This article will introduce the specific mechanism of token market makers and the possibility of potential violations based on the recent Arbitrum incident.
Written by: Alex
Compilation: Deep Tide TechFlow
Today's digital asset market has grown into a huge global industry, attracting more and more investors and institutions to participate. However, with the continuous expansion of the market scope and the increase of market participants, the stability and fairness of the market have become an increasingly important issue.
Therefore, based on the recent Arbitrum incident, the author introduces the specific mechanism of the token market maker (MM) and the possibility of potential violations, and at the same time puts forward his personal views on the need for more disclosure of projects in this field.
Why do all encrypted projects have market maker (MM) transactions now?
In the past, projects typically facilitated Liquidity by providing tokens as incentives to on-chain pools. But now, they offer incentives to sophisticated market makers to provide Liquidity on centralized exchanges (CEXs).
This shift is to increase the efficiency of price discovery and reduce costs for all parties involved.
On CEX, price discovery is more efficient due to greater Liquidity. Additionally, market makers are able to offer buyers and sellers better buy and sell prices, making the market more attractive.
How do crypto projects incentivize market makers?
Typically, projects will lend tokens to market makers for a year, with zero-cost call options attached to the tokens. Specifically, the project will lend tokens to market makers (usually 3-5), and require market makers to guarantee market size and spread during the loan period.
Why do projects need to lend money to market makers?
Market makers need token loans to ensure they have enough inventory in their operations to cover possible excess buying demand.
At the same time, market makers need to conduct efficient borrow operations in order to offset excessive buyer demand when necessary.
Token loans typically have zero or very low interest rates. While market makers need tokens to provide Liquidity, they don't want to incur huge borrowing costs.
Therefore, token loans are a common incentive mechanism, which can provide market makers with the necessary tokens to support market Liquidity, while also reducing the burden of market maker costs.
Why give Bullish options to market makers?
Market makers need to pay a price to provide Liquidity services. Project parties usually choose to use tokens instead of cash to pay this price, because tokens are more Liquidity and operable.
However, in order to prevent market makers from immediately selling tokens and thus affecting the market price and the interests of investors, project parties usually give market makers call options to achieve incentive consistency. If the price of the token rises, the market maker can get more income, and the project party can also benefit from the appreciation of the token.
How is the Bullish option strike price determined if the token has not yet started trading?
In this case, the project party will choose to set the exercise price of the call option at a premium of 50% - 100% of the index price. Since the index price can usually be determined on-chain or in other markets, the strike price does not need to be known at the time of the transaction.
This method of setting the strike price of the call option can provide a certain degree of flexibility for market makers and project parties, and can reduce transaction risks. If the price of the token is higher than the exercise price, the market maker can earn profit from the difference to realize the income. If the price of the token is lower than the exercise price, the market maker can choose not to exercise the call option and give up the income.
The associated mechanism of the token market maker is not malicious in itself. The problem is that these mechanisms often do not disclose information to retail investors.
Therefore, this makes the open market participants feel unfair. They may not be able to obtain important information about the price and Liquidity of the token, and suffer losses in the transaction. If the project party or market maker clearly communicates this information to investors, the entire market can be more transparent and fair, thereby reducing investor losses and improving the confidence of market participants.
Let's take a look at the recent Arbitrum incident.
In the document, there is no mention of the trading terms and conditions of the token market maker, which makes it difficult for investors to understand the actions and potential impact of the market maker.
More importantly, the document does not clearly state whether Wintermute (the market maker) is an investor in Arbitrum, which may lead to conflicts of interest and moral hazard.
When retail investors make investment decisions, they analyze and make decisions based on the assumption that only 1.275 billion tokens are the only supply in the secondary market mentioned in the document. But this is not the case, which leads to some unexpected situations.
1. The number of Bullish options is unknown
These Bullish options will essentially increase the Circulating Supply of the token, and thus cause the price and Liquidity of the token to be affected.
In order to maintain market neutrality, market makers need to hedge the Delta of call options by selling tokens. In this process, market makers sold a large number of tokens, which actually increased the supply of tokens, but these data were not publicly disclosed to investors in a timely manner.
It is reported that the hedging transactions of Wintermute (market maker) have added at least 16 million tokens to the secondary market, which is one of the reasons for the unstable token supply and price fluctuations.
2. OTC trading terms unknown
Another concern is that the foundation sold $10 million worth of tokens through an off-exchange transaction with Wintermute (a market maker).
However, these operations were not disclosed to retail investors before the trades took place. In fact, investors did not learn of this information until after the deal was completed.
At the same time, there is no mention in the original document whether the foundation has the right to sell tokens in such a short period of time.
3. The positioning of investors and market makers is not clear
In the case of Arbitrum, it was unclear whether Wintermute (the market maker) was an investor in the project.
Especially for retail investors, it is very important to understand the relationship between investors and market makers. They should clearly understand the role of market makers in the market and sources of profits in order to correctly assess the risks and opportunities in the market.
Here's a well-known strategy from Alameda:
Retail investors got a double whammy in this incident, first by being forced to accept additional tokens being passed on to them without them being notified.
Then, Arbitrum also tried to sneak up on a fake decentralization plan, but was eventually caught, causing the price of the token to drop.
There is a reason whyan IPO in Tradfi requires a prospectus to clearly outline the following:
number of shares outstanding;
initial public offering price;
The underwriters involved in the transaction;
Profit and dividends received by underwriters.
Such information is very important for investors as they provide comprehensive and transparent information about the company and stock to help investors make informed investment decisions.
Of course, there is another reason that insider trading laws exist. Participants who hold large amounts of tokens or possess insider information will need to publicly disclose their operations in the secondary market. This helps to protect the fairness and transparency of the market.
However, in the cryptocurrency market, some non-compliant operations sometimes occur, such as putting a large number of tokens into the market. These operations often adversely affect the market and cause harm to investors, which cannot be tolerated.
For the development of the token market, transparency and fairness are very important. The events of last week have done a lot of damage to the industry, and have shown some inadequacies and loopholes in the existing rules and mechanisms.
In the current token market, many investors and traders are facing the problems of information asymmetry and market uncertainty. This situation not only affects the confidence and interests of investors, but may also hinder the development and innovation of the entire market.
Therefore, we need stricter regulation and more transparent market rules to promote market stability and reliability. Only by strengthening the transparency and fairness of the market can more investors and participants be attracted to this industry.
I believe that together we can build a social contract that requires more transparent and open information and rules for future projects.
As investors and participants, we can take steps to make this happen. For example, not to buy those governance tokens that do not provide enough information and disclosure; or to protect the fairness and transparency of the market by conducting more research, investigation and supervision on the market.
At the same time, token issuers and market makers also need to take responsibility and provide more information and disclosure to meet the needs of investors and the market. Only through cooperation and joint efforts can the token market be made safer, fairer and more reliable, thereby creating more opportunities and benefits for all market participants.
