PayPal Yang Zhou recalls 2022 Thunder Tide: From Luna to FTX, why did the storm that swept everything happen

Author: Wu Shuo Blockchain

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PayPal Finance is the leader in the field of cryptocurrency lending and financial management. During the 312 year 2020, PayPal Finance was on the verge of bankruptcy due to its high-risk operation model, and Tether's grace and market recovery saved it. On May 26, 2022, it announced the completion of its Series B financing, receiving US$80 million, and was promoted to a unicorn with a valuation of US$2 billion. On June 17, 2022 PayPal told its partners: We are already insolvent. The official website stated that the product redemption and withdrawal functions were suspended. Yang Zhou is the co-founder of PayPal Finance, but has basically withdrawn in 2021; the video interviewer is Bill, and Wu Shuo authorized to reprint and publish.

Yang Zhou: PayPal's peak is from March to April 2021, which is the first impact of Bitcoin's last bull market. That market peak was driven mainly by Coinbase’s listing, with Bitcoin hitting a high of $64,000 in April 2021. At the same time, funding fee arbitrage in the market has also reached its peak. At that stage, PayPal managed total assets (including borrowing and managed funds) of approximately $7 billion.

The scale of centralized lending institutions has always surpassed the decentralized DeFi loan agreements. We do not consider Tether (USDT) because its data is opaque. But in the public information, the largest lending institution at that time was Genesis, whose asset management scale (AUM) reached US$13.8 billion, far exceeding the current AAVE and other DeFi loan agreements.

At that time, the main customer groups of centralized lending institutions included:

● Asian crypto miners (holding large amounts of BTC assets and requiring liquidity);

● American institutional investors (mainly doing GBTC arbitrage transactions).

Asian miners benefited from the rise in Bitcoin, and their assets grew 20–30 times in just a few years. Initially their assets may have been $100 million to $200 million, but they quickly grew to $400 million in a bull market.

The growth momentum of the US market is mainly from arbitrage transactions of GBTC (Grayscale Bitcoin Trust). From 2018 to the beginning of 2021, GBTC has maintained a premium trading, and a stable arbitrage model has been formed in the market:

1. Investors borrow BTC to subscribe for GBTC and lock their positions for 6 months;

2. Sell BTC in the spot market at the same time to hedge;

3. After 6 months, unlock GBTC and sell for profit.

Bill: Yes, GBTC’s 6-month arbitrage window was one of Genesis’s main lending scenarios at that time.

Yang Zhou: Yes, Genesis needs BTC supply, while institutions in the Asian market need US dollars. Therefore, Genesis provides us with US dollar loans, and we provide them with BTC, forming a stable arbitrage closed loop, where both parties meet each other's demand for liquidity. In the market environment where BTC prices are growing rapidly, the scale will naturally become larger and larger.

But this growth is mainly driven by market beta (i.e., the overall growth of the industry), rather than simply institutional expansion. The core factor is the rise in BTC prices itself, as the total supply of BTC has not changed drastically, but demand has grown rapidly in the short term.

Bill: After understanding PayPal's early development, I also know that you later started self-operated transactions, which is also the starting point for the risk explosion later. Can you share the background here?

Yang Zhou:

PayPal's development can be divided into three stages:

1. Pure lending business stage (2018–2020)

● Miners use BTC to pledge and borrow stablecoins (USDT, USDC);

● The business model is simple and mainly serves miners and institutions.

2. Enter the financial management and asset management business (2020–2021)

● Due to market demand, PayPal began to provide BTC-based or ETH-based financial products;

● Use options structures to achieve profits, such as selling CALL/PUT structured products.

3. Proprietary trading and leverage expansion phase (2021–2022)

● In the case of imperfect supervision, lending, asset management and proprietary transactions are mixed together;

● Due to the rising BTC price, the market liquidity is abundant and the trading strategy is aggressive.

Financial institutions on Wall Street have actually experienced a similar process:

● At the beginning, lending, asset management and proprietary trading were mixed;

● The regulatory intervention was split, but the merger began after a period of time;

● Repeatedly go through a cycle of merger-split-risk outbreak.

For the crypto industry, this cycle is shorter, with a major crisis happening almost 3–4 years, while traditional finance may be 10–20 years per cycle.

Bill: Which position in PayPal ultimately leads to a liquidity crisis?

Yang Zhou: To truly trace the source of risks, we have to return to the high-rate market at the beginning of 2021.

● At that time, the market's capital rate arbitrage was maintained at an annualized rate of 40–50%, attracting a large amount of capital influx;

● USDT supply surged from USD20 billion (end of 2020) to USD60 billion (May 2021);

● As a result of a large amount of funds entering arbitrage transactions, many institutions have launched 1–2 years of high-yield products, resulting in funds being locked.

In the fourth quarter of 2021, the market entered a bear market (due to the tightening of the Federal Reserve's monetary policy), resulting in:

● The demand for funds has declined, but funds cannot be withdrawn quickly;

● Funds begin to look for new earnings scenarios, such as the Anchor Protocol (UST & Terra).

Ultimately, the Terra/Luna system collapsed in May 2022, causing:

● The base currency of $400–50 billion disappeared;

● The market value of the crypto market evaporated by US$600 billion;

● Alameda (a market maker under FTX) has undertaken the market liquidity crisis.

Bill: So, after Alameda took over Terra/Luna, it became the biggest loss bearer on the market, right?

Yang Zhou: Yes, Alameda's loss may be between 10 billion and 20 billion US dollars, but since it is a centralized institution, it can hide its losses through some means, so the outside world has not noticed its problems in a short period of time. However, the chain reaction caused by the Terra/Luna collapse has been transmitted to Three Arrows Capital (3AC), PayPal (Babel Finance), BlockFi and many other institutions.

Bill: How does this conduction effect happen?

Yang Zhou: At that time, there were not much capital exports from centralized lending institutions, and there were only a few large institutions that actually provided lending in the industry. Institutions that dare to borrow money at an annual interest rate of 7–8% have even more simple capital flows.

By the late 2021, we found that a large amount of borrowing funds flowed directly or indirectly to the Terra ecosystem.

Bill: So, you actually put the borrowed money into the Terra agreement to manage your finances?

Yang Zhou: Yes, directly or indirectly, these funds are ultimately linked to Terra ecology. When Terra collapsed, centralized lending institutions across the cryptocurrency industry faced huge risks.

Bill: Wait a moment, in other words, in the second half of the 2021 bull market, the flow of borrowing funds is no longer miners to produce and mine, but more people borrow money to speculate, and eventually the funds poured into Luna's UST anchoring mechanism, right?

Yang Zhou: Yes, in fact, miners began to reduce leverage after Bitcoin rose to $20,000 in December 2020. When the price of Bitcoin rose to 30,000 or 40,000 US dollars, they had already reduced their borrowing and began to sell coins to cash out.

Bill: Miners are actually more risk-conscious, right?

Yang Zhou: That's right, miners have experienced too many bull and bear cycles. For example, this time, the price of Bitcoin has not been rising at the $100,000 mark. Part of the reason is that miners are constantly shipping around $100,000. Many miners I know have reduced their positions around $100,000.

In the last cycle (2021), the plunge around $40,000 was also very similar to the situation of $100,000 in this cycle - all the market pressure caused by miners selling coins in large quantities.

By the end of 2021, the flow of borrowing funds had completely changed, mainly for capital rate arbitrage rather than miners' production needs. More than half of our lending portfolios have entered financing arbitrage transactions, which rely heavily on UST (Terra Ecosystem) stablecoin returns.

Bill: When Terra collapsed, all the investment funds on the front end of your borrowers were gone. So how did the next chain reaction happen?

Yang Zhou: At that time, the risks in the entire market had not been fully revealed. The first ones affected were several institutions with the highest leverage ratio, and their positions were first exposed.

● Three Arrows Capital (3AC)

● PayPal Finance

● BlockFi

From a market trading perspective, the first ones that fell were 3AC and PayPal, because both institutions are the largest option market makers and short vol traders on the market.

Their strategy is to sell both PUT and CALL, but as the market plummeted, the losses caused by selling PUT far exceeded the money earned by selling CALL.

Bill: So at that time, these institutions sold PUTs not to really buy at the bottom when the market fell, but to arbitrage? But when the market collapses in a short period of time, they can’t buy at all?

Yang Zhou: Yes. If the market slowly declines by 40% (such as completion within 2–3 weeks), option traders can also hedge the risk or replenish positions by adding margin.

However, the market plummeted 40% in two or three days, resulting in these institutions not having time to hedge.

And the situation at that time was:

● The dynamic hedge mechanism of the options market (Dynamic Delta Hedge) has expired;

● BTC price dropped from $50,000 to $35,000 and then quickly fell to $20,000;

● A large number of options sellers are forced to close their positions, increasing market selling pressure, and forming a spiral decline (death spiral).

Bill: So this is similar to the Gamma Squeeze mechanism that has recently risen by Bitcoin? But this time it is in the opposite direction - the faster the market falls, the more the institutions have to sell, further aggravate the market collapse?

Yang Zhou: That’s right. When the market plummeted, all market makers and option traders had to sell BTC to hedge, and the market eventually fell faster, forming a vicious cycle.

This leads to:

● Three Arrows Capital Bankruptcy

● PayPal Financial Bankruptcy

● BlockFi bankruptcy

Bill: Did Three Arrows Capital and PayPal Finance go bankrupt at the same time?

Yang Zhou: It was basically the same, but 3AC gave up first. Their founder, Su Zhu, is a professional trader, stop loss faster than PayPal.

However, the bankruptcy of 3AC and PayPal has affected more opponents, resulting in:

● Other institutions began to pay Margin Call, further causing panic.

● Other lending institutions such as BlockFi and Voyager have also exposed problems.

Bill: It's June-July 2022, right?

Yang Zhou: Yes, from June to July, the crisis began to pass on to larger institutions, and Alameda was already in a quagmire at this time.

Alameda borrowed a lot of money from BlockFi and Voyager at that time, so FTX chose to help these institutions in an attempt to cover up Alameda's losses.

However, all of this collapsed completely after CZ tweeted and questioned FTX.

Bill: So, if SBF could suspend withdrawals at that time, would it be possible to survive?

Yang Zhou: Maybe. But history has no if. If FTX chose to suspend withdrawals like OKX at that time, maybe she could have been able to survive. But SBF chose to fight hard, and FTX eventually went bankrupt.

If the US government was willing to take action at that time and save the market like traditional finance, maybe FTX would not have gone bankrupt so soon. But the reality is that SBF is just a money cow for politicians, not a financial institution that they see as truly important.

Yang Zhou: After FTX went bankrupt, Genesis could not hold on. Genesis is the industry's largest lending counterparty (AUM $13.8 billion).

Bill: Genesis' asset management scale (AUM) is as high as US$13.8 billion, so where does its capital side mainly come from? Is it from Tether?

Yang Zhou: No. Genesis has a very diverse source of funding, with a large number of credit-money clients, including many traditional financial institutions.

Bill: So, its capital side is relatively diversified?

Yang Zhou: Yes, and many of the sources of Genesis' funding are traditional institutions in the non-crypto industry, which is exactly one of its unique features. This also means that the problems encountered by Genesis eventually spread to traditional financial institutions, indirectly leading to the bankruptcy of several crypto banks in 2023.

But the bankruptcy of these banks was not directly caused by the risks in the crypto market, but because the Democratic government at that time directly ordered the closure of some crypto banks. This is not because these banks have already encountered risks, but more like a mandatory administrative act.

Yang Zhou: In my opinion, the main motivation for the Democratic Party to take this measure at that time was to rush to separate its relationship with FTX. Because FTX has made a lot of money in the past few years and is closely related to some politicians, when FTX explodes, they may be eager to cut and avoid deeper involvement.

At the same time, the Silicon Valley Bank (SVB) crisis is actually not related to cryptocurrencies, but the interest rate risk that the entire banking system is generally facing.

Bill: SVB went bankrupt because there was something wrong with its asset side, right? It holds a large amount of U.S. Treasury bonds, and rising interest rates have caused the market value of these bonds to fall sharply.

Yang Zhou: That’s right. At that time, SVB and other affected banks held large amounts of long-term bonds (long-term bonds), but when interest rates rose, the market value fell, causing huge book losses. Although there will be no problem with these bonds if held to maturity, banks have to sell the bonds to obtain liquidity due to large withdrawals from customers, which leads to actual losses.

The reason for USDC decoupling is that 10% of USDC deposits are in SVB banks. When SVB went bankrupt, the market began to panic, worried that the USDC asset side might not be able to fully cover its issuance volume, so a brief decoupling occurred, and the USDC price fell below $0.90 at one point.

Bill: So, SVB's bankruptcy is not because it holds crypto assets, but because of the debt crisis in the traditional financial system?

Yang Zhou: Yes, this has little to do with the crypto market. But this incident also exposed that cryptocurrency stablecoin issuing institutions have not yet been fully included in the bank risk management system. At that time, many stablecoin institutions were not fully aware of the credit risks of banks themselves.

Bill: But, in the end, the Federal Reserve (FED) stepped in and printed $500 billion to stabilize the banking system, right?

Yang Zhou: Yes, the Federal Reserve finally took action to rescue the market and injected $500 billion into the banking system. In contrast, the overall scale of the crypto market is even far smaller than this rescue fund. But this also reveals a problem:

● If there is a problem with traditional financial institutions, the Federal Reserve will save it;

● If there is a problem with the cryptocurrency organization, you can only seek more blessings.

If Tether had come forward to rescue FTX at that time, maybe FTX would not have gone bankrupt. But Tether is essentially a private institution, it is not a public institution like the Fed, so it has no motivation to save FTX.

Bill: Financial crime is a felony in the United States, but the biggest financial crime in history is actually the CDS (credit default swap) crisis in 2008, right?

Yang Zhou: Yes, the core issue of the 2008 financial crisis was that a large number of subprime loans were packaged into high-rated assets by financial institutions, and then conducted multi-layer leveraged transactions, which eventually led to systemic financial fraud. But because the crisis is too great and affecting the global economy, the Federal Reserve and the government finally chose to save the market, and the real responsible person was almost punished.

You can watch the movie "The Big Short", and this is the final summary. Ultimately, the political systems in the United States and the global world still face the same problems:

● When the crisis is big enough, the government will rescue you;

● If you are just a small pond, then I'm sorry, you can only die.

Bill: So, we can see that when facing political enemies, the US government has also begun to learn China's "anti-corruption" strategy?

Yang Zhou: Yes, the US government is now starting to use "anti-corruption" as a means of political struggle. Just like China is learning from the West in the field of developing AI, the United States is learning from China's strategies in some ways. But for the crypto industry, the scale of the last cycle was not large enough, so the government was unwilling to save it.

Bill: Looking back at the previous cycle, from PayPal Finance to FTX, do you think there will be similar systemic risks in this cycle?

Yang Zhou: I think the situation in this cycle will be much better.

After the last round of crisis, many crypto institutions have greatly strengthened risk control, which is mainly reflected in several aspects:

1. More organizations start using managed services (Custody)

● For example, Binance now has Ceffu custody business, although it is associated with Binance, at least it is off balance sheet.

● Exchanges such as OKX and Coinbase have also strengthened their custody services.

2. The business of exchanges and lending institutions is gradually separated

● Traditional financial institutions have spent decades to undergo steady transformation, while the crypto industry has completed similar adjustments in just two years.

3. Cognitive upgrades of market participants

● After several rounds of crises, the entire crypto industry has evolved faster, and institutions and investors have a stronger sense of risk than in the past.

● This makes me feel that the crypto industry has a particularly strong adaptability. Although it is full of speculation, it is still evolving and moving forward.

Bill: Indeed, the entire crypto industry evolves faster than traditional finance.

Bill: When PayPal broke out, you had retired and left the company. Why did you choose to return and try to save PayPal?

Yang Zhou: Many people have asked this question. Some people would think I have a "handle" on PayPal, so I have to come back? But the truth is, I have no problem, it is purely due to my personal personality.

At the time, I thought the most correct choice was to try to save the company. I want to see if there is a possibility of debt restructuring to save the situation.

PayPal still had:

● 15,000+ BTC exists in Genesis;

● 20,000-30,000 ETH;

● $200 million in cash.

Under the circumstances at that time, I thought it was possible to save it, but in the end Genesis also fell, resulting in the inability to recover all of these assets.

Bill: So, you're writing a Call Option to all creditors?

Yang Zhou: Yes, the debt call Option.