Principles of the Token Sutra

The main principle of the Token Sutra is that the real opportunity for profit in "token market making" isn’t in delivering delta-neutral market making services. Rather, savvy market makers rake in the majority of their earnings from deal clauses completely unrelated to liquidity provision.

The Token Sutra advises that the pathway to profit nirvana is paved with deceptive loan agreements, opaque exchange accounts, intricate legal contracts, embedded options, and false promises. Such strategies typically depict a fundamental misalignment of interests between market makers, and the projects and investors they pledge to serve. By becoming enlightened, they can unlock new opportunities to profit from token projects and their communities.

The strategies outlined here are some of the most striking examples of value exploitation the brief history of our industry. Through this, profits amounting to hundreds of millions of dollars have been made at the expense of communities and project teams.

Part 1: The Options

Market makers have been pivotal in the cryptocurrency industry from the outset of centralized exchanges. They’ve infused liquidity into fresh token launches and reduced price fluctuations during a project's early phases. One notable manipulative practice was the aggressive negotiation and procurement of call options on a project's token.

Initially, call options served a harmless function in market making agreements. They were usually issued under the Liquidity Consulting Agreement (LCA) to hedge risk when market makers had to maintain short positions selling borrowed tokens. These call options evolved into a lottery ticket, offering holders the chance to benefit from the exponential growth of tokens during a bull run, where tokens could swiftly multiply 10x or 100x, realizing 8-9 figures of option delta.

Fundamentally, market makers manipulated, concealed, and complicated their LCAs to extract significant value from unsuspecting projects. This was possible because most project founders lacked the sophistication to accurately identify and value options, and understand their potential risks to their project’s long term success.

Exploiting Knowledge Asymmetry

Market makers capitalized on their expert status in these intricate financial matters, and there was little skepticism (by projects) towards their role as a trusted service provider. This was especially true during bull markets when due diligence was minimal and projects were racing to launch quickly. Ultimately, many projects granted options for free without realizing that they had unwittingly forfeited hundreds of thousands to millions of dollars in net present value, and potentially far more in upside.

In addition to individual market makers trying to extract maximum value, there was heated competition amongst traders and firms for the “hottest” deals. A plethora of financial engineering strategies were employed by shrewd traders to raise the Day 1 value of options obtained from the contract, while claiming to be more competitive than other market makers. Tactics ranged from fundamental methods like competing on strike price, option duration and notional size of options.

More advanced tactics, such as those often employed by Alameda, involved the introduction of more intricate clauses such as multiple tranches with varying strike prices, or knockout clauses. The added complexity created an illusion of alignment and sophistication, further hindering projects’ ability to clearly understand the menagerie they were entering into.

Embedded Call Options

As the cryptocurrency market matured, astute market makers like Alameda devised new profit-maximizing tactics. A crowd favorite was the embedded call option, which cleverly hid an option with upside within a token loan.

Here's the mechanism: MMs required token loans to facilitate their trading activities, enabling them to acquire and trade tokens without the projects bearing the risk of trading losses. Projects were incentivised to provide this token loan as it transferred the burden of potential trading losses to MMs.

The real game-changer was the clause that granted market makers the flexibility to repay the loan either in tokens or USD based on market conditions, effectively creating an embedded call option. If token prices dipped, MMs repaid in tokens at a much lower dollar value than the initial loan. Conversely, if prices soared, they repaid in USD, essentially exercising the call option and profiting off the option delta. In the bull market, this simple strategy forced many projects to surrender massive sums of tokens to their market makers, amounting to hundreds of millions of dollars.

To mitigate this, projects can limit the notional value of the embedded option to a sum they are comfortable allocating to an external investor, ensuring a more equitable distribution of value.

Are Founders to Blame?

A potential argument is that founders are at fault for lacking the legal scrutiny and due diligence necessary to fully understand the value and potential risks associated with these options. However, some market makers were clearly acting in self-interest with misaligned incentives when they designed their service agreements to be unnecessarily complex and skewed for their own benefit.

In addition, the terms of these deals were often discussed through informal channels such as Telegram messages, under immense time constraints and competitive pressures. This environment made proper due diligence more difficult, and became an easy way to further exploit founders who were pressured by rising competition and a raging bull market.

Another perspective suggests that the deal was a win-win, with projects getting cheaper services and market makers being able to share in the upside. After all, in a bear market, the options would be worthless and the market maker would be at a loss. This is reflected in the current state of token market making, where market makers favor compensation in fiat over options for their services. This exposes the motivation behind market makers wanting options only when it allows them to extract more value, rather than the false impression of long-term alignment.

While we are all for free market dynamics and the ability to charge for a unique value proposition, we strongly believe that service providers should not exploit their clients to optimize for their own short-term interests. Exploiting misaligned incentives and knowledge asymmetry with retail investors is harmful to the industry and acts as a bottleneck in our ability to self-regulate and mature.

Suggestions for Options

Moving forward, founders must be cautious of these tactics and carefully evaluate the overarching implications of the contract. Options should be stated clearly, especially when dealing with provisions. Furthermore, making the assumptions and calculations behind the Day 1 option valuation more explicit can contribute to a clearer transaction.

Founders should carefully comb through contracts for embedded options and look for any potential for the service provider to exercise their discretion on how the deal is carried out, particularly concerning the timing or currency of loan repayment. One way to analyse derivatives contracts is to simulate extreme scenarios in token price, and to ask what happens in the event that the price appreciates or depreciates significantly.

Finally, market-making services should generally be considered a service and not an equity investment with hundreds of millions of dollars of upside. If there are additional services being offered such as branding assistance or venture financing, this should be negotiated in specific clauses.

Part 2: Opaque Exchanges and Misappropriated Tokens

The Token Sutra teaches that tokens should not only be used for providing liquidity to specific order books, but can be used to generate higher yields in more lucrative practices such as prop trading, degenerate DeFi yield farming, or simply counter trading your project’s investors.

A common play was for market makers to secure token loans or VC investments, and be deliberately vague about specific details such as what the tokens can be used for, when they can be sold, which exchanges the tokens can be diverted to and the regularity and transparency of reporting. The omission of specific terms opened a loophole for market makers to siphon funds into whatever would produce the highest yield for themselves.

From a founder's perspective, once a market maker sends the loaned tokens to an exchange to provide liquidity, there is almost no way to track what is happening to the funds besides periodically checking the public order books. This requires trust between market makers and projects, a fact of doing business aspect in crypto.

As more sophisticated traders entered the space during DeFi summer, profitable trading became considerably more difficult, and even firms like Alameda were making losses in their market making activities on new tokens. It was far easier to earn money from other pursuits such as using the tokens for yield farming, pump and dumps, or prop trading to profit off the loans they had secured.

Day One Listings

Another exploit market makers are known for is the manipulation of prices during day 1 exchange listings of new tokens. As the primary token holders during these initial hours, they exert a profound influence on the market's initial selling price and use this to dump on unsuspecting retail investors. This unique position also enables them to take advantage of mispricing across various exchanges, often leading to substantial profits, sometimes reaching high 7 figures within the first hour of token trading.

The case of Blur offers a prime illustration of the market makers' strategic advantage. Within the first 30 minutes of its listing, Blur's price escalated to $5, not due to organic demand but due to manual intervention by market makers who held a near monopoly on the exchange’s sellable assets. This artificial ceiling was used to drive up the perceived value of the token during the price discovery phase and capitalised on retail investor FOMO. Similar stories played out on notable projects such as Filecoin, ICP, and Arbitrum.

Reef Finance

The Reef Finance and Alameda fiasco is a prime example of the dangers of a lack of clarity around the use of tokens. Reef Finance engaged with Alameda Ventures as a "long-term strategic partner" for an over-the-counter trade of $80M tokens. However, after the first $20M of tokens were sent, a trader from Alameda deposited them into a Binance account, triggering the Reef Finance team to panic and call off the remainder of the $80M deal with Alameda. Shortly after, $REEF dropped 35%, triggering liquidations and causing massive damage to the project’s reputation and progress.

According to Sam Trabucco, the deal between Alameda and Reef Finance was conducted entirely over Telegram and Reef Finance's Mancheski said that “there was literally no legal agreement/contract (or any kind of paperwork whatsoever)”. After the collapse and disgrace of Alameda, it can be assumed that Reef was right about their allegations of wrongdoing. However, the damage had already been done. This story should serve as a cautionary tale for future founders to insist on specifying details and having written agreements.

Part 3: Big Brand Bondage

In a noisy bull market, having a big brand name like Alameda, Jump, Wintermute, or GSR became a signal of a project's legitimacy, which made a huge difference. These brands were able to entice projects that were desperate for a marketing bump and these brand name firms were able to demand increasingly high percentages of tokens in return for their services.

Some market makers were asking for more than 10% of a project's total supply with the notional of the options adding even more. Alameda was one such firm known to aggressively leverage their brand name to secure a high percentage of tokens, promising to promote the project or increase its chances of being listed on FTX. The situation was made worse by the fact that the venture and market making sides of many deals were mixed together, strong-arming founders to accept unfavorable terms.

This practice exploited token founders by extracting a high rate for basic market making services, and then over-promising and under-delivering on other promises. During frenzied bull markets, support and focus would be directed toward more promising projects, and promises of potential FTX exchange listings and after-market support were often left empty and at the complete discretion of FTX/Alameda management. Projects like Reef Finance even faced the threat from Alameda of delisting from FTX and other tier 1 exchanges.

To combat these practices, token founders must exercise extra caution when negotiating deals and be fully aware of the claims and promises that market makers make. Any service outside the scope of liquidity provision should be evaluated and negotiated in separate clauses that are explicitly stated.

Additionally, token founders can take steps to diversify their market-making providers, ensuring that they are not held hostage by any one firm. By taking these steps, token founders can level the playing field and ensure that they are not exploited by larger market makers.

Takeaways

The Token Sutra exposes the tactics used by market makers to exploit token projects and their communities. The predatory practices documented in this manuscript are just some of the examples of deceptive loan agreements, opaque exchange accounts, convoluted legal contracts, embedded options, and false promises that have been used in the real world. These tactics have resulted in hundreds of millions of dollars in profit for market makers at the expense of the long-term growth prospects and community confidence of token projects.

Founders should fully understand the terms of their agreements, seek legal counsel when necessary, and not be swayed by big brand names promising inflated returns. The only way for our industry to mature is to unite against these practices and remain vigilant and carefully consider each scenario and the overall picture. By doing so, we can prevent future exploitation and pave the way for a more transparent and aligned future.

💡 If you have stories to add to the Token Sutra or wish to provide feedback, please email us at contact@paperclip.partners.

This report demystifies the crypto market-making landscape and offers practical insights for founders engaging market makers (MMs). Key considerations include evaluating whether a MM is necessary for your project, MM selection criteria and contract negotiation.

Our research is bolstered by real project contracts and insights from industry experts in quantitative finance and market making.

💡 Note: throughout this paper, we may refer to some technical financial terminology. Please refer to our glossary here for in-depth explanations of each concept.

Market making 101

Market making involves an institution or trader providing liquidity to a market by simultaneously quoting buy (bid) and sell (ask) prices for a security or asset. The bid price represents the highest price a buyer is willing to pay for a security, while the ask price represents the lowest price a seller is willing to accept for the same security. The difference between the bid and ask prices is known as the spread, and it represents the profit margin for the market maker.

MMs are typically incentivised to maintain a narrow spread and provide liquidity to the market, as this attracts more buyers and sellers and leads to higher trading volume. Higher trading volume, in turn, increases the market maker's profits.

Liquidity refers to the ease with which an asset can be bought or sold without affecting its price. A market with high liquidity has many buyers and sellers, so there is always someone willing to buy or sell an asset. A market with low liquidity, on the other hand, has few buyers and sellers, which can lead to large price movements when someone wants to buy or sell a large number of assets.

Great, so now that we know what a market maker is, what is the concern?

The concern lies in the potential misalignment between an MM's profit-seeking short-term focus and a project team's long-term value creation. Our goal is to help founders form synergistic relationships with MMs and avoid structuring deals that enable MMs to extract value at the expense of the project's long-term goals.

Do you need a market maker?

Founders should initially ponder two questions:

Is a market maker necessary at my project's current stage?

MMs are typically needed during a project’s early listing stages. For example, this can be at the IEO stage, where initially there is near-zero trading volume. Established digital assets usually have ample market-provided liquidity, making MMs less beneficial.

How does engaging a MM benefit my project?

In other words: does my protocol require liquidity? For a DeFi protocol where the token is designed to be traded with high volume, liquidity may be vital. Conversely, for governance tokens meant for holding with low velocity, liquidity isn't as crucial.

In the latter case, a simple 50/50 Uniswap pool or other decentralised liquidity pool may suffice. Setting up a pool can be a simple DIY solution and requires far less capital than engaging a MM that charges recurring service fees. Once the protocol has grown significantly (e.g. daily active users are reaching hundreds of thousands or millions), the project can then transition to a centralized exchange such as Binance, Huobi, or Crypto.com.

Evaluating Pros and Cons

When conducting a cost-benefit analysis, founders should consider their specific circumstances, including finances, project timeline, and token purpose:

Benefits

1. Reduced spread - Reduced bid-ask spread makes transactions more attractive, lowering transaction costs for buyers and sellers. A tight spread ensures a better trading experience with minimal fees and slippage.

2. Liquidity creates further liquidity - Initial liquidity fosters further liquidity, attracting more buyers and sellers into the market (“liquidity breeds liquidity”). This creates a loop that further amplifies volume and liquidity.

3. Price discovery - Liquid markets facilitate accurate price discovery, representing the asset's true value based on decisions by numerous market participants.

4. Price stability - High liquidity mitigates drastic price shifts from large orders, promoting investor confidence. To preserve a project’s long-term vision, users ideally price the intrinsic utility and value of the token, instead of purely viewing it as a speculative asset (which can be the case when prices are highly volatile).

Costs

1. Engagement Fees - Market makers may require setup and recurring fees, or token loans. For instance, GSR, a leading crypto market maker, charges setup fees of US $100,000, monthly fees of US $20,000, plus a $1 M BTC and ETH loan.

2. Imbalanced deals - Founders or token issuers typically have weaker negotiation stances due to their low-volume trading pairs (less profitable for MMs). In these cases, MMs can leverage this to strong-arm a more skewed deal.

3. Bad actors - The lack of regulation in the crypto industry can attract fraudulent MMs that engage in deceptive activities such as wash trading, or misuse of token loans. The risks of damage from a MM’s malpractice or default should be considered.

Criteria to select a market maker for a token

There are over 50 major market makers in the crypto/web3 landscape currently. When it comes to choosing a market maker, we propose 5 key criteria:

1. Fees - The sum of setup fees, recurring fees, performance-based fees, and options.

2. Capabilities (volume and spreads) - the quoted volume or spreads that the MM initially provides. MMs may only guarantee quotes between certain hours of the day, whilst some can trade 24/7.

3. Reputation - established firms with a large balance sheet, strong track record (e.g. working with reputable projects, TradFi experience), and experience in delta-neutral market making.

4. Accessibility - the criteria that the MMs themselves set when choosing markets to trade (e.g. MMs who have minimum volume thresholds for assets).

5. Partnerships - reliable connections to leading exchanges (Binance, Huobi, Crypto.com) which may assist with exchange listings. This must be considered cautiously and conservatively.

💡 A list of major market makers in crypto can be found here - link

The terms of a MM contract

The final step is negotiating and finalising the contract which outlines the terms of the market-making agreement, also known as the Liquidity Consulting Agreement (LCA).

Through analysing public and private market-making agreements, we have identified the key elements within an agreement that any project founder should focus on**:**

Compensation

We consider compensation as any form of financial incentive aimed to reward a MM’s positive behaviour. The three main forms of compensation we have identified (from reviewing several MM deals) are:

• Service fees

• Options

• KPI-based fees

Service fees

Fixed fees paid to the MM can be significant sums of fiat for early-stage projects. There are several pricing structures:

1. Setup fees: initial lump-sum payments to the MM at the beginning of the agreement.

2. Retainer fees: recurring fees (e.g. monthly, fortnightly, quarterly) paid to the MM - this is typically at a specified flat rate.

3. Both setup and retainer fees

4. No fees: In bull markets, market makers may forgo fees for a token loan, especially for popular tokens. The supply-demand dynamic governs the overall market making cost. Hyped tokens are profitable enough for MMs to trade without needing further fees.

Founders should be wary that market makers generally have negotiation leverage due to:

1. Abundant Market Options: MMs have an abundance of different markets they can trade on, so losing a deal with a project has a limited impact on their business.

2. Limited Profitability in Early-Stage Projects: For early-stage projects with limited existing volume or liquidity in their native token, MMs see limited profit opportunity and potential risk in providing their services. Market makers utilise high-frequency algorithmic trading to make a profit, and therefore when there is limited trading volume, the opportunity becomes less lucrative for the MM.

Options

Options are common in MM agreements to provide the MM with financial upside through token price performance. This typically gives the MM the option to purchase the tokens after the loan expires for a pre-agreed price between the parties.

The MM is thus incentivised to keep the price above a specific threshold (the option’s strike price), as this gives the MM the ability to exercise the option to buy X amount of tokens at the pre-specified strike price, and immediately sell at the higher current market price for a healthy profit.

MMs leverage options to persuade founders to sign with them, indicating that using options aligns them with the token’s success (i.e. increasing token price). This was particularly common in bull markets, where there was a non-zero probability of an early-stage project token increasing 100x, and MMs pushed harder for option deals (and often succeeded).

However, these options have an expiry date after which they are worthless to the market maker, so such alignment is always short-term in nature.

Employing options as MM compensation is complex and risky due to:

1. Pricing challenge: Determining a reasonable strike price, option tenure, or volatility for a new asset with a limited price history is incredibly difficult and prone to large inaccuracies. In bull markets, MMs aim to negotiate for huge option packages at cheap prices in order to gain exposure to token price upside in a manner analogous to venture capital.

2. Manipulation risk: Founders with limited financial/statistical literacy may fall victim to the manipulation of key parameters which make up the value of the option. They may even be unaware that the options they are offering have a price/implied value attached - this is analogous to the difficulty of pricing the value of a startup’s equity.

   1. Unethical MMs can understate token options' actual value using unrealistic assumptions in calculations, causing founders to unknowingly give away more value. This can be done by using unreasonable assumptions (e.g., the token's volatility will be equal to the BTC volatility) that implies the contracted option’s value is significantly lower than in reality.

💡 Whilst token founders do not need to learn complex statistical and options pricing theory, there are certain tools that can be useful to generate a ballpark value for a contracted token option. It is difficult to pinpoint the value of your option deal with great precision, but founders should educate themselves on the value of the offer in order to have a more transparent and informed discussion with the MM.

• We have produced a basic tool here to assist with the estimating and valuation of your options contracts:

  Paperclip Option Pricing Tool

• There may be price manipulation risks:

  1. If the option price is too high, then this encourages MMs to pump the price.

  2. If the option price is too low, then the MM (if the loan repayment model is denominated in the quantity of tokens) can maximise profit by shorting the token and ultimately only having to repay a fraction of the principal.

One option pricing format which can be used is having “tranches”, where the token issuer provides several options with differing strike prices or expirations. For example, GenesysGo - which contracted with Alameda - presented three tranches, priced with option strike prices of: $1.88/$1.95/$2.05.

Interestingly, tranches have a very minimal impact on the actual service. Nonetheless, there are two reasons why they exist: a) MMs want to make the deal more complex and therefore seem more “legitimate”. b) A MM may want to offer slightly better deals compared to its competitors.

Performance-based fees

KPIs can be used to create performance-based fees that reward the MM for reaching the project’s desired goals. A few performance metrics (alongside our evaluation of them) can be found below:

1. Volume

   1. Very dangerous as it can incentivise wash trading - this practice is illegal in most markets and is harmful in that it can artificially inflate volume numbers and lead to misleading market data.

2. Price

   1. A very poor metric that can lead to MMs pumping token prices, and subsequently crashing the ecosystem when the prices unravel.

3. Spread

   1. The spread or bid-ask spread is the difference between the prices quoted for an immediate sale and an immediate purchase of stocks. In other words, it is the difference between the highest price a buyer is willing to pay and the lowest price a seller is willing to sell for.

   2. Generally, a fairly robust KPI, although this needs to be supplemented by metrics that capture market depth (else there is a tight spread but the price is fragile).

4. Minimum bid and offer sizes (in USD)

   1. The notional bid and offer size refers to the value in USD (of the project token) that the MM is willing to buy and sell respectively.

   2. Important KPI as it ensures there is a reasonable buffer against large price swings from sizeable orders. Prevents prices from easily skyrocketing or crashing.

Comparing the types of compensation

The process of deciding on what forms of compensation to opt for in a project is ultimately highly personalised and depends on how much cash the founder has, their goals regarding decentralisation and governance, as well as the stage of the project.

Service fees (setup and monthly recurring) are a balanced arrangement, but may warrant high initial costs for a reputable market maker (MM) to boost project liquidity. However, setting vague targets with these fees is suboptimal. Incorporating performance-based fees with concrete targets, like spread percentages, can better align MM behavior with project goals. However, care should be taken to avoid easily-manipulated KPIs like volume during negotiations.

We recommend risk-averse teams to combine service fees with KPI-based bonuses. Cash-poor projects should aim for small to medium market makers with proven records. Cash-rich projects should contract large, top-tier market makers and negotiate for mostly fixed terms.

Compensating through options can lead to overpayment for MM services and increase risk. Another negative outcome is in governance: if a founder issues options at a low strike price for a significant quantity, an MM could accumulate a significant portion of circulating supply. This compromises the decentralisation of the protocol, especially as MMs will likely vote in a profit-maximising manner rather than aligning with the project’s vision.

Cash-poor, risk-tolerant teams may consider using some amount of options in the package, while being mindful of the present value of the options. However, if the project has significant cash reserves and a loyal user base, then using options is typically inadvisable and requires thorough scenario testing to avoid overpayment.

Below is a summary table of the above:

💡 A framework to understand the risks of a MM deal: As a founder, consider what the market maker would gain or lose if: a. the project token price increased by 1000x. b. the project token price went to zero.

Assuming the MM will always act in a way that maximises their profit and earnings, a team should be able to understand which way the MM is motivated to push the price. In an ideal scenario, a market maker should be neutral to the direction the price moves, as they are simply there to provide liquidity.

Loan Terms

A common arrangement in market-making agreements is for the asset issuer or party requesting liquidity services to provide a loan to the MM for the MM to use to trade and provide liquidity for the token. There are a few attributes of a loan clause that are of significance:

1. Loan period: The loan period is important, as it determines how long the project will have to wait before the MM can return the loaned capital. This should be negotiated on a case-by-case basis depending on the roadmap of the project and the financial needs of the core team.

2. Interest rate: This token loan is made on the basis of a 0% interest rate - this is because the MM would otherwise have to make constant repayments whilst earning a variable return from trading, which is unattractive.

3. Token loan quantity and value: The incentive alignment is stronger if the type of tokens given in the loan are that native to the ecosystem. However, it should be noted that a loan denominated in the number of tokens presents an adverse incentive for MMs, who benefit if the tokens decrease in price, as the value of their repayment will be lower. This type of contract term resembles an “embedded option”, as it gives the MM great upside from price drops before repayment at the expiry date.

4. Repayment issues: Projects should be explicit about the contractual obligations which arise if the MM is unable to return the tokens. Clauses also commonly include paying the amount outstanding in BTC/ETH or stablecoins.

Termination rights

1. Notice period

   1. Generally, both parties are able to terminate upon written notice delivered some period in advance. As with many commercial agreements, a range of 14 - 30 days is fairly common for a termination notice. However, each issuer should evaluate the difficulty of securing additional market makers based on their personal circumstances and adjust the notice period accordingly.

2. Additional conditions under which either party can terminate

   1. The Asset Issuer

      1. Rights to terminate if any material breaches any of their obligations.

   2. The MM: the termination rights which a MM holds are more significant here, as they dictate the conditions under which they are no longer obligated to provide liquidity. We outline 4 types of conditions under which the MM can legally be removed with commentary on key considerations (if applicable) for core teams.

      1. Breach of payment terms: issuers should ensure there are safeguards, including the existence of a grace period) to provide the team with buffer time in periods of poor cashflow.

      2. Breach of other terms (e.g. Non-Disclosure)

      3. Conflict with Terms of Service and regulations enforced by exchanges in which liquidity is being provided

      4. Law and regulation: because the regulatory landscape around cryptocurrency is constantly changing, MMs need to protect themselves if the act of performing their obligations suddenly becomes criminalised. One source for potential legal due diligence is understanding the laws around market-making in traditional asset markets, which can set a precedent for future web3 regulation approaches.

Liability

In most liquidity agreements with MMs, the MM is excluded from any liability surrounding the token’s price fluctuations. This can be expected due to the speculative nature of cryptocurrency, whilst noting that there are endless factors beyond the MM’s control that can dictate token price, thus making it fundamentally unreasonable for MMs to bear the financial consequences of such price movements.

Conclusion

In conclusion, market-making plays a crucial role in ensuring liquidity and stability in the cryptocurrency market. This report aimed to demystify the complexities of market-making in crypto and provide actionable insights for founders considering engaging a market maker. Through an analysis of real-life contracts and insights from industry experts, the report highlighted the importance of considering the necessity of a market maker, selecting the right firm, and negotiating terms.

We hope that this report will serve as a valuable resource for founders and other stakeholders in the cryptocurrency ecosystem, helping them to make informed decisions about market making and to drive the growth and stability of the token economy. We are also happy to help founders navigate this difficult stage of their journey with more personalised advice, so please contact us at contact@paperclip.partners for more information.

Appendix

https://www.notion.so/Appendix-f2e357940a1642c5a6c9e5fc7cda7804

The Kama Sutra is an ancient Indian text written by Vatsyayana around the 2nd century CE. It is a treatise on the art of love, sensuality, and relationships, and deals with the different aspects of sexual behavior and pleasure. While the Kama Sutra is already well studied and widely available, a mystifying manuscript known as the "Token Sutra" recently emerged, exposing ways to attain satisfaction through a more lucrative form of liquidity.

Contrary to its more famous counterpart, the “Token Sutra” focuses on optimal positions for exploiting a partner using strict domination and selfish misaligned incentives. It contains positions and advice so predatory and explicit that certain passages could not be translated into modern English. The reason for its disappearance from civilisation is unclear but scholars believe the strategies and tactics inside were deemed too dangerous and destructive for a healthy civilisation.

Allegedly, the tome was unearthed during a several month-long excavation that took place during the building of FTX from late 2018 to summer 2019, funded by none other than Scam Sam Bankman Fried using the earliest customer deposits in FTX. SBF was quick to make the Token Sutra an internal bible during the early days of Alameda, and it formed the foundations of Alameda’s trading strategies. But the intoxicating allure of the Sutra’s power soon overwhelmed them. They started by exploiting small, insignificant token projects, and the rush hit harder than the morning’s first Emsam. The allure of the Token Sutra had them hooked.

In the end, Alameda was a shell of its former self - a cautionary tale of unchecked ambition and the destructive power of the Token Sutra. The following leaked pages were discovered during a law enforcement raid of the Alameda offices in late 2022, and are a fraction of the entire text.

The Token Sutra

We reviewed the Token Sutra to shed light into the dark underbelly of token market making and the predatory techniques that have been exploiting new token projects and users for years. We hope to expose these practices to educate projects on how to prevent past mistakes and pave the way for a more transparent and aligned future.

#13 The Sneaky Spread Eagle

The market maker slides the embedded call options deep into the founder’s loan agreement, squeezed tightly inside the loan terms for token liquidity. The token project gasps with surprise, but the market maker assures them that they are using industry standard protection. As the bull market rages, the founder's eyes widen as they feel the market maker's options pulsating deep inside their contract, the call option premium throbbing with potential profit. Little did they know, the market maker intended to squeeze maximum value out of every transaction, leaving the token project feeling exploited and begging them to stop. As the market heats up and the token's price rises, the market maker's options grow more engorged, ready to be exercised and release a giant load of gains.

Market makers often require token loans to carry out their market making activities, enabling them to acquire and trade tokens without the project bearing the risk of trading losses. The exploit is the embedded American call option in these loans, which gives MMs the implicit option to repay the loan in tokens or USD stables. Unbeknownst to project founders, this crafty tactic can leave them handing over massive sums of tokens at the time the option is exercised.

#21 The Call Option Caress

Like a silver-tongued suitor on a promising first date, the market maker slides into the founder's DMs, whispering sweet nothings about call options. "It's just a bit of harmless fun," they coo, "a safe way to play and maximize alignment." The founder, blushing and doe-eyed, hands over the reins, allowing the market maker to reach down for fistfuls of dirt cheap call options. It's only when the market maker has had their fill and left, and the harsh light of the morning sun hits the balance sheet, that the founder realizes they've been thoroughly shafted.

Call options were commonly issued as part of the Liquidity Consulting Agreement (LCA) as a way to hedge risk when market makers were required to maintain short positions selling loaned tokens. Unlike formal call options, these options were less standardized and were often not explicitly defined. These call options acted as a lottery ticket, giving holders exposure to the dramatic upside of tokens during a bull run, when tokens could rapidly 10x or 100x and materialize into 8-9 figures of option delta.

#32 The Moonshot Menagerie

The market maker seduces the founder with a big-brain display of financial engineering wizardry. The founder, too smitten by the market maker's intoxicating show of Monte Carlo simulations and Brownian motions, leaps deep into their well-lubricated financial fantasies. Unbeknownst to them, their newfound lover's promises are about as solid as the utility of a shitcoin in a bear market. As the founder is left with the aftertaste of a poorly negotiated deal, the market maker flees the scene, with the token project clutching its deflated dreams and staring at a chart that's crashed harder than an autist who ran out of stims.

There were numerous financial engineering tactics that savvy traders employed to maximize the Day 1 value they could extract from the contract, all while claiming to be more competitive than other market makers. These approaches ranged from fundamental tactics, such as competing on strike price or option tenure, to more advanced derivatives that introduced multiple tranches with varying strike prices or knockout clauses. The added complexity created an illusion of alignment and sophistication, but it further complicated projects’ ability to understand the predatory terms they were agreeing to.

#50 The DeFi Dirty Double Dip

The market maker swindles the founder's loan assets, plunging them deep into DeFi's moist depths of yield farming, as the founder moans in confusion, thinking they're in a monogamous liquidity relationship. The market maker has their way with them, exploiting their naivety to double dip into profits from yield farming and prop trading. The founder, now realizing they were nothing more than a side piece, cries out in betrayal, but it was too late. In the end, the DeFi dirty double dip was just another notch on the market maker's bedpost, a fleeting moment of pleasure before moving on to the next victim.

While the Kama Sutra sometimes permits polygamy, the Token Sutra strongly advocates for it as a way to maximise exploitation. This was of particular interest within Alameda's Bahamian offices, where the techniques were practiced religiously, both for work and for pleasure.

A common play was for market makers to secure token loans or VC investments, and be deliberately vague about specific details such as what the tokens can be used for, when they can be sold, which exchanges the tokens can be diverted to and the regularity and transparency of reporting. The omission of specific terms opened a loophole for market makers to siphon funds into whatever would produce the highest yield for themselves.

#69 The Big Brand Bondage

Market maker gags the founder with their big brand name, demanding complete submission and high compensation. The founder hangs onto every word from the dominating market maker, who promises support and exchange listings. Forced into an uncomfortable position, the token project still drools for the facade of legitimacy provided by their domineering partner, but is ultimately deceived by the illusion of prestige and security.

The Token Sutra taught market makers the power of leverage in forcing a subject to submit to their demands. Big brand funds, such as Alameda, leveraged their positioning within the industry. They overpromised on support, such as prioritized exchange listings, marketing benefits, and co-investment deals with top-tier VCs, in an attempt to "strong arm" projects into accepting a bad deal. This power became a core tactic for market makers to exploit projects for more fees, larger allocations, and more aggressive compensation.

During frenzied bull markets, support and focus would be directed toward more promising projects, and promises of potential exchange listings and after-market support were often left empty and at the complete discretion of FTX/Alameda management. Some projects like Reef Finance even faced the threat from Alameda of delisting from FTX and other tier 1 exchanges.

The FTX Raid

During the 2022 raid of FTX’s Bahamas offices, local authorities reported disturbing images of the cult-like worship of the Token Sutra. As they stormed the building, the air grew thick with the musky scent of stimulant abuse and desperation. The office led them to a back room where the Token Sutra was left on the floor, open with an evil aura emanating from its worn pages.

The news of the raid sent shockwaves throughout the crypto community. The fall of FTX was swift and brutal, leaving behind a legacy of debauchery, scandal and greed. As the dust settled, the once-proud empire lay in ruins, serving as a grim reminder of the dangers of unchecked ambition and the intoxicating lure of forbidden knowledge. The infamous mantra, "Om Liquida Shanti,"(Peace in Liquidation) echoed ominously, a haunting refrain of the destructive power of the Token Sutra.

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