shuttling around. And so that was, and so is the price of sort of cascading down on Bitmex, what happened was that market makers basically stopped showing up. This is actually common that like in general, when volatility is increased, market makers widen their spreads.

Starting point is 00:18:14 In general, like market makers, their business mandate is every single day, don't lose money. And like if there's a day where market maker lose money, like that's a very bad day for them. And there's all those businesses are run with like very strict risk. controls on making sure that they're not taking on too much risk and not courting spreads too tight so that they lose money. And so on days like on March 12th, right, like those are days that the volatility is really high and they don't want to lose money. And a lot of market makers may have gotten, may have ended up losing money in the first half

Starting point is 00:18:44 of the day. And so they were already just very risk off and scared. And a lot of market makers just said, hey, this volatility is picking up. This is getting crazy. We don't know what's going on. And so a lot of market makers just stopped providing liquidity entirely. And so as the price of Bitcoin started cascading down in the evening, market makers just didn't show up to provide liquidity on Bitmex.

Starting point is 00:19:05 And people keep getting liquidated. There's a few more. And it wasn't not only that, there were obviously not all market makers disappeared, but some percentage did. And so even the ones that wanted to provide liquidity at that point, they just didn't have collateral on the exchange. And so they were trying to shuttle collateral from, you know, Coinbase, finance, what would be wherever else they had collateral.

Starting point is 00:19:25 well, they were trying to send it to Bitmex, but the blockchain was slow. And so they couldn't get collateral to Midmex, and so they couldn't actually provide liquidity. And so as a result of all of that, there ended up being a point where there were $200 million of outstanding liquidations that needed to occur, but there was only $20 million of orders on the bid side of the book. And so, I mean, had the engine, you know, had they not turned the system off or had it not come down, I mean, the price of Bitcoin would have gone to zero. Yeah.

Starting point is 00:19:53 And so if that would have happened on Bitmex, like what would have happened to the price of Bitcoin more broadly across the market? I mean, nothing. Like, that would have only survived for like one or two minutes, three minutes. Like people were obviously trying to send money to Bitcoin. And there is a price, right? Like if, sorry, yeah. Right. Like, let's say Bitcoin is trading for $500 on Bitmax and $4,000 on Coinbase.

Starting point is 00:20:16 Like, there are people who are going to say, right, like when the price discrepancy is that large, like I don't care if I lose everything and Bitmax blows up in the next five. minutes, I'm willing to risk that to try and make, you know, 8X in five minutes, right? And, like, there are people who have that risk tolerance and have the sophistication to do all that stuff. So as the price of the screpancy gets wider, it obviously encourages more people to, to show up. And so at some point, they would have shown up. But, like, the spike on BitNex, you know, it could have printed zero. And that's just, like, a very bad look, obviously. Wow. Yeah. Oh, my gosh. Just so much craziness. All right. So in a moment, we're going to discuss how all of this played out in Defi and also look at what different on-chain technologies

Starting point is 00:20:57 could be solutions or preventative measures to these issues. But first, we're going to get a quick word from the sponsors who make this show possible. Why should you get an MCO visa card from crypto.com? First, it's a beautiful metal card. You can top up the card with crypto and spend anywhere a visa is accepted. You also get up to 5% back every time you spend on all spending, including your morning coffee, gas, or even a new phone. You know they'll pay for your Spotify and Netflix too. You'll love the unlimited airport lounge access and interbank exchange rates if you travel a lot. There are so many cool perks loaded in one card. Download the crypto.com app and reserve yours now. Will the world follow France and

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Starting point is 00:22:27 crypto-aML reports quarterly. www.w.cifertrace.com slash keep crypto clean. Today's episode is brought to you by Cracken. Cracken is the best exchange in the world for buying and selling digital assets. With all the recent exchange hacks and other troubles, you want to trade on an exchange you can trust. Cracken's focus on security is utterly amazing. Their liquidity is deep and their fee structure is great with no minimum or hidden fees.

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Starting point is 00:23:39 So what happened there? And let's start the story with MakerDAO. Yeah. So of the major DeFi protocol is the one that definitely had the most problems. On March 12th was Maker. So for those that don't know, Maker is a way to get leverage, like everything else in crypto. Getting leverage is generally like the top thing people like to do. They like to trade with leverage.

Starting point is 00:24:03 In the case of Maker, you post Ethereum or ETH as collateral and you withdraw die as a form of debt. And the people who do that are generally doing so for one reason, which is they want to go margin long or levered long ETH. And so they're taking that die and selling it for ETH. all right so they're getting levered exposure to the price of ethereum so on the 12th during the first leg down price leg down bitcoin and ethereum both crashed pretty hard as a result of that a lot of those maker doubt collaterals became under collateralized and so people started liquidating those positions on traditional centralized exchanges like bitmax the exchange automatically runs those liquidations and they just will market sell or market buy and they'll just eat orders on the order book right to execute those transactions in the case of MakerDow, there is no order book, right, and it's not a centralized exchange. And so in those systems, anyone who this term is kind of generically used as a keeper, keepers run some software. That software was written by the MakerDAO team.

Starting point is 00:25:02 And that software basically just looks at the price of Eiff, looks at, you know, the collateralization of all of the outstanding loans. And it says, hey, you know, if anyone is under collateralized, you can go liquidate them and you get some reward for doing so. It's like a few percentage points or something. And so there's a rational motivation for people to do that. So that system broke down in kind of a couple different ways, two to three different ways on Thursday of the 12th. So the first is that the Ethereum network became fully congested. And so, you know, blocks, like gas fees were going up and blocks were full. The keeper software was not written to actually dynamically adjust gas prices.

Starting point is 00:25:41 It was basically using some setting to just say, hey, set the gas fee at, I'm just going to say one penny. There's simplicity. but like the market wasn't clearing transactions with anything below, let's say, 10 cents. And so like the people who were running the keeper software that out-of-the-box keeper software were trying to liquidate collateral and we're just not doing so because the software wasn't configured to do this. Some very smart person realized this, realized it was happening. And so they went into the system and they just changed the parameters and they said, hey, just changed the gas price and increased the gas price.

Starting point is 00:26:12 So that transaction will get, you know, the miners will include the transaction. Well, that person realized is that the way that the liquidations work and maker is that those are actually their collateral auctions. And so the idea is like there's $100 for sale, right? Like you can bid up to let's say $99 and then you'll get $100 and then you make $1 profit. Right. So some guy realized, hey, no one else's transactions are going through. So I can bid $0 and I can get $100. And so some very smart person did that and collected I think $6 million or $8 million.

Starting point is 00:26:45 of ETH over the course of flowers. I think the total was $8 million, but at least one of them was maybe like 4.5. But anyway. Yeah. So someone read out with millions of dollars and paid effectively nothing for it. And so that was the first failure that happened. Now that's fixable. I mean, if the Keeper software was written to dynamically adjust gas prices, that wouldn't have

Starting point is 00:27:05 happened. So that's a pretty fixable problem. The second problem was that liquidity, in order to run those liquidations, you need to be able to, you have to bid in the, those auctions with dye. And so you need to have die. And it turns out that there weren't enough keepers who had enough liquidity, like had enough die on hand to actually engage in those auctions. And so the price of die went up to, I think, a dollar in 10 cents because people realized that like this was happening, we're buying dye at any price to try and run this trade.

Starting point is 00:27:32 So that's obviously a bad thing. You want the price of die to stay at about a dollar. So that was a second problem. The solution to that, I'll come back to the solution. And then the third problem was the oracles. So, right, the maker system needs to know the price of ETHUSD in order to make sure the system is staying solvent. And if the price of ETHUSD falls too low, then, you know, the keepers can come and do the liquidations. Well, again, the Ethereum blockchain became 100% congested. And so the makers either were not configured to adjust the gas prices or they just chose not to submit transactions outright because the price of ETH kept crashing. And so during the second leg down, when ETH touched, I think, $88 on Coinbase, when that happened,

Starting point is 00:28:13 the last price that Maker reported that was formally incorporated in the system was about, I think, $101 or something like that. And it turns out there were a lot of vaults or CDPs in the maker system that were going to get liquidated at $100. And so, like, the conspiracy theory is that the people running the oracles realize what was happening. They probably realized that, hey, if this huge amount of collateral gets liquidated, the people taking that ETH collateral may choose to sell it for dollars. and caused the price of ETH to cascade further. Remember a couple minutes ago, I was saying that in times of crazy volatility, market makers just stopped showing up

Starting point is 00:28:52 because they just don't know what's going on. And so, you know, when ETH was down at $88 or when Bitcoin was down at $3,800 or $4,000, at those prices, there's very, very little liquidity. And so if someone's trying to market sell $5 million, $10 million of ETH, that's going to crash the price. And of course, there were, you know, other maker vaults with even lower, like lower liquidation throughout. And so it's very possible that Eiff could have just cascaded down from 88, like, have the maker

Starting point is 00:29:20 oracles, you know, been reporting the price correctly, it's very possible that ETH could have cascaded from 88 down to 50 or 40 or 30 dollars because market makers just weren't showing up. And so those were kind of the three big problems with DFI that day. You know, even though I read your- It's crazy, Laura. I was just going to say, even though I read your blog post before, my jaw is still like on the floor because I mean the thing about the oracles is like if the oracle really had just dipped one dollar lower to one hundred dollars. I mean, think about it.

Starting point is 00:29:55 And so I actually did not see much chatter about that. But were there any conspiracy theories about what happened there? Because it almost feels like in both instances like things were manipulated. I mean, I look, so the people who run the maker oracles, the way it's designed is there are some people who are publicly disclosed and some people who are not publicly disclosed. And that's like a safety mechanism. I think it's actually a very smart design. The Maker team came up with and I generally agree with it. Some of them, I don't remember all the participants off the top of my head, the ones that

Starting point is 00:30:26 are publicly disclosed, but the Maker team has them written down somewhere. But like I think the Zero X team has, you know, one of the keys. The Maker team is one of the keys. I forget who also the keys. Obviously, even the people who are anonymous who we don't know who they are, obviously those people are vested in the interest of Maker in the long run, right? Like they're not bothering to do this because, like, for fun and because they think Maker are stupid.

Starting point is 00:30:47 They're obviously doing this because they care. And presumably a lot of them own a lot of MKR. A lot of them also probably own a lot of ETH too. Right. Like I think the probability of that is extremely high. And so, I mean, it was very rational that they realized what was happening and said, oh, my God, just stop. We can't prove it.

Starting point is 00:31:08 I'm not accusing them of anything. But on the surface, that is. is a very, very plausible explanation. Right, right. Listeners, we do not know the facts we're speculating here. But in terms of the other explanation, would that just be the congestion on the Ethereum blockchain? Correct.

Starting point is 00:31:26 So that's the other theory is that it was just congested and the software was not configured correctly. And they weren't including the gas fees, you know, to actually get included in the blocks. Wow. Okay. All right. So let's now just talk about kind of, you know, let's just play through like a little hypothetical here. So if those liquidations had occurred at $100 as they were supposed to, what do you think

Starting point is 00:31:57 would have happened next, particularly in terms of the whole maker system and then also the knock-on effects throughout defy? I mean, I think had the Oracle's, you know, reported the price down to $88, I think ETH would have traded down to probably 30 or 40, and that would have caused more liquidations. And it's very possible that 100% of the collateral and Maker could have been liquidated. I don't think, I don't think Maker would have become insolvent in the sense that like the system would, like break, like the contracts would have broken. I just think that, you know, 90 or 100% of the users would have gotten liquidated. And that would have, you know, outright shattered confidence in the system. Yeah.

Starting point is 00:32:39 Well, except for the congestion on the blockchain, but anyway. Yeah. And then so what about the rest of Defi? So, I mean, there's interesting second order impacts on the rest of Defi. So die is collateral for a lot of other protocols. And so, for example, in Compound, right, you get some interesting effects. If A, ETH is collateral in a ton of other protocols. So Compound, Lent for me, you know, BZX, D-Y,X, all these things.

Starting point is 00:33:06 And so had the price of ETH crashed, you know, really low, that would have caused cascading liquidations on other, you know, DFI protocols, which would have probably further cascaded the price of ETH even lower, which would have been bad. The price of die also, like, like as if, if Maker started to become insolvent, the price of die either could have skyrocketed because, like, die would have been contracting. That's unclear.

Starting point is 00:33:30 Or the price of die could have crashed because people realized, oh, my God, the system is insolvent. I don't, and how those dynamics, would have played out on a minute-by-minute basis, I don't know. I don't think it's possible to know. But certainly there's a case where Dye could have become, you know, started trading well below a dollar. You could have traded at 70 cents or 50 cents or something.

Starting point is 00:33:50 And if that happened, then a lot of the loans that are collateralized by Dye, you know, also would have probably become insolvent, which would have caused even more liquidations. And so this would, you know, this already cascaded to some degree into other protocols. For example, compound, you know, compound had a lot of liquidations firing. primarily because of the collateral being low, but it could have caused, you know, just like, like hundreds of millions of dollars of more liquidations could have occurred. All right.

Starting point is 00:34:17 And actually, so one of, at one point earlier when you were talking about how the dye price had gone off its peg, you said you would talk about the solution to that later. Is that the USDC thing that MakerDA adopted later on? Yes. So today, so one of the core problems was that the price of, die went up to $1.10 and it was very hard for people to run these collateral auctions to actually buy the ETH collateral in the system. And so one of the problems was that people couldn't get Dye.

Starting point is 00:34:47 And so today, in order to do that, you have to deposit ETH and you have to effectively take on risk exposure. Like today, if you want to mint new dye, you can do so at any time. But in order to do that, you need to be able to, you have to be able to hold ETH, right, and take on risk of ETH, a price of ETH. a price of ETH. And a lot of market makers don't want to necessarily take on the price risk of holding ETH in order to create more dye.

Starting point is 00:35:13 And so the idea here that's pretty clever is the maker team said, hey, look, we're going to allow anyone to create die using USDA as collateral. Obviously, USDC, the price is very stable at $1. I think it's never gone more than a penny up or down. And so we're going to let anyone create die using USC. And that's basically the solution then that you can deposit USDC create die. and then, you know, run any of these auctions. And so you can, you know, effectively guarantee the price of die

Starting point is 00:35:39 won't go up to $1.10 again. This obviously is controversial because it introduces, you know, trusted collateral into Maker, which has been a pretty controversial debate in that community for a while. I think the way that the Maker team has proposed this, and I think it was voted in last week or, you know, you know, it was voted in recently to be used is that they said, hey, if you're going to borrow deposit USDC and withdraw a dollar,

Starting point is 00:36:05 the interest rate's going to be really high. I think the interest rate is set at 20% or 25%. And so it's designed to deter people from creating large amounts of dye in the system and leaving it there for a long time because a 20% interest rate is really expensive. But of course, if you're just going to borrow it and repay the loan in five or 10 minutes, then you don't really care if the interest rate's 20%. And so they designed it very clever where they said, hey, look, we can solve a liquidity problem by allowing for this other form of collateral, but we just expect no one's going to leave these loans

Starting point is 00:36:33 outstanding for more than a few minutes. Oh, that's interesting. Okay, yeah, I did see some people kind of upset about that, but I feel like what you just explained is kind of a good way to take that criticism into account. Okay, so now let's go to the second blog post that you wrote, which covered all these different solutions for potentially dealing with some of the market failures that we saw in the crypto markets. So obviously, you had talked. talked about how one of the issues here is the fragmented markets of crypto, but you actually say in the second piece that you expect even more fragmentation. So why is that? And then what are some other potential ways to reduce the volatility without more consolidated trading? Yeah. So, I mean, if you look over the history of crypto, I'd say up until second half of 2017, there were generally speaking no more than three to four major liquidity venues. All of those liquidity venues, basically only traded spot.

Starting point is 00:37:38 Those exchanges, for the most part, didn't have any form of KYC. Coinbase, I think, did and Cracken, like none of the other ones did. And so there was just a pretty limited number of venues. Obviously, a number of Mark participants was much smaller. The sophistication of Mark participants was much lower. You didn't have firms like Jump and DRW and Saskatchana in crypto at all at that time. Well, DRW is there, but basically no one else. And so there was, the market was not very sophisticated.

Starting point is 00:38:05 is pretty limited. What happened in the second half of 17 is you got a lot more sophisticated exchanges show up. So Binance showed up. Bitmex got really big. Huo be and OK, and all those guys started started really growing and started adding a lot more sophisticated products. Meanwhile, you kind of got Chinese government cracking down on, you know, like exchanges in China. And as a result of that, basically, who will be okay and finance are kind of sort of the only three exchanges that are allowed to function in China. And although I don't know this for fact, I think with a pretty high probability that if you try and long, launching new exchange in China, the government will basically not let you, you know, get off the ground.

Starting point is 00:38:40 And those three, you know, seem to have some sort of kind of just, they were already here. And so they're allowed to keep living. But no one's allowed to launch new exchanges. So those guys have kind of a kind of inherent, you know, grandfather basically clause from the government. So it's unlikely you're going to see new people show up there. Korea, basically the same thing kind of happened. And so, and then we've also started to see the institutionalization of the U.S. market with firms like CME and DACs getting into space. And so for all these reasons, right, the market structure has really started to diverge where you have just more trading venues.

Starting point is 00:39:12 And people have meaningful network effects around each, those trading venues. There's obviously a lot of traders who value KIC, don't want KIC, you know, their Chinese retail, their American institutions. And so as the markets matured, it's become very clear that there's different types of park participants who want different things. And that really supports structurally having lots of different exchanges. Is it clear the answer is 6 versus 8 versus 12 versus 18? I don't know. That's a pretty wide range, but it's clear that the market is going to support quite a few different exchanges structurally, at least until some of these types of parameters change. And so I don't expect, you know, anytime soon that like that market structure or dynamic is going to change very much.

Starting point is 00:39:53 And then another option you looked at was potentially disallowing extreme leverage, such as the 100x leverage that's allowed on BitMax or the 100. 125x leverage allowed on finance. How would that help, how would, you know, disallowing that help? And why do you think that this is likely not something that they'll actually implement? Yeah. So, I mean, they offer that much leverage because some people want that, right? They're not offering the product and like, like no one's using it. And so people are trading with that much leverage. A lot of people are not trading with that much leverage, but some people are. And so, And these exchanges are unregulated, and so these businesses, rightfully so, want to serve their customers. And if the customers say, I want to trade with that much leverage, then the exchanges want to let them do that. So I think it's unlikely if those exchanges will disallow it basically because they earn their capitalists and they want to serve their customers. The problem with that, unfortunately, is that if you make it too easy to get too much leverage, you can very quickly get cascading liquidations.

Starting point is 00:40:58 And that's what we've seen happen time and time again. the second leg down on Bitmax, you know, when they ended up being $200 million liquidations on, you know, and only $20 million on the order book, that, right, if you simply disallow leverage, let's say Bitmax cap leverage at 10x, I'm fairly certain that that situation would have never come up. Right. And but why do you think, oh, so you're saying that the exchanges won't disallow it just because since there is consumer demand, they'll just meet that demand.

Starting point is 00:41:27 Correct. I mean, like crypto, like one of the. rules of crypto censorship resistance. If your customers want it, then don't, you know, don't censor them, right? Like, that's what they want. They know the risk. Anyone who trades without much leverage knows what they're doing. They understand that it's very risky. And so... Let's hope they know what they're doing. Fair enough. Let's hope they know what they're doing. One other option you looked at was circuit breakers. And I saw that your partner to Sharjane tweeted that as a suggestion. And his tweet got, you know, a fair bit of pushback. Eventually, actually, in recent days, Wobie did introduce a circuit breaker on its derivatives

Starting point is 00:42:04 platform, but do you, it seemed like you believe that the exchanges are not likely to agree on a global circuit breaker provision. So can you talk a little bit about how circuit breakers would help and why you think they're not probably going to be a big solution? Yeah. So if you look in traditional, if you look at like the New York Stock Exchange, for example, they have circuit breakers. I think the rule is if the price moves 7% or more in one day, then they'll, they'll, or in some period of time, then the circuit breaker's kick in and they just freeze all the markets. That works really effectively when the underlying assets only train on a single market. In this case, it's a U.S. equities.

Starting point is 00:42:38 But if you think about it, like if you institute, let's just say that the circuit breaker is 15 minutes, price of Bitcoin goes on 7% in 15 minutes. Well, those terms, because there's multiple menus at the table, those terms become very challenging. There is no like single price of Bitcoin at any moment in time. the price between all of the exchanges varies a little bit. You know, it's usually very small. It's usually a few basis points. But, like, in times of volatility, in times when the circuit breaker would be going off,

Starting point is 00:43:06 like, that's definitely not the case, right? Like, the price of the exchanges is different. And so you end up just creating, right? Like, even if all the exchanges shake hands and say, yes, we'll all institute a 30-minute circuit breaker if the price movement is, you know, X in some number of minutes. It's still really hard because the circuit breakers are, going to go on and off at different moments in time because each exchange has their own local price. And so what you end up doing is you end up just screwing a lot of market participants because

Starting point is 00:43:36 of just like the market microstructure, both as certain exchanges shut down, right? And then others hopefully, hopefully follow. And then also on the reverse side of when those exchanges, you know, light back up, right? And turn back on and start taking trades again because they would end up like turning on at different times. And so you have a lot of like very, very difficult problems with market microstructure and doing that in a fair way. And as a result, like someone's going to get hurt really, someone's going to make money from that, obviously, but someone is going to get hurt in what I would consider an unfair capacity because they just can't compete at that microstructure level. So logistically, it's very, very hard to do.

Starting point is 00:44:15 Time, I mean, even just agreeing on notions of time, notions of price and all those kinds of things. Obviously, volatility is going to be very high in these moments. And also there's just there's a strong. incentive to break range. Let's say all the exchanges get together and shake hands and say, hey, we're not going to do this. And then let's say there's 10 people and nine of them do it and one of them doesn't because that works and says, great, I'm the only one open for business. So all of the trading has to happen on my exchange, right?

Starting point is 00:44:40 I'm going to collect all the trading fees. And so you have a real tragedy to Commons where it's just, it's super difficult to get people on board. And even if you could get them on board, the actual micro structure of the implementation would be very, very, very hard. Yeah, yeah, that makes sense. So in the second essay, you actually also reviewed a whole bunch of different tech solutions for increasing throughput and lowering latency on the blockchain networks themselves. So you started with some of the different technologies on Bitcoin network. Why don't you talk about some of the different ones there and what your assessment is for their potential to help in these situations?

Starting point is 00:45:20 Yeah, so the two major kind of theoretical proposals for improving the, aggregate throughput and decreasing latency of Bitcoin transactions are lightning network and side chains. And I think there's kind of structural problems with both. In the case of lightning, right, like in order, you have to pre-collateralize all the channels and each channel is a bilateral channel between two parties. So today there are about 10 major venues. And so if you wanted to, you know, have channels between all the exchanges, that's about

Starting point is 00:45:46 100 different channels between these folks. And there's 100 channels. And that means each, you know, each exchange has to collateralize, you know, one side of that. And so these exchanges would have to be, in terms of balance of management, it's pretty risky for them to say, hey, I'm going to pre-collateralize all these channels. And like, I don't know if people are going to use this. I don't know which of these exchanges my customers are going to want to send money to.

Starting point is 00:46:10 And that really limits their flexibility because every Bitcoin that's in one channel cannot be using another channel. Not only is it limit their flexibility in that way, it also limits their flexibility in terms of things like, let's say loans. So a lot of the exchanges are starting to loan out assets. And so, you know, like how they think about risk of their own balance sheets as they have all these competing interests is really difficult for them to reason about this. Running a lightning note is expensive. It's risky because it's a, you know, it's a hot wallet.

Starting point is 00:46:34 It's always online. And it's very capitally inefficient because they don't know, you know, where customers are going to want to send the money. And so they have a large amount of overhead for maintaining this. They know for a fact that the customers are not going to use it the vast majority of time. And then even if their customers did start using it, Right. Like people, you know, because the liquidity is divvied up across 100 different channels, you know, there's going to be, like the arbitrages are going to very quickly exhaust that channel. And then that channel is going to become sitting there useless, right? Like, okay, the first few people to arbitrage will get instant transactions. But then as people trying to follow along that same corridor, then that channel gets exhausted. And so you end up having to, you know, recilateralize the base kind of anyways. So I'm pretty skeptical of the lightning is like a quarter. solution to this problem. It just creates a lot of mechanical complexity and you end up just breaking up the basically liquidity between these different channels. So I'm skeptical there.

Starting point is 00:47:33 And what is side chains? Yeah, so the other major proposal for this is side chains. So I think the Blockstream team proposed sidechains, I think, as early as either 2013, if not 13, then definitely 14. 2014. Yeah, 2014. And so it's been talked about for a long time. Today, the usage of side chains on Bitcoin is effectively zero. The only real side chain out there is the liquid side chain made by the block stream team. Liquid has been around for more than 12 months now and still has effectively no usage. And a handful of the major exchanges are signed up to use it, but they're not using it. And there's also quite a few missing

Starting point is 00:48:07 people. I know finance is missing. Coinbase is missing. Cracken is missing. I think a few others are missing too. And so, you know, you don't have everyone on board. Side chain theoretically should solve the problem, but the exchanges are just choosing not to use it. And so the kind of natural question is, well, why? Exchanges have some reason to use sidechains and that it would very clearly help them save gas fees on the blockchain. You can bet that all of the exchanges paid a lot of gas fees on, you know, on March 12th because, you know, transaction costs were going up on the blockchains as networks became congested. And so they're actually incentivized to use something like liquid because it'll actually help them save money.

Starting point is 00:48:43 I don't know for, like I haven't called all of the exchanges and like had, you know, one-on-one conversations with them and ask them in the specific question. But as I think about it, the most obvious reason I think they don't use it is that the exchanges don't trust each other. They are brutally competitive, brutal competitors. They generally don't like each other. And there's a lot of ways where, like, liquid could backfire. So the way liquid works is it's an 11 of 15 multisig.

Starting point is 00:49:09 And so if any 11 of the exchange is clue, they can screw, you know, they can really hurt one of the other exchanges. And so, you know, if I'm, let's say, Coinbase is a good example here, or CME are backed, right? If I know a lot of the other people on Liquid are, you know, Asian exchanges that are unregulated, if those guys, you know, call each other and say, hey, we're just not going to send these coins to Coinbase, even though they're supposed to, they can just choose not to, and they can just take them for themselves. And given the fact there's like almost no legal recourse, right? Like, this would be totally uncharted territory.

Starting point is 00:49:42 Like, that gets really game theoretically dangerous. for for coin base. And so I think that's a big reason why these exchanges haven't opted in to use it is because they just they just undress each other. And like with an 11 to 15 configuration, it's very easy to see how you get you get hurt not for a million dollars. I mean, you could get, you know, hurt out of 50 million dollars. I mean, it could be a huge, huge loss. Wow. So do you see any way to solve these kinds of congestion issues, you know, during times of high volatility like that on Bitcoin, I mean? Yeah, on Bitcoin. I'm not. really optimistic. I don't see how to do it on Bitcoin. I think with the smart contract platforms

Starting point is 00:50:20 that have, you know, newer just approaches to scaling as well as they have kind of full scripting languages that allow for more advanced, more advanced smart contract logic. I'm more optimistic, but on Bitcoin, based on my kind of current outlook, I'm not, I don't see how it's going to get done. All right. Well, let's talk about Ethereum quickly. What, you know, are some of the different solutions there and what's your assessment of those? Yeah, so on Ethereum, there's a handful of solutions. Roll-ups are kind of a common one. Trying to think what are the other ones?

Starting point is 00:50:51 Sharding was another you mentioned in your blog post. Yeah, that's right. Sharding is the other big one. So I kind of touch on sharding first. So, you know, ETH 2.0 is working on charting. A lot of the new layer ones coming out are also working on sharding as well, and they have kind of their own flavors of sharding. And they have different nuances to how they do what they do.

Starting point is 00:51:10 But the really big problem I have with sharding is, is that it's not clear that it actually helps in this specific situation where you have a lot of money needing to shuttle around and kind of much of what I'll call like random ways, meaning you just have random deposits and random withdrawal addresses. And so the reason that I'm concerned that it doesn't solve the problem is that in a charted system, if you send the transaction from shard A to shard B,

Starting point is 00:51:36 or like you send money, you know, and you need to go do a cross-shard transaction, you end up doing a transaction on shard A and on shard B. And so when you do that, if you think about that and then if 100% of the transactions are cross-shard, then what you end up, the net effect you end up getting is that the aggregate throughput of the system ends up approaching the throughput of a single shard. Because every transaction takes up a second, you know, takes up space on a second chart. And so that's really concerning because the, because then you end up like, right, if people are shuttling money around to run these arbitrages. and all these transactions

Starting point is 00:52:14 and they're being cross-shard, then you're kind of defeating the whole purpose of sharding. And so I'm very concerned about that kind of happening. Obviously, in any of these cases, you would not end up with 100% of transactions being cross-sharred, but certainly a meaningful percentage would be.

Starting point is 00:52:29 And that's going to be, again, during a time of volatility, time when things are moving around. And so the idea that sharding is going to increase throughput by 10x, right, 50x or 100x, I'm very skeptical. Like, that may be the case 90% of the time, time. But like during the time when the systems are breaking and when everything is, you know,

Starting point is 00:52:47 volatile and going crazy, that's when you need it to really, you know, maintain that throughput advantage. And during those moments of time is when I think that's going to really get tested in a really negative way. It's terrible. But when you were talking, I realized that it reminded me of the hospital bed or ventilator issue with the coronavirus. I was like, oh, it's the same problem. Right. But anyway. When it's peacetime, everything is good. Like building systems, they're running peace time is easy. Like building systems to work during war time is really hard. Yeah. Well, and then, but what about optimistic roll-ups? Yeah. So, optimistic roll-ups have a similar-ish problem where they, well, a couple problems. So one is the, at least the

Starting point is 00:53:26 vanilla implementation of optimistic roll-ups doesn't solve the latency issue because you still rely on the underlying layer one blockchain for, for clearing transactions. So you increase throughput, but you don't increase, or you don't decrease latency. But the other problem, basically is that if these exchanges end up using their own optimistic roll-up chains, then you haven't really, you're basically recreating the same thing as sharding, where you have to end up having the same transaction on multiple chains or multiple optimistic whirl-up chains in order to produce the kind of same effects. And so as I just think again, like I look at these exchanges, these guys don't coordinate

Starting point is 00:54:00 on much of anything and saying that, hey, they're all going to agree to use the same optimistic roll-up chain just seems to me to be very unlikely. Like they haven't done that in the past. you know, technology still new. These guys all seem to want to kind of like have control of their own systems. And so I just find it unlikely that all of these, you know, players agree to use the same, the same optimistic roll-up chain. And if they don't, then you end up basically in kind of the same kind of sharding logic that I just walked through.

Starting point is 00:54:26 Wow. All right. Well, so you kind of started to go into like how you think we could solve this issue. And I know this is maybe more speculative or, you know, off the future. But why don't you go into that a little bit? Yeah, so I mean, my favorite solutions to solve this problem, I think there's one interesting market structure solution, which is the introduction of prime brokers. I think prime brokers really help a lot because they basically allow you to have a single centralized entity off chain, basically manage all the collateral across all the venues and allow the different funds and traders to do all the trading and then just net all that stuff out on some frequency and kind of after the fact. Prime broker is very big business in traditional markets.

Starting point is 00:55:09 People like prime brokers. The challenge is that, A, you need everyone to trust the same prime broker or prime brokers, which in crypto today there are no single entity that everyone trusts. And then B, that entity needs to have a lot of capital because you need to be able to have enough capital to basically face all of your clients. So if you're a prime and let's say all of your clients have, you know, $5 billion collectively, you need to have at least $5 billion and probably a lot more in order to be effective prime broker. And so that's been kind of a problem is that there aren't prime brokers. I expect we will eventually have prime brokers.

Starting point is 00:55:41 So Togomi, for example, today is trying to do that. They're not there yet, but they're certainly moving in that direction. A handful of other players are trying to do something similar. The good thing about prime brokers is that they don't really change the market. They don't require a change in the market structure. You don't need to get the exchanges to agree on anything. You don't need to introduce some new standards. This can be very much like, you know, the exchanges want to do business with its trader,

Starting point is 00:56:03 which is the prime. and the traders want to have prime services. And so it's a very kind of organic evolution of the current market structure. So I'm optimistic that that will help mitigate this problem over time. The other solution I'm really interested in is the introduction of new layer one assets. Ethereum people have been talking about proof of stake and charting and all these things for years. For the last couple years, you've seen a lot of really smart people say, hey, I have different ideas and different ideas on how to scale these systems.

Starting point is 00:56:31 And a lot of really smart people are working on scaling new layer ones. Of those, the one I'm kind of most interested in is called Solana, and they're really the team focused on optimizing just a single shard and to kind of maximize throughput in a single system. So have most throughput and lowest latency in one shard. And the idea is that if you can actually do that, then all of these problems around throughput, you know, around moving to money around, around the latency, all those things get just magically solved. You don't have to worry about new trust models, new security models, cross-sharded transactions. like just all these other things are just really untested and just introduce lots of new variables. And we just don't know how those things are going to actually work in the real world. But we all know today with a very high conviction that you have a chain and it has assets on it and you shuttle them around and exchanges, you know, take the positives of withdrawals.

Starting point is 00:57:22 And like that market structure is very well understood by everyone in the market. And so I like that that kind of approach plugs into the current market structure very well. The downside of that approach is you need people to agree to use the new chain, which is a non-trivial thing to do. Definitely non-trivial, but it is still early days in crypto, so we'll see what happens. All right. Well, thank you so much for explaining all this craziness. It has been great having you in the show. Thanks for coming on Unchained. Hey, Laura, thank you so much for having me. It was a pleasure to be on. Thanks for tuning in. To learn more about Kyle and Multicoin, be sure to check out the links in the show notes of your podcast player.

Starting point is 00:58:03 you have heard the weekly crypto news recaps I read on Unconfirmed and have asked me for the links to the stories I mentioned there. You can also get them delivered right to your inbox with my weekly newsletter, which comes out Fridays. Go to Unchainedpodcast.com right now to sign up. Unchained is produced by me, Laura Shin, with help from fractal recording, Anthony Yoon, Daniel Nuss, Josh Durham, and the team at at CLK transcription. Thanks for listening.

Unchained - Teetering on the Edge: How Black Thursday Exposed the Flaws in the Crypto Markets - Ep.164

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