Matt Levine Explains Cryptocurrency Markets

Kanav Kariya

Matt Levine's superpower is his ability to describe financial issues in wonderfully simple terms, and in a section of Monday's column entitled Crypto is for fun he is on top form:

In many cases, the essential attribute of a crypto token is liquidity: What you want, often, is a token that trades a lot, because your goal for the token is to trade it a lot. Real-world utility, a sensible business model, acceptance in real transactions, etc., are all less important than just trading if you think of crypto as a toy market for traders to play with. If a token trades a lot at a high price, that in itself justifies the price, because that is all that is asked of a token: It doesn’t need to have a good underlying business or cash flows; it just has to trade a lot at a high price.

Below the fold I discuss the astonishing story behind this explanation of why wash trading is so rife in cryptocurrencies.

Levine is commenting on Leo Schwartz' The rise and fall of a crypto whiz kid: How 25-year-old Kanav Kariya went from president of Jump Crypto to pleading the Fifth. This tells how Jump Crypto got started as a way to evaluate interns, such as Kanav Kariya, as potential hires:

The firm needed to test the mettle of its would-be staffers—whether they could parse the nuances in financial markets and translate them into algorithmic trading models. But it couldn’t give the temporary hires the keys to the kingdom, with its proprietary strategies and billions of dollars in capital.

Crypto offered a solution. The sector had its own tradable assets, exchanges, and quirks, but it was separated enough from Jump’s world of stocks and bonds that it wouldn’t pose a threat.

Levine comments:

It feels like a useful mental model for crypto: Crypto is what you get when you take the smart ambitious interns at traditional financial firms and put them in charge of their own play market. Only for real money.

Jump Crypto made markets, and for many shitcoins they were the dominant market maker, and thus the reason why the shitcoins traded a lot, and thus the source of their value. This was because they made deals with the shitcoin projects:

Token projects will lend market makers a large supply of tokens so they can kickstart trading. Some firms also negotiate a call option, which gives the market makers the right to buy a chunk of the tokens for a steep discount if the project goes well. Selig says that the inverted structure in crypto—where market makers work with token projects, rather than exchanges—makes some sense, given projects’ need to spur trading activity. It also creates dynamics that would never be allowed in TradFi. While crypto market makers still make money off the trading spreads, the massive windfalls often come from those lucrative call options.

If I'm a shitcoin promoter, I can sell Jump Crypto cheap call options for a bunch of my new shitcoin. They will pump the price by wash trading it. We'll, both get rich; me from selling some of my inflated tokens, and Jump Crypto by exercising the options and selling. Who are we selling to? The retail speculators sucked in by the spectacle of a new token with a rapidly rising "price". This is another version of the VC's List And Dump Schemes described by Fais Khan in "You Don't Own Web3": A Coinbase Curse and How VCs Sell Crypto to Retail.

Schwartz writes:

For a firm like Jump, becoming the market maker for a token project meant unlimited upside with no real financial risk. “If you’re at Jump, you decide which one is going to win,” one crypto exchange founder tells Fortune, speaking on the condition of anonymity to discuss industry dynamics.

And Levine comments:

Man, what a crazy time the crypto boom was. It really did teach a generation of young financial traders that they could build perpetual motion machines: You make a token, you trade it, that makes it go up, the value comes from you trading it, you can do no wrong, you get rich, “unlimited upside with no real financial risk.”

Like most financial schemes, this all worked great at first. Two of the shitcoins for which Jump Crypto made markets were Do Kwon's Terra/Luna pair. Schwartz' article starts by recounting a May 2021 crisis:

[Jump Crypto] had become a kind of silent partner for one of the most high-profile projects in crypto, an algorithmic stablecoin called TerraUSD that was meant to maintain a $1 peg through a complex mechanism tied to a related cryptocurrency called Luna—a careful dance that Jump helped coordinate on the backend by fulfilling trades. But despite the bluster of Terra's swaggering founder, Do Kwon, the stablecoin was failing. It had lost its peg.

Jump Crypto and Do Kwon averted the crisis:

Over the next week, Jump secretly bought up huge tranches of TerraUSD to create the appearance of demand and restore the coin's value to $1, according to court documents. Meanwhile, Kwon "vested" Jump, meaning he agreed to deliver 65 million tokens of Luna to Jump at just $0.40, even though the coin would trade, at times, at more than $90 on exchanges.

Jump ultimately made $1 billion from that agreement alone

Terra loses peg

Like most financial schemes it could not last, and the longer it lasted the bigger the crash:

These dubious heroics succeeded only in staving off the inevitable: When TerraUSD lost its peg again a year later, there was nothing Jump could do. By May 2022, the cryptocurrency had grown in popularity, and its failure was catastrophic. Some $40 billion in investors' money evaporated into thin air in a matter of days.

The details of Jump Crypto's involvement with Terra/Luna were revealed because the SEC's case against Terraform Labs and Kwon was based partly on a whistleblower from Jump Crypto. The testimony will probably feature in the criminal case against Kwon, currently awaiting extradition from Montenegro.