How to buy $8 million of Ethereum for $0

As abnormal becomes the new normal, some interesting stories are emerging.

And today, we’re going to take a look at one of them: how a few shrewd traders managed to legally obtain $8 million of Ethereum for $0 on “Black Thursday”.

It’s one of those stories that when you hear about it, you wish you could have been smart enough to have come up with the idea yourself.

But then, ideas like that are always easy to see in hindsight, aren’t they?

I mean, with hindsight you could have just put £6,000 into Ethereum in January 2017 and cashed out in January 2018 for over £1 million.

But that would have involved a whole lot of risk and uncertainty.

Whereas the $8 million of free Ethereum people nabbed in March came with almost zero risk – and was made instantly.

So, what exactly happened… and could it happen again?

Most things in life aren’t a zero-sum game – but this loophole was

Over the last few months, we’ve seen a lot of “Black” days for financial markets.

But the one we’re looking at today fell on the 12^th of March and was known as “Black Thursday”.

That was the day the world imploded with fear of the coronavirus, and markets reacted accordingly.

Around the world, we saw the biggest single-day losses since… “Black Monday” of 1987. And 14 of the G20 entered bear market territory.

Crypto didn’t escape the carnage, falling over 43% in the space of a few hours.

But as with most extreme situations, some people, rightly or wrongly, saw an opportunity.

Because the Price of Ethereum had dropped so far so fast, it meant that a massive amount of the Ethereum loans collateralising the DAI stablecoin suddenly hit their liquidation levels.

And if the above paragraph reads like gibberish to you, you can check out my article on Decentralised Finance from earlier this year: What is DeFi and why is it such a big deal?

But if you’re short on time (If you are, I can relate. Somehow, I seem to be busier than ever during this lockdown) here’s a summary:

• DAI is a decentralised stablecoin created by MakerDAO.
• In order for DAI to be created and to stay at a value of $1, Ethereum needs to be locked up in a smart contract.
• That Ethereum is basically a collateralised loan. If the Price of Ethereum drops too far, and no more Ethereum is added into the loan, it can be liquidated.
• When the loan is liquidated, the Ethereum is sold at auction to the highest bidder.

At the beginning of Black Thursday there was over half a billion dollars of Ethereum locked up in DAI.

By the end there was just over $300 million. As you can see on this chart:

So, as you can gather, on Black Thursday, a lot of loans were liquidated. Which meant a lot of people got to bid on the Ethereum that was locked up in them.

Usually, the people with these loans would have time to add in more Ethereum to make sure they weren’t liquidated or pay them off entirely.

However, because Black Thursday was such a crazy day, the Ethereum network was overloaded and transactions weren’t getting through.

If you remember back in the heady days of 2017, this happened quite a lot.

Back then the network congestions were usually the result of many people trying to get into an Initial Coin Offering (ICO) at the same time.

When this happened, the only way to get your transaction through was to pay a higher transaction cost so the miners would favour it over other people’s transactions.

I remember stories of people paying hundreds of dollars to get their transactions through for those ICOs.

You don’t really hear a lot about the scalability of most cryptos today, but back then it was all people talked about.

(And once Ethereum 2.0 launches those issues should disappear, but for the moment they remain.)

Fast forward to Black Thursday, and Ethereum is clogged up just like it was in the peak of the ICO days.

So, when those DAI loans reached their liquidation points, the only people who could bid on the liquidated Ethereum were people paying extra to get their transactions through.

So few people thought to do this that in many cases there was only one bidder for the liquidated loan.

And that bidder was usually smart enough to realise that if they were the only bidder, they could simply bid $0 and get all the Ethereum for free (minus their transaction cost).

So by the end of the day, $8.32 million worth of Ethereum had been bought for $0.

Or to look at it another way, $8.32 million of Ethereum had been lost by people using DeFi loans.

The aftermath… and the possible death of MakerDAO and its DAI stablecoin

Obviously, people weren’t happy about this situation. Not least those who had lost millions of dollars’ worth of Ethereum when they got liquidated.

There were calls for the people who got the free Ethereum to “do the right thing” and give it back.

For example:

But as you can imagine, those pleas fell on deaf ears.

And I thought the response to that particular argument was summed up well by Tobias W. Kaiser below:

The bigger question now was, what would MakerDAO do about it?

Remember there was still over $300 million locked up in its system. And that system had just had its doors and windows smashed in.

Would you trust leaving $300 million in a traditional bank that had just lost over $8 million of customers’ money, and wasn’t insured?

I’m guessing no.

But what could be done?

Becoming what we hate

MakerDAO is a Decentralised Autonomous Organisation (DAO).

The clue is in the name – decentralised.

But, in order to fix the mess of Black Thursday, this DAO would need to become what it hates. It would need to become centralised.

Here’s what went down (courtesy of build blockchain tech):

The Foundation, in coordination with the rest of the community, went about making changes to try to stabilize the system and avoid a shutdown. To summarize a process that played out over the course of two weeks, and involved a ton of discussion, debate, and multiple governance token votes, the community eventually deployed the following strategy and changes:

• Community outreach to increase awareness about keeper auctions
• Extending the time allotted between bids during these auctions
• Decreasing the Dai Savings Rate to 0% in order to reduce demand for Dai
• Minting and auctioning MKR tokens to make up for the shortfall
• Introducing the dollar backed USDC stablecoin as collateral to provide an easy path for greater Dai liquidity

You’ll notice I’ve bolded that last bullet point.

USDC is a stablecoin created by Coinbase.

It is a traditional stablecoin in that each USDC represents a real $1 held in reserve by Coinbase.

This makes it centralised. Coinbase controls it, and Coinbase can ultimately say who gets to use it or cash it in. And if Coinbase fails, so does USDC.

Critics argue that by including USDC into its collateral, DAI is no longer decentralised. And worse still, it has a central point of failure and control – Coinbase.

So why should people use DAI – which has had quite a few issues keeping its stability over the last couple of years – when they could just use USDC directly?

There is basically now no benefit to using DAI over USDC and big potential downsides.

And this then calls into question anything built on top of the MakerDAO system. As long as it is collateralised by USDC it is not decentralised.

What does this tell us about DeFi?

What can we learn from all this, and does it mean DeFi is doomed to failure?

I would argue it definitely doesn’t doom DeFi to failure, but it does uncover some deep-rooted problems in MakerDAO.

However, DeFi is about a lot more than just MakerDAO and DAI. That is just one small branch of what’s going on.

Even if MakerDAO went on to completely collapse (which is incredibly unlikely), it wouldn’t doom DeFi.

Ultimately MakerDAO is to DeFi what Lloyds – or any single bank or institution – is to traditional finance.

But it does bring up some interesting questions.

As build blockchain tech points out:

The truth is, the Maker system survived largely because of the decisive action of a small group of people whose jobs it is to steward it— the folks at the Maker Foundation. The question we ought to be asking ourselves moving forward is: is that such a bad thing? We should demand maximal decentralization from base protocols, but does it make sense for a system like Maker to be as autonomous as a blockchain network itself? Is it even possible?

Something to think about.

Okay, that’s all for this week.

If you liked this article, you can buy me a pot of tea here.

Thanks for reading.

Harry

PS If you want to read another crazy story – this time from aftermath of the 2008 financial crisis – I always liked this one I covered back when I was Editor of Exponential Investor: Have you heard the one about the retired police officer who repossessed their local Bank of America?