Kyle Samani, managing partner at Multicoin Capital, dissects Black Thursday, March 12, the day the crypto markets plunged twice amid the wider sell-off in the markets due to the coronavirus. He offers several theories for the first price drop that day, how that set off a series of liquidations on various exchanges, and then why liquidations stopped for about 12 hours before the next wave, which triggered the next price slump. He also describes why, at that point, the crypto market structure broke, as arbitrageurs attempted to move collateral from one exchange to another but could not because both the Bitcoin and Ethereum blockchains became congested, setting off a downward spiral particularly in Bitcoin, as miners began turning off equipment due to the falling BTC price. This led, ultimately, to there being $200 million worth of positions to liquidate on BitMEX, but only $20 million worth of bids on the entire BitMEX order book. Then we cover what happened next that ultimately saved the price of BTC dropping to $0 on BitMEXT.
Next, we discuss the second fall in prices that day, and how that affected MakerDAO, with congestion on the Ethereum blockchain preventing keepers from being able to liquidate undercollateralized vaults. A clever keeper sent a bid to liquidate a vault with a higher gas price, but realizing that there was no competition, bid $0, walking away with $4.5 million, and a total of $8 million being won this way. We covered how the price of ETH fell to $88 but because oracles weren’t properly updating, the last price of ETH on MakerDAO was at $101 — a dollar higher than the $100 where a bunch of liquidations would have occurred, which would have likely put more downward pressure on ETH, resulting in another downward spiral.
Kyle also evaluates some of the technical options for preventing these issues in future times of volatility, why many of them aren’t promising but what is.
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Links from news recap:
Kyle Samani: https://twitter.com/KyleSamani
Multicoin Capital: https://multicoin.capital/
Multicoin blog part 1: https://multicoin.capital/2020/03/17/march-12-the-day-crypto-market-structure-broke/
Theory that BitMEX’s maintenance was to prevent a collapse in Bitcoin: https://twitter.com/SBF_Alameda/status/1238306306043162625
How traders took advantage of the roiling markets: https://www.theblockcrypto.com/post/59172/surfing-the-spread-crypto-market-turmoil-arbitrage
More on the liquidations in MakerDAO: https://medium.com/@whiterabbit_hq/black-thursday-for-makerdao-8-32-million-was-liquidated-for-0-dai-36b83cac56b6
MakerDAO weighs emergency shutdown: https://www.coindesk.com/defi-leader-makerdao-weighs-emergency-shutdown-following-eth-price-drop
MakerDAO adds USDC as collateral: https://www.coindesk.com/makerdao-adds-usdc-as-defi-collateral-following-black-thursday-chaos
Kain Warwick on USDC as Dai collateral: https://twitter.com/kaiynne/status/1239795250882740225?s=20
Eva Beylin on USDC as Dai collateral: https://twitter.com/evabeylin/status/1240039492985085952?s=20
Huobi’s derivatives platform introduces circuit breaker:
Debate over circuit breakers in crypto:
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Today’s guest is Kyle Samani, managing partner at Multicoin 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 12, 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, dude to panic over the coronavirus and its effect on the economy, and amid a much wider selloff, 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 CoinMarketCap, you’ll see a lot of the events are reported in UTC time, and actually the first leg down happened on the 12th and the second leg down happened on the 13th. In the US 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.
So, the first leg down happened at about five AM central time, six AM eastern time on the 12th. We don’t know with 100 percent certainty what caused it, but definitely someone who held a lot of Bitcoin started selling their Bitcoin. The two best theories are one, that someone was de-risking because they were kind of concerned about global macro as a result of the coronavirus, and the second theory is that the Plus Token scammers from kind of last summer sold a lot of 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 US futures markets, you know, limit down 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 caused the first leg down on the 12th.
That moved 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 kind of prices stabilized throughout the day.
I can tell you from our side, you know, we were, 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 assets they borrowed had decreased such that the value of the collateral was now higher than the value of the assets that were borrowed, and so…sorry, that the value of the assets borrowed were higher than 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 back and forth went between a lot of lenders over the course of the day, and what appears to be the case is 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 unique characteristics that kind of played into what happened there, so I 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 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, Ripple, et cetera. In traditional markets, by and large you can more or less think of, let’s say equities, as like there being a single exchange where equities are traded. 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 ten or so major venues where people trade, and although the underlying 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 a futures market, you’ve got options, 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 trades spot, they don’t have any derivatives. If you look at BitMEX, BitMEX only trades futures and perps. Deribit really just dominates options trading.
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 derivative products is also changing in real time, and then on top of that, you’ve got different kinds of traders who cannot access certain venues, right?
So if you just say, I want to sell or buy ten million dollars of Bitcoin, let’s just say, 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 pick off the orders off of all of those exchanges. You’d space it out over time and do those kinds of things.
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 Huobi. 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 of venues.
And so as a result of kind of all of these unique dynamics of different products being traded across different venues, and the fact that people are not, you know, doing “best execution” and kind of taking liquidity across all different venues, you end up with pretty meaningful price deviations between those venues.
Ninety-nine percent of the time those price deviations are close to zero or maybe they get a little bit beyond the maker/taker fees, but not much, and arbitragers 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, arbitragers started having to shuttle money between the exchanges because, like…let’s say the price was high on one exchange and low on the other, and let’s say the money they had on each exchange was backwards, so they had to basically flip the positioning of, like, the Bitcoin and let’s say the USDT that they had across those exchanges.
Well, in order to do that they have to use the blockchains and 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, the network started to become congested, transactions started 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 machines 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.
And so those two things kind of happening at once basically made it so that people could not move…you know, arbitragers 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…well, I’ll pause there. Like, that was already a lot.
Yeah. Well, I mean, what you’re describing just sounds like one of those terrible 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 I was a little bit confused when I read this in your blog post, you know, 1 BTC is 1 BTC, and whether or not you choose to sell it at 4,000 or 8,000 or 12,000 or whatever it is is presumably under the miner’s 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, maybe 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 onto it until the price goes back up.
Right, so they can, and certainly miners historically have very much speculated on the price of the coin. As the derivatives markets have matured, specifically the futures markets and the options markets, miners have become a lot…and a lot of miners have gotten blown out, like in 2018 as the market crashed, and so they’ve become 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, 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. So, a lot of miners are becoming a lot more rational about that. 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 miner and let’s say your cost of mining Bitcoin is 6,000, and as the price of Bitcoin, you know, hits 6,000, maybe you keep on mining, but maybe you say, hey, at 5,500, right, am I going to mine for a ten percent loss? Like, if it’s 5,000, am I going to mine for, you know, almost 20 percent loss, 17 or 18, whatever that math comes out to be? And a lot of people started 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 when I have a guaranteed loss? And so that started happening on the 12th.
And then one other thing I wanted to ask about was 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, you know, the decline in the value of the block reward?
Yeah. So I haven’t looked at the math, the ratio recently, but if you just say a miner makes 100 percent of revenue, I think right now it’s something like 90 to 95 percent of miner revenue kind of generally speaking comes from block rewards, and only five to ten percent 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 needle.
Right. Okay. All right. So, then, you know, in the beginning you talked about how part of the reason for the first selloff was perhaps coronavirus or even maybe the Plus Token, but then for the second one, that was, what was the cause of that again? Was that the miners turning off the…
Yes. 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 lenders started liquidating the collateral of the borrowers.
What’s interesting is there’s two different types of ways to get leverage in crypto. You can do it on exchange using BitMEX or Binance or any of the derivatives exchanges all let you take on leverage, and if you follow any of the Twitter accounts like I think one is called WhaleCalls, I think another one is called BitMEX Rekt, there’s probably other ones for the other exchanges, and basically, right, if you follow those accounts, they’ll start tweeting out, you know, 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 either levered long or levered short, if the price moves against you, there are some thresholds at which the exchanges will take your collateral and they will start market selling your collateral, right, to make sure that you stay solvent, and so that happens all programmatically, and the exchanges 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 Matrixport 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 some Bitcoin with me and I’ll give you a yield like a bank, and if you want to borrow some Bitcoin, call me and I’ll lend you some Bitcoin.
And so those guys started to, you know, the people who borrow Bitcoin and ETH 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 the people who borrowed and saying, hey, Bob, hey, Joe, hey, Jim. You’re close to being insolvent. 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 back and forth and dialog, and obviously things did not get resolved in that 12-hour period, and so the lenders contractually had to start liquidating that collateral, and so that’s what caused the second leg down.
Okay, 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’s sort of flat after the first big spike in the morning, and then it continues to go up. Is that kind of what happened there? Like, 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 borrowers saying, hey, guys, here’s your balances, here’s your solvency ratios, and whatever, you know, you need to either deposit more collateral 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 about these kinds of situations very formally defined, right, like, how quickly things need to get resolved. In this case it seems like it was about 12 hours 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 depositor stayed solvent, 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 dollars’ worth of bids left on the entire BitMEX order book, and over 200 million dollars in long positions that needed to be liquidated, and you say that that could have crashed the price of BTC to zero briefly, but what happened 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 US. So, once the lenders started liquidating collateral, obviously the prices of Bitcoin started going down more. At that point, there were people who had leverage on BitMEX. I mean, people have leverage on all of the derivatives exchanges, but on BitMEX specifically there were more people who were levered long, so those liquidations 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, and so a lot of market makers had already moved collateral off of BitMEX to take advantage of arbitrage, you know, on other venues, and so the amount of collateral available on BitMEX was lower than normal.
On top of that, you know, the blockchain was slowing down because you know, 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 as the price started 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. In general, like, market makers, their business mandate is every single day, don’t lose money, and like, if there’s a day that a market maker loses money, like, that’s a very bad day for them, and all those businesses are run with very strict risk controls on making sure that they’re not taking on too much risk and not coordinating spreads too tight so that they lose money.
And so on days like March 12, right, those are days that volatility is really high, and they don’t want to lose money, and a lot of market makers may have ended up losing money in the first half 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, and people keep getting liquidated. There’s a few more…and not only that, obviously not all market makers disappeared, but you know, 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 shovel collateral from Coinbase, Bifnance, Huobi, wherever else they had collateral, they were trying to send it to BitMEX, but the blockchain was slow, and so they couldn’t get collateral to BitMEX, 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 was 200 million dollars of outstanding liquidations that needed to occur, but there was only 20 million dollars 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. So, if that would have happened on BitMEX, 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. People were obviously trying to send money to Bitcoin, and there is a price, right?
Sorry. Yeah. Like, let’s say Bitcoin is trading for 500 dollars on BitMEX and 4,000 dollars on Coinbase. 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 BitMEX 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 there are people who have that risk tolerance and have the sophistication to do all that stuff. So, as the price discrepancy gets wider, it obviously encourages more people to show up, and so at some point they would have shown up, but like, the spike on BitMEX, 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 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.
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Back to my conversation with Kyle Samani. So, let’s now talk about how these market failures on Black Thursday played out in DeFi. You wrote in your first blog post that DeFi “outright failed,” which is interesting phrasing to use. So, what happened there and let’s start the story with MakerDAO.
Yeah. So, of the major DeFi protocols, the one that definitely had the most problems on March 12 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 the top thing people like to do, they like to trade with leverage. In the case of Maker, you post Ethereum or ETH as collateral and you withdraw DAI 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 lever long ETH, so they’re taking that DAI and selling it for ETH, right? So, they’re getting levered exposure to the price of Ethereum.
So, on the 12th, during the first price leg down Bitcoin and Ethereum both crash pretty hard. As a result of that, a lot of those MakerDAO collaterals became undercollateralized, and so people started liquidating those positions. On traditional centralized exchanges like BitMEX the exchange automatically runs those liquidations, and they just will market sell or market buy, and just orders on the order book, right, to execute those transactions.
In the case of MakerDAO, 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 generic they use, is a keeper, keepers run some software, that software was written by the MakerDAO team, and that software basically just looks at the price of ETH, looks at the collateralization of all of the outstanding loans, and it says, hey, you know, if anyone is undercollateralized, 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 of different ways, two of the three different ways on Thursday 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. It was basically using some setting to just say, hey, set the gas fee at, I’m just going to say one penny for simplicity, but the market wasn’t clearing transactions with anything below, let’s say ten cents. And so like, the people who were running the keeper software, out of the box keepers software, were trying to liquidate collateral and were just not doing so because the software wasn’t configured to do this.
Some very smart person realized this, realized what was happening, and so they went into the system and they just changed the parameters and they said, hey, just change the gas price and increase the gas price so that the transaction will…so the miners will include the transaction.
What that person realized is the way that the liquidations work in Maker is that those are actually collateral auctions, and so the idea is that, like, there’s 100 dollars for sale, right, like, you can bid up to, let’s say 99 dollars, and then you’ll get 100 dollars, and then you make one dollar of profit, right? So, some guy realized, hey, no one else’s transactions are going through, so I can bid zero dollars and I can get 100 dollars, and so some very smart person did that and collected I think six million dollars or eight million dollars of ETH over the course of a couple of hours.
Yeah. I think the total was eight million, but at least one of them was maybe 4.5, but anyway…yeah.
Yeah. So, someone made 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, like, that wouldn’t have 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 those auctions with DAI, and so you need to have DAI, and it turns out that there weren’t enough keepers who had enough DAI on hand to actually engage in those auctions, and so the price of DAI went up to I think a dollar and ten cents because people realized this was happening and were buying DAI at any price to try and run this trade. So, that’s obviously a bad thing. You want the price of DAI to stay at about a dollar. So, that was the second problem.
The solution to that…actually, I’ll come back to the solution.
And then the third problem was the oracles, right? The Maker systems needs to know the price of ETH/USD in order to make sure the system is staying solvent, and if the price of ETH/USD falls too low then you know, the keepers can come and do liquidations.
Well, again, the Ethereum blockchain became 100 percent 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 dollars on Coinbase, when that happened, you know, the last price that Maker reported that was formally incorporated in the system was about, I think, 101 dollars 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 dollars, and so like, the conspiracy theory is that the people running the oracles realized 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 cause the price of ETH to cascade further.
Remember a couple of minutes ago, I was saying that, you know, in times of crazy volatility, market makers just stop showing up because they just don’t know what’s going on, and so you know, when ETH was down at 88 dollars or when Bitcoin was down at 3,800 or 4,000, at those prices, there is very, very little liquidity, and so if someone is trying to market sell five million, ten million dollars of ETH, that’s going to crash the price.
And of course, there were other Maker Vaults with even lower liquidation thresholds, and so it’s very possible that ETH could have just cascaded down from 88, like, had the Maker oracles been reporting the price correctly, it’s very possible that ETH could have cascaded down 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 at DeFi that day.
You know, even though I read…
It’s crazy, Laura. It’s crazy.
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 100 dollars…I mean, think about it. Like, 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, in both instances, like things were manipulated.
I mean, 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 are publicly disclosed, but the Maker team has them written down somewhere, but like, I think the 0x team has, you know, one of the keys, the Maker team has one of the keys, I forget who else has 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, like, for fun and because they think Maker is stupid. They’re obviously doing this because they care, and presumably, a lot of them own a lot of MKR. A lot of them probably also 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. I’m not accusing them of anything, but on the surface, that 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. 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 be included in the blocks.
Wow. Okay. All right. So, let’s now just talk about kind of…you know, let’s just play through a little hypothetical here. So, if those liquidations had occurred at 100 dollars as they were supposed to, what do you think would have happened next, particularly in terms of the whole Maker system and then also the knock-on effect throughout DeFi?
I mean, I think had the oracles, you know, reported the price down to 88 dollars, 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 percent of the collateral in Maker could have been liquidated.
I don’t think Maker would have become insolvent in the sense that, like, the system would, like, break, like the contract would have broken. I just think that 90 or 100 percent of the users would have gotten liquidated, and that would have outright shattered confidence in the system.
Yeah. Well, except for the congestion on the blockchain, but anyway.
And so what about the rest of DeFi?
So, I mean, yeah, there’s interesting second order impacts on the rest of DeFi. So, DAI is collateral for a lot of other protocols, and so for example, in Compound, right, you get some interesting effects. A, ETH is collateral in a ton of other protocols, so Compound, Lend4.me, you know, bZx, dYdX, all these things, and so had the price of ETH crashed, you know, really low, that would have caused cascading liquidations on other, you know, DeFi protocols, which would have probably further cascaded the price of ETH even lower, which would have been bad.
The price of DAI also, if Maker started to come insolvent, the price of DAI either could have skyrocketed because like, DAI would have been contracting, that’s unclear, or the price of DAI could have crashed because people realized, oh my God, the system is insolvent, 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 DAI could have become, you know, started trading well below a dollar. It could have traded at 70 cents or 50 cents or something, and if that happened, then a lot of the loans that are collateralized by DAI, you know, also would have probably become insolvent, which would have caused even more liquidations.
And so 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 ETH collateral being low, but it could have caused, you know, just like…hundreds of millions of dollars of more liquidations could have occurred.
All right, and actually, so at one point earlier when you were talking about how the DAI price had gone off its peg, you said you would talk about the solution to that later. Is that the USDC thing that MakerDAO adopted later on?
Yes. So, today…so one of the core problems was that the price of DAI went up to a dollar ten, 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 DAI, and so today, in order to do that, you have to, you know, deposit ETH, and you have to effectively take on risk exposure. Like, today if you’re going to mint new DAI, you can do so at any time, but in order to do that you need to be able to hold ETH, right, and take on risk of ETH, 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 DAI.
And so the idea here that is pretty clever, is the Maker team said, hey, look, we’re going to allow anyone to create DAI using USDC as collateral. Obviously USDC, the price is very stable at one dollar. I think it’s never gone more than a penny up or down, and so we’re going to let anyone create DAI using USDC, and that’s basically the solution, then, that you can deposit USDC, create DAI, and then run any of these auctions, and so you’re effectively guaranteed the price of DAI won’t go up to a dollar ten again.
This obviously is controversial, because it introduces, you know, trust of 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, it was voted in recently to be used, is that they said, hey, if you’re going to deposit USDC and withdraw DAI, the interest rate is going to be really high. I think the interest rate is set at 20 percent of 25 percent, and so it’s designed to deter people from leaving, like, creating large amounts of DAI in the system and leaving it there for a long time, because a 20 percent interest rate is really expensive.
But of course, if you’re just going to borrow it and repay the loan in five or ten minutes, then you don’t really care if the interest rate is 20 percent, and so they designed it very clever where they said, look, we can solve the liquidity problem by allowing for this other form of collateral, but we just expect no one is going to leave these loans 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 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 or four major liquidity venues. All of those liquidity venues basically only traded spot. Those exchanges, for the most part, didn’t have any form of KYC, Coinbase I think did, and Kraken did, but like, none of the other ones did, and so there was just a pretty limited number of venues, obviously the number of participants is much smaller, the sophistication of market participants was much lower. You didn’t have firms like Jump and DRW and Susquehanna in crypto at all at that time. DRW was there, but basically no one else, and so the market was not very sophisticated and it was 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, Huobi and OKEx and all those guys started really growing and started adding a lot more sophisticated products.
Meanwhile, you’ve kind of got Chinese government cracking down on, you know, like, exchanges in China, and as a result of that, basically Huobi, OKEx, and Binance are 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 to launch a new exchange in China, the government will basically not let you get off the ground, and those three seemed to have some sort of…they were already here, and so they’re allowed to keep living, but no one is allowed to launch new exchanges. So, those guys have kind of an inherent, grandfather, basically, clause from the governments. So, it’s unlikely you’re going to see new people show up there. Korea, basically the same thing happens.
And so, and then we’ve also started to see the institutionalization of the US market with firms like CME and Bakkt gettin in the space.
And so for all of these reasons, right, the market structure has really started to diverge where you have just more trading venues, and people have meaningful network effects around those trading venues. There’s obviously a lot of traders who either value KYC, don’t want KYC, they’re in Chinese retail, they’re in American institutions, and so as the market has matured, it’s become very clear that there’s different types of market participants who want different things, and that really supports structurally having lots of different exchanges.
Is it clear the answer is six versus eight 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, any time soon, that that market structure dynamic is going to change very much.
And then another option you looked at was potentially disallowing extreme leverage such as the 100x leverage that’s allowed on BitMEX or the 125x leverage allowed on Binance. How would, you know, disallowing that help, and why do you think this is likely not something that they’ll actually implement?
Yeah. So, I mean, they offer that as leverage because some people want that, right? They’re not offering the product and like, no one is using it. So, people are trading with that much leverage. A lot of people are not trading with that much leverage, but some people are, and you know, these exchanges are unregulated, and so you know, 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 those exchanges will disallow it, basically because they’re 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, and that’s what we’ve seen happen time and time again. The second leg down on BitMEX, you know, when there ended up being 200 million dollars of liquidations and only 20 million dollars on the order book, that, right, if you simply disallowed leverage, let’s say BitMEX capped leverage at 10x, I’m fairly certain that that situation would have never come up.
Right, but why do you think…oh, so you’re saying that the exchanges won’t disallow it just because since there is consumer demand, customer demand, they’ll just meet that demand.
Correct. I mean, like, crypto, one of the rules of crypto is censorship resistance. If your customers want it, then you know, don’t censor them. Right? Like, that’s what they want. They know the risk that…anyone who trades with that much leverage knows what they’re doing. They understand 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, Tushar Jain, tweeted that as his suggestion, and his tweet got, you know, a fair bit of pushback. Eventually, actually, in recent days, Huobi did introduce a circuit breaker on its derivatives 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 on 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 seven percent or more in one day or in some period of time then the circuit breakers kick in and they just freeze all the markets. That works really effectively when the underlying assets only trade on the single market, in this case it’s US equities.
But if you think about it, like, if you institute, let’s just say the circuit breaker is the price of Bitcoin goes down seven percent in 15 minutes. Well, those terms, because there’s multiple venues 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 terms of volatility, in terms when the circuit breaker would be going off, 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 x in the certain number of minutes, it’s still really hard because the circuit breakers are going to go on and off in 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 of just, like, 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, like, 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 very, very difficult problems with market microstructure and doing that in a fair way, and as a result, like, someone is going get hurt really…someone is going to make money from that, obviously, but someone is going to 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. Time, I mean, even just agreeing on notions of time, notions of price, and all those kinds of things, and obviously volatility is going to be very high in these moments.
And also there’s a strong incentive to break reins. 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, like, there’s ten people and nine of them do it and one of them doesn’t because that person says, great, I’m the only one open for business, so all of the trading has to happen on my exchange, right, I’m going to collect all the trading fees, and so you have a real tragedy of the commons where it’s just super difficult to get people on board, and even if you could get them on board, the actual microstructure 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 you know, what your assessment is for their potential to help in these situations?
Yeah. So 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, you have to pre-collateralize all the channels, and each channel is a bilateral channel between two parties. So, today there are about ten major venues, and so if you wanted to have channels between all the exchanges, that’s about 100 different channels between these folks, and there’s 100 channels, that means each exchange has to collateralize, you know, one side of that, and so these exchanges would have to, in terms of balancing management, it’s pretty risky for them to say, hey, I’m going to pre-collateralize all these channel, 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, and that really limits their flexibility, because every Bitcoin that’s in one channel cannot be used in another channel.
Not only does 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, is they have all these competing interests. It’s really difficult for them to reason about this, running a Lightning Network is expensive, it’s risky because it’s a hot wallet, 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 the customers are not going to use it the vast majority of the time, and even if their customers did start using it, right, because the liquidity is divvied up across 100 different channels, you know, there’s going to be…like, the arbitragers are going to very quickly exhaust that channel, and then that channel is going to become sitting there useless, right? Okay, the first two people to arbitrage will get instant transactions, but then as people try and follow along that same corridor, then that channel gets exhausted, and so you end up having to re-collateralize the base kind of anyways.
So, I’m pretty skeptical the Lightning is a core solution to this problem. It just creates a lot of mechanical complexity, and you end up just breaking up basically liquidity between these different channels. So I’m skeptical there.
And what about side chains?
Yeah. So, the other major proposal for this is side chains. So I think the Blockstream team proposed side chains I think as early as 2013, if not ’13 then definitely ’14.
- Yeah. 2014.
Yeah, 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 sidechain made by the Blockstream 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 people. I know Binance is missing, Coinbase is missing, Kraken is missing, I think a few others are missing too, and so 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 side chains in that it would very clearly help them save on gas fees on the blockchain. You can bet that all of the exchanges paid a lot of gas fees on March 12 because transactions costs were going up on the blockchain as networks became congested, and so they are actually incentivized to use something like Liquid because it’ll actually help them save money.
I don’t know if, like, I haven’t called all of the exchanges and had one-on-one conversations with them and asked them the specific question, but I think about it, the most obvious reason I think they don’t use it is that exchanges don’t trust each other. They’re brutally competitive, they’re brutal competitors, generally they 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 11/15 multi-sig, and so if any 11 of the exchanges collude, they can screw, they can really hurt one of the other exchanges. So, you know, if I’m, let’s say Coinbase is a good example here, or CME or Bakkt, 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, called each other and said, hey, we’re just not going to send these coins to Coinbase even though we’re supposed to, they can just choose not to, and they can take them themselves. And given the fact that there’s, like, almost no legal recourse, right, like, this would be totally uncharted territory, like, that gets really theoretically dangerous for Coinbase.
So, I think that’s a really big reason why these exchanges haven’t opted in to use it, is because they just don’t trust each other, and like with the 11/15 configuration, it’s very easy to see how you get hurt, not for a million dollars. I mean, you could get hurt out of 50 million dollars. I mean, it could be a huge, huge loss.
Well, 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 am not really optimistic. I don’t see how to do it on Bitcoin. I think with the smart contract platforms that have newer approaches to scaling, as well as they have full scripting languages that allow for more advanced smart contract logic, I’m more optimistic, but on Bitcoin, based on the kind of current outlook, I don’t see how it’s going to get done.
All right. Well, let’s talk about Ethereum quickly. What are some of the different solutions there, and what’s your assessment of those?
Yeah. So, on Ethereum there’s a handful of solutions. Rollups are kind of a common one, I’m trying to think what are the other ones.
Sharding was another you mentioned in your blog post.
Yeah. That’s right. Sharding is the other big one. So, I’ll kind of touch on the sharding first. So ETH 2.0 is kind of working on sharding, 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, but the really big problem I have with sharding 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 in kind of a bunch of what I’ll call random ways, meaning you 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 sharded system, if you send the transaction from shard A to shard B, or like, you send money and you need to do a cross-shard transaction, you end up doing a transaction on shard A and shard B. And so when you do that, if you think about that, and then if 100 percent of the transactions are cross-shard, then what you end up effectively 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 shard.
And so that’s really concerning because then you end up, like, right, if people are shuttling money around to run these arbitrages and all these transactions are cross-shard, 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 percent of transactions being cross-shard, but certainly a meaningful percentage would be, and that’s going to be, again, nearing a time of volatility, a 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 percent of the time, but like, during the time when the systems are breaking and when everything is volatile and going crazy, that’s when you need it to really maintain that throughput advantage, and during those moments in time is when I think that’s going to really get tested in a really negative way.
This is 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, but anyway…
Right. When it’s peacetime, everything is good. Like, building systems to run during peacetime is easy. Like, building systems to work during wartime is really hard.
Yeah. Well, and then but what about optimistic rollups?
Yeah. So, optimistic rollups have a similarish problem where…well, a couple of problems. So, one is, at least the vanilla implementation of optimistic rollups doesn’t solve the latency issue because you still rely on the underlying layer 1 blockchain for clearing transactions. So, you increase throughput, but you don’t decrease latency.
But the other problem basically is that if these exchanges end up using their own optimistic rollup 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 rollup chains in order to produce the same effects, and so as I just think again, I look at these exchanges, these guys don’t coordinate on much of anything, and saying that hey, they’re all going to agree to use the same optimistic rollup chain just seems to me to be very unlikely. Like, they haven’t done that in the past, you know, technology is still new, these guys all seem to want to kind of have control of their own systems, and so I just find it unlikely that all of these players agree to use the same optimistic rollup chain, and if they don’t then you end up in basically the same kind of sharding logic that I just walked through.
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 off in 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 of 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 kind of after the fact.
Prime broker, you know, is a very big business in traditional markets. 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 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 five billion dollars collectively, you need to have at least five billion dollars and probably a lot more in order to be an 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. Tagomi, 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 require a change in the market structure, right? You don’t need to get the exchanges to agree on anything. You don’t need to introduce new standards. This is going to be very much like the exchanges want to do business with the trader which in this case 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 1 assets. You know, Ethereum people have been talking about proof of stake and sharding and all these things for years, you know, for the past couple of years you’ve seen a lot of really smart people say, hey, I have different ideas, and different ideas of how to scale these systems, and a lot of really smart people are working on scaling new layer 1s.
Of those, the one I’m kind of most interested in is called Solana, and they’re really the team focused on optimizing just the 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 you know, all of these problems around moving throuput around, around moving latency, all those things get just magically solved.
You don’t need to worry about new trust models, new security models, cross-sharded transactions. 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 very high conviction that like, you have a chain, you have assets on it, and you shuttle them around, and exchanges take deposits and withdrawals, and 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 nontrivial thing to do.
Definitely nontrivial, 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 on 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.
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Unchained is produced by me, Laura Shin, with help from Fractal Recording, Anthony Yoon, Daniel Nuss, John Durham, and the team at CLK Transcription. Thanks for listening.