Why is the market crashing?
Learn about the leveraged carry trade that is causing the crypto contagion
Hey all! Every fortnight at ARCx we have a segment called "The Dining Table” which covers updates about what’s going at ARCx but also a story about the broader market. The first episode is up and you can watch it below, or read along at your own convenience :)
Watch the second episode of Narrative Alpha on YouTube!
Transcript:
Welcome everyone to season seven episode three of The Dining Table, today's episode is called Crypto Contagion. So Crypto Contagion, let's get into it.
We're gonna mix up the format, focus on a single story and double down on that.
So the whole bit about Crypto Contagion is just seeing things fall like dominoes one by one, and I've been thinking a lot about how did we exactly get here. And I basically stumbled across Arthur Hayes who's the co-founder of BitMEX which is the legendary derivative exchange from the last, last cycle. So basically he's made an article called number three that I kind of derived this from. It’s a great read, I thought I'd simplify it and present in a more fun way.
So our story begins with Three Arrows Capitals humble Arbitrage beginnings so for those of you that don't know what Arb or Arbitrage is, it's basically a very risk-free way of making money, you find a discrepancy in a price in one place, you find it in the second place, and you basically balance out the price discrepancy by making a profit in between and I’ll kind of explain this in the next slide but the whole idea is that Three Arrows Capital they started off as Arbs effectively.
So the Arb that they were really good at were these things called non-deliverable forward markets, they're basically a way to lock in an exchange rate in future, denominated US dollars. So suppose you have the Korean won, you can basically buy an NFT that locks in the exchange rate in 30 days from now. So it's a Futures contract you're locking in the price of the trade in the future. The reason why this discrepancy starts off is because there's no proper way to price something in the future, everyone has a slightly different methodology. So the way that something would work or that a trader like an Arb trader like Three Arrows Capital would make money is, broker one will allow them to buy 1300 Korean won for one US dollar, settled in 30 days, and the second one allows them to sell 1301 Korean wons for a US dollar today, settled in 30 days. So I can basically execute a risk free trade by purchasing 1300 Korean won today from broker one and then selling it to work or two and earning one green won in the middle. Now that's a really tiny amount of money and if you do that with a million dollars you make like 770 dollars. Not really that interesting, but if you were to do it with a billion dollars you'd make about close to a million. So the point of this example is that like these Arb trades typically require a lot of capital to really generate like absolute profit for the person that's executing them. So if you imagine someone like Three Arrows Capital that are Arb traders- Leverage is really important for them because that's how they're actually going to be able to make profit effectively.
That's basically why this obscure Arb trade matters, it just demonstrates the fact that these risk-free trades need a lot of Leverage and Three Arrows Capital was really good at this before they enter the crypto markets. They are really astute traders that could do this consistently, so when Three Arrows Capital sees something like 20% risk free…
You get this cycles Arb carry trade. Probably one of the best ones in history that they've seen, so what was the UST carry trade? Like what was the Arb trade here? Well it was actually fairly simple.
Basically if you can borrow US Dollars whether it's from a bank or anywhere else for 20% per annum, convert those US dollars to UST and deposit UST to Anchor to earn 20 per annum, your profit is basically the difference between borrowing and earnings, and to exit the trade you just withdraw the UST, plus the earned interest convert it to US dollars re-pay your loan and keep the profit. So depending on how long you've been in this trade for if you were to enter in with say a billion dollars a month, you'll be making hundreds of millions of dollars in a year or tens of millions of dollars per month. So a trade like this, if you've been used to these really tiny trades like in this example and then you come across something like this, this is probably one of the best trades you've encountered in your life from a risk perspective, but what do you do when you come across something like this? Well you leverage up of course, you leverage up hard. So this is where the story gets more interesting.
How do you leverage to the max? Well essentially you need to convince lenders to give you as much money as possible with as little collateral as possible. So basically this was kind of Three Arrows Capital, they created an immaculate reputation on crypto Twitter to make them look like a god amongst mortals, predicting prices and making outlandish claims and kind of convincing many human beings at scale like hey we know what we're doing, then because 3AC is also a venture investor or in a lot of these private companies, a lot of their assets were illiquid, meaning you couldn't really liquidate them if you wanted to but they can still post them as collateral and not only do they post them as collateral once, but they did it multiple times to multiple lenders. So they tell different lenders hey I have this asset you should lend to me but then the do it to the next lender, and the next lender, and the next lender. So because there's the opaqueness of the information you're like “oh yeah they own it” but if the lender is actually spoken to each other or the information was public they couldn't have done it, but that was kind of the other thing which let them roll. And then the third bit and this is where contagion begins, they need to be able to find lenders who want to offer or have offered juicy rates to their depositors. So if you think about who are lenders who have offered high rates to their customers and want to keep them around, well it was basically CeFi lenders - such as Blockfi and Celsius, because in the bull market they were growing like crazy and they wanted to keep growing, so how do you keep growing? Well you offer high interest rates, but if you've promised a high interest rates, how do you sustain that? Well you need to find a borrower, and turns out the borrower was 3AC and the only reason why 3AC is willing to borrow at that high rate of four percent is because they are making 20% on the other side, so suddenly you've got like this huge chain where you've got a lot of leverage to execute this risk free trade then you've got lenders who are also a part of this trade, but not directly.
So then, for example Voyager one of the ones, it's a publicly listed company. They gave to the tune of hundreds of millions of dollars to 3AC. So all these CeFi lenders, because they were CeFi they had made agreements with 3AC based on their reputation, so they were like yeah we trust you, just take our money, so now 3ACl is leveraged to the max and all these CeFi lenders who have retail depositors on the other side, but retail don't know it. And then what happens?
Well when a hole blows through 3AC it blows up everyone. It's quite literally a nuclear blow up, so that's really kind of what we're experiencing aftermath of, it was like this risk-free Arb trade leveraged up to the max and as soon as a crack appears in the arb trade everyone connected with that arb trade got completely annihilated and we're just seeing that reckoning happening as the months go by, and the problem is that as like this blow ups happening all of the assets that 3AC had basically aren't worth much, so if the crypto market hadn't tanked they probably could have satisfied a lot of their obligations, but because everything is worthless now, they've become insolvent.
So that kind of like leads me to my next point which is, a lot of people say is DeFi bad? Is this a house of cards? And it's like not at all, DeFi actually worked exactly as it intended to, and it liquidated all the bad risky borrowers. Naysayers are gonna hate anyways but what we saw was really why DeFi is amazing and why CeFi and her opaqueness is terrible. I find this discussion really relevant because it's like well what about credit score based borrowing? Aren't you kind of trusting someone in a way like CeFi is? And my answer is not really, a DeFi native credit score is really different because when you're using algorithms, when you've got DeFi custody, you've got on-chain assets, you've got transparent open data sets, it's a much more effective much more efficient system. Like 3AC it was opaque about which collateral they were using and how many times they were using, something you can't do in DeFi and furthermore the assets you use in DeFi are always liquidatable, so you don't have to settle in courts and I think the biggest one is like humans making decisions who to lend and borrow to. Algorithms aren't prone to corruption.
So a DeFi native credit score is really kind of using that open nature of blockchains to allow algorithmic credit worthiness, without humans to extend credit to humans by algorithms.