Remembering the Panic of 1907 On October 16, 1907, stock market speculators F. Augustus Heinze and Charles W. Morse were trading on the curb. They were attempting to corner the stock of mining company United Copper. But the trade failed. The two suffered huge losses. And they couldn’t pay back their loan setting off the first worldwide financial crisis of the 20th century. The banks associated with Heinze and Morse and their disastrous trade suffered runs on their deposits. And while the banks were able to squash the runs, the problem spread to trust companies. Trust companies were state-chartered intermediaries that competed with banks for deposits. But they weren’t a central part of the payments system. And as a result, they held a low percentage of cash reserves relative to deposits (around 5%). Knickerbocker Trust, associated with Heinze and Morse and New York City’s third-largest trust, suffered an intense run and had to suspend operations. That led to a full-scale financial crisis in New York that spread across the country and around the world. There were numerous runs on banks and trust companies. Businesses throughout the country entered bankruptcy. The NYSE fell almost 50% from its peak the previous year. Overall, it made the public distrust the banking system. But it also served as an impetus for change. The panic exposed problems in the system. And it led to the Federal Reserve Act of 1913 and the Federal Reserve System. This, of course, is the panic of 1907… but it’s reminiscent of the crypto markets today. The Fall of FTX and Centralized Exchanges On November 2, 2022, rumors began swirling that FTX, the world’s second largest crypto exchange was insolvent.
A leaked document showed that the exchange's sister company, Alameda Research, had a huge stake in FTX's native FTT “token” (like stock but highly liquid in the digital marketplace). While there's nothing illegal about that, it set off all sorts of red flags. Essentially, Alameda's value rested on a token created by its sister company. Soon after, Binance, the world’s largest cryptocurrency exchange announced it was selling all of its FTT holdings causing the price of the token to crater as panicked investors rushed to withdraw their funds. Some faced delays, which triggered a run on the exchange as even more people tried to withdraw. The FTT token fell from more than $22 to $2 and withdrawals from the exchange were halted. A few days later, U.S. federal agencies started investigating FTX. And on November 11, FTX, FTX.US, Alameda, and their subsidiaries filed for bankruptcy. But the turmoil didn't end there. Later that day, FTX was hacked, and more than $400 million was moved off the exchange. Today, it's still unclear where most of the company's money went. At its height, FTX had a valuation of $32 billion. According to Time, at least $8 billion in customer funds can't be accounted for. And CNBC says FTX could have more than 1 million creditors affected by its bankruptcy. A class-action lawsuit has been filed against FTX and its celebrity endorsers. And FTX's founder, Sam Bankman-Fried, has been arrested on charges that include wire fraud, securities fraud, and money laundering. Meanwhile, the implosion has sent shockwaves across the industry. However, just like banking survived and became an even more integral part of the economy, the same will happen for crypto. Although it doesn’t feel like that now the shock to the system today is akin to the fallout from 1907.
Life After FTX FTX isn’t the first collapse this year. In May, crypto hedge fund Three Arrows Capital collapsed after the TerraUSD (UST) stablecoin de-pegged from the U.S. dollar. Three Arrows had $10 billion in assets and had to file for bankruptcy. Others exposed, such as Celsius and Voyager, also filed for bankruptcy. And firms such as Galaxy Digital, Digital Currency Group, and Blockchain.com took losses. The crypto industry’s already seeing spillover effects from FTX as well. Crypto lenders BlockFi, Salt Lending, and Genesis Global have halted operations. And we’ll likely see more negative news in the weeks and months to come. The impact of FTX cannot be underestimated. The incident makes crypto look like it’s still in its Wild West days – a black mark on an industry already down. But just like the panic of 1907 didn’t kill banking, the FTX collapse will not kill the cryptocurrency industry. It very well might do the opposite.
DeFi Benefits From Centralized Greed One area that’s already seeing activity is regulation. Several agencies are investigating FTX and Alameda. This will also likely accelerate regulation of the entire industry. For example, we might see a proper regulatory framework for crypto exchanges established. And that wouldn’t be a bad thing. We would see stronger oversight of reserves, audits, and risk controls. And that would certainly help investor confidence. Of course, we’re talking about centralized crypto enterprises. The FTX implosion just shows the importance of decentralization. FTX was able to mishandle customers' funds because there was no transparency. And it could shut down withdrawals because it was controlled by a single entity. We recently saw a similar situation with Binance. The world's largest centralized crypto exchange temporarily paused withdrawals for USD Coin (USDC) after it saw $5 billion in redemptions over two days. The withdrawals were eventually honored when traditional banking hours resumed. But it was a reminder to investors of the risks of centralized services. Decentralized finance (DeFi) has operated just fine over this tumultuous year. Uniswap, Aave, and Maker keep on running as intended. DeFi’s protocols are public, open, and more transparent. So, it doesn’t require trust in the same way as its centralized counterparts. Consequently, in the week after the FTX collapse, decentralized exchange (DEX) volume exploded to $32 billion. That was up roughly 150% from the week before. According to reports, there was a large BTC flow out of centralized exchanges – nearly $3 billion in the week after the FTX fallout. On-chain figures suggest that many BTC owners opted for non-custodial wallets. That’s good news as well as the ability to self-custody your assets is a key tenet of cryptocurrency. The best projects going forward will be ones that are borderless, global, and run by the same people who use them or in other words, those that are “truly” decentralized. With FTX gone and trust for centralized exchanges at an all-time low, traders are looking for new places to trade cryptocurrencies – especially with leverage. There's a huge hole in the market. We are now witnessing the advent of exchanges that offer margin trading along with fast and cheap transactions, much like centralized ones but with an emphasis on decentralization, security, and transparency. An example of such a new entrant that is taking on market leaders with millions of customers is GMX. In addition to decentralization, GMX offers users the ability to provide liquidity to the exchange thereby earning a variable cash flow with reduced volatility.
Rise of GMX and Decentralized Exchanges
The GMX (GMX) decentralized exchange ("DEX") lets users swap coins with low fees like a centralized exchange but with the security of a decentralized exchange. And like centralized platforms, it offers spot and perpetual futures trading.
Perpetual-Futures Trading
A perpetual contract is a futures contract that doesn't expire at a specific date. So, when you buy a perpetual contract, you can hold it for as long as you want. Trading perpetuals is based on index prices of the underlying assets. The perpetual price is determined by exchange of contracts between long and short contract holders. A funding fee is paid regularly (every 8 hours) when future price diverges from spot so as to encourage arbitrage and have the futures and spot prices track each other. As a result, a perpetual bitcoin contract, for instance, trades at or very near the index price of bitcoin spot market price.
Perpetuals are popular with active traders because they give traders exposure to the market activity of an asset and can be leveraged using margin (borrowed and loaned out). They're also easier to liquidate than the underlying asset. But long-term investors who just want to own an asset outright don't need perpetuals. They can just buy an asset on the spot market and move it to their wallet.
Low Transaction Fees and Execution Speed
The GMX platform was originally built on Arbitrum, an Ethereum (ETH) Layer 2 (L2) solution. L2 blockchains are built on top of base-level blockchains like Ethereum to help speed up transactions and lower fees, all while inheriting the security of the base-layer blockchain. L2s are commonly referred to as "rollups" because they bundle up individual transactions, condense the data and roll it all together. Then, they send all that information to the base-level blockchain in one go. Because the (gas) fees of the final Ethereum transaction are spread across hundreds of transactions, a transaction that would normally cost $10 on the ETH main network (mainnet) might cost less than a dollar on the L2 blockchain.
Arbitrum is known as an "optimistic rollup" since the transactions posted to the network don't have accompanying proof to guarantee their validity. The chain is optimistic that the transaction is valid. When a transaction is posted by a validator, the validator also posts a bond. Anyone on the network can challenge this transaction for seven days if they think it's incorrect. If a transaction lasts seven days with no successful challenges, it's accepted. If a transaction is challenged and overruled, then the initial validator loses the bond to the challenger. So, validators are economically incentivized to post honest transactions and challengers are incentivized to root out misbehavior.
Ethereum L2s have become increasingly popular as Ethereum fees have increased. Since the beginning of 2022, total value locked ("TVL") in L2s (priced in ETH) has more than doubled.
In short, L2s are the scaling solutions that Ethereum needs to be more commercially viable. The sheer growth in TVL shows that there is plenty of demand for them. And Arbitrum is one of the largest Ethereum L2 blockchains.
These innovations enable GMX to remain as fast and affordable as any centralized exchange. But importantly, it's secure and decentralized.
Staking Rewards
GMX differs from other DEXs because it offers a decentralized alternative to futures and margin trading. But it also offers stakers of the native GMX token big rewards. GMX tokens can be staked to earn 30% of the platform's trading fees. That's something that large DEXs like Uniswap (UNI) don't offer. And it incentivizes traders to use the DEX so they can earn back some of the fees they send to swap assets.
So far, GMX has seen a lot of success. While the overall crypto market is down 63% over the past year, the GMX token has increased 33%. And on November 28, 2022, GMX surpassed Uniswap, the largest DEX, in daily fees.
On its own, GMX is an innovative DEX. But it also has a unique way to get liquidity.
Liquidity Pools
While most cryptocurrency traders agree that decentralization is a core tenet of crypto they still tend to trade on centralized platforms because that's where the liquidity is. Traders will only trade if there's sufficient liquidity but platforms only have sufficient liquidity if there are enough traders and market participants using them. So it's extremely challenging for an exchange to grow organically. GMX invented a new solution where users provide liquidity through a pool of assets. This innovation has helped GMX bootstrap its own liquidity to grow.
To secure liquidity, GMX uses a basket of eight different cryptos in the GMX Liquidity Pool (GLP). This is different than other DEXs that provide liquidity for a pair or numerous pairs of assets. Liquidity providers can purchase or mint the GLP token using any of its underlying assets. By minting GLP, one can gain exposure to the eight crypto assets that can be traded on the platform. And in return, GLP holders earn 70% of GMX's platform fees.
GLP is composed of wrapped bitcoin (WBTC), Wrapped Ethereum (WETH), USD Coin (USDC), Dai (DAI), Tether (USDT), UNI, Chainlink (LINK), and Frax (FRAX). As you can see below, WETH and a basket of USDC, USDT, DAI, and FRAX make up 94% of the pool.
One can buy GLP tokens using any of the pool's underlying assets. But the fee for purchasing or minting tokens varies based on the asset chosen. The pool has a weighting for each token. For example, if there's too much ETH in the pool, minting or swapping for GLP using ETH will incur a larger fee. Likewise, burning GLP for ETH will have a smaller fee, since you're helping to make the pool more balanced. This is a smart strategy as the variable fees guides investors to assets that benefit the pool.
Platform fees
When you conduct a transaction on a blockchain, the blockchain charges a fee for confirming what you're doing and locking it into a block. Generally speaking, the Ethereum and Arbitrum networks charge some ETH to pay for fees. This is different than the fees GMX charges for using its services.
Since everything is done on chain, you're charged fees by Arbitrum for the transaction, and you'll pay a fee to the GMX platform for using its services – like swapping tokens, minting or burning GLP, buying or selling tokens, margin trading, or if your position is liquidated. The GMX platform fees pay liquidity providers cash flow but not the network fees. The network fees go to stakers of the corresponding network.
GMX is extremely transparent about how much it's collecting. It even shares what proportion of fees comes from swaps, minting GLP, burning GLP tokens, liquidations, and margin trading.For example, here's what the Arbitrum GMX Liquidity Pool fee history looks like.
The fees collected fluctuate considerably day to day. But one thing stands out: Margin trading is by far the biggest contributor to the fees the GMX platform earns.
Since August 2021, margin fees averaged 84% of the fees collected by the platform. Swapping was second place, averaging 10% of the fees collected.
There were some days where the platform collected zero mint, burn, or liquidation fees but not a single day went by without it collecting some swap and margin fees.
On a recent average trading day, the Arbitrum GLP pool collected $547,000 in fees. And we expect the total fees GMX is collecting to only increase. The platform has been gaining around 400 to 500 new users every day.
The Risks of GLP
Just like with any decentralized finance ("DeFi") project, there's the ever-present risk that the smart contracts could be exploited. GMX recognizes this risk. It uses bug bounties, third-party auditing, and a publicly available list of contract operations to encourage community involvement and mitigate this risk.
Another risk is that traders who use GMX will be profitable in the long run. By providing liquidity for leverage trading, we're essentially on the lenders’ side of the positions GMX traders are holding on aggregate.
Remember, 84% of the fees collected by GLP are margin fees. Traders are paying those fees so they can borrow more of whatever crypto they're buying. There are examples of traders using up to 150X leverage.
Studies from the U.S. Securities and Exchange Commission, Taiwan, Brazil, and eToro show that the majority of short-term traders lose money. But if these aggregate trades ever make a net profit, GLP will take on a portion of the losses. The opposite is also true, if traders are losers on aggregate, then GLP will benefit. While there are always a few traders who outperform, the average trader loses money in the short run and nearly all of them will lose in the long run. So while this is a risk, it's one worth taking.
Finally, there's the risk that traders stop using GMX. That won't affect our GLP tokens (since they are collateralized with other stable assets), but the cash flow from user fees will dry up with departing traders
Future of GLP Token
Since WETH makes up 57% of GLP, the pool is heavily tied to the price of Ethereum. Plus, we'll be collecting a variable cash flow. Recently, this rate has fluctuated between 7% and 30% in WETH rewards from fees generated on the platform.
So in the end, a lot of GLP gains rely on the success of ETH. But Ethereum's future success is highly likely and we could see ETH reach a $1 trillion market cap. That would be a more than 500% increase from today. Since Ethereum's successful merge to Proof of Stake, it has set itself up to remain the dominant DeFi blockchain for the foreseeable future. And Layer 2 chains like Arbitrum are helping secure that spot.
Meanwhile, GLP also has exposure to assets like WBTC, LINK, and UNI. When the overall market recovers, these key tokens should rise in price, all while we earn a variable cash flow in WETH. And since the pool is currently made up of 37% stablecoins, this will help reduce its short-term volatility.
Summary
We shouldn’t confuse the ills of centralized crypto players like FTX and Alameda Research with the validity of blockchain. The FTX collapse is like a forest fire. While devastating, a forest fire cleanses the forest and sets the stage for future growth. Likewise, the FTX collapse will help cleanse the centralized crypto industry of its poor business practices and opaqueness. It will be the impetus for a stronger, more mature crypto industry. And when the dust settles, we will see the likes of Bitcoin, Ethereum and decentralized projects soar to new highs.
* For more information on investing for DeFi yield, contact info@der.finance
References
1. FTX’s Collapse Will Pave the Way for “True” Decentralized Finance, Greg Wilson, Palm Beach Daily
2. How We’re Setting Ourselves Up to profit from the FTX implosion,” Eric Wade, Crypto Cashflow, Stansberry Research