ETHUSD Perpetual Swap Two Week Update

One of our strengths at BitMEX is financial innovation. We created the XBTUSD perpetual swap, a truly unique product to any financial market. XBTUSD is now the most liquid crypto instrument globally by a factor of 10 and has been emulated by a half dozen crypto markets.

On the back of that success, BitMEX has created a way to replicate the same Bitcoin-margined perpetual swap but on Ether / USD via a quanto pricing model. This product is the ETHUSD perpetual swap. In just under two weeks, this product has become the most liquid Ether / USD (or USD equivalent) pair globally, and has proven to be a vital instrument in speculating or hedging on the ETH/USD price pair.

In the last 24 hours, BitMEX’s ETHUSD swap has traded the equivalent of 800,000 ETH. The next most liquid ETH/USD and ETH/USDT markets, Bitfinex and Binance, traded just under 500,000 ETH each in the same period.

If you are still unsure on the pricing or trading of this instrument, please take a look back at our newsletter from last week where we run through multiple worked examples on hedging and speculating. To aid in your understanding, we have also created a downloadable spreadsheet to work through the math.

Does Satoshi have a million bitcoin?

Abstract: We examine the extent to which one miner dominated Bitcoin in 2009. We review Sergio Demian Lerner’s 2013 analysis, where he discovered that the increase in the ExtraNonce value in the block can potentially be used to link different blocks to the same miner. We build on his analysis and conclude that although the evidence is far less robust than many assume, there is reasonable evidence that a single dominant miner in 2009 could have generated around 700,000 bitcoin. Although our analysis itself is weak and there is no perfect way of approaching this problem.

Bitcoin blocks mined in 2009 – ExtraNonce vs block height


(Source: BitMEX Research, Bitcoin blockchain)

The history of the debate over the dominant miner in 2009

Towards the start of April 2013, blockchain researcher Sergio Demian Lerner attempted to argue that Satoshi had mined a million bitcoin in 2009. The logic behind this assertion was that the hashrate throughout 2009 was at a low level, around 7 million hashes per second and this was said to be consistent with one miner being highly dominant. At the same time this hashrate was around the same to that which was present in Bitcoin’s first 14 days, which Sergio assumes may be a period in which Satoshi was the only miner. Many in the community were sceptical of Sergio’s claims. The scepticism seems to be based on the following:

  1. The 7 MH/second estimate is based on block timestamps and unreliable, nor is the sample size large enough
  2. There is no reason to believe Satoshi mined alone in the first 14 days
  3. Many individuals recalled mining themselves in the period
  4. Sergio’s assumptions about hardware were incorrect

It is likely that some people could have been biased in dismissing Sergio’s claims, since if Satoshi had mined a significant proportion of the early coins, in the eyes of some that could damage the monetary integrity of the system. However, in our view, the evidence Sergio initially presented was somewhat weak.

The ExtraNonce bombshell

Just a few days later, Sergio then posted a far more persuasive argument on his blog, with much stronger evidence that a single miner was dominant. This then eventually convinced many in the community and to this day many people believe Satoshi is likely to have mined around one million bitcoin.

Sergio’s evidence centred around something called the ExtraNonce. The ExtraNonce is not part of the Bitcoin protocol, in that it is not part of the consensus rules nor is there a formal specification about how to interpret the field. The ExtraNonce is an area in the Coinbase transaction which can vary after several hashing attempts to provide extra entropy for miners, once the standard nonce in the block header has been used up. As the image below illustrates, as the ExtraNonce changes, the impact works its way up the merkle tree into the block header (although in 2009 most blocks contained only the Coinbase transaction, as the network was not used for transactions.)

(Illustrative diagram of the structure of a Bitcoin block)

Sergio published the below picture, with the ExtraNonce on the y-axis and the blockheight on the x-axis (He incorrectly labeled the x-axis as time). The image shows that the ExtraNonce increase over time, in a series of slopes. Some of the slopes (in black) are said to be of a similar gradient, not to overlap and to go back down to zero once they reach a certain height. This is said to demonstrate that all the black lines belonged to one miner (potentially Satoshi) and that this miner now controlled almost a million Bitcoin. Although the technical points about the gradient of the slopes, the height and the lack of overlap may be quite difficult to appreciate and evaluate, the image itself is clearly very powerful and persuasive, in our view.

(Source: Bitslog)

The new BitMEX Research allocation of blocks to the dominant miner

We decided to repeat Sergio’s analysis, except our objective was to count the blocks mined by the apparent single entity and allocate all the blocks. The excercise was challenging, since the slopes interact with many other points. It is therefore impossible to do an accurate allocation. As a result, our analysis is far from perfect and we used a variety of methods, including statistical analysis, random number generators and even manual review to allocate some blocks. We will have made many errors and we do not claim our methodology is robust or scientific. However, as far as we are aware, this is the first attempt to allocate every block in 2009 as belonging to the apparent single entity or not. The below high resolution image below represents our allocation for every block in 2009.

Bitcoin blocks mined in 2009 – Allocation to the dominant miner – ExtraNonce value (y-axis) vs block height (axis)

(Source: BitMEX Research, Bitcoin blockchain)

Analysis of the allocation

Up to August 2009 we agree with Sergio’s conclusion.  There are 22 slopes prior to August, which all have both similar height and gradient (Around an increase in the value of the ExtraNonce by 4 per block found). At the same time these slopes almost never overlap. (The tiny amount of apparent overlap in some instances in less than 5 blocks and therefore may just be coincidence).

After August 2009 the pattern breaks down to some extent. The gradient of the slopes varies considerably (from 1.1 nonces per block to 10 nonces per block). At the same time the height of the slopes is inconsistent and there are many large gaps between them. Therefore although the image still looks compelling, the evidence that the miner is one entity is somewhat weak, in our view. We have presented results below, which include figures both pre and post August 2009.

Category Number of blocks Number of bitcoin
Allocated to the dominant miner 14,815 740,750
Weak allocation (After August 2009) 4,553 227,650
Total 19,368 968,400
Not allocated 16,920 846,000
Grand total 36,288 1,814,400

(Source: BitMEX Research, Bitcoin blockchain)

Debate over the strength of the analysis

Supporting the analysis Weaknesses of the analysis
  • The image is highly powerful, just looking at it illustrates there is a dominant miner. Although explaining it statistically may be challenging, the conclusion is clear.
  • Many of the slopes have the following characteristics:
    1. A similar gradient to each other
    2. Similar heights
    3. Slopes often start shortly after another slope has finished
    4. The slopes rarely overlap
    5. Many of the slopes are hundreds of blocks long
  • This is all too much to be a coincidence. Therefore the evidence that many of the blocks were mined by a single entity is highly compelling
  • Although the ExtraNonce analysis is interesting and revealing, when it comes to estimating the number of coins mined by the dominant miner, it is essentially useless. The methodology used when conducting the allocation involves maximising the number of blocks in each slope, this is required due to the lack of any other available mechanism for allocation. Therefore the number of blocks allocated to the dominant miner is grossly overestimated.
  • The analysis is built on a logical fallacy. In any period there is going to be at least one miner who has the largest share or the steepest rate of increase in the ExtraNonce. There are also going to be at least some types slopes which do not overlap. Grouping these slopes from potentially different miners together is misleading and potentially based on flawed reasoning.
  • Even if the slopes are similar, this could be because different entities had a similar setup. Each miner is not independent, in the sense that they are likely to be running the same software or could be using the same popular hardware, which could produce the same pattern.

Conclusion

In conclusion, although there is strong evidence of a dominant miner in 2009, we think the evidence is far less robust than many have assumed. Although a picture is worth a thousand words, sometimes pictures can be a little misleading. Even if one is convinced, the evidence only supports the claim that the dominant miner may have generated significantly less than a million bitcoin in our view. Perhaps 600,000 to 700,000 bitcoin is a better estimate.

None of the above says much about whether the dominant miner was Satoshi, although we know Satoshi mined block 9, which we have allocated to the dominant miner in our analysis. However this is in a slope of just 11 blocks, so it’s certainly not conclusive. Whoever the dominant miner was, it is of course possible the keys have been lost or discarded by now.

We will end with one famous quote from Satoshi to consider:

Why delete a wallet instead of moving it aside and keeping the old copy just in case?  You should never delete a wallet.

(Source: Bitcointalk)

Although, maybe we are giving that quote out of context…

 

Hedging a Quanto Perpetual Swap

Hedging a quanto perpetual swap is not straightforward. The added component of correlation risk between two crypto assets complicates things. I will take things from first principles, then provide a more general formula.

Assumptions:
Symbol: ETHUSD
Multiplier: 0.000001 XBT
ETHUSD Price: $500
.BETH (ETH/USD Spot Index): $500
.BXBT (XBT/USD Spot Index): $10,000

Scenario 1 – Short ETHUSD and Hedge

You are lifted for 100,000 contracts of ETHUSD.

First let’s compute your currency exposures:

XBT Value = $500 * 0.000001 XBT * -100,000 = -50 XBT
ETH Value = XBT Value / [ .BETH / .BXBT ] = -1,000 ETH

Next you hedge your ETH/USD exposure by purchasing 1,000 ETH at the spot price. Assume you can match the current .BETH Index price on your purchase.

You have hedged your underlying currency exposure. At this point your exposure is perfectly hedged. However, as the price of ETHUSD changes, your PNL on ETHUSD will be in XBT, while the PNL on your ETH hedge will be in USD.

Let’s look at two extreme examples.

Example 1: .BETH Rises and .BXBT Falls

.BETH and ETHUSD rises to $750
.BXBT falls to $5,000

ETHUSD PNL = (ETHUSD Exit Price - ETHUSD Entry Price) * Multiplier * # Contracts = -25 XBT, USD Value -$125,000

ETH Spot USD PNL = (.BETH Exit Price - .BETH Entry Price) * # ETH = $250,000

Net USD PNL = ETHUSD XBT PNL in USD + ETH Spot USD PNL = +$125,000

In this example the correlation between the USD value of XBT and ETH is -1. They moved in a perfectly negatively correlated fashion, and you made money.

Example 2: .BETH Rises and .BXBT Rises

.BETH and ETHUSD rises to $750
.BXBT rises to $15,000

ETHUSD PNL = -25 XBT, USD Value -$375,000
ETH Spot USD PNL = $250,000
Net USD PNL = -$125,000

In this example the correlation between the USD value of XBT and ETH is +1. They moved in a perfectly positively correlated fashion, and you lost money.

The short ETHUSD position + Hedge profited when correlation fell, and lost when the correlation rose. Due to the flat ETHUSD vs. .BETH basis, the entry price assumed a correlation of zero between the two cryptos.

Scenario 2: Long ETHUSD and Hedge

You are hit for 100,000 contracts ofETHUSD.

First let’s compute your currency exposures:

XBT Value = $500 * 0.000001 XBT * 100,000 = 50 XBT
ETH Value = XBT Value / [ .BETH / .BXBT ] = 1,000 ETH

Next you hedge your ETH/USD exposure by shorting 1,000 ETH at the spot price. Assume you can match the current .BETH Index price on your purchase, and there is no cost to borrow ETH for this short sell.

You have hedged your underlying currency exposure. At this point your exposure is perfectly hedged. However, as the price of ETHUSD changes, your PNL on ETHUSD will be in XBT, while the PNL on your ETH hedge will be in USD.

Let’s look at two extreme examples.

Example 1: .BETH Rises and .BXBT Falls

.BETH and ETHUSD rises to $750
.BXBT falls to $5,000

ETHUSD PNL  = 25 XBT, USD Value $125,000
ETH Spot USD PNL = -$250,000
Net USD PNL = -$125,000

In this example the correlation between the USD value of XBT and ETH is -1. They moved in a perfectly negatively correlated fashion, and you lost money.

Example 2: .BETH Rises and .BXBT Rises

.BETH and ETHUSD rises to $750
.BXBT rises to $15,000

ETHUSD PNL = 25 XBT, USD Value $375,000
ETH Spot USD PNL = -$250,000
Net USD PNL = $125,000

In this example the correlation between the USD value of XBT and ETH is +1. They moved in a perfectly positively correlated fashion, and you made money.

The short ETHUSD position + Hedge profited when correlation rose, and lost when the correlation fell. Due to the flat ETHUSD vs. .BETH basis, the entry price assumed a correlation of zero between the two cryptos.

The below table summaries the two scenarios:

Time Horizon

The correlation between XBT and ETH is not static. The longer you hold a hedged swap position, the more chance that the correlation regime you expect based on the recent past, will change.

Unlike a futures contract, the ETHUSD swap has no expiration date. Therefore your quanto risk is specific to your time horizon. For market makers who are in and out quickly, the quanto effect is negligible. For cash and carry market makers who hold a position for an extended period of time to capture funding, the quanto effect can destroy one’s PNL.

Covariance

Many market makers will not be satisfied leaving their correlation risk unhedged. They will constantly hedge their PNL on the BitMEX and spot leg of their portfolio. Depending on the XBT and ETH volatility, and their correlation, the covariance will determine whether the hedging of PNL positively or negatively impacts your overall profits. If both assets are highly volatile and the correlation is moving in or out of your favour, your gains or losses from hedging the PNL are amplified.

We are in uncharted territory. In a few month’s time, I will observe the past data and attempt to calculate what portion of the funding is attributed to market makers pricing in a quanto risk, and what portion is due to the interest rate differentials between ETH and USD.

Quanto for Speculators

Speculators care about obtaining exposure to risk. How they get that exposure if they can get in and out cheaply is secondary. If BitMEX is able to create a liquid market for Bitcoin quanto’ed derivatives, speculators will flock to them.

As I previously explained in “Why Quanto?”, in order for BitMEX to offer ETH/USD risk, we had to quanto into Bitcoin. This post will explore the concepts speculators care about.

For all the below examples we will use the following assumptions:

Contract: ETHUSD
Multiplier: 0.000001 XBT per 1 USD
Contracts: 10,000

Contract Value


The most important aspect to a speculator is the contract’s payoff function. Since we are speculating on the ETH/USD price, ideally the contract’s Bitcoin value should increase and decrease in a linear fashion with respect to the ETH/USD price.

I assume the speculator denominates their profit in Bitcoin (XBT) terms. Therefore the value of Bitcoin in USD terms at a particular ETH/USD price is irrelevant. Put simply, the speculator wants to use Bitcoin as a margin to earn more Bitcoin.

The above chart illustrates that at different ETHUSD values, the XBT value of the position changes linearly. That is exactly what the speculator desires.

XBT Value = ETHUSD Price * Multiplier * # Contracts

Calculating Margin

How is the amount of Bitcoin margin calculated? The initial margin for the ETHUSD contract is 2%, or 50x leverage.

Initial Margin (IM) = 2% * XBT Value

If you enter the trade at an ETHUSD Price of $500, this is your initial margin requirement:

IM = 2% * $500 * 0.000001 XBT * 10,000 = 0.10 XBT

The next important consideration is what is your liquidation price. That is determined by the maintenance margin. The maintenance margin for the ETHUSD contract is 1%. If the underlying ETH/USD spot price declines by 1%, you will be liquidated.

Calculating Profit and Loss (PNL)


The PNL is denominated in Bitcoin. In Bitcoin terms, the PNL changes linearly with the ETHUSD price. If the contract goes up 1%, your Bitcoin PNL also goes up 1%. The chart above illustrates that.

XBT PNL = (ETHUSD Exit Price - ETHUSD Entry Price) * Multiplier * # Contracts

In the above example, if the ETHUSD price moves from $500 to $600, this is the XBT PNL:

XBT PNL = ($600 - $500) * 0.000001 XBT * 10,000 = 1 XBT

Number of Contracts

To get a certain amount of Bitcoin exposure requires a little math.

The following describes how to calculate how many contracts it takes to equal a desired Bitcoin notional.

Contracts = XBT Notional / [ ETHUSD Price * Multiplier ]

If you want 100 XBT of risk, how many contracts of ETHUSD must you trade:

Contracts = 100 XBT / [ $500 * 0.000001 XBT ] = 200,000 Contracts

The quanto structure satisfies the desires of a Bitcoin-based speculator. The major components that speculators care about all vary linearly with respect to the ETH/USD price. The relative rich or cheapness of the contract vs. the underlying is not a major concern if the contract is liquid.

The factors that govern whether the contract will be at a premium or discount will be explored in the subsequent piece. These considerations heavily depend on how to hedge a quanto derivative from first principles. The hedging of the contract is where the non-linear effects matter.

Why Quanto?

The USD is the biggest shitcoin out there. However, all assets are priced against it. Crypto is not immune. The Bitcoin / USD price is the most important cross in the crypto asset universe.

Moving into the altcoin space, the most active crosses are against the USD as well. To replicate our inverse style derivatives on an altcoin / USD cross requires us to accept the altcoin in question as collateral. The next natural altcoin BitMEX could accept is Ether. However, to fit into our multi-sig security process, it requires us to use/code an Ethereum multi-sig smart contract.

Unfortunately, due to various exploits of popular Ethereum multi-sig smart contracts, we never felt comfortable custodying Ether. Rule 1, to infinity minus 1, of operating a crypto trading platform, is don’t lose the crypto. Anything we can do to limit our risk surface area we must do. Therefore, taking Ether as collateral given the current state of the protocol is a non-starter.

Given these constraints, we cannot launch an Ether margined inverse ETHUSD contract. An inverse style contract is one where the margin and PNL currency is denominated in the home currency (ETH), the quote currency is denominated in the foreign currency (USD), and the contract value is a nominal amount of the foreign currency (USD).

Inverse Contract Example: XBTUSD Swap

Margin Currency: XBT (Bitcoin)
Quote Currency: USD
Contract Value: $1

In order to offer risk on ETH/USD where Bitcoin is used as the margin and PNL currency, the quanto derivative type is necessary.

From Wikipedia:

quanto is a type of derivative in which the underlying is denominated in one currency, but the instrument itself is settled in another currency at some rate. Such products are attractive for speculators and investors who wish to have exposure to a foreign asset, but without the corresponding exchange rate risk.

Quantos are exotic derivatives that can move non-linearly with respect to the underlying. However, they are very beneficial for speculators and hedgers in search of liquidity, where they can post margin in a currency in which they feel comfortable. In my time as a delta one trader, we routinely traded USD quanto derivatives to get exposure to local currency futures contracts in countries that restricted the trading ability of foreigners (e.g. India and Taiwan).

The recently launched BitMEX ETHUSD Perpetual Swap is a quanto derivative. The contract pays out 0.000001 XBT per 1 USD. This means that the Bitcoin multiplier is constant regardless of the nominal USD price of ETH. This is great for speculators, the Bitcoin return varies linearly with respect to the ETHUSD price. For those using this contract to hedge the ETH/USD cross or market makers, it gets a bit trickier. I will get into the mechanics of hedging and market-making later in this newsletter.

Quanto Worked Example Spreadsheet
We have created a spreadsheet for users to download and work through some of the below use cases that can be accessed here.

Downtime Aug 4, 2018

From 14:29 to 15:26 UTC today, August 4, 2018, access to BitMEX.com and the BitMEX API was severely impaired.

A large spike in load caused an overload in a critical internal system used for rate limiting and sessions, creating a feedback loop in that system where data was recalculated more often then usual, exacerbating the load.

The feedback loop has been fixed and systems have returned back to normal. BitMEX engineers are working to separate these systems entirely, so that these particular non-critical operations cannot affect processing time of critical trade requests and logins.

We apologize for the disruption. BitMEX engineers have disabled the cause of the feedback loop and are working the weekend to separate these critical systems so that such an event cannot occur again.

The bitcoin flash crash to $0.01 in June 2011

Abstract: We look at the events surrounding the bitcoin price rally in June 2011 to $32 and the following temporary flash crash down to $0.01, on the MtGox exchange. We look at the incompetence of MtGox and examine the causes of the crash. We then look at the political battle and uncertainty which occurred in the aftermath of the crash.

Bitcoin price from May 2011 to 18 June 2011

(Source: YouTube, MtGox, BitMEX Research)

 

Click here to download the pdf version of this report

 

Overview

If one likes price volatility and scandals, the summer of 2011 was an exciting time for Bitcoin. Over the course of a few days, bitcoin plummeted in value from a peak of $32 to just $0.01 on the MtGox exchange, a trading platform based in Tokyo, which was dominant at the time. This was after a recent rally, with bitcoin trading at around $2 a couple of months earlier. The crash down to $0.01 is now a famous part of Bitcoin history.

In this piece, we look at the cause of the crash and its aftermath. Although the major exchange of the time, MtGox, was shown to the community to be largely negligent, which may not have been the best advertisement for Bitcoin. In our view the engaging nature of the events which occurred that summer, ironically made a significant contribution to the level of interest in the space.

MtGox security issues & the context of the event

There was significant uncertainty surrounding the hack at MtGox which caused the June 2011 price crash and the issues surrounding it were never fully explained. The Bitcoin community was riddled with rumours about whether MtGox was solvent and how much bitcoin was stolen.

Thanks to a report published in 2017 by Kim Nilsson, we now have a relatively strong understanding of what occurred in 2011 and the damage that this caused to MtGox.  Ironically, despite the huge impact on the market and the company’s reputation, in terms of MtGox’s solvency, this event was largely insignificant compared to other security incidents. For many however, a new window into MtGox was opened up, which illustrated a severe lack of monitoring systems, governance, controls and security measures.

The  table below lists some of the major security incidents at the MtGox exchange, with the June 2011 hack highlighted in green. This incident may have only directly cost the exchange 2,000 bitcoin, an inconsequential amount, compared to roughly 837,000 bitcoin of total losses.

List of known MtGox losses

Date Incident name Description USD lost BTC lost
20 Jan 2011 Liberty Reserve withdrawal exploit 50,000
30 Jan 2011 Liberty Reserve withdrawal exploit 2 A user supposedly withdrew US$2billion from their account which never existed. Although it seems no wire transfer actually occurred and therefore there may have been no losses
1 March 2011 Wallet theft 1 Hackers obtained the MtGox wallet.dat file from the server. This is believed to be the withdrawal transaction. As of 19 July 2018, the stolen 80,000 bitcoin has never been moved. 80,000
22 May 2011 Wallet theft 2 Somebody is believed to have accessed a wallet containing 300,000 bitcoin, which was kept unencrypted on a public drive. The thieves decided to return 297,000 bitcoin, keeping a 1% fee. The return transactions are believed to be for 280,000 and 17,000. 3,000
19 June 2011 Price crash to $0.01 Hacker gained access to Jed McCaleb’s administrative account, and sold bitcoins to crash the price, to withdraw as many bitcoins as possible within the US$1,000 per day limit. Other users who purchased bitcoin at low prices may have also withdrawn funds. 2,000
11 Aug 2011 Bitomat Took over the debts of Bitomat after the company deleted its private keys 17,000
Sept 2011 Database hacked A hacker gained write access to the database and inflated balances to withdraw funds 77,500
Sept 2011 Wallet theft 3

A hacker obtained the main wallet.dat file again and began withdrawing funds in October 2011.

MtGox appears not to have noticed this.

603,000
October 2011 Incorrect deposits The change from the above hacker’s withdrawal transactions were incorrectly booked as new MtGox deposits, totalling 44,300 bitcoin. This resulted in customers seeing new deposit balances in their accounts. In some ways the hackers therefore caused more damage to MtGox than the value of coins which were stolen. Some of these errors were corrected, so the net impact may be around 30,000 bitcoin. 30,000
28 Oct 2011 Destroyed bitcoin

A software bug caused funds to be sent in such a way that they could not be redeemed.

Example of such transactions can be found here & here

2,609
May & Aug 2013 US law enforcement seizures Federal agencies in the US seized funds from MtGox’s Dwolla account due to allegations the exchange was not complaint with US regulations. 5,000,000
May 2013 Coinlab dispute Coinlab sued MtGox in a dispute over a licensing agreement. 5,000,000
2011 to 2013 Willy Bot MtGox trading program designed to make up some of the above losses, but actually ended up making things worse. 51,600,000 22,800
Total 61,650,000 837,909

(Source: Cracking MtGox, BitMEX Research)

Overview of the events in June 2011

In the weeks leading up to 19 June, many users of MtGox were reporting that their accounts had been hacked. At around the same time a database of MtGox users, including an MD5 hash of their passwords (with an unclear/inconsistent salt policy) was leaked and made available. Many passwords were identified. Some traders used the same credentials at the rival exchange, Tradehill, who also experienced security issues. Despite this, MtGox did not suspend trading, a decision which many traders questioned.

On 19th June 2011 (3am on 20th June Tokyo time), there were large sell orders on the exchange and the price crashed from around $17.50 to $0.01 and trading continued at this level for several minutes before recovering. This lead to a high degree of uncertainty, with some assuming there may be a problem with the Bitcoin network.

It now seems likely that what actually happened was that a hacker may have obtained access to the account of Jed McCaleb, the founder of MtGox who sold the exchange to Mark Karpeles around three months earlier. This account appears to have retained administrative rights to the database and therefore the hacker was able to manipulate account balances and grant themselves a large number of bitcoins on the MtGox system. The hacker is the likely to have begun selling some of these coins.

Due to the poor management of MtGox, in our view it is unlikely that the company were aware of this, even in the aftermath of the hack, and therefore the explanations provided at the time of the events were incomplete or inaccurate.

The withdrawal limits

At the time, MtGox had a daily withdrawal limit of US$1,000, this applied to both bitcoin and USD (via Dwolla). This meant that the hacker (or any others who benefited from the hack by buying bitcoin at low prices), would be unable to benefit by withdrawing the funds, except within the US$1,000 limit. However, the US$1,000 bitcoin limit was based on the market price of bitcoin on the platform and since the price fell to $0.01, in theory the maximum each user could withdraw was 100,000 bitcoin, certainly not a small amount.

Fortunately, however, MtGox appeared to also have a bitcoin based withdrawal limit, that many users were unaware of. As the Mark Karpeles said at the time:

2011-06-20 00:16:43 MagicalTux the btc withdrawal limit saved us

(Source: IRC, Note: MagicalTux is the CEO & owner of MtGox, Mark Karpeles)

Mark then mentioned that only 2,000 bitcoin were withdrawn in the aftermath of the event, which was a relatively positive result for MtGox.

Got about 2,000 BTC out

(Source: IRC)

There was widespread scepticism about this number at the time, with many believing much more was stolen. Ironically, this 2,000 bitcoin figure now seems about right, although MtGox had lost far more in other incidents. However, due to the price crash and suspension of trading, this incident was very public at the time and resulted in the incompetence of the MtGox platform being exposed to the community.

The rollback debate

Many trades took place at the artificially low price of around $0.01 during the crash. Some traders & investors were unhappy at missing out on the price rally from around $1 to $32, and therefore had buy orders waiting in the system, all the way down the order book to $0.01. To them, this crash is exactly what they were waiting for. To the dismay of many of these traders, in the aftermath of the incident MtGox said they would reverse the trades which occurred during the crash:

The bitcoin will be back to around 17.5$/BTC after we rollback all trades that have happened after the huge Bitcoin sale that happened on June 20th near 3:00am (JST). One account with a lot of coins was compromised and whoever stole it (using a HK based IP to login) first sold all the coins in there, to buy those again just after, and then tried to withdraw the coins. The $1000/day withdraw limit was active for this account and the hacker could only get out with $1000 worth of coins. Apart from this no account was compromised, and nothing was lost. Due to the large impact this had on the Bitcoin market, we will rollback every trade which happened since the big sale, and ensure this account is secure before opening access again.

(Source: MtGox)

After this announcement there was significant debate in the community as to whether the rollback should occur. Obviously many participants in the debate had a financial interest in the outcome and this was no doubt effecting their views. In many ways, there were some parallels between this rollback and the 2016 DAO “rollback” on the Ethereum network, with some similar arguments being made.

Supporting the rollback Opposing the rollback
  • Most traditional exchanges tend to roll back trades in exceptional circumstances, particularly if trades occur at extremely unusual prices. The prices in this instance were certainly extreme.
  • The bitcoin were stolen and therefore users should not benefit from stolen goods.
  • The bitcoin may never have existed and may only have been entries in MtGox’s database and therefore it may not be possible to deliver the coins.
  • MtGox should take responsibility and compensate all parties involved. In particular MtGox did not act appropriately in the weeks prior to this event when many users reported that their accounts were hacked and they allowed trading to continue.
  • MtGox had no policy with respect to the matter and should therefore honour the trades.
  • If MtGox reversed the trades in this case, then users may not trust them again.
  • Reversal is an arbitrary process, would MtGox reverse trades if a much smaller amount of money was stolen? This is one rule for the rich and another for the poor.
  • Although there are some examples of major traditional exchanges reversing trades in exceptional circumstances, there are examples where they have not done so.
  • Honouring the trades is more consistent with the no bailout, dog eat dog, 24×7 uptime, immutability type culture in the community, which was in some ways more prevalent at the time than it is today.

The community appeared to be split on this issue, with some even favouring a vote to decide.

The trader who bought 260,000 bitcoins for US$2,622

The day after the incident, a trader called “Kevin”, claims to have purchased around 260,000 bitcoins during the crash and was arguing that he should be able to keep the coins. As he explained:

I had around $3,000 USD in my MtGox account, from earlier sales I’d made. I looked at the market stats, and realized that there were tons of orders to buy BTC at $0.01 that would likely eat up any remaining bitcoins this seller had on the order. I figured if I put a buy order in for $0.0101, my order would execute first and I could buy a huge amount of bitcoins

(Source: Bitcointalk)

Kevin posted what he claimed to be the trade confirmation:

06/19/11 17:51  Bought BTC 259684.77 for 0.0101

Kevin then went on to explain the likely reason behind the price crash, which was that the seller was trying to manipulate the price down so that they could withdraw more coins within the US$1,000 limit. In our view this part of Kevin’s story is likely to be an accurate explanation for the price crash. This logic contradicts the claim from MtGox that the person who conducted the hack was also the buyer of the bitcoin.

I could place a reasonably sized sell order for $0.001, crash the market again, and withdraw probably all of the bitcoins, since they’d be valued at $0.001 each and would fit under the $1,000 USD limit. I also decided against this, when I realized that whoever placed the gigantic sell order was probably doing so for the exact same reason

However, some have doubted the accuracy of Kevin’s story, claiming the volume of trades he claims is not consistent with the MtGox feed. The feed appeared to show trading volume of only 55,000 bitcoins during the crash past $0.0101 and only 238,000 bitcoins traded in the period. Only 3,000 bitcoin seem to have been traded at the $0.0101 price. These figures are lower than those implied by Kevin, although Kevin’s trades could have been excluded from this data for a variety of reasons. The feed was also notoriously unreliable and it was not clear if there was a precise definition of some for the information in the feed. In our view, there is no reason to believe the whole truth of any of the parties involved in this incident, but Kevin’s explanation for the crash itself seems plausible to us.

MtGox price feed during the crash

(Source: BitMEX Research, MtGox. Note: Volume in bitcoin)

The proof of reserves

The MtGox exchange was down for several weeks and many users were becoming anxious about the solvency of the platform. There was uncertainty over the amount of bitcoin which were lost and users were concerned about a run on MtGox, eventually leading to the exchange going into liquidation and users losing funds. In an attempt to reduce some of these concerns, as the chat log and bitcoin transaction show below, MtGox attempted to prove it had access to a significant quantity of bitcoin, by conducting an onchain transaction on 18th July 2011.

IRC Chat log – 18 July 2011

(Source: IRC Logs)

(Source: blockchain.info)

At the time, the above action seemed to settle the nerves of many of the traders.

Conclusion

A few weeks after these events, after many false starts, trading at MtGox eventually resumed and the bulk of the trades were reversed. However, to this day, as far as we are aware, MtGox has not been able to provide a coherent explanation for what occurred. The lack of a consistent narrative from MtGox lead many to believe that MtGox had poor monitoring and controls of its systems and that the company was run negligently. Many concluded “never to trust MtGox again”.

Unfortunately, however, MtGox somehow continued to dominate the exchange ecosystem for another three years. However one views the conduct and transparency of some of the platforms and players in the ecosystem today, we can at least conclude that things have  significantly improved since 2011.

 

Tether: Puerto Rico financial data quarterly update

Abstract: Following our earlier research pieces on Tether, financial information from Q1 2018 has been released by the financial regulators in Puerto Rico, providing more evidence of the impact of Tether. In addition to this, a source close to Tether has confirmed to us that the speculation in our initial report is correct.

After our earlier speculation that Noble Bank in Puetro Rico was Tether’s primary reserve bank, a few months later in May 2018 Bloomberg released an article further substantiating our claims. As Bloomberg put it:

According to three people with knowledge of the matter, Noble Bank International, based in San Juan, Puerto Rico, took over banking duties for Bitfinex last year.

In addition to the above, BitMEX Research has also now spoken to people close to Tether, who have also confirmed the reliability of most of the claims in our February 2018 report. Our initial discovery was based on the disclosure of data from the financial regulator in Puerto Rico, who have recently provided the latest update, for the quarter ended March 2018. In our view, the data continues to support our initial speculation.

New Financial Data for Q1 2018

Bank deposits in the International Financial Entities (IFE) category, which includes Noble Bank, were $3.5 billion, up 6.9% in the quarter. Total assets in the category were $4.1 billion, up 7% in the quarter. This moderate growth coincides with a the moderate increase in the volume of crypto-coin trading, which has likely resulted from the continued growth of the Tether balance and crypto-coin ecosystem, moderated by crashing crypto-coin prices in the quarter. In the quarter, the value of Tether in issue increased by 62.7% to $2.3 billion.

We have updated the chart below from the version in our earlier piece, which compares the Tether balance with the deposits in the banking category in Puerto Rico which contains Noble Bank.

Puerto Rico’s IFE aggregate deposits versus the Tether balance in millions of USD. (Source: IFE Accounts, BitMEX Research, Coinmarketcap)

 

Cash as a percentage of total assets (an indication of full-reserve banking) also increased in the quarter, from 85.8% to 91.0%. This also indicates crypto-coin or Tether-related activity, as we explained in the previous piece.

Puerto Rico’s IFE aggregate cash balance as a percentage of total assets. (Source: IFE Accounts, BitMEX Research)

 

In the quarter the regulator appears to have changed the name of the Tether balance, to “Deposits, money market investments and other interest-bearing balances” from “Cash in banks“. We do not view this as suspicious.

 

Calling the Curve

The BitMEX Bitcoin / USD 28 December 2018 futures contract, XBTZ18, recently began trading. The following trade ideas assume that spot in the short term will continue to fall and bottom in 3Q2018, and then aggressively rebound into 4Q2018. This scenario also assumes that trader sentiment will not fall out and enter a protracted bear market.

However, if you have very high conviction in that scenario, the riskiest and potentially most profitable strategy would be to:

  1. Go short XBTU18 from now until you believe Bitcoin has bottomed.
  2. Cover the short XBTU18, and then go long XBTZ18.

The reason to go short the 3m initially is that it should be more responsive to spot movements due to its lower time value. It is also more liquid so panicked speculators and hedgers will use that futures contract. Its annualised basis should trade at a steeper discount than XBTZ18.

You go long XBTZ18 on the rebound because it has more time value. If the market does perform as you expect, speculators will bid up the backend of the curve. A lot of things can happen by the end of December. Given that Bitcoin is a call option, the future implied volatility has a greater probability of causing the price to rise rather than fall. The more time value housed in the instrument you are trading, the better change the long convexity can work in your favour.

If you believe this a credible sequence of events, but want to reduce risk, a spread trade is advisable. The reduced risk comes at a the cost of reduced profit potential.

  1. Go short XBTU18 vs. long XBTZ18 from now until you believe Bitcoin has bottomed.
  2. Replace the above short XBTU18 with a short on XBTUSD

Because you expect the sell pressure to happen at the short-end of the curve, the term structure will steepen causing the profit made on the short XBTU18 position to offset losses on the long XBTZ18 position. The term structure chart shown above shows the current curvature of the BitMEX Bitcoin / USD futures markets. It is relatively flat, which indicates now is the time to enter into this spread trade.

This is a price neutral trade; however, be aware that each position is margined separately. Unrealised profit from the short XBTU18 position cannot be used to offset unrealised losses from the long XBTZ18 position.
The second trade is a funding plus long 6m basis trade. As the market rebounds, the swap will be pushed into a premium which means shorts will receive funding. The long end of the curve will also get bid up in annualised basis terms due to the greater time value. You earn money from the swap funding, and futures basis appreciation. Again this trade is price neutral, and you must be cognizant of each positions’ margin.
The reason why I prefer the use of spread trades to express directional moves is that if my prediction is wrong, it does not destroy my capital base. The more conviction around the prediction, the more leverage I employ on each leg to juice up my return on equity.

The Volatility Blues


The anguish experienced by traders worldwide during the $20,000 to $6,000 slide further proves that recently experienced losses matter more than gains. The financial media and many traders forget that 18 months ago the price was $1,000 and then in the fall of 2015 the price was $200.

Jonny-come-lately traders / investors were eviscerated by the recent moves. To make matters worse, the volatility collapsed alongside the price. For crypto, this is deadlier than white wine and painkillers.

But what about adoption? One of the major facets of Bitcoin preventing further adoption is its high volatility. In a pure Bitcoin economy, how can people trade Bitcoin against real goods if its value violently fluctuates? The underwater trader laments that the market just doesn’t get the “fundamental” value of this new transaction network. Well, what transaction network’s monetary token do you know increased 20x in value in under one year? None. Therefore, the driving force is not about current utility but intense speculation on future utility.

Changing the way in which humans use money is an extremely long and difficult process. This process by its nature must be chaotic. Money and the means by which it is handled is personal and sometimes religious. If you tell a society that tomorrow things will be done differently than how they were done over the past 200 years, there will be an intense reticence to change. A violent upheaval is necessary. Therefore, if Bitcoin is to be used in any productive manner, the period leading up to this new epoch must be extremely volatile.

Bitcoin is a call option on a new monetary system. The most important option pricing input is the underlying asset’s implied volatility. As the above chart illustrates, the realised 30-day annualised volatility crashed alongside the price. When volatility returns, the price will go higher.

We Have Been Here Before

The nuclear bear market of 2015 started in January when the price broke $300. For the next 10 months, the price traded between $200 and $300. While that is a 50% range, the daily movements were very slight.

Without volatility, many traders, investors, and market commentators wrote off Bitcoin. Why should one care about an asset that has crashed over 80% from its recent all-time high, and has barely moved since?

Traders returned to the market because the volatility re-emerged. If Bitcoin can gyrate 100% in annualised volatility terms in a 30-day period, then quick gains can be made. The FOMO “investors” who believe they can change their lot in life with little effort and in little time took us from $200 to $20,000. There were not many things that fundamentally changed about the adoption of Bitcoin in real commerce from 2015 to 2017.

Return to $20,000

The path to parity will not begin in earnest until volatility rises materially. People need to be excited again. 10% pump & dumps in one day will bring back the good times. The real questions are what catalyst will start the party again, and how long will it take.

During the 2017 bull market, the effect of global macro events on Bitcoin was forgotten. For 2H2018, a global macro event will have to prove that Bitcoin is a safe-haven asset. In 2015 Greece almost told Frau Merkel to do one, but chickened out at the crossroads. Bitcoin responded positively when the market believed Greece could actually liberate itself. If a similar type scare happened later this year, would Bitcoin regain its safe haven status?

With the Fed, ECB, and BOJ effectively flatlining or outright reducing their balance sheets, cracks in the financial markets will show later this year. Money printing has never led to prosperity in the long run, and when you shut off the tap the ghosts and ghouls of the financial markets will play.

The MSM Still Loves Bitcoin

Thankfully the mainstream financial press loves talking about crypto. The personalities of the leading figures are larger than life. Even at Bitcoin $6,000 and Ether $400 a whole cadre of individuals are generationally wealthy, and are making interesting life choices the media can’t stop covering. In 2015 no one was watching, in 2018 everyone is.

In order to prove their prescience, MSM outlets will fall over themselves attempting to call the bottom in Bitcoin.  The foolish many who believe these pundits actually can divine the future will attempt to knife catch. Many will fail, but if enough try, some will succeed. These successful retail punters will be paraded on the airwaves as trading gods. This will further increase the FOMO, volatility, and price appreciation.

Nothing goes up or down in a straight line. I still haven’t seen enough pain and anguish to believe we are done bloodletting. In true Bitcoin fashion, the price will go to the level no one thinks is possible and rebound faster than traders can work up the nerve to BTFD.

A brief history of Stablecoins (Part 1)

Abstract: In this piece we look over the history of distributed stablecoins, focusing on two case studies, BitShares (BitUSD) and MakerDAO (Dai). We examine the efficacy of various design choices, such as the inclusion of price oracles and pooled collateral. We conclude that while a successful stablecoin is likely to represent the holy grail of financial technology, none of the systems we have examined so far appear robust enough to scale in a meaningful way. The coins we have looked at seem to rely on “why would it trade at any other price?” type logic, to enforce price stability to some extent, although dependence on this reasoning is decreasing as technology improves.

 

Please click here to download a pdf version of this report

 

Overview

Distributed stablecoins aim to achieve both the characteristics of crypto-coins like Bitcoin (censorship resistant digital transactions) and the price stability of traditional financial assets, such as the US Dollar or gold. These systems are distinct from tokens such as Tether, where one entity controls a pool of US Dollar collateral, ultimately making the system centralised and thus susceptible to being shut down by the authorities.

Along with the somewhat related idea of distributed exchanges, distributed stablecoins have been referred to as the “holy grail” of financial technology, due to their very strong potential benefits. In our view the transformative nature of such a technology on society would be immense, perhaps far more significant than Bitcoin or Ethereum tokens with their floating exchange rates. Distributed stablecoins could have the advantages of Bitcoin (censorship resistance combined with the ability to transact electronically), without the difficulties of a volatile exchange rate and the challenge of encouraging users and merchants to adopt a new unknown token. Such a system is likely to be very successful and therefore it is no surprise that so many people have attempted to launch such projects:

List of stablecoin projects

Name Type Launch Date White paper link
BitShares (BitUSD) Crypto-collateralized 21 July 2014 White paper
Nu (NuBits) Crypto-collateralized 24 Sept 2014 White paper
Steem (SteemUSD) Crypto-collateralized 19 April 2016 White paper
Corion Non-collateralized 14 Oct 2017 White paper
MakerDAO (Dai) Crypto-collateralized 27 Dec 2017 White paper
Alchemint Crypto-collateralized Sept 2018 White paper
BitBay Non-collateralized Sept 2018 White paper
Carbon Non-collateralized n/a White paper
Basis Non-collateralized n/a White paper
Havven Crypto-collateralized n/a White paper
Seignoriage Shares Non-collateralized n/a White paper

The technical challenges involved in creating such systems are often underestimated. Indeed constructing a distributed stablecoin system, which is robust enough to withstand cycles or the turbulence and volatility linked to financial markets may be almost impossible. For instance perhaps most forms of fiat money, even the US Dollar itself, have not even achieved that, with credit cycles putting US Dollar bank deposits at risk. A stablecoin system which builds on top of the US Dollar is therefore never going to be more reliable than traditional banking, in our view.

In economics there is a concept of money supply, with risk and the potential inflationary impact increasing as the number of layers increase. One could add this stablecoin systems on top, as a new high risk layer:

  • M0 – Notes & coins plus deposits at the central banks
  • M1 – Money on deposit in a bank current account (including M0)
  • M2 – Money on deposit in a bank savings account (including M1)
  • M3 – Money in a money market account (including M2)
  • MZM – Money in all financial assets redeemable on demand (including M3)
  • MSC (Synthetic Crypto Money) – Money inside synthetic crypto stablecoin systems  (including MZM)

However advanced or sophisticated the distributed stablecoin technology is, we believe the token is likely to be less robust than the layers above it in the money supply tree.

In this piece we review some of the most prominent and interesting attempts at building these synthetic US Dollar type systems. BitUSD in 2014 and then a more recent project, MakerDAO (Dai).

 

Case study 1: BitShares (BitUSD) – 2014

Factbox
Coin Name BitUSD
Launch Date 21 July 2014
Crypto collateral Yes
Price oracle No

The first stable coin we will discuss is BitUSD, a stablecoin on the BitShares platform. BitShares was a delegated proof of stake (DPOS) platform launched in 2014 by:

  • Daniel Larimer (The primary architect behind EOS and Steem),
  • Charles Hoskinson (the former Ethereum Foundation CEO & Cardano architect), and
  • Stan Larimer (Daniel’s father).

BitShares is just one in a long line of decentralised autonomous corporation (DAC) type platforms released by Daniel Larimer, as the below image shows:

(Note: Daniel Larmier’s company Invictus Innovations launched a number of token/DAC platforms including Protoshares, Angelshares and BitShares. The black arrows represent Protoshares coin holders being granted tokens in the new chains, which Invictus Innovations promised to deliver on all new DAC platforms. Source: BitSharestalk)

 

BitUSD Marketing material

(Source: Introduction to BitShares Youtube video)

BitUSD System dynamics

Pools of Funds Description
Bitshares The native currency of the BitShares platform
Bitshares held as collateral Separate pools of Bitshares  held as collateral, used as backing for the stablecoin.
BitUSD The stable token, designed to track the value of the US Dollar

 

Groups of Participants Description
BitUSD holders Investors and users of the BitUSD stable coin. Holders of BitUSD are able to redeem the tokens for the Bitshares held in collateral.
BitUSD creators Those that create new BitUSD, by selling it into the market (creating new loans), by posting BitShares as collateral. This loan may be for a small period of time, after which it needs to be rolled over or have its collateral topped up to the initial margin level.
Traders Those exchanging BitUSD for Bitshares, and vica versa, on the platform’s own distributed exchange. There is therefore a Bitshares vs BitUSD market price.
Block producers Bitshares block producers/miners have a role of spending the BitShares backing BitUSD, something they are only entitled to do if the value of the BitShares is less than 150% of the value of the BitUSD it is backing (based on the BitUSD vs BitShares exchange rate on the system’s own distributed exchange). The miner can then uses the Bitshares to redeem/destroy the BitUSD. (After the launch the 150% margin level was increased to 200%)

 

Price Stability Mechanisms Price Direction Description
Investor psychology (Unclear/”Why not trade at $1?”) Both directions There does not appear to be a specific price stability mechanism in the BitUSD system. One can redeem and create BitUSD, however the price this transfer occurs at is determined by the BitUSD vs BitShares price in distributed exchange, which is not linked to “real USD”. In a way the price references itself. There is therefore no direct mechanism keeping the price of BitUSD at $1, but the argument put forward is “why would it trade at any other price?” In our view this logic is weak.
BitUSD redemption (indirect) Positive Should the value of the collateral currency (BitShares) fall, any BitUSD holder can redeem the BitUSD and obtain $1 worth of BitShares, assuming the market price of BitUSD is still worth $1 and there is sufficient BitShares held in collateral.

This stability mechanism protects the integrity of the system only in the event that the value of BitShares falls and the BitUSD market price remains at $1. It does not directly stabilize the price of BitUSD around $1, in our view. If the price of BitUSD deviates from $1, this mechanism may not help correct the price.

In our view, it is important to draw the distinction between a mechanism designed to protect the value of collateral and that of a mechanism which directly causes the price of the stablecoin to converge.

Weaknesses

Exposure to a fall in the value of collateral – BitShares was a new, untested and low value asset, and therefore its value was volatile. If the value of the token falls by 50% sharply, in a period spanned by one of the loans used to create BitUSD, there may be insufficient collateral and the peg could fail.

Lack of a price oracle – In our view one of the most controversial aspects of this design is the absence of any price oracle mechanism, providing the system with real world exchange rates. However any price oracle system is challenging to implement and may introduce several weaknesses and avenues for manipulation. We will talk more about this in part 2. In our view, the only real way around this may be that any stablecoin system may require a price feed from a distributed exchange, which can in theory publish a distributed price feed from real world US Dollar transactions. The distributed exchange in BitShares did not allow “real USD”. A distributed exchange system like Bisq, without a central clearing could in theory allow “real USD” prices and provide a distributed price feed.   Therefore stablecoins may eventually be considered as a layer two technology on top of liquid and robust distributed exchange platforms, should these systems ever emerge.

Manipulation – Trading volume in the Bitshares vs BitUSD market on the distributed exchange platform was low, it was therefore possible for block producers to manipulate the market by causing the value of Bitshares to fall relative to BitUSD, enabling them to obtain Bitshares at a discount.

Lack of any price stability mechanism – The main weakness of the system is the lack of any mechanism to move the price towards $1, other than the “where else would it trade?” logic.

Daniel Larimer’s defence of the system

In Daniel’s view, the mechanism of BitUSD creation is analogous to how USD are created in the economy, in that financial institutions lend them into existence.

It’s the same way dollars are created in the regular banking system. Dollars are learnt into existence backed by collateral, in the case of the current banking system the collateral is your house. In the case of our system its shares in the DAC itself.

(Source: Lets talk Bitcoin episode 129)

 

In a way Daniel is correct here, however as we explained in the introduction to this piece, these synthetic dollars are far less reliable than those created by more traditional banks, and can be considered as a whole new layer of risk, as they are even further away from base money. In addition to this, when obtaining a bank loan, the bank typically has a legal obligation to provide the customer physical cash should they demand it. While such an outcome for BitUSD holder is possible, its not a legal obligation for the creators of BitUSD. Although obviously banks typically do not have the cash in reserve to pay back their deposits, we think the fact they have a legal obligation to do so is an important distinction to draw when comparing BitUSD to US Dollar banking deposits.

In response to the supposed weakness of a lack of a price peg, Larimer argues in favor of his “hypothesis that the price feed is unnecessary” as follows:

It implements automatic margin calls, such that if the price moves against someone who is effectively short, it forces them to cover and buy it back in the market and that creates a peg. The market peg works on the premise that all market participants buy and sell based on what they think market participants will be buying and selling in the future. The only rational choice is to assume that it’s going to trade based on the peg in the future. If you don’t believe that they you have to decide on which way it’s going to go, up or down. And if you don’t have a way of saying you abstain from the market. If you don’t think it works you sell the shares and get out, as the systems going to fail in the first place. So its a self reinforcing market peg, that causes the asset to always have the purchasing power of the dollar.

(Source: Lets talk Bitcoin episode 129)

 

In our view this idea that a price of $1 is the “only rational choice” is a weak argument. It is basically saying that if the price is not $1, then what will it be? This logic may hold true for some periods, but it is not sustainable and will not scale, in our view.

Conclusion

The volume of BitUSD in existence was a lot lower than many had hoped, in some periods there was only around $40,000 in issuance. At the same time liquidity was very low and the price stability was weak, as the below chart illustrates. The main architect of BitUSD went on to propose a new stablecoin SteemUSD in 2017, this time including a price feed system. Therefore we consider BitUSD as an interesting early experiment, it did not achieve what was hoped nor did it build a robust stablecoin.

(Source: Coinmarketcap)

 

Case Study 2: MakerDAO (Dai) – 2017

Factbox
Coin Name Dai
Launch Date 27 Dec 2017
Crypto Collateralized Yes
Price Oracles Yes (indirect)

The next stablecoin we look at is Dai, which exists on the Ethereum platform. This system is highly complex, with four relevant pools of funds and six possible stability mechanisms. There are currently around $50 million worth of Dai in issuance and the peg seems to be holding up reasonably well.

System dynamics

Pools of Funds Description
Ethereum Ethereum is the native token of the Blockchain platform used for Maker & Dai
Pooled Ethereum Ethereum is placed in pools used as collateral for issuance of the Dai token. These are often referred to a collateralized debt positions (CDPs)
Dai Dai is an ERC-20 token that is generated by collateralizing pooled Ether. Dai is the stablecoin token, designed to be valued at $1.
Maker The Maker token is MakerDAO’s governance token. It is used to vote on various initiatives that pertain to the stability of the ecosystem. It is also mandatory to possess during the collateral unlocking process. During such a process, a stability fee is garnered from the user, where payment is accepted exclusively in Maker. Maker is also an ERC-20 token.

 

Groups of Participants Description
Dai Creators An individual who sends Ethereum to a smart contract, locking up Ethereum in exchange for Dai. These people are also known as CDP owners.
Dai Holder/User A Dai holder may or may not be a Dai creator. They may invest in or use the Dai stablecoin token.
Maker Token Holders Maker token holders vote on several functions and parameters of the MakerDAO system. They manage aspects such as stability fees and liquidation ratios, as well as having responsibility to nominate other groups.
Keepers These traders monitor the Dai collateral and if it falls to an insufficient level, purchase the collateral in an open auction, by spending Dai.
Oracles Price feed producers submit price information that is aggregated and used to select a given price for both Maker and Ethereum (but not Dai itself). These agents are nominated by MakerDAO token holders.

In order to prevent manipulation, there is a one hour lag between the price publication and when it impacts the system. In addition to this a median type mechanism is used to select the price, which involves ignoring the highest and lowest prices. In our view this may not prove to be robust enough if the oracles have a conflict of interest and try to engage in manipulation.

Global settlers This is another group nominated by the MakerDAO token holders. This group can unwind the entire Dai system, by giving Dai holders the right to redeem their collateral at a fixed price.

 

Price Adjustment Mechanics Price Direction Description
Dai Redemption Positive The primary stability mechanism is the ability, in theory, to redeem Dai for $1 worth of Ethereum. Redemption can only be conducted by CDP owners (unless there is insufficient collateral). If the price of Dai falls, CDP owners need to either use Dai they currently hold or buy it in the market, and then they can redeem/delete Dai for $1 worth of Ethereum based on the price feed provided by the price oracles.
Dai Creation Negative To complement the Dai redemption process, the mechanism to prevent the price of Dai climbing too high, is the ability of Ethereum holders to create new Dai, by placing Ethereum inside of CDPs.
Target rate (Not active) Both directions There is a “Target Rate Feedback Mechanism” (TRFM), which appears to be another price stability mechanism in the system. However, it is not yet active nor have several specifications of the mechanism been worked out yet.

The the idea is that a target rate is set by the MakerDAO token holders. The target rate is essentially a spread which applies to the creation or redemption of Dai, designed to correct the price.

CDP liquidation (indirect) Positive There is a mechanism by which traders/keepers can redeem the Ethereum collateral held by another CDP. This can only occur if the value of this collateral falls to an insufficient level to backup the Dai, in this case 150% of the value of Dai. This should incentivise CDP owners to keep topping up their CDPs to ensure there is a large buffer of Ethereum.

This is a necessary mechanism to ensure the integrity of the system and ensure the value of the collateral is always sufficient. However it is not clear if this directly keeps the value of Dai at $1. This mechanism can be thought of as a building block on the stability mechanism, which merely ensures the level of collateral is sufficient. Other redemption systems are needed to make this meaningful, in our view.

Global Settlement Positive This mechanism can be triggered at any time. The triggering essentially gives all Dai holders an option to convert back to a fixed value of Ethereum, worth $1 according to the oracle price feed, at the time of the triggering (or whatever price is possible given the total level of collateral in the system). The difference between this and normal redemption, is that the price is fixed and its open to all Dai token holders and not paired to a particular CDP.

The idea is that this mechanism can be used as a threat against CDP holders, to ensure they keep redeeming Dai in the event the price falls, rather than holding out for an even lower price.

Global settlement can also be used in the event of bugs or other emergencies.

MakerDAO token issuance (indirect) Positive MakerDAO token holders act as the buyer of last resort. If the collateral (pooled Ethereum) in the system were to drop below 100% collateralization, MakerDAO is automatically created and auctioned on the open market to raise additional funds to collateralize the system. Hence, if the system becomes undercollateralized, Maker holders absorb the damage.

Again this mechanism protects the value of collateral, but does not directly help the price of Dai converge to $1, in our view.

Analysis of the core stability mechanism – Dai redemption

The primary stability mechanisms appear to be the ability of CDP owners to redeem if the price of Dai is too low and for people to create new Dai if the price is too high. For example if the price of Dai falls to 80 cent, CDP owners could purchase Dai in the market and redeem it, unlocking $1 worth of Ethereum and making a nice profit. This is how the system should work under normal circumstances.

The above appears to be a robust stability mechanism which should keep the price of Dai at or near $1. However, the theory may only work if CDP owners expect the price of Dai to correct back to $1. If the price of Dai has fallen to 80 cent, CDP owners may be reluctant to redeem if they expect the Dai price to fall further to 60 cent, as such a price would enable them to make even more profit. There is no guarantee that once the price reaches 80 cent, it won’t continue to fall.

Therefore the stability mechanism could depend somewhat on the power dynamics between two groups, Dai owners and CDP owners. These two groups are essentially trading against each other in the market, Dai owners are selling of Dai and CDP owners are the potential buyers. If the power balance shifts towards CDP owners, such that they are well capitalised, patient, collaborative and determined, this group could outmaneuver the Dai token holders, drive the price down, and then buy it back and make a large profit. This may seem unlikely, but in our view the stability mechanism may not work in all market scenarios. Although we consider Dai as superior to BitUSD, in some limited ways, the Dai peg relies on market psychology and investor expectations, in the same way as BitUSD. Therefore the Dai peg is also weak and unlikely to scale.

The global settlement system can mitigate the above risk. If CDP owners are successfully manipulating the price of Dai down too far, this could trigger global settlement. Dai holders would then get around $1 of Ethereum back. Therefore the threat of global settlement may keep the price of Dai up. However again the effectiveness of this threat depends on the determination of the various groups, the CDP owners, MakerDAO token holders and global settlement activators.

Conclusion

We consider Dai to be one of the most sophisticated and advanced stablecoins systems which has been produced so far. In our view, when digging into Dai’s stability mechanisms, there is no one powerful mechanism which ensures stability. Instead we have a complex network of systems, which to some extent reference each other and use circular logic.  One could claim this complexity was created to obfuscate the lack of a strong and clear stability mechanism, but it is more likely to be an indication of an experimental trial and error type approach to the design of the system.

Therefore the system is still reliant on investor expectations and psychology, although to a lesser extent than the BitUSD. While the stability systems in place could work, at least for a while, we think they are not robust enough to withstand market turmoil or some types of power imbalances between Dai holders and CDP owners. Therefore, the search for the holy grail continues.