Bonus: The Crypto Story by Matt Levine - Part 6

Matt's gone deep into the blockchain to break down its origins, it's possible, futures, and the current state of a technology that's showing up everywhere in industries ranging from finance to shipping too, of course video games. And we're going to be bringing his exploration to you in audio form thanks to the talents of Bloomberg editor and professional voice actor Mark Ledoff. You'll get weekly chapters of the special Crypto

issue of Bloomberg Business Week. Welcome to the sixth chapter of the special audio edition of the Bloomberg Business Week Crypto issue, written by Matt Levine and narrated by Mark Ledoff. Mr. Previous chapter and need to catch up. You can find previous episodes right here in the Bloomberg Crypto podcast feed d Defy. The thing about centralized crypto exchanges is that

they're centralized. Broadly speaking, you have to trust the people running the exchange to run it in a good way, not to steal customer money, not to get hacked, not to take advantage of their knowledge of customer orders to trade ahead, not to blow up by allowing too much leverage, et cetera. Sometimes that trust is misplaced and the exchange does steal the money. Sometimes the exchange is honest, careful, and well regulated by the responsible national authorities. But still,

you're in crypto. You want to avoid trusting centralized intermediaries and national regulation. Also, you're in crypto you want smart contracts. A financial products exchange can be thought of as a computer program. Most stock exchanges long ago got rid of trading floors with human traders and are now just computer servers matching electronic buy and sell orders. Certainly every crypto exchange works like that. A centralized crypto exchange is fully electronic.

It has computers that keep ledgers of customer assets and run the programs, matching orders and moving assets between customers. The blockchain is already designed to keep a ledger of customer assets, so why keep your assets on an exchanges ledger? And you can on computer programs on Athereum or most other modern blockchains, why not run the exchange programs there?

A venue for trading tokens that isn't a company but is instead a set of smart contracts on a blockchain is called a decentralized exchange or d e X, and the broader idea of having a financial system with lending and derivatives and everything else that runs as smart contracts on a blockchain is called decentralized finance or DEFY. A

few more points of terminology. Decentralized finance is DEFY, so centralized finance, meaning specifically the bits of crypto that use centralized trusted intermediaries, mainly exchanges and lenders, is c FI, and I will sometimes refer to defy things as protocols. A protocol is a set of smart contracts, the computer programs that run on the blockchain and do stuff, or at least a set of rules for creating them. A decentralized ex change isn't an exchange in the traditional sense.

It certainly isn't a building in New York where traders meet in person to shout orders at each other. And it also isn't a data center in New Jersey where an exchange company keeps its computer service to match orders with each other. It's a protocol, a set of smart contracts that let people move cryptocurrencies around. There might be a company involved, and surely someone is making money somewhere, But even if the company goes away, the smart contracts

will keep running as long as the blockchain does. One some background on exchanges and market makers one clob Here's what an exchange is. People send it orders buy one hundred shares at one hundred, sell one hundred shares at a hundred two dollars, etcetera. The exchange is, at its heart, a system for matching those orders, finding a buyer for each seller, and vice versa. The orders come in at

different times. When the exchange gets an order to buy one hundred chairs at one hundred dollars, it puts the order on its order book, just an electronic list of orders that haven't been executed yet. When it gets its next order to sell one hundred shares for a hundred two dollars. It looks at its order book to see if there are any orders to buy one hundred chairs

at one hundred two dollars. Nope, not yet. The one hundred dollar buyer doesn't want to pay one hundred two dollars and the one two dollars seller doesn't want to accept one hundred dollars. It puts the cell order on the order book to the one hundred dollar buy order, and the one D two dollars cell order rest on the order book. Then another order comes in to buy

a hundred shares at a hundred and two dollars. The exchange sees in the order book that a ha, yes, there's an order to sell a hundred shares at a hundred and two dollars. So the matching engine matches the one D two dollar buy and the one D two dollars cell order. They pair off with each other and do their trade, and then the orders are removed from the order book they've been filled, and the exchange waits

for the next order. In general, a centralized exchange will have lots of orders resting on its order book at any time. All the resting by orders will have lower prices than all the resting cell orders. If a buy order has a higher price than arresting cell order, those two orders will pair off and execute with each other. If I want to pay one three dollars and you will accept a hundred two dollars, the exchange has found

a mutually beneficial trade. And this way of running an exchange is usually called a central limit order book or c l OB. You could certainly build a smart contract to do this on the blockchain. The contract would take orders, keep them on a central limit order book, and execute them against each other. And smart contracts like this do exist, but most d x is don't work this way. Two market makers. You may ask, where do all these resting

orders come from? Who's going around thinking up these specific prices they want to pay for a stock or prices they want to sell for. Ordinary people might not bother with this. If they think a stock is a good investment, they will often send in market orders just buy from whoever, selling at whatever the best prices. Resting orders come mainly from professional investors called market makers, who help make fast

and efficient trading possible. Their job is to sell stock or crypto or whatever to people who want to buy and buy from people who want to sell and collect the spread, the difference between their bid or buying price and their offer or selling price. If you send a market order to buy, you buy immediately, but you pay a bit of money the spread to the market maker for that service. The market maker, meanwhile, is in the

business of providing that service and collecting that spread. It's not really betting that prices will go up or down. In modern stock and crypto markets, market makers are also largely computer programs, and their programs are pretty simple. This is oversimplified, but not by that much. One post a bid and an offer for a stock. Two. If someone sells you stock at your bid price, lower your bid

and offer slightly. If someone immediately hits your bid, then you might worry that your bid was actually too high and you could have paid less. Anyway, Now you own some stock and want to get rid of it, so you might as well put it on sale. Three, if someone buy stock from you at your offer price, raise your bid and offer slightly for similar reasons. For keep doing this. The system is self correcting. The more stock people want to sell you, the less you pay them

for it. The more they want to buy from you, the more you charge them. Hopefully it all balances out and you end up flat. You sell all the stock you bought and buy all the stock you sold, and you collect the spread along the way. Five. Also, you're probably keeping an eye on general market conditions and raising and lowering your bids and offers based on what's happening

in other markets. Market Makers in US stocks are often called high frequency traders or sometimes even flashboys, and part of what that means is that they're constantly changing the prices of their orders as their information changes. And the result is that when you want to buy a share of stock, you can send in a market order and you will quickly trade with a market maker at a price that's pretty much the market price, one that's updated

continuously to reflect supply and demand and all available information. Three. Nope, this doesn't work on the blockchain. The problem with the blockchain is that it's a slow computer. Ethereum runs computer programs by sending them to thousands of nodes to confirm transactions, and that takes time. You wouldn't want to run a

self driving car on the Ethereum virtual machine. It turns out, you wouldn't want to run a high free concete trading platform there either centralized exchanges in traditional finance and in crypto have lots of very fast computers with very fast connections that allow market makers to constantly update their prices in response to trades and new information. Traders build fancy fiber optic lines to get their orders to the exchange a few milliseconds faster than the competition speed matters, and

they update their orders many times a second. This is harder when the computers are on the blockchain. It's also more expensive. Every action in Ethereum requires gas fees, and sending a message to a smart contract saying cancel my buy order at one point oh one dollars and put in a new order at one point two dollars would use Ethereum's computer power and cost gas. It turns out this is nearly fatal for clob market making. In Ethereum,

market making is very expensive. Vitallicquterian wrote as creating an order and removing a order both take gas fees, even if the orders are never finalized. Two automated market makers one mechanics. So Vitallic proposed a different idea here. It is the mechanism would be a smart contract that holds A tokens of type T one and be tokens of type T two, and maintains the invariant that A times B equals K for some constant K. In the version where people can invest, K can change, but only during

investment withdrawal transactions, not trades. Anyone can buy or sell by selecting a new point on the X Y equals K curve and supplying the missing A tokens and in exchange receiving the extra B tokens, or vice versa. The marginal price is simply the implicit derivative of the curve x y equals K or y slash x. That's just a comment that he wrote on Reddit. Later, a whole business model grew out of it. Here's the simplified version.

I decided to be a market maker in some token pair, say ethereum and U s d C. A dollar denominated stable coin. Let's say one Ether currently trades for six d U s d C six hundred dollars. I set up a smart contract. Again, that's a computer program on the blockchain, but in this case it might be easier to think of it as a pot of money managed by the computer program. I can deposit both ether and

USDC into this pot. Anyone who wants to buy ether with U s DC or sell either for U s DC can come to my smart contract and make that trade with it, and the contract will adjust its prices to reflect supply and demand. But it will do it in an absurdly simple manner that doesn't require much in the way of computation or updating prices. It will just

try to keep one number constant. When I set up the contract, I deposited equal values of ether and U s d C. If one ether was worth sixteen hundred U s DC, I put in one hundred ether and one hundred sixty thousand U s DC each set of tokens worth a hundred and sixty thousand dollars. The program multiplies those two numbers one hundred times one hundred sixty thousand is sixteen million, and then it will just hold

that product constant. That is, the number of Ether multiplied by the number of U s DC will always be sixteen million. A trader will try to buy, say ten Ether, that would leave ninety ether in the fund. Sixteen million divided by ninety is one hundred seventy seven thousand, seven

hundred and seventy seven point seventy eight. The pot has one hundred sixty thousand U s DC now, so it will need seventeen thousand, seven hundred and seventy seven point seventy eight more U s DC to keep the product constant. That's what my smart contract charges. The trader has to pay me seventeen thousand, seven hundred seventy seven point seventy eight U s d c one thousand, seven seventy seven point seven seventy eight U s DC per Ether to

do this trade. Someone wants to buy ether from my smart contract, So my smart contract automatically raises its price for Ether. But it doesn't have to go around constantly updating prices and posting new prices on central limit order books. It just advertises its constant product and that updates prices on its own. It's a kind of automated market maker, or a m M. That's cool. I don't know it's cool. This isn't a thing that really exists in traditional finance.

It was developed almost by accident, as a workaround to a novel problem that the computers are too expensive in decentralized finance. You might be asking, wait, how do I know the price charged by the smart contract is correct? Is the computer program ever checking Ether's price quoted on say,

coin base to make sure it's price makes sense? No, insofar as demand for ether by people interacting with the contract reflects demand for either in the rest of the world, than the price created by the contract is the price. Sometimes different smart contracts and different centralized exchanges could have different prices for ether, But if they get two out of whack, people can try to buy ether where it's cheap and sell it where it's expensive for a quick

profit and close that gap two LPs. In my description above, I assume that I want to be a market maker in some currency pair, so I set up a smart contract to do it on my own. In reality, the way d X is normally work is that a MM smart contracts pool liquidity. If you want to be a market maker in stocks, it helps to be a large financial institution in crypto. Anyone who wants to be a market maker in a pair of tokens can contribute that pair to a liquidity pool and get back liquidity tokens

representing their stake in that pool. Their call liquidity providers. They collect fees in crypto for providing liquidity in the pool. There's a risk though in general, if you provide liquidity in an asset in defy or centralized finance, in crypto or otherwise, and the asset price steadily goes down, you'll find yourself buying more and more of it, and it

will be worth less and less. In an a MM liquidity pool, if the price of one token keeps going up against the other token, the pool will have more and more of the token worth less and less. This is a risk that all market makers take in traditional finance, it's sometimes called adverse selection. In defy, though it delights in the name impermanent laws. I don't know why, but

I love it. There's nothing particularly impermanent about it unless the price bounces back, of course, but that's what it's called. Crypto is so optimistic. How can you not be charmed. We'll be right back with more from Berg Business Week special Crypto issue, written by Matt Levin a narrated by Mark Ladoff. Three lending exchanges providing liquidity between different tokens are a key function of defy, but there are others.

One important function is lending one secured. Most defied lending is what you would call in traditional finance margin lending. You have a volatile asset ether, say, and you want to borrow some money a dollar like USDC stable coin, say, using that volatile asset as collateral. Perhaps you're borrowing that money to buy more volatile assets, or perhaps you're borrowing against your ether to buy a sandwich or a house

without selling your either. If you went to a broker for a margin loan against one d dollars of stock, the broker might lend you fifty dollars. It's over collateralized because the stock is worth more than the loan, which makes the broker feel safe. If the stock then fell to seventy dollars, the broker might send you a margin call. Pay down fifteen dollars of this loan, or I'll liquidate your stock. That way, it's less likely the broker will end up holding the bag for your loss if the

stock keeps falling. If you failed to meet the margin call, the broker would sell your stock clear, say sixty dollars for it, keep enough money to repay the loan, and give you what's left. This is pretty straightforward to automate with smart contracts. There are robust. Defied lending systems such as compound Lenders put up tokens and earn interest. Borrowers

borrow tokens overcollateralized by other tokens and pay interest. And automatic liquidation provisions make sure that if the value of the collateral goes down, it's sold to pay back the loans two unsecured. What's much harder in defied are the main businesses of traditional finance, unsecured lending and lending secured by physical assets such as houses. Defy is good at lending crypto secured by crypto. The collateral lives on the blockchain,

the loan lives on the blockchain. They're connected by smart contracts on the blockchain. It's all pretty neat, but this sort of lending crypto against crypto doesn't do much. It's mostly useful for crypto speculation. You lend ether, get us DC and use it to buy even more ether. By contrast, a mortgage lets you buy a house and then pay for it with your future income. An unsecured business loan helps you build a business and then pay off the

loan with the business's future earnings. Finance at its heart is about moving future wealth into the present by borrowing, or moving present wealth into the future by saving. There are deep philosophical reasons that crypto is bad at this. An unsecured loan is essentially about trust. It's about the lender trusting that she'll be repaid not out of a pool of collateral, but out of the borrower's future income. She has to trust that the borrower will have future

income and that he will pay. Relatedly, an unsecured loan requires identity. You need to know who's borrowing the money, what their payment history looks like, what their income is. The default approach and much of crypto is pseudonymity. Anyone can set up any number of crypto wallets or bitcoin account numbers, and they're generally not tied to a name. If you borrow money against crypto collateral, all your lender needs to know is that the collateral is on the blockchain.

If you borrow money against your future income, your lender needs to know who you are. That said, there's nothing in principle to prevent unsecured lending in defy, and there are projects such as Goldfinch that do it. You get together a smart contract where people deposit money in exchange for tokens and a DOW, a decentralized autonomous organization that controls the money. The tokens give them a share in the tao's profits and the right to vote on who

gets the money. People propose potential borrowers, token holders consider them and vote, and if the holders vote yes, then they make a loan. As with any dow, the token holders can get together in a chat room and consider off chain information. If they want, they could make the borrowers send in a driver's license in two bank statements. You can build some incentive mechanism to punish members for proposing borrowers who default and reward them for proposing good borrowers.

Decentralized finance is made up of smart contracts, but it's also made up of people, and if they want to do unsecured lending, they can. We've talked about web three as a source of online reputation about soul bound tokens that could be used to verify a person's actions, connections, and characteristics. A soul in this terminology is something close to a credit report. It's a list of stuff that a person has done that should make you trust them.

A decent centralized and blockchained source of reputation information. The right assortment of degrees and endorsements might make you feel good enough about a person or rather a soul an address on the blockchain that you give them an unsecured loan, and then I suppose if they default, you can take their soul four token omics of defy. The basic mechanism of defy is that you put some tokens up in

a smart contract to generate fees or interest. You put your tokens in an automated market making contract to get liquidity provider fees, You put your tokens in a lending protocol to get interest, etcetera. Generally, this is referred to as locking your tokens because they're being used for lending or whatever, you can't get them back for some period, and people often talk about defy protocols in terms of

their TVL or total value locked. Mechanically, the way this generally works is that you send your tokens to the smart contract and it sends you back other tokens that are basically receipts for the tokens you locked up. Instead of having ether or USDC, you have liquidity provider tokens. Saying you've put some ether and USDC into a smart contract.

What do you do with those liquidity provider tokens. Well, in theory, you hold them until you want your locked tokens back, and then you hand them in and get back the underlying tokens. The liquidity provider tokens are just a receipt. But at some point people realized that those tokens represent something of value. We can do something with them.

If you have a token representing a receipt on some ether that you locked into a smart contract, then that's almost as good as having some ether, and someone might give you some money for it. Now you can borrow against those receipt tokens and defied too. Everything is like this. In proof of steak ethereum, you can steak ether to earn staking rewards. A protocol called Leedo runs a big steaking pool. If you stake your ether with Lido, it will give you back a token called s t e

t H, basically a receipt for your staked ether. The ether that you staked with Ledo will earn staking rewards, while the st E t H that you get back can be sold or invested in other defied protocols to earn more money. More broadly, the business of DeFi is about reusing tokens as much as possible. You have some tokens, you lock them up in a smart contract that does

a thing and pays you a return. The smart contract gives you some sort of receipt token, and you turn around and lock up those receipt tokens in another smart contract that does another thing and pays you some more. People talk about yield farming, the process of bouncing between DeFi protocols to try to earn the maximum yield reusing tokens and getting paid in protocols own tokens to make as much money as possible. This can create a self reinforcing cycle, by which I kind of mean a ponzi.

It goes like this. One there's a protocol that does some stuff with ether or stable coins or whatever. Two, if you put your ether or stable coins or whatever into the protocol for lending or liquidity provision or whatever, it will give you some of its own tokens. This is no problem. It can print those tokens for free. Three if you put those tokens back into the protocol, locking them up rather than selling them it will give you even more of those tokens. It'll pay you ten

percent interest every hour if you want. Who cares? The tokens are free for by this token. It pays ten percent interest every hour. The promoters of the protocol can say more or less accurately. They can quote an a p y an annual percentage yield, a normal finance concept that's much beloved and defied, yield farming with an enormous number of digits, and people will get very excited. Five, So they'll buy the token and it will go up.

Or they'll put their ether or stable coins into the pro a call to earn its tokens, and the protocol's total value locked will go up. Six. Look at this protocol. Its tv L is huge and rising. It's token has doubled in price this week, people will say, and they'll buy more of it. Seven. People keep getting paid comical interest rates in the token, which is fine as long as the token price keeps going up or stays flat, or goes down at a slower rate than the interest rate.

Even though the market is being flooded with tokens, people still seem to be making money and will do so as long as new money comes in eight, the amount of tokens issued rises inexorably toward infinity, the amount of

new money coming in does not, and tragedy ensues. The greatest of these protocols is probably Olympus Dow, which is run by a pseudonymous founder called Zeus Colorful Character, has a group of loyal investors called Omi's, and at its peak offered yields of seven thousand percent and was worth three billion dollars. According to a coin Desk article titled Olympus Dow might be the future of money, or it might be a ponzi. Since then it's lost about its value,

so there's your answer. Olympus Dow also sparked an even funnier copycat called Wonderland on the Avalanche blockchain, which offered yields of more than eighty percent and was partly run by a pseudonymous person who it turned out, also co founded quadriga colorful Character. Last year, I needed physical therapy from my knee, and I ended up bonding with my therapist by talking about crypto. He was heavily invested in Wonderland, which he cheerfully described as a ponzi, but one that

was making him a lot of money. Olympus became particularly famous for the three three meme, based on the notation of game theory. The idea is that the payoff in a two player game can be written as X Y, where X is what I get and why is what you get. These outcomes could be dollars, but often they're written as abstract utility numbers. A payoff of three three is better for both of us than a payoff of two negative one without worrying too much about what those

numbers mean. Olympus Is pitch was that if everybody buys home and locks it up, then everybody's payoff will be good i e. Three three, while if everybody does bad things like sell their home, then everybody's payoff will be negative three negative three. Those numbers are abstract and unitless, and actually the payoff was negative negative. This, of course,

exactly describes any PONDSI. As long as people keep investing new money and not withdrawing it, everyone will get richer on paper, but it will unravel when people start taking their money out. Olympus always struck me as charmingly forthright about what it was up to. It's the future of money, because as long as every one keeps buying, it will keep going up. People have tried that one before. Five

Some arbitrages in traditional finance. People devote their careers to finding arbitrages circumstances in which they can buy something at a low price and instantly sell the same thing at a high price. This is hard to do because traditional finance is very competitive and people aren't regularly leaving twenty

dollar bills on the sidewalk. Even if you think you've spotted an arbitrage the same thing trading at different prices in different places, you have to worry about some legal or operational reason that you can't actually move between those places. Maybe there's a five percent tax to move the stock

off shore, maybe short selling isn't allowed, etcetera. Most of what people call arbitrage in traditional finance is buying one thing at a low price, simultaneously selling a slightly different thing at a higher price and hoping they turn out to be the same thing, or buying one thing at a low price, selling the same thing a bit later

and hoping it turns out to be at a higher price. Meanwhile, the centralized finance is new enough that pricing anomalies exist, but efficient enough that everything happens visibly on a virtual computer running public code, so you can reliably exploit them.

There are magical possibilities one flash loans. Let's say you're a smart young person and you discover an arbitrage stock x y z is trading at ten dollars on Exchange A and eleven dollars on Exchange B. You can buy it on Exchange A for ten dollars and sell it on Exchange B for eleven dollars, making an easy one dollar profit. That's fine. Now you have one dollar. But you want to buy ten million shares on Exchange A for one hundred million dollars and sell ten million on

Exchange B for one ten million dollars. Then you'd have ten million dollars, which is much more worth doing. The only problem with this plan is, while you're a smart young person, you don't have one million dollars. Why would you. In financial theory, the solution is simple. You borrow the one hundred million dollars at the market rate of interest by the stock, sell it, pay back a little interest, and keep your profits. In practice, no one is going

to lend you one million dollars. I mean If you really have found a perfect arbitrage, maybe you'll be able to raise one million dollars. You can work your connections, cold call some hedge funds, maybe get some meetings where you present your strategy and say, see, it's a perfect arbitrage. I just need a hundred billion dollars. Are you in and they'll just do the strategy and leave you out. Maybe they'll pay you a small finders fee, Or you

could start small. Do your arbitrage for one thousand dollars, make a hundred dollars, do it again for eleven dollars, etcetera. Until you have a huge bank roll. But that's not great either. The longer it takes you, the more likely it is that the clever arbitrage you've spotted will go away. In particular, the more you do the trade, the more likely someone else is to notice and do it in a big size and make the arbitrage go away. In

crypto finance, the situation is different. If say you spot ether trading at two different prices on two different decentralized exchanges, you can just write a program that does the following. One borrows a hundred million dollars from some decentralized lending protocol, such as A two uses the hundred million dollars to buy a token on decentralized exchange. A three sells the token on decentralized exchange B for hundred ten million dollars.

Four returns the hundred million dollars to the lending protocol plus a small fee. Five sends the leftover ten million dollars to you. Six, all in the same transaction that executes all at once. The lender in step one can make the return in step four a condition of the loan. The loan and the payback occur simultaneously in the same computer program, executing in the same block of the blockchain. As far as the lending protocol is concerned, there's no

credit risk. If any of the intermediate steps fail, if it turns out you're wrong about the arbitrage and you can't sell the token for more than you paid for it, etcetera, then the whole thing never happens and the loan isn't made. The lending protocol isn't evaluating your credit worthiness, your resume, or your track record as an investor. It's just making sure that the code works. This is clever and neat and feels like a good way to build a financial system.

It's an egalitarian, decentralized, permissionless, computerized way for anyone who spots an arbitrage to be able to exploit and close it. It should make markets more efficient and prices more accurate. The problem is, in crypto an arbitrage often means a

mistake in a smart contract. Of course, this is true and traditional finance to some do he notices a flaw in a loan agreement or credit default swap contract, buys up a bunch of the bond or CDs, then goes to court to try to extract money from the person who wrote the contract wrong. This, however, is a lengthy and risky process, and one of the main risks is that the court will say, oh, come on, that's not what they meant. Get out of here, whereas a smart

contract will never say that. Somebody writes some contract that has some bug that occasionally lets a user put in one token and get back to Then somebody notices and writes a program to use flash loans to put in one billion tokens and get back two billion tokens and blow up the smart contract Entirely. People sometimes leave money lying around in crypto, and crypto has built very efficient ways for other people to take their money. It's not clear that that is a good way to build a

financial system. Two m e v. It gets stranger. Let's say you notice that a token is trading at ten dollars on decentralized exchange A and eleven dollars on decentralized exchange B. So you send an order to exchange A to buy one thousand tokens for ten thousand dollars, and a simultaneous order to sell one thousand tokens for eleven thousand dollars. What happens to those orders in the US stock market, Whole books have been written about that question.

People get really mad about it. Your order goes to your broker, who routes it to different exchanges at different times through different pipes. High frequency electronic traders who see your order execute on one exchange might raise ahead to

another exchange to push up the prices. There are controversies about colocation, where the high frequency traders pay fees to the stock exchanges to keep their computers in the same room as the exchanges computers so they can get a tiny speed advantage by connecting to the exchange through a fairly short wire. In crypto, the answer is different. It's easiest to understand if you start with how trades worked

on Ethereum before the switch to proof of steak. When you made a trade, your transaction would be broadcast out to the entire network and included in the list of transactions that miners were working on executing but that hadn't yet made it into a block. When a block was finalized, miners would include your transaction in the block. But the miners decided which transactions got included in a block and in what order, and they also earned gas fees for

executing transactions. Users could specify how much they wanted to pay for gas, and transactions with higher gas fees were usually prioritized. This created a trade. One you find an arbitrage and send some orders to decentralized exchanges to do that arbitrage. Two, I see those orders on the network and think, hey, that's a good trade. Three I send the same orders to the exchanges to do the same transaction. For I pay a higher gas fee to get priority over you so that I can do the trade ahead

of you. Five. By the time you get to do the trade, it's no longer available. I bought everything available at the good price. Hah ah. This is usually called m e V, which originally stood for minor extractable value, because one winner in this scenario was the miner, who got to charge higher gas prices to people who wanted

to front run trades or avoid getting front run. It's the subject of a twenty nineteen paper by Philip dion at All titled Flashboys two point oh, a reference to the high frequency traders in US stock markets who purportedly raise ahead of other traders orders to extract value from them. Rather than solve this concern about traditional markets, crypto made it explicit. Time priority was subject to an explicit gas auction where whoever paid the most to the transaction orderers

got to go first. Sure, yes, in crypto you could get front run all the time by more sophisticated electronic traders, but in a transparent and descent realized way. As Ethereum moved to proof of steak, m e V was rebranded maximal extractable value. There's still money to be squeezed from traders by the people maintaining the network, but the mechanics

have changed in today's ethereum. There's a division of labor between block builders who compile and order transactions and validators, the replacement for minors who do the proof of steakwork to make blocks official. And if you're doing arbitrages, you can send your transactions privately to block builders. You can still pay for speed and priority, but you can't see

everyone else's trades to front run though. Coming up next, you'll hear more from Matt Levine's special Crypto issue of Bloomberg Business Week, narrated by Mark leadoff E Reinventing two thousand and eight. In two thousand and eight, Stoshi Nakamoto invented bitcoin. One thing that seems to have motivated him was a distrust of banks and financial intermediaries. This was understandable because it was two thousand and eight. The modern

banking system was at a low EBB. Banks had taken risks that few people understood and ended up losing tons of money on supposedly safe investments. High levels of leverage in the banking system and in the more opaque and less regulated shadow banking system made those systems fragile. A bank that borrowed thirty dollars for every one dollar of shareholders equity would go bust if the value of its assets fell for the high leverage and lack of transparency

caused contagion, an assets price would fall. The highly leveraged banks and funds that held it would get margin calls and they'd have to sell whatever they had on hand. That would cause more prices to fall, which would lead to more margin calls, which would bankrupt some the banks and funds, which would lead to more fire sales and more price jobs. Meanwhile, the lenders to those banks and funds who thought their money was safe would have losses.

Many were also highly leveraged and might go bust. All of this was opaque enough that even banks and funds that hadn't taken big risks or lost a lot of money were treated with suspicion by lenders, which could cause them to fail to Ultimately, the banking system was bailed out by massive infusions of money from central banks. All of this was gross. Satoshi didn't like it, and he built a new payment mechanism that escaped the need to

trust banks. It was irreversible and decentralized. Everyone was responsible for their own mistakes. No one could be bailed out by central banks printing money. It was transparent, Every transaction was recorded on the blockchain. There were no hidden chains of leverage. In a deep sense, it wasn't built on debt at all. To some bitcoiners, the central sin of the banking system is that every bank deposit is a liability.

It's a debt payable on demand from the bank to its depositors, and so every dollar that you keep in the bank necessarily adds to the leverage of the system. This complaint is not limited to bitcoiners. After the two thousand and eight crisis, there was a lot of interest in the Chicago plan of narrow banking, where every bank deposit would be backed by real dollars reserves at the Federal Reserve, and lending financed out of equity. But in

today's world, dollars are debt. Meanwhile, bitcoin are not debt. They're just bitcoin. They exist in themselves on the block chain, rather than being liabilities of banks. In early two thousand and nine, when Satoshi mind Bitcoin's genesis block, this message resonated with a lot of people. A new financial system with transparent and irreversible transactions, with no special power for governments or big banks had an appeal Over time, though

there was another, much more obvious appeal to bitcoin. It's price kept going up. If you bought a bitcoin for a hundred dollars, you could soon sell it for a thousand dollars. This got a lot of people very interested in crypto, not for philosophical or monetary structure reasons, but because getting rich is nice. Many of these people came from traditional finance because they saw that crypto finance was fun. It was wide open, it allowed for permissionless innovation, and

everyone was getting rich. These people, the people who left trad vi for crypto because the money was better, didn't necessarily have strong philosophical commitments to all that Setoshi stuff. They weren't like leverage is bad banks or evil. Monetary soundness is what matters. Some came from banks. They were there to make money. One way to make money is by finding good trade aids, finding cheap ways to borrow money, and then borrowing as much as possible to put into

those trades. And so somehow crypto had itself a two thousand and eight. In two the crypto financial system rediscovered what the traditional system had discovered in two thousand and eight. It was honestly kind of impressive. One Terra in two you'll recall the algorithmic stable coin Terra USD collapsed. If you had money in Terra Luna, odds are that you

lost roughly all of it. Many of the people who lost money were regular retail savers who had been suckered by Terra usd s promises of stability and of a safe interest rate, or regular retail cryptocurrency investors who speculated on Luna and lost, but not all of them. One victim of the Terra collapse was a hedge fund called Three Arrows Capital, run by two former Credit Suite Group currency traders colorful characters and also former trad FI guys.

Speaking from an undisclosed location in July three, a c S founders explained to Bloomberg News that what they'd failed to realize was that Luna was capable of falling to effective zero in a matter of days, and that this would catalyze a credit squeeze across the industry that would put significant pressure on all of our liquid positions. Meanwhile, the Federal Reserve was raising rates and speculative assets generally

were losing value. It turns out that crypto is basically a speculative asset and that it's not particularly a hedge for stock market volatility. Everything in crypto went down. Bitcoin was worth more than sixty seven thousand dollars at the peak in October, it fell below twenty thousand dollars in June. Ether went from forty eight hundred dollars to less than a thousand dollars. The total market value of all cryptoc enci's fell from about three trillion dollars in late to

about one trillion dollars in June two. Two thirds of all crypto wealth just vanished. That's just a very traditional story, isn't it. Leveraged hedge funds piled into crowded trades that seemed, on the basis of a fairly short series of historical

data to be safe. This made the trades unsafe, so the hedge funds lost money, so their lenders sent them margin calls, so they were forced to sell off other better assets, assets that were more liquid and could be sold to meet the margin calls, which made those better assets bad too. In a crisis, correlations go to one. Traders say losses on bad trades force leveraged hedge funds to sell good assets, and so everything goes down at once.

Two contagion. Three a C the leveraged hedge fund. When it blew up, the people who loaned it money didn't get their money back. Three a C went into a complicated cross border insolvency process that will presumably eventually recover some money for its creditors, but they'll lose at least some of their money, and it will take a while to get back the rest. Who are these creditors, Well,

a little of everyone, really. Documents filed in three a c's insolvency process reveal that the hedge fund was borrowing from de FI platforms, but also from an assortment of big name centralized or c FI crypto lenders borrowing platforms and exchanges. The de FI platforms mostly did fine. They had collateral, they had automatic liquidation mechanisms, they liquidated the collateral, and they got their money back. The centralized lenders did less well. It turns out a lot were less strict

about demanding collateral than you might have wanted. Three a C was one of the biggest and best known hedge funds in crypto, working with three A C was a stamp of approval for many lending platforms. It was prestigious to say our customers include three arrows. Also, three A C was viewed as a smart fund doing clever, low volatility arbitrage trades with good risk management rather than taking

wild gambles. So if three A C came to a lending platform and said, hey, we'd like to borrow five million dollars unsecured, the platform might say yes, oh boy did they. Voyager Digital, a crypto brokerage that let customers buy, sell, borrow, and lend crypto, is a public company listed in Canada. It had two point three billion dollars of assets at the end of June, about six fifty million dollars of which was unsecured loans of USDC and bitcoin to three

A C. Oops, it went bankrupt too. Celsius Network is the same basic idea, but worse. It offered customers willing to lend out their crypto up to eight percent interest on deposits, with pretty vague descriptions on how it earned that yield. CEO Alex Maschinsky, colorful character once explained to Bloomberg Business Week that it's ridiculous that banks take deposits, used them to make loans, and then don't pay eighteen percent interest. Somebody is lying, Mashinsky said, either the bank

is lying or Celsius is lying. Only one possible answer. Celsius had also loaned three A C money, though that was the least of its problems, and it was in some of the same trades as three A C, which blew up. When three A C did, it also went bankrupt. The leverage of these platforms is pretty astonishing. Celsius was levered about nineteen to one. It had almost ninety dollars of debt, mostly customer deposits, and about five dollars of

equity for every hundred dollars of assets. Voyager was levered twenty three to one. A fairly small loss could wipe it out entirely, and did that. Some banks were levered thirty to one. Going into the two thousand and eight financial crisis became a matter of intense scandal, and post crisis reforms require much higher capital levels for banks. Also,

banks mostly invest in mortgages and stuff. These guys were investing in crypto loans, hugely volatile stuff with nothing in the way of long term through the cycle history, and they were doing it with five percent capital ratios three non contagion. In many ways, this looks like two thousand and eight, but it's striking how little effect the loss of two trillion dollars of crypto wealth had on anything else.

The two thousand and eight crisis in the banking and shadow banking system led to a global recession, foreclosure, crisis, and real political instability two crisis, and crypto seems to have been pretty walled off from real world effects. Two trillion dollars of market capitalization were lost without much of a visible impact outside crypto. Why Part of the answer is about who lost money and how they thought of

the money they lost. A lot of people who put money into crypto, we're using their gambling money, and when their bets didn't pay off, they thought, ah, well, that was fun. Too bad. Almost everything about the world of crypto screams high risk to anyone who knows at all

what to look out for. And so if you do know what to look for, you take your crypto risks with money that you can afford to lose, and in ways that account for the risks, you don't take your life savings lever them up ten to one and invest everything in doge coin. The great lesson of two thousand and eight is that the real systemic risk is in the safest assets. The problem isn't banks and investors buying insane, risky securities that promise returns and then go to zero.

The problem is banks and investors buying triple A rated bonds that promise an extra point oh three percent of yield and borrowing of the money they used to buy those bonds, then finding out those securities shouldn't have been rated triple A. People invest money they can't afford to lose, and often money they borrowed in safe assets, and when those assets lose money, the system breaks. By two the

crypto financial system was working on creating safe assets. That's what Celsius and Voyager and tara U s D promised, safe and stable ways to earn high returns without a lot of volatility. But in crypto some people were taken

in by those promises and invested their life savings. Some hedge funds bet on those promises and levered up those bets, but mostly look the guy who promises eighteen percent yields and says either the bank is lying or Celsius is lying, isn't going to persuade that many people to entrust him with their life savings. Part of the answer, though, is

about the traditional financial system. Traditional big financial companies have been dipping their toe into crypto, but for the most part, the traditional and crypto financial systems have stayed pretty separate. You don't hear a lot about banks keeping of their assets in bitcoin, and in fact, banking regulators have been rather stern about letting banks own crypto, so when crypto prices collapsed, banks and other financial institutions weren't particularly harmed.

This matters a lot. If you want to buy a house or open a store, you go to a bank for a loan. When banks are in crisis, as they were in two thousand and eight, they will be less likely to lend you money, so you won't buy a house or open a store. There will be less credit, less economic activity, less growth in the real economy. Government's bailed out banks in two thousand and eight, not because they love bankers, but because banks matter for the rest

of the economy. The crypto financial system is very fun and cool and has invented a lot of interesting stuff, but it's mostly not where people go to get money to buy a house or open a store. Bitcoin and ethereum and defy could all vanish tomorrow without a trace, and most businesses that make stuff in the physical world would be just fine. Thank you Matt Levine, and thank you Mark Ledoff. As a reminder, if you're looking for these episodes in the Crypto Feed, will be publishing them

every Sunday through December. If you'd like to read this issue in print form, you can head on over to Bloomberg dot com slash the Crypto story. This is Bloomberg Crypto, a daily podcast from Bloomberg and I Heart Radio. For more shows from I Heart Radio, visit the I Heart Radio app, Apple Podcasts, or wherever you get your podcasts. Send us your comments, questions, or suggestions for the show to Crypto at Bloomberg dot net or find us on Twitter.

We're at Crypto. The supervising producer of Bloomberg Crypto is Vicky Vergelina. Our senior producer is Janet Babin. Our producers are Mohammed Farouk and Sharon Barriro. Our associate producers are Ty Butler and Moses on Them. Desta wonder At is our Engineer, original music by Leo Sidron. I'm Stacy Marie Schmaal. We'll be back tomorrow.