Original editor: Wu said blockchain
PayPal Finance is a leader in the field of cryptocurrency lending and financial management. During the 312 period in 2020, PayPal Finance was on the verge of bankruptcy due to its high-risk operating model. Tethers tolerance and market recovery saved it. On May 26, 2022, it announced the completion of its Series B financing, raised $80 million, and became a unicorn with a valuation of $2 billion. On June 17, 2022, PayPal told its partners: We are insolvent. The official website stated that the product redemption and withdrawal functions were suspended. Yang Zhou is the co-founder of PayPal Finance, but he has basically withdrawn in 2021; the video interviewer is Bill, welcome to follow Bills personal Youtube and Xiaoyuzhou. Wu Shuo authorized the reprint and release.
Background information: Old article: Investigation of PayPals financial model 2 years ago Why did 312 collapse? How can Tether save it?
Yang Zhou: PayPals peak was in March and April 2021, which coincided with the first impact of Bitcoins last bull market. That market peak was mainly driven by Coinbases listing, and Bitcoin hit a high of $64,000 in April 2021. At the same time, funding fee arbitrage in the market also reached a peak. At that stage, PayPals total assets under management (including lending and managed funds) were about $7 billion.
The scale of centralized lending institutions has always surpassed that of decentralized DeFi lending protocols. We do not consider Tether (USDT) because its data is not transparent. But in public information, the largest lending institution at the time was Genesis, with assets under management (AUM) of US$13.8 billion, far exceeding the current AAVE and other DeFi lending protocols.
At that time, the main customer groups of centralized lending institutions included:
Crypto miners in Asia (who hold a large amount of BTC assets and need liquidity);
U.S. institutional investors (mainly engaged in arbitrage trading of GBTC).
Asian miners benefited from the rise of Bitcoin, and their assets increased 20-30 times in just a few years. Initially, their assets may have been only $100-200 million, but they quickly increased in value to $4-5 billion during the bull market.
The growth momentum of the US market mainly comes from arbitrage transactions of GBTC (Grayscale Bitcoin Trust). From 2018 to the beginning of 2021, GBTC has been trading at a premium, and a stable arbitrage model has been formed in the market:
1. Investors borrow BTC to purchase GBTC and lock up their positions for 6 months;
2. Sell BTC in the spot market for hedging;
3. After 6 months, unlock the GBTC and sell it for profit.
Bill: Yes, the GBTC 6-month arbitrage window was one of Genesis’ main lending scenarios at the 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, and both parties meet each others liquidity needs. This model will naturally grow in scale in the market environment where BTC prices are growing rapidly.
However, this growth is mainly driven by market Beta (i.e. overall industry growth) rather than pure institutional expansion. The core factor is the rise in BTC prices itself, because the total supply of BTC has not changed dramatically, but demand has grown rapidly in the short term.
Bill: After learning about PayPals early development, I also know that you later started proprietary trading, which was also the starting point for the subsequent risk outbreak. Can you share the background here?
Yang Zhou:
PayPals development can be divided into three stages:
1. Pure lending business stage (2018 – 2020)
Miners use BTC as collateral to borrow stablecoins (USDT, USDC);
The business model is simple, mainly serving miners and institutions.
2. Entering the wealth management and asset management business (2020 – 2021)
Due to market demand, PayPal began to provide financial products based on BTC or ETH;
Use options structure to realize returns, such as selling CALL/PUT structured products.
3. Proprietary trading and leverage expansion phase (2021 – 2022)
In the absence of perfect supervision, lending, asset management and proprietary trading are mixed together;
As BTC prices rise, market liquidity is abundant and trading strategies are aggressive.
Financial institutions on Wall Street have actually gone through a similar process:
In the beginning, lending, asset management and proprietary trading were mixed;
After regulatory intervention, they split up, but after a while they started to merge again;
Repeatedly experiencing the cycle of merger-spin-off-risk outbreak.
For the crypto industry, this cycle is shorter, with a major crisis occurring almost every 3-4 years, while traditional finance may have a cycle of 10-20 years.
Bill: Which position ultimately became risky and led to PayPals liquidity crisis?
Yang Zhou: To truly trace the source of the risk, we have to go back to the high-fee market at the beginning of 2021.
At that time, the markets funding rate arbitrage was maintained at 40-50% annualized, attracting a large amount of capital inflow;
USDT supply surged from $20 billion (end of 2020) to $60 billion (May 2021);
As a large amount of funds entered into arbitrage trading, many institutions launched high-yield products with a term of 1-2 years, resulting in the locking of funds.
In the fourth quarter of 2021, the market entered a bear market (due to the Fed’s tightening monetary policy), resulting in:
The demand for funds has decreased, but the funds cannot be withdrawn quickly;
Funds began to look for new profit scenarios, such as Anchor Protocol (UST Terra).
Finally, the Terra/Luna system collapsed in May 2022, causing:
$40-50 billion of monetary base disappeared;
Crypto market value evaporates by $600 billion;
Alameda (market maker under FTX) took over the market liquidity crisis.
Bill: So when Alameda took over Terra/Luna, it became the biggest loss bearer in the market, right?
Yang Zhou: Yes, Alameda’s losses may be between 10 billion and 20 billion US dollars, but because it is a centralized institution, it can hide its losses through some means, so the outside world did not notice its problems in a short period of time. However, the chain reaction caused by the collapse of Terra/Luna was transmitted to Three Arrows Capital (3AC), PayPal (Babel Finance), BlockFi and many other institutions.
Bill: How exactly does this conduction effect occur?
Yang Zhou: At that time, there were not many centralized lending institutions with capital outlets, and there were only a few large institutions in the industry that actually provided loans. For institutions that dared to lend money at an annual interest rate of 7-8%, their capital flows were even more limited.
By late 2021, we found that a large amount of loan funds flowed directly or indirectly to the Terra ecosystem.
Bill: So, you actually put the borrowed money into the Terra protocol for financial management?
Yang Zhou: Yes, directly or indirectly, these funds are ultimately linked to the Terra ecosystem. When Terra collapses, centralized lending institutions in the entire cryptocurrency industry face huge risks.
Bill: Wait a minute, in other words, in the second half of the bull market in 2021, the flow of borrowed funds is no longer used by miners for production and mining, but more people borrow money for speculation, and eventually a large amount of funds flow into Lunas 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, they had already reduced borrowing and started selling coins for cash.
Bill: Miners are actually more risk-conscious, right?
Yang Zhou: That’s right. Miners have experienced too many bull and bear cycles. For example, the price of Bitcoin has not risen above the $100,000 mark this time, partly because miners have been shipping around $100,000. Many miners I know have reduced their positions around $100,000.
In the last cycle (2021), the plunge to around $40,000 was very similar to the $100,000 in this cycle - both were caused by market pressure due to miners selling a large number of coins.
By the end of 2021, the flow of loan funds has completely changed, mainly used for funding rate arbitrage rather than miners production needs. More than half of our loan portfolio has entered into financing arbitrage transactions, and these arbitrage transactions rely heavily on the stablecoin income of UST (Terra ecosystem).
Bill: When Terra collapsed, your borrowers lost all their front-end investment funds. So how did the subsequent chain reaction happen?
Yang Zhou: At that time, the risks of the entire market had not yet fully emerged. The first to be affected were several institutions with the highest leverage ratios, and their positions were the first to be liquidated.
Three Arrows Capital (3AC)
Babel Finance
BlockFi
From a market trading perspective, the first to fall were 3AC and PayPal, as these two institutions are the largest options market makers and sellers (short vol traders) in the market.
Their strategy was to sell both PUTs and CALLs, but as the market plummeted, the losses from selling PUTs far exceeded the profits from selling CALLs.
Bill: So these institutions sold PUTs not to really buy at the bottom when the market fell, but for arbitrage? But when the market collapsed in a short period of time, they couldnt buy at the bottom at all?
Yang Zhou: Yes. If the market falls 40% slowly (for example, within 2-3 weeks), then option traders can also hedge the risk or replenish their positions through margin calls.
However, the market plummeted 40% in just two or three days, leaving these institutions with no time to hedge.
The situation at that time was:
The dynamic hedging mechanism (Dynamic Delta Hedge) in the options market has failed;
TC price dropped from $50, 000 to $35, 000 and then quickly dropped to $20, 000;
A large number of option sellers were forced to close their positions, increasing the selling pressure in the market and forming a death spiral.
Bill: So this is similar to the Gamma Squeeze mechanism behind the recent rise in Bitcoin? Only this time it’s the other way around — the faster the market falls, the more institutions are forced to sell, further exacerbating the market crash?
Yang Zhou: That’s right. When the market plummets, all market makers and options traders have to sell BTC for hedging, and eventually the market falls faster, forming a vicious cycle.
This leads to:
Three Arrows Capital goes bankrupt
PayPal Financial Bankruptcy
BlockFi Bankruptcy
Bill: Did Three Arrows Capital and PayPal Financial go bankrupt at the same time?
Yang Zhou: Basically at the same time, but 3AC gave up first. Their founder Su Zhu, as a professional trader, stopped losses faster than PayPal.
However, the bankruptcy of 3AC and PayPal affected more counterparties, resulting in:
Other institutions began to make margin calls, further causing panic.
Other lending institutions such as BlockFi and Voyager have also exposed problems.
Bill: This is already June-July 2022, right?
Yang Zhou: Yes, in June and July, the crisis had already begun to spread to larger institutions, and Alameda was already in deep trouble.
Alameda borrowed heavily from BlockFi and Voyager at the time, so FTX chose to rescue these institutions in an attempt to cover up Alameda’s losses.
However, all this collapsed after CZ tweeted questioning FTX.
Bill: So, if SBF had been able to suspend withdrawals at the time, would it have been able to survive?
Yang Zhou: Maybe. But there is no if in history. If FTX had chosen to suspend withdrawals like OKX did, it might have survived. But SBF chose to fight hard, and FTX eventually went bankrupt.
If the US government was willing to step in and rescue the market like traditional finance, perhaps FTX would not have collapsed so quickly. But the reality is that SBF is just a cash cow for politicians, not a truly important financial institution in their eyes.
Yang Zhou: After FTX collapsed, Genesis could not hold on. Genesis is the industrys largest lending counterparty (AUM $13.8 billion).
Bill: Genesis’s assets under management (AUM) is as high as $13.8 billion. So where does its funding mainly come from? Is it also from Tether?
Yang Zhou: No. Genesis’ funding sources are very diverse. It has a large number of credit clients, including many traditional financial institutions.
Bill: So, its funding side is relatively diversified?
Yang Zhou: Yes, and many of Genesis’ funding sources are traditional institutions outside the crypto industry, which is one of its unique features. This also means that the problems encountered by Genesis were eventually transmitted to traditional financial institutions, indirectly leading to the bankruptcy of many crypto banks in 2023.
However, the bankruptcy of these banks was not directly caused by the risks in the crypto market, but because the Democratic government at the time directly ordered the closure of some crypto banks. This was not because these banks had already shown risks, but more like a compulsory administrative action.
Yang Zhou: In my opinion, the main motivation for the Democrats to take this measure at the time was to be eager to distance themselves from FTX. Because FTX has made a lot of money in the past few years and has close ties with some politicians, when FTX exploded, they may have been eager to cut ties and avoid deeper involvement.
Meanwhile, Silicon Valley Bank’s (SVB) crisis has nothing to do with cryptocurrencies, but rather the interest rate risk facing the entire banking system.
Bill: SVB went bankrupt because it had problems with its assets, right? It held a lot of U.S. Treasury bonds, and rising interest rates caused the market value of these bonds to fall sharply.
Yang Zhou: That’s right. At that time, SVB and other affected banks held a large number of long-term bonds (long debt), but these bonds fell in market value when interest rates rose, resulting in huge paper losses. Although these bonds would not have been a problem if they were held to maturity, due to the large-scale withdrawals from customers, banks had to sell bonds to obtain liquidity, which led to actual losses.
The reason for USDC decoupling is that 10% of USDC deposits are in SVB Bank. When SVB went bankrupt, the market began to panic, worrying that the USDC asset side might not be able to fully cover its issuance, so there was a short-term decoupling, and the USDC price once fell below $0.90.
Bill: So, SVB’s bankruptcy was not due to its holdings of crypto assets, but due to 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 the stablecoin issuers of cryptocurrencies have not been fully incorporated into the banks risk management system. At that time, many stablecoin institutions did not fully realize that banks themselves also had credit risks.
Bill: But, in the end, the Federal Reserve stepped in and printed $500 billion to stabilize the banking system, right?
Yang Zhou: Yes, the Fed finally stepped in to save the market and injected $500 billion into the banking system. In comparison, the overall size of the crypto market is even smaller than this rescue fund. But this also exposes a problem:
If traditional financial institutions run into problems, the Federal Reserve will rescue them;
If there is a problem with cryptocurrency institutions, they can only hope for the best.
If Tether had stepped in to save FTX, perhaps FTX would not have gone bankrupt. But Tether is essentially a private institution, not a public institution like the Federal Reserve, 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 was actually the CDS (credit default swap) crisis in 2008, right?
Yang Zhou: Yes, the core problem of the 2008 financial crisis was that a large number of subprime loans were packaged into high-rated assets by financial institutions, and then multi-layered leveraged transactions were carried out, which eventually formed a systemic financial fraud. However, because the crisis was so large and affected the global economy, the Federal Reserve and the government finally chose to rescue the market, and the real responsible persons were almost not punished.
You can watch the movie The Big Short, which concludes with this truth. In the end, the political system in the United States and the world still faces the same problem:
When the crisis is big enough, the government will come to the rescue;
If you are just a small pond, Im sorry, you can only fend for yourself.
Bill: So, we can see that the US government has also begun to learn Chinas anti-corruption strategies when facing political opponents?
Yang Zhou: Yes, the US government has also begun to use anti-corruption as a means of political struggle. Just as China is learning from the West in the development of AI, the United States is also learning from Chinas strategies in some aspects. But for the crypto industry, the scale of the last cycle was not large enough, so the government is unwilling to save it.
Bill: Looking back at the last 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 significantly strengthened risk control, which is mainly reflected in the following aspects:
1. More institutions start using Custody
For example, Binance now has Ceffu Custody, which, while affiliated with Binance, is at least off balance sheet.
Exchanges such as OKX and Coinbase have also strengthened their custody services.
2. Gradual separation of the business of exchanges and lending institutions
Traditional financial institutions spent decades on robust transformation, while the crypto industry completed similar adjustments in just two years.
3. Market participants’ awareness upgrade
After several rounds of crises, the entire crypto industry has evolved faster, and institutions and investors have become more risk-aware than before.
This makes me feel that the crypto industry is particularly adaptable. Despite being full of speculation, it is still evolving and moving forward.
Bill: Indeed, the entire crypto industry is evolving faster than traditional finance.
Bill: When PayPal collapsed, you had already retired and left the company. Why did you choose to come back and try to save PayPal?
Yang Zhou: Many people have asked this question. Some people wonder if I have a handle on PayPal, so I have to come back? But the fact is, I have no problem, its purely my personality.
At the time, I thought the best option was to try to save the company. I wanted to see if it was possible to restructure the debt and save the situation.
PayPal still had:
15,000+ BTC in Genesis;
20,000 – 30,000 ETH;
$200 million in cash.
Under the circumstances at the time, I felt it was possible to save it, but ultimately Genesis collapsed, rendering all of these assets irrecoverable.
Bill: So, you wrote a call option to all creditors?
Yang Zhou: Yes, the Call Option of debt.
