This is the sequel to Part 1 of our market making series. For Part 1, visit The Token Sutra: 101 Positions For Market Makers To F*ck You.

Principles of the Token Sutra

The main principle of the Token Sutra is that the real opportunity for profit in "token market making" isn’t in delivering delta-neutral market making services. Rather, savvy market makers rake in the majority of their earnings from deal clauses completely unrelated to liquidity provision.

The Token Sutra advises that the pathway to profit nirvana is paved with deceptive loan agreements, opaque exchange accounts, intricate legal contracts, embedded options, and false promises. Such strategies typically depict a fundamental misalignment of interests between market makers, and the projects and investors they pledge to serve. By becoming enlightened, they can unlock new opportunities to profit from token projects and their communities.

The strategies outlined here are some of the most striking examples of value exploitation the brief history of our industry. Through this, profits amounting to hundreds of millions of dollars have been made at the expense of communities and project teams.

Part 1: The Options

Market makers have been pivotal in the cryptocurrency industry from the outset of centralized exchanges. They’ve infused liquidity into fresh token launches and reduced price fluctuations during a project's early phases. One notable manipulative practice was the aggressive negotiation and procurement of call options on a project's token.

Initially, call options served a harmless function in market making agreements. They were usually issued under the Liquidity Consulting Agreement (LCA) to hedge risk when market makers had to maintain short positions selling borrowed tokens. These call options evolved into a lottery ticket, offering holders the chance to benefit from the exponential growth of tokens during a bull run, where tokens could swiftly multiply 10x or 100x, realizing 8-9 figures of option delta.

Fundamentally, market makers manipulated, concealed, and complicated their LCAs to extract significant value from unsuspecting projects. This was possible because most project founders lacked the sophistication to accurately identify and value options, and understand their potential risks to their project’s long term success.

Exploiting Knowledge Asymmetry

Market makers capitalized on their expert status in these intricate financial matters, and there was little skepticism (by projects) towards their role as a trusted service provider. This was especially true during bull markets when due diligence was minimal and projects were racing to launch quickly. Ultimately, many projects granted options for free without realizing that they had unwittingly forfeited hundreds of thousands to millions of dollars in net present value, and potentially far more in upside.

In addition to individual market makers trying to extract maximum value, there was heated competition amongst traders and firms for the “hottest” deals. A plethora of financial engineering strategies were employed by shrewd traders to raise the Day 1 value of options obtained from the contract, while claiming to be more competitive than other market makers. Tactics ranged from fundamental methods like competing on strike price, option duration and notional size of options.

More advanced tactics, such as those often employed by Alameda, involved the introduction of more intricate clauses such as multiple tranches with varying strike prices, or knockout clauses. The added complexity created an illusion of alignment and sophistication, further hindering projects’ ability to clearly understand the menagerie they were entering into.

Embedded Call Options

As the cryptocurrency market matured, astute market makers like Alameda devised new profit-maximizing tactics. A crowd favorite was the embedded call option, which cleverly hid an option with upside within a token loan.

Here's the mechanism: MMs required token loans to facilitate their trading activities, enabling them to acquire and trade tokens without the projects bearing the risk of trading losses. Projects were incentivised to provide this token loan as it transferred the burden of potential trading losses to MMs.

The real game-changer was the clause that granted market makers the flexibility to repay the loan either in tokens or USD based on market conditions, effectively creating an embedded call option. If token prices dipped, MMs repaid in tokens at a much lower dollar value than the initial loan. Conversely, if prices soared, they repaid in USD, essentially exercising the call option and profiting off the option delta. In the bull market, this simple strategy forced many projects to surrender massive sums of tokens to their market makers, amounting to hundreds of millions of dollars.

To mitigate this, projects can limit the notional value of the embedded option to a sum they are comfortable allocating to an external investor, ensuring a more equitable distribution of value.

Are Founders to Blame?

A potential argument is that founders are at fault for lacking the legal scrutiny and due diligence necessary to fully understand the value and potential risks associated with these options. However, some market makers were clearly acting in self-interest with misaligned incentives when they designed their service agreements to be unnecessarily complex and skewed for their own benefit.

In addition, the terms of these deals were often discussed through informal channels such as Telegram messages, under immense time constraints and competitive pressures. This environment made proper due diligence more difficult, and became an easy way to further exploit founders who were pressured by rising competition and a raging bull market.

Another perspective suggests that the deal was a win-win, with projects getting cheaper services and market makers being able to share in the upside. After all, in a bear market, the options would be worthless and the market maker would be at a loss. This is reflected in the current state of token market making, where market makers favor compensation in fiat over options for their services. This exposes the motivation behind market makers wanting options only when it allows them to extract more value, rather than the false impression of long-term alignment.

While we are all for free market dynamics and the ability to charge for a unique value proposition, we strongly believe that service providers should not exploit their clients to optimize for their own short-term interests. Exploiting misaligned incentives and knowledge asymmetry with retail investors is harmful to the industry and acts as a bottleneck in our ability to self-regulate and mature.

Suggestions for Options

Moving forward, founders must be cautious of these tactics and carefully evaluate the overarching implications of the contract. Options should be stated clearly, especially when dealing with provisions. Furthermore, making the assumptions and calculations behind the Day 1 option valuation more explicit can contribute to a clearer transaction.

Founders should carefully comb through contracts for embedded options and look for any potential for the service provider to exercise their discretion on how the deal is carried out, particularly concerning the timing or currency of loan repayment. One way to analyse derivatives contracts is to simulate extreme scenarios in token price, and to ask what happens in the event that the price appreciates or depreciates significantly.

Finally, market-making services should generally be considered a service and not an equity investment with hundreds of millions of dollars of upside. If there are additional services being offered such as branding assistance or venture financing, this should be negotiated in specific clauses.

Part 2: Opaque Exchanges and Misappropriated Tokens

The Token Sutra teaches that tokens should not only be used for providing liquidity to specific order books, but can be used to generate higher yields in more lucrative practices such as prop trading, degenerate DeFi yield farming, or simply counter trading your project’s investors.

A common play was for market makers to secure token loans or VC investments, and be deliberately vague about specific details such as what the tokens can be used for, when they can be sold, which exchanges the tokens can be diverted to and the regularity and transparency of reporting. The omission of specific terms opened a loophole for market makers to siphon funds into whatever would produce the highest yield for themselves.

From a founder's perspective, once a market maker sends the loaned tokens to an exchange to provide liquidity, there is almost no way to track what is happening to the funds besides periodically checking the public order books. This requires trust between market makers and projects, a fact of doing business aspect in crypto.

As more sophisticated traders entered the space during DeFi summer, profitable trading became considerably more difficult, and even firms like Alameda were making losses in their market making activities on new tokens. It was far easier to earn money from other pursuits such as using the tokens for yield farming, pump and dumps, or prop trading to profit off the loans they had secured.

Day One Listings

Another exploit market makers are known for is the manipulation of prices during day 1 exchange listings of new tokens. As the primary token holders during these initial hours, they exert a profound influence on the market's initial selling price and use this to dump on unsuspecting retail investors. This unique position also enables them to take advantage of mispricing across various exchanges, often leading to substantial profits, sometimes reaching high 7 figures within the first hour of token trading.

The case of Blur offers a prime illustration of the market makers' strategic advantage. Within the first 30 minutes of its listing, Blur's price escalated to $5, not due to organic demand but due to manual intervention by market makers who held a near monopoly on the exchange’s sellable assets. This artificial ceiling was used to drive up the perceived value of the token during the price discovery phase and capitalised on retail investor FOMO. Similar stories played out on notable projects such as Filecoin, ICP, and Arbitrum.

Reef Finance

The Reef Finance and Alameda fiasco is a prime example of the dangers of a lack of clarity around the use of tokens. Reef Finance engaged with Alameda Ventures as a "long-term strategic partner" for an over-the-counter trade of $80M tokens. However, after the first $20M of tokens were sent, a trader from Alameda deposited them into a Binance account, triggering the Reef Finance team to panic and call off the remainder of the $80M deal with Alameda. Shortly after, $REEF dropped 35%, triggering liquidations and causing massive damage to the project’s reputation and progress.

According to Sam Trabucco, the deal between Alameda and Reef Finance was conducted entirely over Telegram and Reef Finance's Mancheski said that “there was literally no legal agreement/contract (or any kind of paperwork whatsoever)”. After the collapse and disgrace of Alameda, it can be assumed that Reef was right about their allegations of wrongdoing. However, the damage had already been done. This story should serve as a cautionary tale for future founders to insist on specifying details and having written agreements.

Part 3: Big Brand Bondage

In a noisy bull market, having a big brand name like Alameda, Jump, Wintermute, or GSR became a signal of a project's legitimacy, which made a huge difference. These brands were able to entice projects that were desperate for a marketing bump and these brand name firms were able to demand increasingly high percentages of tokens in return for their services.

Some market makers were asking for more than 10% of a project's total supply with the notional of the options adding even more. Alameda was one such firm known to aggressively leverage their brand name to secure a high percentage of tokens, promising to promote the project or increase its chances of being listed on FTX. The situation was made worse by the fact that the venture and market making sides of many deals were mixed together, strong-arming founders to accept unfavorable terms.

This practice exploited token founders by extracting a high rate for basic market making services, and then over-promising and under-delivering on other promises. During frenzied bull markets, support and focus would be directed toward more promising projects, and promises of potential FTX exchange listings and after-market support were often left empty and at the complete discretion of FTX/Alameda management. Projects like Reef Finance even faced the threat from Alameda of delisting from FTX and other tier 1 exchanges.

To combat these practices, token founders must exercise extra caution when negotiating deals and be fully aware of the claims and promises that market makers make. Any service outside the scope of liquidity provision should be evaluated and negotiated in separate clauses that are explicitly stated.

Additionally, token founders can take steps to diversify their market-making providers, ensuring that they are not held hostage by any one firm. By taking these steps, token founders can level the playing field and ensure that they are not exploited by larger market makers.

Takeaways

The Token Sutra exposes the tactics used by market makers to exploit token projects and their communities. The predatory practices documented in this manuscript are just some of the examples of deceptive loan agreements, opaque exchange accounts, convoluted legal contracts, embedded options, and false promises that have been used in the real world. These tactics have resulted in hundreds of millions of dollars in profit for market makers at the expense of the long-term growth prospects and community confidence of token projects.

Founders should fully understand the terms of their agreements, seek legal counsel when necessary, and not be swayed by big brand names promising inflated returns. The only way for our industry to mature is to unite against these practices and remain vigilant and carefully consider each scenario and the overall picture. By doing so, we can prevent future exploitation and pave the way for a more transparent and aligned future.

💡 If you have stories to add to the Token Sutra or wish to provide feedback, please email us at contact@paperclip.partners.