Author: Alex, Crypto KOL
Compiled by: Felix, PANews
What every investor should know before buying crypto governance tokens on the open market: the mechanics of crypto market maker (MM) trading and the potential for abuse.
Why do all crypto projects have market makers now?
The project previously used native tokens to incentivize on-chain liquidity pools, but now uses experienced market makers to provide liquidity on CEX because price discovery on CEX is more efficient and can reduce costs for all parties.
How do projects incentivize market makers?
The project provides a 1-year token loan to market makers (usually 3-5 market makers), and the token comes with a zero-cost call option. During the loan period, the market maker needs to ensure that there is a specified market size within the specified spread. (To ensure a certain trading depth)
Why do project parties need to lend coins to market makers?
Market makers need to borrow to ensure they have enough inventory to operate. They effectively borrow to offset any excess buying that may occur. The interest rate on borrowing is usually zero (or very low).
Why give call options to market makers?
Projects need to pay market makers for their services. Since they have little cash but have tokens, they would rather pay with tokens. However, they don’t want market makers to sell immediately, so they adjust incentives and offer call options. If the token price is high, everyone is happy.
So what are options?
A call option is the right, but not the obligation, to buy an asset at a specific price (strike) after a specific time (expiration).
The expiration date of the call option given to the market maker is usually consistent with the loan term, usually 1 year.
How to set the strike price of a call option if the token has not started trading yet?
The strike price is at a 50-100% premium to the index price, which means that the strike price is unknown at the time of the trade.
One last interesting thing:
Call options have a “delta”, which is the sensitivity of the option value to changes in the underlying asset. If a market maker wants to “delta hedge” on a call option, the market maker needs to sell tokens.
The trading mechanism of market makers is not inherently malicious, but the problem is that no information is disclosed to retail investors, which is unfair to public market participants.
Look at the recent Arbitrum failure.
In the file:
There is no mention of market making transactions. There is no mention that the foundation will sell tokens immediately, and there is no OTC transaction clause. There is no mention of whether the market maker Wintermute is an investor in Arbitrum.
Retail investors make investment decisions based on the assumption that the 1.275 billion tokens mentioned in this document are the only supply on the secondary market, but unfortunately, this is not the case.
Here is a description of what went wrong.
1. The number of call options is unknown
Call options add liquidity in aggregate.
Because market makers must maintain market neutrality, they hedge their call option deltas by selling tokens. In the case of Arbitrum, Wintermute’s hedges added roughly 16 million unknown tokens to the open market.
2. OTC transaction terms are unknown
The foundation sold $10 million in tokens in an over-the-counter transaction with Wintermute, and none of this was disclosed in any filings to retail investors until after the transaction took place. There was no mention that the foundation would sell tokens any time soon.
3) The difference between investors and market makers is unknown
It is unclear whether Wintermute is an investor in Arbitrum, but retail investors should be aware of any potential conflicts of interest between investors and market makers.
Here is Alameda's trick:
1. The project has a large investment, but only has a 1-year cliff (note: it will be vested in one lump sum after 1 year)
2. Lock in the market making agreement and loan for 1 year
3. Obtain a large loan from the project party
4. Sell all tokens immediately
5. Repay the loan within one year after the tokens are in place
6.??? (Note: refers to the secret operation)
7. Get Profit
Therefore, the double whammy of dumping the excess tokens on retail investors without their knowledge, and the Arbitrum project pretending to be decentralized but getting caught, caused the token price to fall.
In traditional financial markets, there is a reason why IPOs require a clearly outlined prospectus that needs to be made public:
Number of shares issued IPO price Underwriters involved in the transaction Spread received by underwriters
This information is critical in making investment decisions.
This is the crux of the problem of insider trading, where parties with large amounts of tokens and insider information need to disclose their market operations. But in the crypto space, suspicious token transfers occur with a frequency that is, frankly, disgusting.
Everyone can appreciate how devastating last week's crash was to the crypto space. The rules are unfair. Without basic transparency and assurances for public market participants, the trading environment for retail investors will only deteriorate.
In order to create a fairer environment for all market participants, we call on everyone to jointly implement a social contract (including future projects) - that is, not to purchase governance tokens with opaque information.
Alex doesn't mean to single out Arbitrum or Wintermute as villains.
Arbitrum is a great project, but unfortunately it was punished for being exposed. They allocated a relatively small number of tokens to the foundation and tried to create their foundation in a decentralized manner. The intention was good, but the execution was poor.
Wintermute is a respected market maker in the space. After all, there are many malicious companies like Alameda out there. As a premium for dealing with a market maker with a good brand reputation, the Arbitrum project paid more money on top of the necessary token loans and options.
Alex has shared his thoughts on the matter on the Arbitrum governance forum and is working on submitting a proposal to resolve the issue.
