Market Making: Guidebook to Crypto Foundations & Token Issuers


By Stéphane Reverre & Chadi El Adnani @SUN ZU Lab

February 2024


Link to PDF version

[NB: See the glossary at the end of the article for a definition of technical terms]

Liquidity(*) is the gasoline of any exchange, whether traditional or crypto, and the engines pumping it are called Market Makers. We have provided in a previous article a rather technical view on the subject. Today’s approach targets a broader non-technical, non-financial audience, with a focus on token foundations and issuers.

Questions and comments can be addressed to c.eladnani@sunzulab.com or research@sunzulab.com.

What is Market Making (MM)? The case of the used car market:

Say you are looking for a car, and quite naturally, end up at your local dealership. Under normal circumstances, the salesman can offer a brand-new vehicle, or a used one. Those prices are “offered” prices: the salesperson is selling/you are buying. 

Done deal: you get a used car, but unfortunately, realize 5 months later that it really doesn’t do the job. Too small, too big, whatever it is, you go back to the salesperson: “Hello, I bought a car from you 5 months ago, and it is not quite what I need. Can I sell it back?”. At this point, you may receive two different answers: 

i/ “Sorry, I don’t have a buyer; let me call you back when I do.” In that case, you will be able to sell when a buyer comes along, not before. You may also look for a buyer yourself.

ii/ “Yes, of course, I’ll take it from your hands at …”. This price is a bid price i.e., the dealership is buying/you are selling. 

The bid price will be lower than the original offer for obvious reasons (you drove the car for 5 months). Now, let’s assume, for the sake of the discussion, that you go back the day after your purchase. Will the salesperson bid the same price they offered the day before? Probably not. A bid will be lower than the offer price, if it is forthcoming. 

The difference between bid and offer (also called the “ask” or “asking” price) is called the “spread”(*). In practice, this is the minimum profit margin the dealership will want to secure to offer the used car service. This margin exists for a number of reasons, but most notably because the dealership is taking a financial risk in carrying an inventory of used cars. Bottom line: the bid-offer spread is necessary to remunerate a risk. This is why even if you bring the car the next day, you will not get the offer price: the dealer takes a risk by accepting the car back, and a profit will be needed to pay for that risk.

Market Making in Finance:

The SEC defines a market maker as “a firm that stands ready to buy or sell a stock at public quoted prices.” A market maker (MM) is a professional trader who actively quotes two-sided markets in a particular asset, providing Bids(*) and Asks(*) for a given quantity.

There is, in practice, no difference between a financial MM and a car dealership (no kidding). The difference is in the asset: contrary to cars, stocks are fungible (i.e., perfectly identical for a given issuer), not subject to wear and tear, and not continuously produced, which means that the “second hand” market is very active (you cannot get a “brand new” share).

A car dealership will always provide an offer price for a new car because it is its primary business, the one from which it derives most of its revenues. The fact that it would provide a bid price for a used car depends on a number of factors, and no dealership will consider that it has an obligation to do so. To be clear, selling new cars doesn’t create a financial risk: the dealership takes a deposit, orders the car, and delivers it against payment when the manufacturer has shipped. Buying a used car means getting cash out, with the risk of getting stuck with a car that nobody wants. 

Like the dealership, a MM may choose to participate in the market at all times or not, buying assets from sellers and selling them to buyers. MMs’ primary mandate is to provide liquidity, which ensures investors can trade quickly and at a fair price in all conditions. This creates a win-win situation where the MM earns profits for its services, and the overall market enjoys a certain level of liquidity, price stability and confidence. Evidently, MMs that decide to participate at all times carry a larger financial risk than those that do not. For a dealership, the level of financial risk is captured by the inventory of used cars waiting to be sold. This is exactly the same thing for the financial MMs. 

It is essential to note that MMs have a mandate to provide liquidity (i.e. help investors trade better), but not to move the price. This is achieved by keeping MM obligations symmetric, with a bid AND offer price published simultaneously and a maximum spread, in all market conditions. Obviously, if a MM is stuck with too much inventory, its risk management may push for liquidation, which in turn may impact the asset price. However, this impact is not a primary result of the MM intervention; it is a consequence of adverse risk conditions (even if the risk results from poor management). Ideally, a car dealership will want to buy and sell used cars so quickly that its inventory remains near zero as often as possible. It’s the same thing for a financial MM: trading is rapid on both sides of the spread, and inventory is null at the end of every day.

In real life, two situations occur: extremely liquid assets/tokens that can be easily bought or sold without causing significant price impact, and less liquid assets/tokens that experience substantial price swings every time a sizeable trade is executed. MMs are extremely useful in the second case.

Liquid asset: BTC-USDT on Bitstamp

Source: SUN ZU Lab Live Monitoring Dashboard

Let’s take Bitcoin (BTC) as an example of a very liquid asset. The lowest number in red represents the best Ask/Offer (the lowest price at which sellers are willing to sell, on this specific exchange, at the moment). In contrast, the highest number in green represents the best Bid (the highest price buyers are willing to offer for Bitcoin), the difference between the two is the Bid-Ask spread (4 USDT or 0.916 bps). We can see on the last column (cumulative $ USDT sell/buy order amounts at each level) that a $11K (USDT) spot buy order would leave the best Ask at 43,671 USDT, moving the mid-price by a mere 3 USDT to 43,676, and the new spread to 10 USDT or 2.3 bps. This would be a temporary situation as market participants would move quickly to fill this gap and bring the spread back to previous levels.

Illiquid asset: POLIS-EUR on Kraken

Source: SUN ZU Lab Live Monitoring Dashboard

In the case of POLIS-EUR as an example of an illiquid asset, a €1000 sell order would move the best Bid down to €0.301, creating a €0.027 spread, or a whopping 8.6%!

The business of Market Making: 

In TradFi, there are situations where market-making is voluntary and optional, and others in which it is self-imposed or even constrained by a contract. There are, for example, many hedge funds running “statistical arbitrage” strategies that are akin to voluntary market-making. The strategy stands ready to buy and sell in the market with a certain spread, and doing so will (hopefully) generate trading profits without too big an inventory. But if you want to become a registered MM with certain privileges, you must commit to continuously quoting prices. Examples of that abound in Europe; most electronic exchanges have MM programs for specific products: in exchange for a commitment to provide liquidity, MMs will enjoy reduced fees or sometimes outright payments. Under those commitments, MMs must quote a minimum volume at a maximum spread, and stick to those parameters at all times and during all market regimes.

When MMs operate under a contract with an exchange, they will often benefit from specific technical provisions: typically, the exchange will implement a “market maker protection,” which essentially cancels all orders (at once) from a MM when violent price moves occur. There are also different modalities for order management (for example, a “bulk order” capability, whereas regular investors can only send single orders, one at a time). Those features incentivize MMs to stay in the market even when volatility rises (i.e., when they are most needed) by offering privileged risk management tools. 

As an industry, market makers earn the ‘spread’ between bid and ask prices because they accept to carry inventory risk. When the spread is contractually set, their profit margin is mechanically constrained.

In today’s highly competitive markets, the bid-ask spread is often razor thin (0.1 to 1 bp for Bitcoin on leading centralized exchanges). To remain profitable, a market maker must price assets quickly and accurately, be able to execute trades at scale, and manage its inventory properly.

Inventory risk is indeed the most important risk here. You have to have some to fulfill your obligations (what if a buyer comes asking for some?), and yet it is subject to price movements. Too much of it will cost if prices are going down, and too little may prevent you from fulfilling investors’ demands. Incidentally, this risk is even more pronounced in crypto markets, where prices are more volatile.

The Importance of Market Making:

Liquidity & Depth

Market makers make it easier for investors to buy or sell an asset quickly or in large volumes. In financial terms, they deliver liquidity and depth to the market.

Attracting and concentrating the asset’s tangible volume is crucial – as opposed to engaging in practices like wash trading (*), layering or spoofing(*), which attempt to create fake or misleading volume. This distinction is significant in maintaining ethical financial practices and building investors’ trust. Market makers play a vital role in this, as their ability to optimize liquidity directly impacts the organic volume and, in the end, investors’ confidence. 

Insuring New Token Launch Success

New tokens are usually not widely known after their initial listing on exchanges and may suffer from a limited community of buyers and sellers, making it challenging for market participants to find each other and agree on a price. This is where MMs are extremely important to tighten the spreads, buying from sellers and selling to buyers at prices they both deem fair and acceptable. We covered in a previous article how the Worldcoin team relied on five MMs during the launch phase to ensure “sufficient liquidity for WLD traded on centralized exchanges outside the US, to facilitate price discovery, and to enhance price stability of WLD.”

Greater Price Stability and Lower Volatility

Market makers’ presence streamlines the execution of trades, reduces fluctuations in prices, and dampens supply and demand gaps. These activities build confidence among market participants. Market makers help ensure that markets function reliably and remain resilient even during times of turbulence.

Enforcing Price Coherence across Venues and Products

Crypto market makers can play a role in mitigating price discrepancies between different exchanges or instruments. They continuously quote buy and sell prices across different venues and related instruments, thereby strengthening market integration.

 How to choose your crypto Market Maker:

Because of their role in providing liquidity, MMs have an important role to play in the crypto ecosystem. Yet, bulletproof standards have not found their way into the marketplace, and stakeholders are not necessarily well protected – without even being aware of it. When choosing a MM to contract with, the most important questions are often those that are not even on the table. You know, the old adage: “What should I ask that you are not telling me?”

Here are, in our views, a few important considerations and certainly questions for which you should be getting answers – or your money back: 

Glossary:

Disclaimer

No Investment Advice

The contents of this document are for informational purposes only and do not constitute an offer or solicitation to invest in units of a fund. They do not constitute investment advice or a proposal for financial advisory services and are subject to correction and modification. They do not constitute trading advice or any advice about cryptocurrencies or digital assets. SUN ZU Lab does not recommend that any cryptocurrency should be bought, sold, or held by you. You are strongly advised to conduct due diligence and consult your financial advisor before making investment decisions.

Accuracy of Information

SUN ZU Lab will strive to ensure the accuracy of the information in this report, although it will not hold any responsibility for any missing or wrong information. SUN ZU Lab provides all information in this report and on its website.

You understand that you are using any information available here at your own risk.

Non Endorsement

The appearance of third-party advertisements and hyperlinks in this report or on SUN ZU Lab’s website does not constitute an endorsement, guarantee, warranty, or recommendation by SUN ZU Lab. You are advised to conduct your due diligence before using any third-party services.

About SUN ZU Lab

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboards & API streams or customized reporting. SUN ZU Lab provides Token Issuers & Market Makers with institutional standard actionable data solutions to improve the transparency and fairness of Crypto markets.

WorldCoin: Crypto’s holy path to mass adoption or a dystopian nightmare?


By Chadi El Adnani @SUN ZU Lab

August 2023

Worldcoin, the new cryptocurrency project co-founded in 2019 by OpenAI CEO Sam Altman, Alex Blania, and Max Novendstern, went live on July 24th with a bold aim to conquer the world. Sam, the creator of widely popular chatbot ChatGPT is looking to sign-up billions of users globally to use its cutting-edge iris-scanning and identity-verifying technology, in an effort to help solve what many have called a problem he actively contributed to creating: halting Generative AI’s hellish pace rise. The coming tsunami of AI-generated fake news and content is not an if but a when matter; Vitalik Buterin, Ethereum’s co-founder, was very clear about all the potential risks and what could go wrong with biometric proof-of-personhood solutions. He also acknowledged, however, that the efforts of teams tackling the problem, such as WorldCoin, could be humanity’s best chance against AI.

Weeks after its international launch, Worldcoin is drawing the attention of privacy watchdogs all around the globe, with Kenyan authorities going so far as to suspend the project’s activities in the country. We cover in this article Worldcoin’s fundamentals and tokenomics, trying to analyze whether it is indeed crypto’s holy path to mass adoption or a dystopian nightmare!

Questions and comments can be addressed to c.eladnani@sunzulab.com or research@sunzulab.com

Description & Value proposition:

According to the project’s white paper, Worldcoin aims to create a “globally-inclusive identity and financial network” that has the potential to “increase economic opportunity, scale a reliable solution for distinguishing humans from AI online while preserving privacy, enable global democratic processes, and show a potential path to AI-funded UBI.”

Worldcoin uses custom biometric imaging devices that scan users’ irises for Proof of Personhood (POP), an identity verification mechanism that uses unique attributes of individuals for Sybil resistance (preventing individuals from creating multiple fake identities). The team notes that irises are data-rich and offer strong fraud resistance beyond other biometrics like thumbprints and facial recognition. Since commercially available iris imaging devices did not meet the team’s needs, the Worldcoin team built their custom hardware known as “Orbs.” Users can register and verify their accounts by visiting an Orb operator (currently ~330 Orbs active in the last 30 days) and having their irises scanned to pass the humanness and uniqueness checks. A unique IrisCode is calculated on the Orb, which then gets verified using ZK proofs, allowing users to access their self-custodial World App wallets.

Regarding user privacy, the Worldcoin team claims they only use the data for the uniqueness check and do not collect PII such as names, phone numbers, or emails. Using ZK proofs enables users to pass the uniqueness check while retaining anonymity. Biometric data is processed locally on the Orb and then deleted by default once the IrisCode is created. However, users can opt into data custody to back up their biometric data with Worldcoin to reduce the times they may need to revisit an Orb.

For the project’s rollout, the Worldcoin team focuses on markets in the developing world, which could serve as launchpads for more significant regions. WLD token is used to incentivize user signups and the development of its Orb network through third-party manufacturers and operators. Currently, World ID has ~2.2 million signups with verified World ID users from 120 countries; 2,000 Orbs have been manufactured, and ~28 million WLD tokens have been claimed by users. At the current price of ~$1.3, WLD has a Market Capitalization of ~$160 million and a Fully Diluted Valuation (FDV, taking into account the total supply) of ~$12.7 bn, which would make one of the most valuable token across the entire crypto market few weeks after its launch. “Tools for Humanity”, the technology company behind Worldcoin, announced in May that it has raised $115 million in series C funding led by Blockchain Capital. The round also saw participation from major crypto investors a16z, Bain Capital Crypto, and Distributed Global.

Worldcoin is built over three pillars:

The project’s mission (from the whitepaper):

The mission of the Worldcoin project is to build the world’s largest identity and financial network as a public utility, giving ownership to everyone. A key component of the project is the development of the infrastructure that will be important for a world where AI plays an increasingly important role.

The project’s goals regarding the WLD token are as follows:

Tokenomics:

Worldcoin (WLD) is an ERC-20 token on Ethereum Mainnet and individuals will receive their user grants on Optimism Mainnet. Therefore, most WLD transactions will likely take place on the Optimism network. If needed, the token can be bridged back to Ethereum through the Optimism bridge.

The tokenomics of Worldcoin is laid out on its whitepaper on the website:

The “Liquidity Provisioning” section adds more details:

World Assets Ltd. (a subsidiary of the Worldcoin Foundation) has entered into loan agreements with five market makers operating outside of the US. The goal of engaging these entities is to ensure sufficient liquidity for WLD traded on centralized exchanges outside the US, to facilitate price discovery, and to enhance price stability of WLD.

Collectively, the five entities have received loans of 100M WLD for a time period of 3 months after token launch. At the end of the three months, each entity must return its loan or alternatively it may elect to purchase any amount of tokens up to the loan amount it has received. The price per WLD for this purchase will be set according to the following formula: $2.00 + ($0.04 * X), with X being equal to (i) the amount of tokens being purchased, divided by (ii) one million.”

Vitalik Buterin’s take on biometric proof of personhood and risks related to Worldcoin (link)

Ethereum co-founder Vitalik carefully assessed the pros and cons of the different approaches to proving proof-of-personhood, raising several concerns around the hardware, accessibility, privacy, and security.

He asks what the consequences might be if an “adversary can forcibly (or secretly) scan your iris and compute your iris hash themselves.” He raises the specter of AI bots fighting back with “3D-printed fake people” that could hoodwink biometric scanners. And he posits that a malicious actor could Sybil attack WorldCoin by paying low-wage people for their iris scans.

What are the major issues with Worldcoin’s construction?

There are four major risks that immediately come to mind:

It’s important to distinguish between (i) issues specific to choices made by Worldcoin, (ii) issues that any biometric proof of personhood will inevitably have, and (iii) issues that any proof of personhood in general will have. For example, signing up to Proof of Humanity means publishing your face on the internet. Joining a BrightID verification party doesn’t quite do that, but still exposes who you are to a lot of people. And joining Circles publicly exposes your social graph. Worldcoin is significantly better at preserving privacy than either of those. On the other hand, Worldcoin depends on specialized hardware, which opens up the challenge of trusting the orb manufacturers to have constructed the orbs correctly – a challenge which has no parallels in Proof of Humanity, BrightID or Circles. It’s even conceivable that in the future, someone other than Worldcoin will create a different specialized-hardware solution that has different tradeoffs.”

He concludes, however, that, despite “dystopian vibez,” a solution like WorldCoin could “do quite a decent job of protecting privacy.” And that, given the AI risk, it’s probably worth trying: “A world with no proof-of-personhood seems more likely to be a world dominated by centralized identity solutions, money, small closed communities, or some combination of all three.”

MIT Technology Review: Deception, exploited workers, and cash handouts: How Worldcoin recruited its first half a million test users (link)

An April 2022 MIT Technology Review article claimed that Worldcoin used “deceptive marketing practices, collected more personal data than it acknowledged, and failed to obtain meaningful informed consent.”

The blistering report chronicles a shoddy operation rife with misinformation, data lapses and malfunctioning orbs. “Our investigation revealed wide gaps between Worldcoin’s public messaging, which focused on protecting privacy, and what users experienced,” write Eileen Guo and Adi Renaldi. “We found that the company’s representatives used deceptive marketing practices, collected more personal data than it acknowledged, and failed to obtain meaningful informed consent.”

The company issued a 25-page rebuttal to MIT Technology Review’s criticisms.

“We want to make it very clear that Worldcoin is not a data company and our business model does not involve exploiting or selling personal user data,” it wrote. “Worldcoin is only interested in a user’s uniqueness—i.e., that they have not signed up for Worldcoin before—not their identity.”

WLD Market Charts:

Source: SUN ZU Lab Data

Conclusion – SUN ZU Lab’s initial take on WorldCoin:

About SUN ZU Lab:

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring better data to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboards, API streams, and historical files. SUN ZU Lab provides crypto professionals with actionable data to monitor the market.

Why will at least 80% of centralized crypto exchanges (CEXs) disappear?


By Stéphane Reverre & Chadi El Adnani @SUN ZU Lab

August 2023

TL;DR

It was October 2022 when we published an article titled “Why has liquidity become a question of survival for crypto venues?” urging centralized crypto exchanges to consider liquidity as the “gold standard” of their future profitability and deploy all necessary resources to monitor it and understand its drivers. Little did we know that one month later, the FTX/Alameda implosion would put the entire crypto ecosystem, and mostly centralized exchanges, on the brink of collapse.

Halfway through 2023, CEXs’ order book depths and trading volumes are ~10x thinner on average than 2022 levels, prompting us to express an even more aggressive view: “Why at least 80% of centralized crypto exchanges (CEXs) are going to disappear?Liquidity attracts more liquidity in the same way success is a magnet for even more triumphs. Add to that the looming regulatory pressure, and the bottom majority of CEXs will start falling like a domino chain, with the losers dying slowly.

Questions and comments can be addressed to c.eladnani@sunzulab.com or research@sunzulab.com

In TradFi, capital markets have been all about scale. Whether in banking, asset management, hedge fund, or trading venues sectors, the bigger are getting bigger! M&A has been one of the most significant value drivers for TradFi exchanges over the last 20 years, allowing groups to generate significant economies of scale by mutualizing costs from data centers, matching engines, and employees. Here is a selected list of the major acquisitions of the century:

Even though it is not exactly the same industry, The FDIC’s website provides additional valuable information on the evolution of the banking industry in the US. Between 1990 and 2022, the number of commercial banks insured with the FDIC went from 12,347 to 4,136, with the number of newly issued charters virtually near zero since 2008. As the retail and corporate segments increased significantly over the same period, the major remaining banks enjoyed the full benefits of consolidation and economies of scale with minimal efforts!

The list of exchanges’ failed M&A deals is even longer:

The remaining big five exchanges have also gone on an acquisition spree for data, analytics, indices, execution, settlement, and other infrastructure providers, as can be seen in the graph below, with the crown going to LSEG for its $27 bn acquisition of data and trading group Refinitiv, approved by EU regulators in 2021. 

Source: FT

Overall, the exchange business in Tradfi has seen many agitations up to the 2000s. This was followed by an accelerated consolidation wave, leading to the current market state post-2008’s GFC (“Global Financial Crisis”), where there is virtually no room for another newcomer due to the heavy regulation and high cost of capital (unless through an acquisition). The exact cause having the same effects, we expect the same level of consolidation to happen over the next couple of years for centralized crypto exchanges. This trend should be accelerated with the recent rise of “institutional” crypto trading venues, the latest being the launch of EDX Markets, backed by Citadel Securities, Charles Schwab, & Fidelity. EDX will operate as a non-custodial exchange, serving only institutional clients with plans to launch EDX Clearing to settle trades matched on the exchange, a feature still absent from nearly all CEXs.

Coinbase, the first crypto exchange to go public, provides us with a valuable sneak peek into its financials through regulatory filings:

Source: Coinbase Shareholder Letter Q1 2023

We can notice that, disregarding a slight uptick in Q1 23, transaction revenues have been free-falling since 2022, with total revenues divided by three over the period. However, revenues from subscriptions and other services more than doubled to $362 million. The compensation from diversification channels wasn’t enough to compensate for the loss from transaction revenues, as Net Revenue fell 37% YoY. Coinbase also introduced in May 2023 a new subscription service called “Coinbase One,” available for a monthly fee of $29.99 and providing a range of features that include zero trading fees, increased staking rewards, and round-the-clock customer support. The service was launched in the US, UK, Ireland, and Germany, with plans to extend its availability to 35 countries. Coinbase’s race and doubling down on revenue diversification is a strong distress signal for all other centralized crypto exchanges, which we are sure are in a far worse state than the leader Coinbase.

To put matters into perspective, here is a financial performance comparison in 2022 between Coinbase and the major TradFi exchanges around the world:

Source: 2022 10-K Forms and Annual Reports

The proportion of non-transactional revenues for TradFi exchanges (45% on average) is way higher than Coinbase’s figure. TradFi exchanges are also impressive cash cows, with an average EBITDA margin of 49% and an average profit margin of 31%. The fact that the leader of crypto centralized exchanges is nowhere near these profitability levels is one major alarming sign for the whole sector. The only path to recovery is through revenue diversification, and one surprisingly unexplored gold mine is data monetization!

Below are two examples of how Euronext and LSEG diversify their revenue streams:

Source: Euronext Q4 and FY 2022 results
Source: LSEG 2022 Annual Report

Centralized crypto venues should realize the magnitude of the problem and face the fact: if the market leader still hasn’t found a magic formula to profitability, maybe the solution isn’t different from what has been a major success in TradFi for years!

The path to recovery and survival, in our view, starts with asking the right questions:

A thorough internal process revue around the previous questions should give the first movers among CEXs the opportunity to:

We have been connected to 40+ major centralized crypto exchanges at SUN ZU Lab for years. Our cutting-edge technology and deep market microstructure expertise provide us with a sharp view of tick-level order book activity in these exchanges, most often giving us a better understanding of their trading dynamics than management teams lacking internal resources. We have the right combination to accompany a centralized crypto venue to answer the previous problems before it is too late!

Let’s discuss

About SUN ZU Lab:

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring better data to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboards, API streams, and historical files. SUN ZU Lab provides crypto professionals with actionable data to monitor the market.

Market Making Overview: TradFi vs Crypto


By Stéphane Reverre & Chadi El Adnani @SUN ZU Lab

June 2023


Link to PDF version

Market Making Overview: TradFi vs Crypto – SUN ZU Lab

[NB: See the glossary at the end of the article for a definition of technical terms]

Liquidity(*) is the gasoline of any exchange, whether traditional or crypto, and the engines pumping it are called Market Makers. We define them in this article and go over their role, strategies, and risks, as well as a thorough comparison between market making in Tradfi and crypto.

We have already provided in-depth detail about TradFi and crypto market liquidity here, and why liquidity has become a question of survival for crypto venues here, so let us dive right into the nitty-gritty of market making.

Questions and comments can be addressed to c.eladnani@sunzulab.com or research@sunzulab.com.

Market Making in TradFi

Historically, cash equity markets used to execute auctions manually to match buyers and sellers, and it could take seconds to fill a marketable order. Today, they are mainly electronic, with trading occurring on fully-automated exchanges and dark pools. In contrast, fixed Income markets remain primarily dealer-driven and over-the-counter (OTC)(*), in many cases still trading via person-to-person telephone interactions – although electronic trading is taking ground under regulatory pressure. Contrary to equities, foreign-exchange (FX) markets are dominated by a handful of the world’s largest banks and market-making firms, who stand ready to provide two-sided markets and liquidity even when central banks intervene, driving periods of high market volatility.

Registered market makers (MM)(*) generally provide transparent two-sided bid-ask(*) quotes at all times when a market is open, meaning that MMs will publish a price and amount that they are willing to buy or sell at throughout the trading session. In fact, Reg NMS(*) requires that registered MMs provide firm quotes immediately accessible to incoming orders. They are also usually constrained to maintain spreads below a maximum limit, a minimum order book depth and presence in the order book a minimum duration within trading sessions (the uptime requirement). As a result, MMs collect trading profits from their activity, in addition to incentives (for example, rebates against regular trading fees) offered for displaying orders at certain venues (from exchanges or issuers who want to maintain adequate liquidity). Liquidity providers are mostly passive in the order book, but they may occasionally aggressively take liquidity in some circumstances to manage their risk and inventory.

It is essential to note that MMs have a mandate to provide liquidity (i.e. help investors trade better), but absolutely not to move the price. This is achieved by keeping the MM obligation symmetric, with a bid AND ask price at the same time and a maximum spread to make sure MM prices are not too far from the actual price.

In the US, for example, the regulatory requirement is that the Designated Market Maker (DMM) must always be willing to buy or sell one round lot (usually 100 shares). They are further required to quote at the National Best Bid or Offer (NBBO) at least 15% (10%) of the trading day for securities trading over (under) 1,000,000 shares per day. When they are not at the NBBO, their quotes can be at most 8% away for stocks in the S&P 500 or Russell 1000 indexes. For other stocks, the maximum amount their quotes may be away from the NBBO is 28% for stocks trading at or over $1 and 30% otherwise. Market making obligations are only active during regular trading hours (9:30 AM – 4:00 PM) on most days: market makers are not required to quote outside these time frames.

On the European markets operated by NYSE/Euronext, there are two types of market makers – auction or permanent. The former add liquidity for stocks only traded through call auctions and the latter for stocks traded continuously. Auction market makers (also called “liquidity providers”, LP), are only required to maintain a spread during the order collection phase of each auction. The maximum spread width for both market makers is between 2% and 5% (€0.10 and €0.25) for stocks trading above (at or less than) €5. Euronext LPs obtain a reduction in fees and may receive side payments from the companies they trade. Such a payment occurs under a “liquidity contract”, under which a market maker receives a pre-agreed remuneration from the issuer to maintain a certain liquidity. Trading profits (and/or losses) are usually carried by the issuer (i.e. the market maker is insulated from market risk).

Market Making in TradFi overall is a heavily regulated and transparent business; regulators surveil MMs to ensure they comply with their obligations. Regulators (or exchanges) can impose both positive and negative obligations on market makers, requiring them to provide liquidity to the market or preventing them from executing a trade if a retail order could execute instead of it, for example. For example, EUREX (a European derivatives exchange) states here the specifics of Regulatory Market-Making, according to MiFID II, and Commercial Liquidity Provisioning on its platform. In practice, MMs sign a contract with exchanges, and the list and details of contractual MMs are public for everyone to see. The idea is that an investor looking for liquidity may directly contact a MM.

Market Making strategies, risks & examples

Here is an overview of the most common market making strategies in TradFi:

Delta Neutral Market Making: A market maker seeks to self-hedge against the inventory risk and wants to offload it in another trading venue. For that, a MM would place limit orders on an exchange with low liquidity, and when those are filled, immediately send a market order (on the opposite side) to an exchange with higher liquidity.

High-frequency “at touch” Market Making: A common strategy for MMs is submitting limit buy/sell orders at the best bid/ask prices. The MMs bid/ask order spread is then equal to that of the limit order book (LOB). Sometimes, MMs will submit orders at prices marginally higher than the bid and lower than the ask to gain order execution priority. However, this is only possible when spreads are not already very tight. Alternatively, a market maker could place their orders further into the LOB queue (lower bid and higher ask). This strategy produces higher margins but also a lower order execution rate.

Last Price: In this case, MMs will reference the last price a security traded at when placing their bid/ask quotes, submitting bid/ask orders one or two ticks away in either direction. This strategy provides a higher return than the “at touch”; however, this comes at the expense of higher end-of-day inventory of the given security.

Grid Market Making: In this case, a market maker places limit orders throughout the book, of increasing size, around a moving average of the price, and then leaves them there. The idea is that the price will ‘walk through’ the orders throughout the day, earning the spreads between buys and sells.

These strategies work well when prices are relatively stable but may lose money heavily during sustained momentum or volatility periods. When prices keep going up, the MM will find it extremely difficult to execute bid orders, accumulating an increasingly significant losing-money short position, and the same applies in the opposite direction. MMs should pay close attention to market volatility and order book imbalances to avoid being trapped in such situations.

According to studies published in 2014 and 2021, market makers are likely to reduce their market participation in periods of significant volatility. MMs often farther into the LOB in such situations to avoid being caught out by significant and abrupt changes in the market, reducing liquidity and potentially making markets even choppier. In addition to reduced trading volumes in periods of volatility, MMs will adjust their quoting price based on movements in the order book, monitoring the LOB for any order imbalances. For example, MMs will adjust their ask/bid quotes if the volume difference between bid and ask quotes grows, expecting an uptrend in price movements.

It is also interesting to note that when MMs operate under a contract with an exchange, they will often benefit from specific technical provisions: typically, the exchange will implement a “market maker protection” which essentially cancels all orders (at once) from a MM when violent price moves occur. There are also different modalities for order management (for example, a “bulk order” functionality, whereas regular investors can only send single orders, one at a time). Those features act as an incentive for MMs to stay in the market even when volatility rises (i.e. when they are most needed) by offering specific risk management tools.

All else equal, strategies accounting for order book imbalances increase returns and end-of-day inventory. Those adjusting the bid/ask quote for volatility will also increase returns while decreasing inventory. These two strategies are hence often combined to achieve optimal performance.

One of the most significant risks of market making is the inventory risk. MMs have to store a particular amount of assets to fill a buy/sell order, and the inventory risk manifests itself every time markets start forming a trend (upwards or downwards) for a sustainable period. The inventory risk in a scenario of decreasing prices results in the risk of having more of an asset at the wrong time, with difficulties to find buyers to unwind it. This risk is vastly larger in crypto markets, where prices are  more volatile.

To illustrate the above, let us give a quick example of how a basic market-making trade takes place, a MM active on a stock X shows a bid and ask price with a quote of $10.00 – 10.05 (not necessarily the same bid and ask volumes). This means that the MM is willing to buy X stocks for $10.00 and sell them at $10.05, earning a spread of 5 cents per share (in the absence of market movement, this is indeed a maximum gain). If everything goes well, the MM could buy and sell 10,000 shares at these quotes, earning $500 from this trade.

If, on the contrary, a large sell order takes place, the MM could find itself long Y shares with the best ask down to $99.95, for example. The MM is faced with the choice to hold its position if it believes prices will reverse higher, post an order to sell at $99.95, or even choose to simply trade out of the position by selling to the prevailing highest-priced buy order, locking in a trading loss.

Crypto Market Making

The market making business in the crypto space has little to do with its older, more established counterpart in TradFi. After 14 years, crypto markets are still in a “far west” state. It is not an exaggeration to say that exchanges are far from mature, from both a technical and regulatory standpoint: liquidity is low (to very low), highly concentrated on a few instruments, slippage risks are high, manipulation is frequent, and there are clear probabilities of flash crashes when large orders appear.

Market Making agreements in crypto are also different from TradFi in many aspects, mainly:

The terms of the market-making agreement, also known as the Liquidity Consulting Agreement (LCA), often evolve around compensation: MMs will receive financial incentives to reward improvements in a token’s liquidity and market value. Typical components are  service fees, options, or KPI-based fees:

Examples of such crypto market making agreements are public and can be found here or here.

Crypto markets also bring the question of CEXs vs DEXs market making. Market making on centralized exchanges is similar in principle to what professional firms do in Tradfi. Another critical concept is the difference between “maker” and “taker” orders. The former refers to orders where the buyer or the seller defines a price limit at which they are willing to buy or sell. Taker orders, by contrast, are orders that are executed immediately at the best bid or offer. Thus, maker orders add liquidity, and taker orders remove it. Crypto market makers must be meticulous when managing their inventory to not pay excessive taker fees (example of the fee structure on Coinbase).

Regarding market making on DEXs, we previously highlighted the process of price discovery in DeFi protocols, taking the example of liquidity pools in Automated Market Makers (AMMs) with a focus on Uniswap (qualitative and quantitative analysis).

Market depth comparison between BTC/USD (~$60m/$45m bid/ask volume at 200 bps) and MATIC/USD (~$2.3m/$1.3m bid/ask volume at 200 bps), on Binance.Us, Bitstamp, Coinbase-Pro, Kraken and Bitfinex

Source: SUN ZU Lab Live Dashboard

Glossary:

Disclaimer

No Investment Advice

The contents of this document are for informational purposes only and do not constitute an offer or solicitation to invest in units of a fund. They do not constitute investment advice or a proposal for financial advisory services and are subject to correction and modification. They do not constitute trading advice or any advice about cryptocurrencies or digital assets. SUN ZU Lab does not recommend that any cryptocurrency should be bought, sold, or held by you. You are strongly advised to conduct due diligence and consult your financial advisor before making investment decisions.

Accuracy of Information

SUN ZU Lab will strive to ensure the accuracy of the information in this report, although it will not hold any responsibility for any missing or wrong information. SUN ZU Lab provides all information in this report and on its website.

You understand that you are using any information available here at your own risk.

Non Endorsement

The appearance of third-party advertisements and hyperlinks in this report or on SUN ZU Lab’s website does not constitute an endorsement, guarantee, warranty, or recommendation by SUN ZU Lab. You are advised to conduct your due diligence before using any third-party services.

About SUN ZU Lab

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboards & API streams or customized reporting. SUN ZU Lab provides crypto professionals with actionable data to monitor the market and optimize investment decisions.

(2/2) Commentary notes on Credit Suisse’s rescue deal and recent banking turmoils


By Stéphane Reverre and Chadi El Adnani @SUN ZU Lab

March 2023

Following the first article last week, where we analyzed in detail the behind-the-scenes of SVB’s fall, and after another crazy weekend with the mega-deal between UBS and Credit Suisse, one of the biggest since the GFC in 2008, we are happy to provide some further analyses on the ongoing situation.

Deal terms:

Swiss authorities sprinted over the weekend to engineer a takeover of spiraling Credit Suisse before the markets opened on Monday, a globally accomplished mission. However, nervousness was mounting on Monday in the markets following Sunday’s announcement that UBS will buy Credit Suisse for CHF 3 bn, a 95% discount to the bank’s 2010 market capitalization levels. Under the deal’s terms, Credit Suisse shareholders will receive one UBS share for every 22.48 Credit Suisse shares held, or CHF 0.76 per share (Credit Suisse closed Friday at 1.86 Swiss francs). This rescue, organized by the Swiss authorities to avoid a loss of confidence in the global banking system, was made at the cost of significant guarantees given by the Swiss government to UBS. Credit Suisse declared it intends to hand out bonuses to its staff despite the rescue deal.

Moreover, following the historic deal on Sunday, FINMA ordered that CHF 16 bn of Credit Suisse’s additional Tier one (AT1) bonds be written down to zero. AT1s were introduced as part of the post-GFC regulatory reforms to push banks to increase their capital levels. They are a form of contingent convertible security (coco) that can be converted into equity in case of trouble. This surprising decision will likely shock the market due to the hierarchy inversion between equity and bondholders. European financial regulators expressed concerns around the Swiss authorities’ decision, issuing statements on Monday to reassure holders of additional tier 1 (AT1) bonds in eurozone banks that they would not suffer the same fate as those at Credit Suisse.

How did we get here?

The 167-year-old financial institution was mismanaged for years before its collapse: conviction for cocaine-money laundering in June 2022, leaks about $8 bn in accounts of criminals, dictators, and rights abusers held by the bank in February 2022, $5.5 bn loss following Archegos default and Greensill fund collapse in March 2021, etc. Last week, the global panic surrounding the banking industry caused massive outflows from the bank (up to $10 bn per day, according to the WSJ), bringing CS to the brink of collapse.

How is the situation looking from the US side?

We learned that SVB priorly hired BlackRock’s consulting arm, Financial Markets Advisory (FMA), to analyze the potential impact of various risks on its securities portfolio. The report found that the bank lagged behind similar banks on 11 of 11 factors considered and was “substantially below” them on 10 out of 11. BlackRock’s consultants found that SVB could not generate real-time or even weekly updates about the state of its securities portfolio, but the bank didn’t take any follow-up actions. The bank was also on the Fed’s radar for over a year before its collapse; the WSJ reported that SVB was using an incorrect model as it assessed its own risks amid rising interest rates and spent much of 2022 under a supervisory review. The fair conclusion is that we’re facing a massive failure of risk management, nothing more, nothing less. Senior management failed to adjust its practices and business mix and assess the implication of the yet all-too-visible inflationary pressures with its train of rate hikes.

Regarding the upcoming FOMC meeting this week, Whatever decision the Fed takes will be heavily criticized. Suppose it decides to raise its main policy rate by 50 basis points (which would be legitimate given the level of inflation). In that case, it will be criticized for adding to the banking sector’s difficulties. This will also be the case if it raises its rate by only 25 basis points (which the market sees as the most likely scenario). Some analysts consider that it could take a break from monetary policy. This is challenging as it risks losing credibility in the fight against high inflation. Moreover, resuming a rate hike cycle quickly after stopping it is difficult. Finally, a rate cut would risk accentuating the panic and underlining that the situation on the banking front is undoubtedly worse than expected… In any case, the Fed seems bound to fail on Wednesday.

What happened as well?

Last thoughts:

After Lehman Brothers, Bear Sterns, SVB, Credit Suisse, First Republic… senior bank management should not doubt anymore: poor risk management will kill in the blink of an eye. Crypto players, whether CeFi or DeFi, should not feel immune from this. If we had one primary piece of advice to the community, it would be K.Y.R, Know Your Risks! which is probably not so frequent in crypto.

Disclaimer

No Investment Advice

The contents of this document are for informational purposes only and do not constitute an offer or solicitation to invest in units of a fund. They do not constitute investment advice or a proposal for financial advisory services and are subject to correction and modification. They do not constitute trading advice or any advice about cryptocurrencies or digital assets. SUN ZU Lab does not recommend that any cryptocurrency should be bought, sold, or held by you. You are strongly advised to conduct due diligence and consult your financial advisor before making investment decisions.

Accuracy of Information

SUN ZU Lab will strive to ensure the accuracy of the information in this report, although it will not hold any responsibility for any missing or wrong information. SUN ZU Lab provides all information in this report and on its website.

You understand that you are using any information available here at your own risk.

Non Endorsement

The appearance of third-party advertisements and hyperlinks in this report or on SUN ZU Lab’s website does not constitute an endorsement, guarantee, warranty, or recommendation by SUN ZU Lab. You are advised to conduct your due diligence before using any third-party services.

About SUN ZU Lab

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboards & API streams or customized reporting. SUN ZU Lab provides crypto professionals with actionable data to monitor the market and optimize investment decisions.

(1/2) Commentary notes on SVB’s failure Credit Suisse, implications for crypto, and where do we go from here


By Stéphane Reverre and Chadi El Adnani @SUN ZU Lab

March 2023

To be clear from the start, we do not try to undermine the gravity of what happened this weekend. The implosion of Silicon Valley Bank (SVB) on Friday could have quickly turned, under other circumstances, into a full-blown banking crisis in the US and worldwide. Contagion fears are far from over, as underlined by the events around Credit Suisse yesterday. We would like, however, to share some of our thoughts to reassure and clarify some points. There is already plenty of (more or less) good analyses around the bank’s failure, so we’ll dive straight into it.

1 — Summary of the events

The US banking sector had its worst week since the GFC in 2008. In a span of 2 days, Silvergate Capital collapsed, while Silicon Valley Bank (SVB) sent chills through the industry after it launched a failed effort to raise more than $2 billion in capital to bolster its capital base. SVB worked with nearly half of US VC-backed tech companies, and VC funds responded to this news by advising portfolio companies to withdraw capital. The media reported that Founder’s Fund and a16z advised portfolio companies to take these actions. SVB responded by informing select customers that it has ~$180B of available liquidity and top-tier capital ratios relative to its peers. Later the same week, US regulators closed SVB before moving to close Signature Bank as well, the last of the three crypto-friendly banks in the US. Now, one cannot help but wonder: would such a dramatic collapse have taken place if VCs had not advised their portfolio companies to withdraw their money? Intrinsically it was in their best interest to get their money out as quickly as possible, ironically though it was probably also in their best interest not to.

From the European side, stock markets fell sharply Wednesday, with banking stocks deep in negative territory following more bad news from Credit Suisse. The bank fell 24% amid growing concerns about a run after its biggest backer, Saudi National Bank, said it would not provide any further financial support.

2 — This was a very usual bank run on a very unusual bank

While Signature Bank faced a criminal probe ahead of its collapse, according to Bloomberg, Silvergate and SVB suffered from a lack of client diversification (crypto focus for the former and VC-backed tech for the latter). The events are also causing new investor concerns about some of the US and EU’s largest financial institutions. This is linked to two main factors, rising interest rates and the inversion of the yield curve, which recently dipped below 100 bps for the first time since 1981 for the 10Y-2Y yields. The inversion significantly affects banks as they usually invest their short-term client deposits into long-term bonds. As the yield curve inverts, they have to pay more on deposits than they earn on their investments, while higher rates lower the value of their existing bonds. In this context, SVB was forced to sell all its available-for-sale bonds at a $1.8 billion loss as its startup clients withdrew deposits. This situation is not unique to SVB; many banks have parked depositor money in fixed-rate government bonds that have lost value due to the rapid rise in interest rates. The FDIC recently reported that US banks are sitting on $620 bn of combined unrealized losses in their securities portfolios. SVB would have been capable of staying afloat had there not been this panic movement that eventually caused the run. (…apparently, they were already in trouble at the end of 2022 when losses were much higher than 2 bln$)

Many economists have thoroughly studied the mechanics of a bank run, but at the core of it, a run is a self-fulfilling prophecy that could annihilate the most robust of banks. As soon as a critical mass of clients is persuaded that the bank is likely to suffer a run, a race to zero is triggered by everyone trying to pull their money in an attempt to get ahead of everyone else. It all comes down to the confidence factor, and SVB’s failure was not the first but one of the biggest. There have been more than 500 bank failures in the US alone since 2008.

To prevent this vicious circle from getting into action, the FDIC in the US insures all accounts up to $250,000, which for a standard bank should amount to around 50% of the client base. The problem was that most of the deposits in SVB (c. 95%) were not FDIC insured as they were over the $250,000 limit. This is maybe the biggest cause of SVB’s woes: lack of client diversification outside the tech VC-backed startup base. It also needs to be clarified why so many startups were incentivized to use SVB as a bank instead of relying on a more classic and robust choice, such as JPM or BoA. Some plausible explanation would be that SVB was a primary lender to these startups, with the condition to keep their money in the bank. From this point, all it took was a bunch of prominent VCs, led by Peter Thiel’s Founders’ Fund, advising their portfolio companies to pull their money out of SVB to run the bank in less than two days.

3 — The worst is never certain — “Le pire n’est jamais certain”

Over the weekend, much speculation existed about whether the US government would intervene to save the situation. Sunday evening, the Treasury, the Fed, and the FDIC released a joint statement to inform SVB depositors that they would have access to all their money on Monday. The US startup ecosystem was saved from an “extinction-level” event, but there was little doubt that the US government would allow something this dramatic to happen.

Secretary of the Treasury Janet Yellen set things straight over the weekend: “Let me be clear that, during the financial crisis, there were investors and owners of systemic large banks that were bailed out . . . and the reforms that have been put in place means we are not going to do that again…”. The released joint statement later added that “Shareholders and certain unsecured debtholders will not be protected. Senior management has also been removed. Any losses to the Deposit Insurance Fund to support uninsured depositors will be recovered by a special assessment on banks, as required by law.”

Regarding the CS situation, Switzerland’s Central Bank pledged to fund the bank with liquidity “if necessary,” a first for a global bank since the GFC. In a joint statement with FINMA, they insisted that CS was sound and “meets the capital and liquidity requirements imposed on systemically important banks. Later the same day, we learned that CS would borrow around CHF 50 bn from a Swiss National Bank liquidity facility and repurchase certain OpCo senior debt securities of up to CHF 3 bn.

4 — Who lost what exactly?

Officials insisted this was NOT a bailout, as only the banks’ clients were getting their money back. President Biden later added, “That’s how capitalism works, “ referring to SVB and Signature Bank investors who lost their money.

As a reminder, the Basel III accord raised banks’ minimum total capital requirements to 8%, as a percentage of the bank’s risk-weighted assets (RWA), with a minimum Tier 1 capital ratio of 6%. Tier 1 refers to a bank’s core capital, equity, and the disclosed reserves that appear on the bank’s financial statements. Here, major US banks maintain Tier 1 capital ratios well above 10%. The Basel accords also require a minimum of 100% LCR ratios as of 2019 (The Liquidity Coverage Ratio (LCR) refers to the proportion of highly liquid assets held by banks to ensure their ability to meet short-term obligations). SVB was a category IV bank; although it was the 16th largest bank, it was never subjected to the Fed’s LCR requirements.

SVB’s regulatory disclosures at the end of 2022 show the following:

The bank shows $17 bn of Tier 1 Capital and $111.4 bn of Risk-Weighted Assets for a CET1 capital ratio of 15.26%.

SVB Financial Group’s consolidated balance sheet is detailed below:

Was the bank solvent? Theoretically, yes! as of the end of 2022 it held:

These securities offer all the liquidity guarantees since they are HQLA-eligible (High-Quality Liquid Assets) and guaranteed by US state agencies. However, these securities are bonds whose value falls mathematically when rates rise, and the Fed’s rates have increased dramatically and faster than anyone had expected last year from 0.25% to 4.5%.

Moreover, the necessary disposal of part of the AFS securities to ensure the bank’s liquidity generated the aforementioned $1.8 bn in losses. The bank also disclosed in a footnote of its December 10-K Form that the HTM book had $15 bn of unrealized losses. Considering that SVB’s capital stood at $16 bn at the end of 2022, the bank only had limited capital to absorb the losses even before the run began. On paper, everything looked ok, but in reality, the rapid rise in interest rates had devastated SVB’s capital buffer (Before Collapse of Silicon Valley Bank, the Fed Spotted Big Problems). The fair conclusion is that we’re facing a massive failure of risk management, nothing more, nothing less. It is a failure of senior management to adjust its practices and business mix and to assess the implication of the yet all-too-visible inflationary pressures with its train of rate hikes.

Here lies another important part of the problem. In a recent article following the events, the CFA Institute criticized HTM accounting, calling it “Hide-Til-Maturity” and advising FASB to eliminate it. They continue to precise that “Overall, SVB’s total assets at 12/31/2022 were $211.8 billion of which only approximately $40 billion (cash and available-for-sale (AFS) securities) were at fair value and immediately available to pay the $173 billion in deposit liabilities — which are all due within the next year, according to SVB’s contractual obligations table.

Another interesting observation, rather than selling its securities on the market, SVB has liquidity lines in the form of repo agreements with bank counterparties, the FHLB, or the Fed, allowing it to collateralize its investment-grade bonds with cash. However, the management has decided to sell part of its bond portfolio quickly. We still need a convincing reason as to why they took this decision.

The deposits’ details were the following:

From the $173.1 bn in total deposits, $165.4 bn (95%) exceeded the FDIC insurance limit.

5 — What now?

Now that the FDIC controls SVB, its assets will be sold to the highest bidder. An auction on the assets already started Sunday, but there are very few banks capable of absorbing the significant quantity, and a deal has yet to be reached. SVB did not pose a systemic risk, and the US government’s quick actions over the weekend ensured the contagion didn’t spread. The events still negatively influence sentiment towards the financial sector, particularly US regional banks.

On the other hand, Credit Suisse is part of the closed club of Bulge Bracket banks imposing a global systemic-level risk. The fact that quotes for Credit Suisse’s 1yr CDS exceeded 3000 bps on Wednesday is historic and approaching a rarely-seen level that typically signals serious investor concerns.

Circle’s USDC was one of SVB’s most significant casualties over the weekend, as the firm confirmed having $3.3 bn of its $40 bn reserves in the failed bank. Over the weekend, USDC lost over 10% of its value, trading as low as $0.87 before regaining its peg on relatively joyful news Sunday evening. It is interesting to note the parallel with Tether’s USDT, which was trading at a premium for most of the weekend. In times of crisis, the market preferred Tether’s opacity to Circle’s mishandled communication. Some argued that trusting one entity with 8% of the stablecoin’s reserves was a strategic mistake.

The closure of Silvergate, SVB, and Signature, the last of the three crypto-friendly banks, creates a significant gap in the market as the industry lost 3 of its major fiat on-ramp/off-ramp partners. This will create a considerable liquidity decrease in the ecosystem, and other banks and financial intermediaries will have to step in to fill this gap.

Before last week, Fed Chair Jerome Powell seemed determined to continue hiking rates until inflation returns to a long-lost 2% threshold. With the second and third largest bank failures in US history happening in less than two days, some economists predict that Powell will change his strategy to put the health of banks above all other considerations. Goldman Sachs no longer expects a rate increase at the Fed’s meeting next week, while Nomura made an even bolder prediction of a rate cut. According to Bloomberg, The ECB will forgo earlier guidance for a half-point interest-rate increase at this week’s meeting and only hike by half that amount amid concerns over the financial sector’s health. The European Central Bank should either delay or pare back this week’s planned interest-rate increase to avoid a policy error reminiscent of 2011, added former executive board member Lorenzo Bini Smaghi.

We have indeed avoided, for now, a 2008-level crisis. Still, the events will not go unnoticed, with many debates underway regarding the utility and threshold of the FDIC insurance, regulation of mid-sized banks, and the Fed’s monetary policies in times of crisis. One thing is clear; we should, at all costs, avoid creating unnecessary panic given the current fragility of the world economy.

Disclaimer

No Investment Advice

The contents of this document are for informational purposes only and do not constitute an offer or solicitation to invest in units of a fund. They do not constitute investment advice or a proposal for financial advisory services and are subject to correction and modification. They do not constitute trading advice or any advice about cryptocurrencies or digital assets. SUN ZU Lab does not recommend that any cryptocurrency should be bought, sold, or held by you. You are strongly advised to conduct due diligence and consult your financial advisor before making investment decisions.

Accuracy of Information

SUN ZU Lab will strive to ensure the accuracy of the information in this report, although it will not hold any responsibility for any missing or wrong information. SUN ZU Lab provides all information in this report and on its website.

You understand that you are using any information available here at your own risk.

Non Endorsement

The appearance of third-party advertisements and hyperlinks in this report or on SUN ZU Lab’s website does not constitute an endorsement, guarantee, warranty, or recommendation by SUN ZU Lab. You are advised to conduct your due diligence before using any third-party services.

About SUN ZU Lab

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboards & API streams or customized reporting. SUN ZU Lab provides crypto professionals with actionable data to monitor the market and optimize investment decisions.

The Future of Trustless and Decentralized Cross-Chain DeFi – Focus on Interlay


By Chadi El Adnani @SUN ZU Lab

January 2023

This article was part of a broader report on the following theme: “Challenges and opportunities: The future of DeFi in TradFi”. Crypto Valley Association selected it among the top 5 pieces for its 2022 Call For Papers challenge.

Interlay came into existence based on the observation that all current existing cross-chain Bitcoin, and other digital tokens, are all centralized and custodial, like the major USD-pegged stablecoins USDT and USDC. These bridges make users give up control over their assets and trust a third party to maintain the bridge, thus creating a weak centralized link in the overall decentralized chain. DeFi Llama data shows that several dollar billions are locked in protocols that bridge tokens from one network to another, the majority of them being centralized, custodial bridges (wBTC, renBTC…), putting the whole crypto ecosystem in a catastrophic situation in case these custodial bridges are hacked, lose keys or commit fraud. Following a previous article on how Polkadot is tackling the complex blockchain interoperability problem, we analyze in this article Interlay’s potential to deliver a rock-solid decentralized cross-chain bridge.  

Questions and comments can be addressed to c.eladnani@sunzulab.com or research@sunzulab.com

Introduction:

Blockchain bridges have already suffered several hack attacks, exceeding $1 billion in cryptocurrency stolen. The latest significant episodes include Axie Infinity’s Ronin bridge $600 million hack, Harmony’s Horizon bridge hack for $100 million, and the $190 million Nomad bridge hack in August 2022, described as one of the most chaotic hacks web3 has ever seen. In a much-publicized tweet earlier in 2022, Vitalik Buterin voiced his opposition to using cross-chain solutions in the blockchain ecosystem in favour of a multi-chain future, arguing that the former increase the security risks in the process of transferring assets. Indeed, the attack vectors of the assets are increased across a more comprehensive network surface area as it is moved across an increasing number of chains and dApps with different security architectures. We believe at SUN ZU Lab that a minimum of standardization is required for blockchains to co-exist in parallel. Several organizations (IEEE, ANSI…) are doing this very well, so why shouldn’t the core blockchain teams start integrating these organizations?

We will cover in this next part the specifics of Interlay, its technical design, and how it differentiates from its centralized peers.

What is Interlay?

Interlay’s flagship product, iBTC, is a 1:1 Bitcoin-backed stablecoin that can be used to invest, earn and pay with BTC across the DeFi ecosystem on Polkadot at first, with future deployment plans on Ethereum, Cosmos and many other blockchains. Interlay also deployed Kintsugi, iBTC’s canary network, a testnet with real economic value deployed on Kusama (Polkadot’s canary network). Kintsugi and iBTC share the same code base, with the difference that the former will always be two to three releases ahead with more experimental features. Interlay won Polkadot’s 10th parachain slot auction, while Kintsugi won Kusama’s parachain slot 11.

Interlay was created in 2020 by Alexei Zamyatin and Dominik Harz, who met in October 2017 as the first two PhDs in the Imperial College’s cryptocurrency research lab. They have worked together since, publishing more than 20 papers on specific problems such as blockchain security, scalability, interoperability and DeFi.

After the successful launch of its flagship product, iBTC, the company now sets its eyes on becoming a one-stop-shop for Bitcoin DeFi with a new roadmap that includes decentralized lending, borrowing and trading for BTC.

Tokenomics:

Interlay and Kintsugi will be governed by their communities via INTR and KINT, their governance tokens on Polkadot and Kusama, respectively. INTR and KINT tokens’ primary purposes are:

INTR and KINT have an unlimited supply with the following emission schedule:

The project emphasizes community, with 70% of tokens distributed as airdrops and block rewards. Moreover, starting from the 5th year, only the community will receive newly minted KINT and INTR tokens.

Technology:

The Interlay network operates as follows: collateralized vaults hold BTC locked on Bitcoin, while iBTC is minted on the parachain. These vaults can be individuals or service providers who lock collateral in a MakerDAO-inspired multi-collateral system to protect users against theft and BTC loss, and receive BTC into custody for safekeeping while iBTC exists.

There are four main phases in each iBTC life-cycle:

1. Lock: users can run their vault or pick one to lock BTC. BTC is always backed by the vault’s collateral

2. Mint: iBTC is created at a 1:1 ratio to locked BTC

3. BTC DeFi: iBTC could be used as collateral for lending or yield farming, for example, on Polkadot, Kusama, Cosmos, Ethereum and other major DeFi platforms

4. Redeem: iBTC is eventually redeemed for physical BTC on Bitcoin in a trustless manner

iBTC’s main difference from existing wrapped Bitcoin products is its trustless and decentralized aspect. It is secured by insurance as vaults lock collateral on the iBTC parachain in a multi-collateral system. In case of misbehaviour, the network slashes their collateral and reimburses users. Moreover, it is radically open, meaning anyone could become a vault and help secure iBTC. However, running a vault is currently a highly technical role, requiring advanced proficiency in computer system administration, which constitutes a high barrier to entry. The Interlay team is working on democratizing this role by making it simpler to run a vault.

Comparison between different wrapped BTC asset

Source: Interlay documentation

Use case: BTC DeFi on Karura with Kintsugi:

Karura is Kusama’s central DeFi hub, built as Acala’s sister network (Polkadot’s first parachain winner). Karura offers a suite of financial primitives: a multi-collateralized stablecoin (kUSD) backed by cross-chain assets like Kusama and Bitcoin, a trustless staking derivative, and a DEX to increase liquidity.

Kintsugi suggests many use cases for using kBTC with Karura’s DeFi products, for example:

Conclusion

These were just a few examples of what is possible with Interlay products today, and use cases will explode shortly as the DotSama ecosystem continues to grow and Interlay expands to other protocols. Overall, Interlay has a promising future in tackling the complex decentralized cross-chain bridge problem within the blockchain ecosystem. Its founders’ solid research background, combined with its unique decentralized and trustless network, gives it a considerable advantage over its peers. However, it still has a long way to go to compete against centralized, custodial wrapped bitcoin leaders wBTC and hBTC.

References

Disclaimer

No Investment Advice

The contents of this document are for informational purposes only and do not constitute an offer or solicitation to invest in units of a fund. They do not constitute investment advice or a proposal for financial advisory services and are subject to correction and modification. They do not constitute trading advice or any advice about cryptocurrencies or digital assets. SUN ZU Lab does not recommend that any cryptocurrency should be bought, sold, or held by you. You are strongly advised to conduct due diligence and consult your financial advisor before making investment decisions.

Accuracy of Information

SUN ZU Lab will strive to ensure the accuracy of the information in this report, although it will not hold any responsibility for any missing or wrong information. SUN ZU Lab provides all information in this report and on its website.

You understand that you are using any information available here at your own risk.

Non Endorsement

The appearance of third-party advertisements and hyperlinks in this report or on SUN ZU Lab’s website does not constitute an endorsement, guarantee, warranty, or recommendation by SUN ZU Lab. You are advised to conduct your due diligence before using any third-party services.

About SUN ZU Lab

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboards & API streams or customized reporting. SUN ZU Lab provides crypto professionals with actionable data to monitor the market and optimize investment decisions.

On Blockchain Interoperability — Focus On The Polkadot Ecosystem


By Chadi El Adnani @SUN ZU Lab

January 2023

This article was part of a broader report on the following theme: “Challenges and opportunities: The future of DeFi in TradFi”. Crypto Valley Association selected it among the top 5 pieces for its 2022 Call For Papers challenge.

Since the birth of bitcoin in 2009, the blockchain ecosystem has not stopped expanding. It is now based on multiple layer 1 (L1) blockchains, each with a different philosophy and unique infrastructure architecture. Such L1s include Bitcoin, Ethereum, Solana, Polkadot, or Cosmos. While Solana’s approach to growth focuses on the network effect of bringing many developers and users on-chain, the Ethereum community believes that mass adoption will come primarily from blockchain security and decentralization superiority. These cultural differences are reflected in how these blockchains operate and process data, making direct inter-blockchain communication very hard and creating one of the most critical challenges for the web3, and hence DeFi, ecosystems: interoperability. The following metaphor best describes this situation: imagine an internet where it was only possible to send emails within isolated platforms, Gmail to Gmail, Yahoo to Yahoo, etc. This is the case today for data and tokens stored on different blockchains.

Questions and comments can be addressed to c.eladnani@sunzulab.com or research@sunzulab.com

Introduction:

The benefits of blockchain interoperability are necessary to achieve mass adoption and an optimized user experience. It also helps avoid “winner takes all” monopolies (think about the blu-ray technology, for example). It will allow for entirely composable web3 services, with interoperable smart contracts leading to primary industries exchanging important business information between private and public networks in a completely customizable and controllable manner. Moreover, blockchain interoperability should enable multi-token transactions and wallet systems, a significant phase for DeFi’s usage growth.

Another critical benefit to blockchain interoperability is the ability to create a more decentralized ecosystem (in terms of players/actors). Instead of having one blockchain like Ethereum processing transactions of thousands of dApps, leading to recurrent congestions in the network and excessive transaction gas fees, thousands of application-specific blockchains could communicate with one another through a decentralized central hub. Enter Polkadot!

Interoperability can also be achieved through cross-chain bridges that allow for digital assets owned by someone to be locked on one chain, while an identical asset is minted on another chain and sent to an address owned by the original owner. These bridges can be decentralized blockchain ecosystems or centralized custodians. Interlay, Polkadot’s 10th parachain, is working to provide similar services for Bitcoin. We make an interesting parallel in TradFi with the concept of American Depository Receipts (ADRs); an ADR is a certificate representing shares of a foreign security. It is a form of indirect ownership of foreign securities not traded directly on a national exchange in the US. Financial institutions purchase the underlying securities on foreign exchanges through their foreign branches, and these foreign branches remain the custodians of the securities. The financial institutions hold legal title to the underlying stock through these foreign branches. This structure of indirect ownership has caused non-negligible problems in the past.

In the following parts, we will dive deeper into how Polkadot operates. We will analyze in a coming article Interlay’s specific operating model. 

Polkadot – the first fully-sharded blockchain:

Polkadot is a layer 1, or even layer 0, nominated proof-of-stake (nPoS) blockchain protocol connecting multiple specialized blockchains into one network. It was founded by Gavin Wood, a co-founder of Ethereum and the Ethereum Foundation’s first CTO, alongside co-founders Peter Czaban and Robert Habermeier in 2016. Dr Wood has an impressive background as he invented Solidity, the language developers use to write decentralized applications (dApps) on Ethereum. He developed as well in 2015 a company called Parity Technologies that maintains Substrate, a software development framework primarily used by Polkadot developers who wish to create parachains quickly. Polkadot is run by the Web3 Foundation and developed by Parity Technologies. It uses a relay chain / parachain model, allowing multiple blockchains to communicate and securely share information. This unique model allows digital assets and data to be interchanged and transferred within a multi-chain network through efficient and secure data exchange between private/public blockchains, dApps and oracles. The parachains are entirely independent in governance but have shared security structures through the relay chain.

Polkadot’s functioning structure is best explained by the United States model: each state (parachain) has its sovereignty and rights but must rely on the federal government (relay chain) for governance and security. To be more precise, parachains remain fully independent governance entities, with the relay chain only governing block production, DOT treasury or parachain slot auctions, among others. Parachains connect to Polkadot by leasing a slot on the relay chain for a renewable period of 96 weeks. Parachain slots are assigned through auctions, and auction winners lock up a bond in DOT for the duration of the lease. 

As of January 2023, the Polkadot network is ranked at the 13th position on Coinmarketcap, being the eleventh-largest blockchain in terms of its native token DOT’s market capitalization ($5.4bn), behind Dogecoin ($9.6bn), Cardano ($9.2bn), and Polygon ($7.0bn). Polkadot runs parallel to its twin canary network, Kusama, where teams and developers can build and deploy parachains or try out Polkadot’s governance, staking, nomination and validation functionalities in a living environment.

Polkadot’s technical documentation provides a good description of its architecture. There are three fundamental roles in the upkeep of the Polkadot network: collators, nominators and validators:

Polkadot’s architecture

Source: Polkadot lightpaper

For the main differences between Polkadot and Ethereum, let’s look at Polkadot’s wiki page. Here is an extract:

“There are two main differences between Ethereum 2.0 and Polkadot consensus:

Polkadot parachains started going live in December 2021. As of January 2023, 36 parachains have secured auction slots. These parachains include DeFi chains (Acala, Parallel, Centrifuge, Interlay), smart contract platforms (Moonbeam, Astar and Clover), and web3 infrastructure (Efinity, Nodle).

Moreover, a significant milestone was crossed in May 2022, with Polkadot finally enabling the Cross-Consensus Message Format (XCM). XCM is a communication language allowing parachains to exchange messages with other parachains, similar to Inter-Blockchain Communication (IBC) on Cosmos. At the close of Q2 2022, 16 parachains began opening bi-directional Horizontal Relay-routed Message Passing (HRMP) channels with other parachains to start communicating with each other, as can be seen via the following link.

XCM is designed around four principles:

The agnostic aspect allows XCM to be suitable for messages between disparate chains connected through one or more bridges and even for messages between smart contracts. For example, a smart contract, hosted on a Polkadot parachain, may transfer a non-fungible asset it owns using XCM through Polkadot to an Ethereum-mainnet bridge located on another parachain, into an account controlled on the Ethereum mainnet.

Market adoption charts:

We provide in the following section a comparison over October 2022 of different trading metrics between the following tokens: ETH (Ethereum), DOT (Polkadot), ADA (Cardano) and ATOM (Cosmos). The latter three are blockchains focused on tackling the interoperability problem.

Over October 22, DOT price-performance was +4%, against +20% for ETH, -7% for ADA and +11% for ATOM.

Conclusion

With the launch of XCM, DOT will finally be ready to be traded, sent, and composed across all parachains on the Polkadot network. The passage of this milestone represents a massive leap in blockchain interoperability. We will see in a future article how Interlay, Polkadot’s 10th parachain, has a promising future in tackling the complex decentralized cross-chain bridge problem within the blockchain ecosystem. Nevertheless, it is still unclear whether the web3 ecosystem’s future will be cross-chain or multi-chain.

References

Disclaimer

No Investment Advice

The contents of this document are for informational purposes only and do not constitute an offer or solicitation to invest in units of a fund. They do not constitute investment advice or a proposal for financial advisory services and are subject to correction and modification. They do not constitute trading advice or any advice about cryptocurrencies or digital assets. SUN ZU Lab does not recommend that any cryptocurrency should be bought, sold, or held by you. You are strongly advised to conduct due diligence and consult your financial advisor before making investment decisions.

Accuracy of Information

SUN ZU Lab will strive to ensure the accuracy of the information in this report, although it will not hold any responsibility for any missing or wrong information. SUN ZU Lab provides all information in this report and on its website.

You understand that you are using any information available here at your own risk.

Non Endorsement

The appearance of third-party advertisements and hyperlinks in this report or on SUN ZU Lab’s website does not constitute an endorsement, guarantee, warranty, or recommendation by SUN ZU Lab. You are advised to conduct your due diligence before using any third-party services.

About SUN ZU Lab

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboards & API streams or customized reporting. SUN ZU Lab provides crypto professionals with actionable data to monitor the market and optimize investment decisions.

DeFi and the rise of DEXs and DAOs (1/2): Qualitative Analysis


By Chadi El Adnani @SUN ZU Lab

November 2022

Decentralized Finance and the rise of DEXs and DAOs

This article was part of a broader report on the following theme: “Challenges and opportunities: The future of DeFi in TradFi”. Crypto Valley Association selected it among the top 5 pieces for its 2022 Call For Papers challenge.

DeFi and DEXs have recently attracted much attention. Uniswap raised in October 2022 a $165 million Series B funding round that valued the company at $1.7 billion, and DEXs globally are profiting from the hit that confidence in CEXs suffered following the FTX fallout. We provide in this first article a general overview of DeFi, DEXs and DAOs, focusing on Uniswap V3. In the second part of this article, we will cover a more technical analysis of price discovery and on-chain/off-chain arbitrage opportunities.

Questions and comments can be addressed to c.eladnani@sunzulab.com or research@sunzulab.com.

1. General Overview

DeFi, an abbreviation for Decentralized Finance, refers to peer-to-peer finance enabled by Ethereum, Polkadot, Avalanche, Solana, Cardano and other layer-1 blockchain protocols. It is often depicted as the opposite of centralized finance (CeFi) or traditional finance (TradFi), where buyers and sellers rely on trusted intermediaries such as banks, brokers, custodians and clearing firms. While some trace DeFi’s origins back to bitcoin and Nakamoto’s invention of blockchain concepts, it mainly was the introduction of smart contracts by Ethereum that helped DeFi apps flourish in the following years.

There are some direct pros and cons that come out of this opposition. Due to blockchain technology characteristics and removing intermediaries, financial transactions are usually faster with lower costs using DeFi. On the other hand, the absence of centralized banks and custodians often means that DeFi app users need to ”self-custody” their assets in their wallets, with the risks and logistical difficulties that this may bring.

The proliferation of DeFi has also brought the concept of DAOs, or Decentralized Autonomous Organizations, into the central stage. DeFi apps are usually managed through a DAO, where the process of management decision-making is made by decentralized validator nodes who own or possess sufficient tokens to approve blocks.

Vitalik Buterin defined DAOs as entities with internal capital with automation in the centre and humans at the edges. In simpler terms, DAOs could be seen as multi-signature wallets (multi-sig), releasing funds based on predetermined voting thresholds. Several characteristics follow from this definition:

The above definitions put the DAO construct and existing legal categories at odds. Laws are nationspecific, and DAOs are nation-agnostic. Legal entities rest on the sovereignty of nation-states, while DAOs operate through the pure power of mathematics and cryptography. There exists, however, DAOs that are legally incorporated, but these are closer to organizations leveraging DAO tooling rather than pure DAOs.
The absence of a centralized authority characterizes DAOs; there is no executive management, a board of directors, or shareholders to satisfy. Instead, community members submit proposals to the group, and each node can vote on each proposal. The proposals supported by a certain percentage of voters (1/2, 2/3 or 3/4 depending on the structure) are passed and enforced by the rules coded into smart contracts.


DAO benefits could be summarised as follows:

According to Coinmarketcap, the top 5 DAO projects by market capitalization are the following (as ofNovember 2022): Uniswap ($5.5bn), ApeCoin ($1.4bn), Aave ($1.2bn), BitDAO ($0.9bn), and Maker ($0.9bn). We notice a clear DeFi dominance over the DAO category.

2. Focus on DEXs – Deep dive into Uniswap v3

Decentralized Exchanges (DEXs) are a set of smart contracts that run on different blockchains and allow for decentralized swaps of selected tokens. DEXs popularity and usage have grown exponentially during the 2020 DeFi summer period, marked by the launch of Uniswap v2, allowing for ERC20 / ERC20 token swaps on Ethereum and the liquidity mining frenzy with the launch of governance tokens such as COMP or UNI. This was followed in 2021 by the release of Uniswap v3, which provided increased capital efficiency, improved the accuracy of price oracles and introduced a more flexible fee structure.

In 2021, Uniswap launched its v3. While this version used a constant function market maker model (CFMM), it came with significant enhancements to capital efficiency (up to 4000x relative to v2), a more flexible fee structure, and a more accurate price oracle. [tea21].

Liquidity providers (LPs) are able in v3 to concentrate their liquidity by allocating it to a specific arbitrary range. Individual positions are aggregated into a single pool, forming a combined curve against which users can trade. This improvement has paved the way for low-slippage trade execution, surpassing centralized exchanges and stablecoin-focused AMMs. Users can also add liquidity to a price range entirely above or below the market price to sell one asset for another, approximating a fee-earning limit order that executes along a smooth curve.

In previous versions, every pair of tokens corresponded to a single liquidity pool, which applied a standard fee of 0.30% to all swaps. This uniform fee structure was not optimal, being too low for some pools (such as high volatility or illiquid token pools) and too high for others (such as pools between two stablecoins).

This is why Uniswap v3 introduced multiple pools for each pair of tokens, each with a different swap fee: 0.05%, 0.30% or 1%. Due to this new non-fungible nature of positions, fees earned are no longer continuously deposited in the pool as liquidity as before. Instead, fee earnings are stored separately in the form of the tokens in which they are paid.

Uniswap v3 is governed like the previous versions by UNI tokenholders, but it is more flexible regarding the fraction of swap fees that go to the protocol. Users can choose for each pool any fraction 1/N for N ranging from 4 to 10, or 0. UNI governance can also add fee tiers beyond the initial tiers of 0.05%, 0.10% and 0.30%.
Finally, users can transfer ownership to another address.

Uniswap v3 comes with three main changes to the time-weighted average price (TWAP) oracle that Uniswap v2 introduced. First, v3 removes the need for users of the oracle to track previous values of the accumulator externally, bringing the accumulator checkpoints into the core. Thus, v3 allows external contracts to compute on-chain TWAPs over recent periods without storing checkpoints of the accumulator value.

Second, Uniswap v3 tracks the sum of log prices instead of accumulating the sum of prices, allowing users to compute the geometric mean TWAP instead of the arithmetic mean TWAP. This change avoids the need to track separate accumulators for price ratios between tok1 and tok2. Indeed, the geometric mean of a set of ratios is the reciprocal of the geometric mean of their reciprocals. Finally, Uniswap v3 adds a liquidity accumulator that it tracks parrallel to the price accumulator, which accumulates 1/L for each second.

This liquidity accumulator is helpful for external contracts that want to implement liquidity mining on top of Uniswap v3. Although these enhancements to Uniswap v3’s TWAP oracle are encouraging, research was published suggesting that TWAP oracles are unsuitable for the vast majority of DeFi use cases compared to Chainlink’s volume weighted average price (VWAP) oracles. The main differences between these two systems can be summarised as follows:

For all the reasons stated above, TWAP oracles remain unsuitable for the vast majority of DeFi applications that secure user funds, compared to Chainlink’s VWAP oracles that provide DeFi with higher quality price data.


3. The dominance of Uniswap v3

In less than a year, Uniswap v3 has gained significant dominance over other DEXs and even CEXs. Some factors that could explain this meteoric rise include the composability enabled by AMMs with other DeFi protocols and the ability to trade without asset custody by intermediaries.

Another factor that gained in strength over 2022 is simply Uniswap’s ability to provide higher liquidity levels than larger centralized exchanges. The Uniswap team shows in an analysis titled ”The dominance of Uniswap v3 liquidity” that, compared to other larger CEXs, Uniswap v3 has around two times higher market depth on average for spot ETH-USD pairs (using the most liquid dollar or stablecoin on each platform for comparison).

Market depth in traditional limit order books is computed by adding the limit order amount at each price level. As there are no limit order books in AMMs, the Uniswap team provides a methodology to derive an equivalent market depth using liquidity distribution over a price range (detailed methodology available in the original document).

Figure 1: Market depth comparison for ETH/USD pairs.
Daily average +/- 2% spot market depth in $ millions for the sample period from June 1, 2021 to March 1, 2022.
The comparison uses the most liquid ETH/USD pair for each of these markets
(ETH/USDC on Uniswap v3, ETH/USDT on Binance, ETH/USD on Coinbase, and ETH/USD on Gemini)
Source: the dominance of Uniswap v3 liquidity [LR22]

The analysis further shows that Uniswap v3 has had significantly higher market depth throughout the
sample period compared to CEXs in spot trading, as can be seen in the following graph:

Figure 2: 7-days rolling mean +/- 2% spot market depth comparison for Uniswap v3 (ETH/USDC), Binance
(ETH/USDT), and Coinbase (ETH/USD)
Source: the dominance of Uniswap v3 liquidity [LR22]

Additionally, Uniswap v3 displays higher market depth levels across all price levels, making it more advantageous to choose Uniswap v3 for larger trades relative to CEXs:

Figure 3: Average spot market depth comparison for Uniswap v3 ETH/USDC vs Coinbase ETH/USD
from June 1, 2021 to March 1, 2022.
Source: the dominance of Uniswap v3 liquidity [LR22]

It is important to note that the above analysis does not consider transaction costs, including gas costs on Ethereum, fees, or unexpected pre-trade slippage. The Uniswap team advances that these costs are broadly comparable for Uniswap v3 and CEXs, and are small relative to costs associated with market depths for large trade sizes.

Fee tiers on Uniswap v3 range from 1 bps, famous for stablecoin-only pairs, to 100 bps for the most volatile long-tail assets. Fees on Coinbase Pro, for example, range from 5 bps to 60 bps depending on the monthly transaction volume. CEXs have bid/ask spreads that vary based on the market and time. On the other hand, network congestion determines gas costs for on-chain transactions through AMMs. Since its
inception, the Uniswap v3 team computes a $31 median cost of a swap transaction.

The benefits of trading on a more liquid market are directly visible. Trading an ETH/dollar pair on Uniswap v3 would roughly generate a 3.8 bps price impact on average, against a 5 bps average price impact in Coinbase Pro, saving 1.3 bps of the notional (0.6 bps net of gas cost). The savings are even more significant for larger trade sizes. For a trade size of $5 million, the savings would be around 0.5% of the notional given the expected price impact difference. A ETH/dollar trade executed on Coinbase Pro that results in an average price impact of 0.05% (corresponding to a notional size of $650,000 at 0.1% market depth, assuming linear scaling of price impact with notional) would only have an average price impact of 0.0375% on Uniswap v3.

This is equivalent to around $81 on the price impact and around $36 of saving net of gas and fees. The weighted average of fee tiers is around 20 bps for Uniswap v3, the same as Coinbase Pro for the 650k – 1m volume tier. For $5 million notional, the average price impact is roughly 0.5% on Uniswap v3 and 1% on Coinbase. The fee is about 2 bps lower on Coinbase.

In addition to this analysis, data from Chainalysis in its latest web3 report showed that DEXs had dethroned CEXs in terms of on-chain transaction volumes for the first time in 2021. Indeed, while most CEX transactions happen off-chain on centralized databases and are captured on their order books to save on transaction fees, every DEX transaction occurs on-chain through smart contracts.

This helps explain how DEXs are leading in on-chain transaction volume. From April 2021 to April 2022, $175 billion was sent on-chain to CEXs, well below the $224 billion sent to DEXs.

Figure 4: On-chain transaction volume on CEXs vs DEXs
Source: Chainalysis June 2022 web3 report

It is crucial, however, to put things back into perspective. The following graph, although a bit outdated (global cryptocurrency market capitalization is around $1 trillion as of November 2022, according to Coinmarketcap), gives a precise idea of the scale of DeFi and crypto markets compared to more traditional and mature stock, real estate or derivatives markets.

Figure 5: Comparison of on-chain and off-chain markets
Source: SmartContent

The following picture helps to better grasp what $100 billion represents in terms of value.

Figure 6: How much value is $100 billion?
Source: Markets Insider

Do you want to go further? Read our quantitative analysis here!

We would be happy to hear your thoughts about DeFi in crypto markets!

Questions and comments can be addressed to: research@sunzulab.com

References:

Disclaimer:

No Investment Advice
The contents of this document are for informational purposes only and do not constitute an offer or solicitation to invest in units of a fund. They do not constitute investment advice or a proposal for financial advisory services and are subject to correction and modification. They do not constitute trading advice or any advice about cryptocurrencies or digital assets. SUN ZU Lab does not recommend that any cryptocurrency should be bought, sold, or held by you. You are strongly advised to conduct due diligence and consult your financial advisor before making investment decisions.

Accuracy of Information
SUN ZU Lab will strive to ensure the accuracy of the information in this report, although it will not hold any responsibility for any missing or wrong information. SUN ZU Lab provides all information in this report and on its website. You understand that you are using any information available here at your own risk.


Non Endorsement
The appearance of third-party advertisements and hyperlinks in this report or on SUN ZU Lab’s website does not constitute an endorsement, guarantee, warranty, or recommendation by SUN ZU Lab. You are advised to conduct your due diligence before using any third-party services.

About SUN ZU Lab

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboard & API stream or customized reporting. SUN ZU Lab provides crypto professionals with actionable data to monitor the market and optimize investment decisions.

FTX Post-Mortem Analysis – Why Transparency Matters?


By Chadi El Adnani @SUN ZU Lab

November 2022

“In the midst of chaos, there is also opportunity”

Sun Tzu – 500 BC

This quote by our spiritual father, Sun Tzu, has never been more true in the crypto ecosystem as we all battle to survive the most significant blow ever to the nascent industry. FTX’s bankruptcy was described as crypto’s Lehman Brothers moment, or as more evidence came to light, more “Enron” than “Lehman” moment. Trying to cover this story as it unfolded before our shocked eyes was like trying to catch a bullet bare-handed. This article provides a preliminary post-mortem analysis of where the situation stands today. Unfortunately, we sincerely believe that we have only seen the tip of the iceberg, and we brace for many more casualties to be affected in the near future. We have already covered in SUN ZU Lab’s weekly insights (here & here) the story’s timeline and the significant headlines surrounding it. We will therefore move directly into a more technical analysis.

As a reminder, FTX and Alameda Research constituted the bulk of ex-crypto billionaire Sam Bankman-Fried’s empire. The former being the exchange arm and the latter being the trading firm.

Understand the man to understand his actions:

Sam Bankman-Fried (SBF) had a reputation for being very smart and a highly talented trader. However, as more revelations come to light, we are convinced now that his supposedly spectacular trading returns (as well as some of his peers) were mainly driven by 2020 and 2021’s bull run. His crypto empire’s implosion is due instead to his betting big philosophy! A leveraging strategy mainly fueled FTX and Alameda’s stratospheric rise in the last two years via deceptive fundraises and financial engineering before eventually using plain fraud, as was revealed by the preliminary investigation.

In this Twitter thread, we get an interesting glimpse of SBF’s motives behind creating FTX; he explains, among others, that he was deeply frustrated by two things in the way other crypto exchanges operated. Contrary to TradFi, where an exchange focuses on managing its order book matching engine, leaving margin handling to the clearing house, a crypto exchange has to handle both responsibilities. He was therefore losing millions from what he called “socialized losses”, where the collectivity ends up paying the losses of a liquidated negative account. The second reason was that he viewed BTC’s price as being hit every time it suffered selling pressure from a cascade of liquidated accounts, which wasn’t fair from his point of view.

He initially addressed white papers proposing new ways of functioning to other exchanges before creating FTX as a new crypto derivatives exchange where, we cite: “The entire margin system is reworked to a way almost no exchanges in crypto work. We can take huge size & also have lots of leverage & have a solid blocker against ever having clawbacks.”

A trending video of Alameda’s CEO Caroline Ellison resurfaced where she was saying: “Being comfortable with risk is very important. We tend not to have things like stop-losses, I think those aren’t necessarily a great risk-management tool. I’m trying to think of a good example of a trade where I’ve lost a ton of money … well, I don’t know, I probably don’t want to go into specifics too much.”

We can see a recipe for disaster starting to take form.

A complicated SBF-Ellison / FTX-Alameda love story

Alameda Research and FTX were supposed to be entirely separate entities in theory. We instead learn that Alameda’s CEO Caroline Ellison has dated at times SBF. More shockingly, several top execs from FTX and Alameda lived in the same luxury penthouse in the Bahamas, where Ellison was rumoured to have access to FTX screens showing client trades. A recent Wall Street Journal report indicates that Alameda was frontrunning FTX token listings. Between the start of 2021 and March 2022, the trading firm held $60 million worth of 18 different tokens that were eventually listed on FTX.

This intimacy could also explain why SBF later allowed customer funds to be used to pay for Alameda’s loans, building a software backdoor to outwit FTX compliance systems.

FTX and Alameda’s Balance Sheets were bad, very bad!

The massive bank run suffered between November 6 and 11 drove FTX and Alameda eventually to the ground, and the word bank is chosen wisely as it appears FTX was more a bank than an exchange! They suffered as much as $6 billion of withdrawals in the final 72 hours, except they didn’t have customers’ money as FTX had loaned it to Alameda, which used it to make venture capital investments!!

Let us stop a moment on the last revelation. Every first-year finance student could tell you to never, never use extra-short-term liabilities (client funds, with a theoretical maturity of 0) to finance the riskiest and most illiquid investment in the spectrum (VC investments, with an expected maturity higher than ten years).

Ellison explains in an interview with the New York Times that lenders moved to recall their loans around the time the crypto market crashed this spring. But as the funds that Alameda had spent were no longer easily available, the company used FTX customer funds in an emergency procedure to make the payments.

Let’s go back first to where troubles began to appear. Anyone remotely familiar with the hedge fund space knows that the financials (P&L and Balance Sheet, among others) are protected at all costs. The fact that Coindesk managed to put their hands on that “secret sauce” leaves a place for a plethora of conspiracy theories. We refrain from venturing into that territory.

On November 2, CoinDesk published an article highlighting the following facts from a private document they reviewed:

To put things into perspective, this puts a total of $5.8 billion in FTT tokens on Alameda’s balance sheet as of June 30. The market capitalization of circulating FTT was around $3.3 billion that day. Indeed, a quick look at FTT’s page on Etherscan shows that over 74% of the token’s total supply is held by two addresses belonging to FTX and Alameda.

FFT’s page – Source Etherscan

This partial information meant that most of Alameda’s net equity was comprised of FTT tokens, printed out of “thin air” by its sister company FTX.

In a volatile and fragile global crypto environment, rumours were quickly forming about how SBF could be just another flywheel / Ponzi scheme magician! Here is what we mean by a flywheel scheme in crypto:

  1. Create a token
  2. Artificially pump its price (wash trading through a market maker)
  3. Mark the artificial gains in the balance sheet
  4. lure the community and investors with “realized” gains
  5. Raise capital through equity sales, ICOs or loans
  6. the hype continues to fuel the token’s price, and the loop continues!

The fears were extreme, especially since the Celsius bankruptcy and the CEL token explosion still haunt most of us. Celsius was a multi-billion dollar crypto lending firm, or Ponzi scheme, which was destroyed in part by its own token, CEL!

As it appears, this is exactly what SBF was doing with some of his investments, known as “Sam coins”, including Serum, Raydium and FTT.

The way it would work with our exchange/trading firm duo is that Alameda would fund a project at a $50 million fully diluted valuation (considering the total number of tokens to be issued) with $5 million, for example. FTX would then list the token on its exchange, releasing only a tiny fraction of the total tokens to the market. Given the illiquidity of this token, Alameda could easily deploy a few millions to artificially inflate the fully diluted valuation 100x, increasing the stake’s value on its books to $500 million. This inflated figure is then used as collateral for borrowing purposes.

The Financial Times shared a copy of an FTX balance sheet dated November 10, shared with prospective investors one day before the company filed for bankruptcy.

Here is a visualization of this balance sheet provided by Visual Capitalist:

FTX Balance sheet provided by Visual Capitalist
FTX balance sheet | Source: Visual Capitalist

We fell from our seats when we first saw this balance sheet! And we wouldn’t put it better than Bloomberg’s Matt Levine:

“It’s an Excel file full of the howling of ghosts and the shrieking of tortured souls. If you look too long at that spreadsheet, you will go insane.”

Citing the FT, we learn that “A spreadsheet listing FTX international’s assets and liabilities, seen by the Financial Times, point at the issues that brought Bankman-Fried crashing back down to earth. It references $5bn of withdrawals last Sunday, and a negative $8bn entry described as “hidden, poorly internally labled ‘fiat@’ account”.

“Bankman-Fried told the Financial Times the $8bn related to funds “accidentally” extended to his trading firm, Alameda, but declined to comment further.”

When we look at the “less-liquid assets” category, the most considerable number is $2.2 billion of SRM, the Serum DEX native token (we will talk later about Serum). This is a clear example of the flywheel scheme described above in the article. As of November 17, CoinMarketCap shows a $70 million market cap for SRM (market cap of circulating tokens) against a $2.7 billion fully diluted market cap (theoretical figure taking into account the token’s max supply). The FTX team are basing their $2.2 billion valuation on an impossible illiquid scenario.

Okay, but one big question remains: how did they manage to burn through more than $10-15 billion of “realized” profits?

In our eyes, the bad VC investments and mishandling of client funds don’t explain alone the $8 billion hole in the balance sheet, especially when taking into account FTX and Alameda’s extremely profitable history due to high trading fees and lucrative venture deals. The only plausible explanation we see is that Alameda was bleeding money for a long time in 2022’s harsh bear market and possibly long before that, slowly decaying from its market-neutral market-making strategies into taking losing directional bets.

This seems to be exactly what we learned from a recent motion filed in the Delaware district court handling the bankruptcy procedure. The entities’ 2021 tax returns collectively showed a net operating loss carryover of $3.7 billion, meaning that the main entities (FTX & Alameda) had posted that much in losses since their inception. This completely contradicts the image SBF was circulating of his businesses and is quite shocking when considering that several competing crypto exchanges and trading firms, such as Wintermute or Coinbase, have realized significant gains over 2020 and 2021’s roaring crypto bull runs!

We end this paragraph on the wise words of newly appointed FTX CEO John Ray III: “Never in my career have I seen such a complete failure of corporate controls and such a complete absence of trustworthy financial information as occurred here. From compromised systems integrity and faulty regulatory oversight abroad, to the concentration of control in the hands of a very small group of inexperienced, unsophisticated and potentially compromised individuals, this situation is unprecedented.”

The biggest winners & losers:

Losers:

It is tough to choose one big loser from the FTX fiasco. There is obviously SBF himself, whose net fortune went from $26 billion at its peak to less than $1 billion. FTX employees are set to lose big, having most of their wealth linked to the exchange. VC and institutional investors have bet big on the disgraced young prodigy: between 2021 and 2022, SBF raised more than $1.5 billion from esteemed investors such as SoftBank, Sequoia Capital, Temasek, Tiger Global Management, Paradigm or the Ontario Teachers’ Pension Plan. Without forgetting the more than a million creditors still waiting to see how this insolvency will be unpicked. It was typically revealed in a court filing that FTX owes almost $3.1 billion to its top 50 creditors. 

We want to focus on the Solana ecosystem as one major casualty. The Solana Foundation declared days after the bankruptcy that it held 134.54m SRM tokens and 3.43m FTT tokens on FTX when withdrawals went dark on November 6. Those assets were worth around $107m and $83m one day before the freeze. It also held a 3.2 million common stock ownership in FTX.

As we can see, Solana and FTX maintained deep financial ties. The problem gets bigger when considering Serum, a DEX created by SBF and at the centre of much of Solana-based DeFi. SBF even went on to call Serum the “truly, fully trustless” backbone of Defi on the Solana blockchain. DeFi protocols across the Solana ecosystem were rushing to unplug from Serum after the post-bankruptcy hack at FTX. It was reported that the true power over Serum rested with FTX and SBF, which continue to hold the program update authority keys. This led the Solana community to move to create a new version of Serum that they could govern without influence from FTX.

The total value locked (TVL) on the Solana network has seen a 70% drop in November 2022 alone, reaching lows of $300 million from a $10 billion peak in November 2021. SOL is down more than 60% since the start of the month and the Coindesk article release.

In a previous article by SUN ZU Lab titled “What is Tokenomics and why does it matter?”, we interestingly took the Solana case study to highlight the importance of good governance practices that protect users. One of the main questions we left our readers to reflect upon was the following: Is it really that decentralized? – We now have our answer!

Winners:

There aren’t many winners from this situation, except maybe DEX’s, which are seeing an impressive peak in interest since FTX’s implosion. Uniswap, in particular, has risen to become the world’s second-largest venue for trading Ethereum, having recorded more than $1 billion in ETH trades in 24h, surpassing Coinbase (c. $0.6bn). Since the news that Binance was about to bail out FTX, DEXs around the crypto ecosystem saw $31 billion in trade volumes, with Uniswap alone accounting for $20 billion.

We want to highlight, however, that while DeFi’s “permissionless, trustless self-custody” ideology seems to be winning short term, we don’t bet a lot on new institutional money going directly into DeFi, mainly for KYC and AML reasons, among others.

How did crypto markets react to all this?

Whether we analyze crypto markets from a price, bid-ask spread or volume perspective, we see that the turning point in FTX’s downfall was the announcement of Binance’s non-binding offer to buy its rival (11/08/22 around 5 PM UTC). It was the first major event that worried the markets that something was off. FTT’s price dropped by more than 80% in the following hours, while bid-ask spreads on FTT briefly reached 400 bps.

Bid ask spread | Why transparency matters

Could we have seen this coming?

Yes! We have already voiced our opinions and concerns over crypto risk assessment in general and how crypto venues should be managed and audited in these previous articles: “Everything you’ve always wanted to ask your crypto exchange” and “Crypto Risk Assessment: Way to Go“. FTX was ranked among the top crypto exchanges, just days before its fall, by major industry players, non of which were able to underline the significant governance, operational or counterpart risks surrounding FTX and Alameda. We believe the crypto industry now has few shots “to get this right” after this spectacular failure.

We put the emphasis again on this table from the Crypto Risk Assessment article, which summarizes, in our opinion, the significant risks that should be closely monitored and audited regarding crypto exchanges.

crypto risk assessment and the need for transparency

The magnitude scale is as follows (applied to capital at risk, whether it is a nominal amount for cash products or notional amounts for derivatives):

+ (very small to small): a fraction of a percent to a few percents

++ (medium to significant): a few percents to a few tens of percents

+++ (high to very high): up to 100% and beyond. The vital prognostic of the firm may be engaged

who knows? This one is exactly what it reads; possible losses range from trivial to life-threatening

We also highlight this chart from the Financial Stability Oversight Council’s (FSOC) latest report, released in early October 2022. It highlights the major parties related to loans or investments made by 3AC, where we can see all the now-troubled actors following the explosion of the Terra ecosystem.

Where do we see things going from here?

For one thing, the FTX and Alameda implosion will hurt crypto liquidity badly. Alameda was one of the largest market makers in a space dominated by a handful of actors, among which we can cite Wintermute, B2C2 or Genesis. More disturbing, 56 market makers and fund managers reported FTX exposures of up to $500 million in an invite-only Telegram chat reviewed by TechCrunch.

As of November 24, the expanding list of FTX casualties now accounts for crypto-giants Genesis and Grayscale, BlockFi, Gemini, Multicoin and CoinHouse to cite a few. Genesis Global announced having lent around $2.8 billion to various crypto firms, including large loans to its parent company DCG. It confirmed that it had hired investment bank Moelis & Co to explore how to shore up its crypto-lending business’ liquidity and address clients’ needs days after halting withdrawals.

The bankruptcy procedure will surely be a long, drawn-out court case in which depositors will try to recoup their losses. But at which cost and after how many years?

FTX’s failure is unsurprisingly sparking a massive regulatory response, with several US state and federal agencies launching or expanding investigations into the company, including the DoJ, the SEC, the Securities Commission of the Bahamas and the Bahamas’ Financial Crimes Investigation Branch. More globally, crypto regulation in most markets has been slow to materialize. We see that changing in the wake of these recent events, with MiCA regulation in Europe heading for final approvals in 2023.

As this situation continues to evolve, we can’t yet draw final lessons and conclusions, except repeating our core message and belief at SUN ZU Lab: liquidity and transparency are core constituents to every efficient market worthy of the name. Remove one or both, and even “Too Big To Fail” giants start to shake.

We would be happy to hear your thoughts. You can address questions and comments to c.eladnani@sunzulab.com or research@sunzulab.com

About SUN ZU Lab

SUN ZU Lab is a leading data solutions provider based in Paris, on a mission to bring transparency to the global crypto ecosystem through independent quantitative analyses. We collect the most granular market data from major liquidity venues, analyze it, and deliver our solutions through real-time dashboard & API stream or customized reporting. SUN ZU Lab provides crypto professionals with actionable data to monitor the market and optimize investment decisions.