John Gu Profile picture
Nov 15 20 tweets 3 min read
Times like these highlight the importance of good risk management. This is where 3AC and Alameda both fell down. What were the warning signs?

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1. Both 3AC and Alameda called themselves market makers, but what does this actually mean?
2. In simple terms, market makers provide liquidity to the markets, enabling others to trade at reasonable costs (fees + spread / slippage).
3. An OTC desk - whether high touch or low touch - is a market maker, as is an electronic trading firm quoting bids and offers on electronic exchanges.
4. Market makers profit by taking a small cut of each transaction, and often seek to be market neutral where possible.
5. An OTC desk might charge 25-50 bps for liquid tokens (BTC, ETH, etc.), and multiples of that for more illiquid tokens.
6. If an OTC desk does $100M of volume a day, they would make somewhere in the range of 250K to 500K (or more) a day, depending on the composition of their business.
7. Electronic market makers have much thinner margins, and typically make 1 to 5 bps per trade. If an electronic market maker does $1B of volume a day, they are making $100K to $500K a day.
8. Market makers are a low margin, high volume business. The “edge” is realized over a large number of relatively small transactions (repeated trials). Think about flipping a coin 100,000 times for $10 each, vs. flipping a coin a single time for $1M.
9. As such, large losses are rare, and come primarily in the form of counterparty risk (e.g. a counterparty backing out of an unprofitable OTC trade, or a situation like FTX), or technology risk (e.g. Knight Capital Group).
10. The very best market makers, during the hay days of 2021, made $1B to $1.5B. This is money made from the activity of market making, as opposed to directional exposure to the market (i.e. real alpha).
11. For an OTC desk, this requires the support of a large BD / sales team. For electronic market makers, this requires a substantial amount of quantitative alpha and technological support.
12. So what explains 3AC and Alameda’s astronomical rise from obscurity? How do you make multiple billions of dollars with a skeleton crew?
13. My guess is that while 3AC and Alameda might have started as market makers, most of their profit came from taking on large - and likely leveraged - directional exposure to the markets.
14. After all, why put in the hard work of building out all that technological and operational infrastructure when you can ape into shitcoins and 10x to 100x your money with very little work?
15. In the bull markets of 2020 and 2021, this worked spectacularly well. Anyone who applied this strategy looked like geniuses. In the bear markets, the same strategy spelled doom.
16. The moral of the story is that the often unobserved “cost” of spectacular gains is the spectacular risks that were undertaken to achieve the gains.
17. A famous Buffett quote: "Over the years, a number of very smart people have learned the hard way that a long stream of impressive numbers multiplied by a single zero always equals zero."
18. In another life, when I was interviewing for a quant position at Two Sigma, John Overdeck gave me a piece of advice: to succeed in the asset management business, the key is to stay in the business, that is, to survive.
19. Given the events that have unfolded over the past months, I remember this advice with renewed appreciation.

Stay safe out there.

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