The 1010 Exploit and other broken market structures

All right, guys. Today we have on Lucas from World Markets. I wanted to say World Capital Markets, but World Markets. And then Hersh, well-known god tier poster, one of my favorite accounts, follow who is working with world markets on go to market and business development.

Welcome, Lucas. Give us a little bit of background. We're going to spend more time on your background because I think people are going to find it really interesting. But yeah, just give us like a brief overview and then Hersh you can do the same after.

I started my first crypto company in 2017 that was a derivatives exchange backed by Susuana the headquarters in Philadelphia and we sold that business to Amber Group in 2021. The business was from a technical perspective onchain custody, onchain settlement, offchain matching, which is what any engineer will tell you you should build if you want to have a trustful setup without sacrificing performance.

The really counterintuitive insight in that business which we had like 2 and 1/2 3 years into building it and at peak we had 60 employees 40 full-time engineers very smart people with PhDs etc. There is a relationship between state synchronization and the risk calculation which without all the technical jargon really means the following. If you want your users to make as much money as possible for a certain risk profile, like a given risk profile, then you actually have to build an entirely centralized or an entirely onchain architecture, including the matching engine.

So that's super counterintuitive and it's with that insight that world markets was created. So in 2022, we started thinking about where the exchange space would end up in terms of crypto and that insight and kind of the conclusion suggests that either we need to build something centralized like hyperlquid and what they did starting around a similar time or we need to adapt our view of the world and believe that eventually the EVM will it fast and cheap enough to support a fully on chain X with all the functionality that is really required for proper usage and we went with the latter approach not knowing whether it would be two years or 10 years.

We started a hedge fund in parallel that does today reasonably successful and does a lot of trading in DeFi and CFI and then eventually we actually first learned about Monad and kind of joined the Monad ecosystem and kind of really started to understand more about their technology and their ecosystem. Then members of the same team met East and really started to lean into like Megie's core technology and value proposition and comparing the two.

And when we fully understood what Megith was doing, we decided like now's the time to launch the business. Because they have the technology that kind of fulfills this thesis. And so that's how World Markets was born.

Wait just quickly since you're on this topic you said you initially were looking at monad and then decided on mega e what was the rationale there and like it tell me if I'm incorrect in believing this but was the thinking that it's just much more difficult when there's a decentralized validator set versus a single sequencer to do what you wanted to do or is there more to it than that?

There are really two parts of the puzzle. One is ecosystem and two is technology. Technology being really being the priority for us because the success of an ecosystem is very hard to bet on. They're just so many more kind of variable external external variables. Whereas as long as the technology works to the level we needed to the ecosystem could actually fail and we would still have a business.

So the first thing on the technology side was that we actually believe in the in the L2 thesis meaning that if you're L1 there's this dilemma between the apps and the token holders because the token the network token is also the gas token. So token price goes up you benefit the investors but at the expense of the apps you know vice versa you could also benefit the apps at the expense of the investors. L2s don't have that dilemma because the gas token is not the network token.

So that was a really big one and kind of then tying into the ecosystem when we would ask monad folks these questions it felt like we were punished actually for asking things. I don't want to get too much into sort of the um kind of experience there but it wasn't an especially like kind of you know op open anonymous experience. And then you know on the the other thing is like just speed and and cost.

So Mega ETH is you know a heck of a lot faster. And obviously that's because Monad is running more decentralized than Mega is. But we felt that tradeoff made sense given kind of you know our business model. And then you know the ecosystem Megie's ecosystem is everybody can form their own view. My view it's meaningfully better and so that was kind of a cherry on top.

And working with Elong and Shu and Nomir and kind of the rest of the eco team has been really good.

Okay so then let's go back to your like trading experience. What were you trading? You said you like ran a hedge fund. So wait just for a little bit context you said you sold your business to Amber Group. Was that the hedge fund?

Yeah that's right.

Okay. What was that was the derivatives exchange.

Okay got it. All right. And so then you started a hedge fund and that's and for the past five years you've been trading on chain.

Yeah, we approximately maybe four. So we started prop well we started really building this is a a rabbit hole. I'll give you kind of the go. So we started building trading infrastructure because I actually wanted to start a hedge fund in 2022 and the CEO of of my first company wanted to do it together and kind of called me.

So we started looking into it and found that the infrastructure was so primitive for DeFi trading that it actually made more sense to start a tech business and then service like these future clients. And really where that business ended up was we started focusing on security. So here's the crazy thing about DeFi trading and which is true today by the way. Every firm that operates on chain, almost every firm, I would say like nine out of 10, maybe 19 out of 20, runs the risk of the avoidable risk of losing basically all of the money at any given time, not due to a protocol hack, but due to transaction security, which is this topic that like everybody seems to ignore.

So what I mean by that is the most popular custodian for DeFi historically and and today is Fireblocks for institutions. If you go into Fireblocks's policy engine, this has been true forever. It's true today. It's nuts. And you set unis swap like let's say you're trading on unis swap, right? And you go into a policy engine and you you say okay well this trader can trade on Binance but they can't trade more than this amount of money. they can't withdraw, whatever it is, right?

You set those settings and you do the same thing on unis swap even though it allows you to like set the settings. It doesn't enforce it. So you can literally just steal the money as a trader or if it's automated trading, which it usually is, then you just inject a bug in the code or you know you could click the wrong button. So, and the way you do it is you what the policy engine checks and they now have like a manual kind of side process to try and prevent this, but it's also I mean it's I just think the whole thing's a joke.

But the policy engine checks is the from field and the to field of the transaction. So, it says, okay, is the transaction coming from the wallet? Yes. All right, good. Is it going to unis swap? Yes. Okay, no problem. And then it totally ignores the instruction set.

So the instruction set could say okay when it gets to unis swap and does the swap from like a to b right set the recipient address of the swap which is a parameter in the function to my private wallet. So I'm swapping A for B send all of B to my private wallet. You can do that in Firefox doesn't check.

Interesting. So we built a solution to that problem and I went around to the plus like the trading tech and eventually went around the market and it's it was a pretty crazy experience because you would think that that would just sell off the shelf. What I realized kind of you know after doing that for a number of months and is that the reason Fireblocks doesn't solve the problem is because the market for it is so small. There historically have been about 20 businesses that actually trade on chain and it's really more like 10 with like you know another 10 as like a buffer globally period.

Recently that number has been increasing materially because of like the recent bull run but from like 2022 to like 2024 say like early mid I mean it was it was nobody.

Okay so the first chain like yeah there was a rabbit hole by the way. No no that it's it's interesting but let me like let me interrupt for a second just like again to provide more context as we now lead into what you're building now. When you say you're trading on chain, like talk to me about what type of strategies that looks like. Like were you doing sex orb? Were you doing any stuff? Were you doing like latency? Like what would

Okay, so you were trading like just for some like interesting background like you are trading against like Wintermute and SCP and all of these on.

Okay, got it. And what was like in so when you started this hedge fund in your mind you were looking at the market like this is wildly inefficient because Ron's 12 seconds behind you know the real world what was in your mind like what was the big alpha you had like what what made you successful just out of curiosity with like yeah trading on chain yeah that's a great question so it's a combination of two things one is that we are pretty technical so I was the CEO of the company so everybody else on the team is way more technical than I am.

And I was the CTO of my first company which wrote the largest Ethereum codebase globally, the derivatives exchange. At least to my knowledge. I think that was validated by consensus diligence at the time. And then our approach was a little different. So we run what's called a multi-manager hedge fund, which is like is this a prop shop? We started out prop and then we launched it as a fund.

Oh, sorry, sorry. But is this a pod shop? Is it like that equivalent for

Okay, that's exactly right. So we actually So like we have internal trading but really where we like we we basically don't invest in that. So more for for all practical purposes like we've done internal trading but the way the business evolved is we actually stopped the internal trading or or did it on small sizes and spent all of our resources on sourcing every single trading team in crypto CFI or DeFi and then onboarding them onto our infrastructure to capture the alpha and run the strategy on our infrastructure legal and technical and that creates this kind of diversified portfolio where it flattens volatility.

And then finding like cheap sources of capital to apply leverage to the portfolio as a whole. And nobody had done that with any kind of I mean almost nobody's done that did that in crypto period but like especially within DeFi, right? Like nobody had done that in DeFi. And so because we were able to get this like unique view on the market as a whole because I know what every trading team is doing, you know, that's willing to take capital. Well, I don't know what SCP is doing, right? They're not going to take capital from us.

But say you're like, you know, like Subway, right? We work with them specifically, but you know, you're you're three to five man me shop. I know what all those guys do like down to the wire. And when you kind of you can kind of like cross-pollinate and like, you know, for all like HFT and centralized trading, we can start to combine those. And that was sort of our edge and still is today.

Okay. Wait, so just one one last thing. Are you still is the hedge fund still active?

It is. It has a full-time team, full-time co-founders that don't do anything world markets related.

Got it. Uh, did you have do you have experience in Tradfi?

My first company, the reason that I have sort of Trafy knowledge is because I just got exceptionally lucky is is the honest answer. I think a lot of us did. Right. I'll give a very brief version of my life story not to get too deep into this topic but I was born in North Carolina in like a really small town. So, you know, dad had like a construction crew about five people. And my mom was a stay at home mom originally and then just get a little bit more household income became the equivalent of like a school teacher like 3,000 people in my town and I moved to Germany on a government scholarship as a teenager just because I wanted to kind of leave and then moved to Morocco, learned Arabic just for the giggles.

And then uh moved to Hong Kong for college cuz I wanted to basically like I went to school for computer science. They offered me a scholarship. I wanted to go to school in Asia cuz I never been there. I didn't at the time it was like I felt like I hadn't learned anything in school and I learned a lot living abroad. And so it was like let's just do more of that. And you know I didn't have to pay tuition or boarding. So it's just kind of a no-brainer. Really transformative sort of experience.

And so what's crazy is when I was a a sophomore or a junior in college I was an early adopter to like blockchain tech at a time when everybody was sort of laring about it but nobody knew what the it did. And because Hong Kong is a little small and I had unique knowledge of the technology, I was kind of I like for a little while I was like the guy in Hong Kong or one of the main guys who understood blockchain tech and if the thing about Hong Kong is that there's it has very limited technical capabilities but the financial industry is booming and financial services etc.

So my first company like the CEO and my co-founder essentially brought Goldman Sachs to Asia like he was a partner of Goldman for a long time. His boss was the the president of Goldman Asia. He was head of co distribution. So head of sales for golden age I think like actually Japan PhD at Chicago and you know finance and just like just a a resume and background and credibility that I had never seen before much less like worked with and then he brought on two tenure chaired professors at Harvard who created Harvard's like fintech program who and like when you hang out with them like 20% of the conversation is like they're mutual friends who have Nobel prizes in economics.

So like and like I just fell in because I'm like the crypto kid tech guy, right? And so you know I was just lucky enough to kind of like that serendipity happened. And I worked hard. I didn't I slept four hours like at most four hours at a time for years because I was worried that like too much in the world would happen while I was sleeping for me to like keep up with it and like take advantage and like you know execute on the business side which I think they saw and they were like Jesus Christ this kid like you know they're like when do you sleep?

So I learned everything traditional markets related from them. uh obviously asked a heck of a lot of questions and so even though I've never worked in traditional markets like our BD team was like Goldman Partners and MDS and all this stuff and it was hilarious is like I have friends from college who like went into investment who like work at Goldman now they've worked at Goldman for like 10 years. And they have like a you know the thing about finance is that it's actually shockingly simple. It's one of the simplest industries I think like I've ever seen.

But it's also like it's deceptively simple. Meaning that there are a thousand ways to do something and five of them are right. And if you don't know the if you haven't like talked to the person or read the research or understood the literature, if you don't know the history of the evolution of financial markets, you don't know those five ways. And I can give a lot of examples in DeFi and CFI.

So so it's deceptively simple but if you know kind of how things were properly structured then it's actually not that hard to understand.

Okay so then like okay that that now we can kind of come into what you're working on now. So what was then the motivation for world well first of all explain world marketers because I've done a number of so I've done actually a podcast with like seemingly everybody building a perex right now at this point. So it's right it's like quite a competitive environment and everybody is I think competing on fairly like similar dimensions but it does seem that you like part of the reason that I you know wanted to have you on is because I think you guys are doing something somewhat unique.

So like talk to me about like world markets and then what the kind of design of it is and what you're hoping to achieve. Yeah and I I totally agree. So the funny thing about the origin story is like you know so after selling to Amber in 2021 I took a step back from crypto because you know it's it can be sometimes you're like you know is it worth it right? Like are we really saving the world here? And I looked at quantum computing because I thought that was and I I built some like um kind of like circuits on like IBM's quantum computer.

I looked at brain machine interface uh the medical applications and you know I thought to myself like what business can I build which kind of moves humanity forward and is also like relatively unoccupied from a competitive advant right like I don't want other people sort of just working on the same thing and the obvious answer if you just look at kind of the world as a whole is humanity really needs another perex That was the only like I could not agree.

So yeah, right. It's like Jesus Christ. So world markets is per spot and lending all on one venue under a unified risk engine, fully on chain, fully on order books. That's the the product. The reason it's important is because users on world markets make more money for less risk than anywhere else in crypto at least to my knowledge. Conditional on there being a comparable level of liquidity. So you can't do anything about liquidity. As long as liquidity there, there is no other venue in crypto where you're going to make more money more safely.

Let's dive into that. What does that mean in practice? Right? There are uh two parts. There's a financial component and a technical component. I'll touch on the technical component briefly. Metallic wrote this great article called lowrisk defi basically saying that Ethereum's product market fit is you know like Ethereum has at any given point a little bit worth it like hundred some billion dollars of TVL right it's you know slow expensive Ethereum right so where what the is all this money doing here well it's because there's real product market fit in safety like I don't care what you are buying I don't care if it's milk at a grocery store.

You're going to go to the grocery store where you have a lower chance of getting mugged, right? And Ethereum pushes the bounds on safety. So that's thing number uno, the technology and sort of the safety associated with being fully on chain, transparent, deterministic, there's no internal trading desk that's rugging you, blocking your orders, like so on and so forth. All right. Then there's the financial component of it, which is if you can correctly calculate risk, then you unlock additional returns for your users.

And nobody's really done that yet. Binance has similar features, almost basically the same features actually for certain markets where they own the asset. the end soul they're like the dollar and the ETH rappers that they own I believe Athena as well USD they don't offer this for markets that where they don't own the asset because they're centralized and whatever the they want and you know that kind of thing so we do we offer it for Bitcoin for Ethereum you know for your majors I can walk through a trade that will sort of illustrate that but the simplest explanation or the simplest version is let's say you're trading per hyper liquid.

You know, let's say you have $1,000, that $1,000 just sits there. On road markets, you can lend that $1,000, get 78% interest, and use the loan as collateral to trade your pairs. That's like the simplest example. You can then kind of layer in more complex examples and arbitragees on the exchange and across exchange but at its core it's like correctly calculating risk which has a bunch of dependencies that are very nuanced which I will kind of skip but does that answer the question?

Yeah, I think so. I mean if you want to like dive a little bit more into that like I think so my initial understanding is that this is first of all it's a form of cross margin is that correct like or yeah and well maybe talk a bit about that because that's something that people have wanted for quite a while and is only now I think on the current perex is really being implemented and I think it's quite well it can be quite difficult from a risk profile if you're allowing like just all of the assets to be collateral at once it really kind of like can create this house of cards dynamic if the risk isn't you know like really well implemented.

So maybe talk a bit about that and also yeah like am I correct in saying that's sort of the reason why this hasn't taken off yet on on dexes specifically?

So okay so I'll start with the first question. But yeah your intuition is is exactly right. So cross margin as it's implemented today just allows you to take your unrealized P&L from one per and use it as collateral for another purp. That's that's the whole thing. It also means that if one position triggers a liquidation, it will liquidate all of your positions and that's the risk.

So that is now if you take that core concept, you've introduced more capital efficiency than isolated margin. Now, where it gets really interesting, and I'll kind of tell you why I think the risk of this like liquidation risk is like something that is like I don't say easy to mitigate, but you you'll kind of see where I'm going. So, if you take that core concept and you expand it to lending, per spot, etc., some categorically new uh things happen, right?

So on world markets if you do the basis trade you can make 50% returns 50-0 for very little risk and at least I think almost everybody would say very little risk. It's not risk- free but it is low risk for sure. Um on hyperl you can make if you're lucky like 7% on the same trade. So the you know the unlock is meaningful. Now how do you then what about liquidations? How do you kind of like manage that?

The first thing is that the liquidation levels on world markets are lower if you're long than hyper liquid, meaning that they're safer. So and the reason is because like if I'm long ETH, let's say I'm short ETH per and I hold ETH spot, world markets understands that they have the same underlying asset and will then like only factor in your net exposure or it will primary factor in your net exposure to the asset and your risk calculation.

So the the liquidation price on your per let's say that you're long you if you're using isolated I'm just making up some numbers here but you know ETH may be trading at like 3,000 and it's pretty typical for your liquidation price to be like 2900 2800 right if you're long ETH let's say you're like reasonably collateralized on world markets if you hold like if you hold ES spot on Hyperlid like that's how that works on world markets if you're long ETH and you hold Espot your liquidation price is going to be like $500. Like ETH has to have $500 to get liquid. It's like none.

Like the chance is very low of that happening. So and then the other thing is like what I where I think the market will evolve is um with isolated margin every trade is separate. And if you're trading meme coins like that's probably where you want what you want to do or like super like crazy stuff. But if you're trading the majors or even just kind of like higher quality assets that aren't going to zero, what you really want is something in the middle.

Meaning like you probably want cross margin as like the default feature, but you want to separate your portfolios into different accounts either different sub accounts or different wallets so that you're like maybe this is like these, you know, this set of stuff maybe maybe this trade I just want isolated. So I'm just going to like throw it in this account, right? give it a little bit of collateral. These two trades, they're correlated or they're anti-correlated and so I'm going to package them together because like you know that isolates the risk, right?

And like it's unlikely that they'll get liquidated. You see what I'm saying? That configuration is actually like how you're going to manage your risk. And kind of what people are doing in traditional markets.

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Okay, now back to the show.

I heard you talking also um about ADL u circuit breakers, maybe a little bit of like remin. First of all I want to ask since you ran a hedge fund now stepped away but were very much involved in in this domain. Uh what do you think like about 1010 and how it was handled? I mean, was there anything I So, obviously there's rumors and then I've heard le I think obviously second or third hand, but um I've also heard from more s slightly more credible slashsubstantiated sources that there was some real shenanigans going on on some of these centralized exchanges potentially.

Um you have any thoughts or insight there?

Yeah, I think that 1010 was just a perfect illustration of why centralized exchange trading is. And like here's what people don't fully understand. Centralized exchange trading is not because the exchanges are untrustworthy. Like yeah, that is a big problem. And that's definitely true in my mind. And it depends on the exchange, but on the whole that's true. Centralized trading as because it's like actually more than people think.

So once you get into like the really like the more sophisticated stuff which is the prime brokers and the you know off exchange clearing and credit lines and uh you know like working with different lenders and LP like trading really professionally in the centralized exchange world or just the centralized world it is like un let me give you an example. So I won't say um who this is so I can say more about it but good good I like it uh two funny well one the fund does not put capital on exchange it's actually in our mandate uh as a requirement of of our LPs that we only use off exchange settlement because of FTX right and sort of the broader concerns so the way that works is we actually borrow capital and put the borrowed capital on the exchange and typically the lender takes that risk and we pay the lender to take the risk.

One of the main prime brokers we use and are actually like kind of the prime broker for crypto at the moment won't say who like I at least 25% of the time no maybe that's a little bit much 20% of the time 15 20% of the time they have no money to lend us and the accounts are in their name what that means is like when we need to trade like hey you know we need to move we need to like whatever it's like our job to trade we need to move capital into this account so that we can like get up this arbitrage strategy or whatever.

They're like, "Sorry guys, we can't give you any money." So then the next obvious question is, "But what if we just give you the money to give to us, right?" And then they just take the risk, right? It's almost like an insurance policy.

Yeah. They still can't do it. Like we can't give them the money to then put in our account.

Okay. Wait, let me ask you something. Because operationally they are not capable of doing that. Is this standard? Like are all the big trading firms using this?

It's so It's crazy. This is so weird. So, so wait, this is what nobody talks about because the worlds are like bifurcated. You're either in the centralized exchange world doing this kind of or you're in DeFi. Nobody kind of sees into the other. At least not with this level of granularity.

So, wait, like let just like reiterate this for me. Trading firms go to a prime broker who you guys wait. So, do you send them money? You don't send them money first, but they take the risk on the exchange.

We give them collateral. Okay. You give them collateral and they hold it somewhere in a separate account and then you are then allowed to effectively trade their capital through your own account on the exchange using our collateral.

That's right. That is super bizarre. That seems like one of the most like inefficient Yeah, that's how it works. Unnecessarily like intermediated system. So in and the the rationale behind that is because LPS literally are not willing to to accept the exchange risk moving large sums of money on so like but that that's really bizarre billion dollar New York hedge funds are like this no chance really that's fascinating.

So they won't even they they basically don't trust Binance. I mean I I'm Jesus. Yeah at all. Wow. I mean it depends on who they are. Like Asian LPS tend to trust Binance a lot. uh New York LPs if they're very cryptonative, like most of them do, some of them don't, but if they're running like 20 billion dollars, which by the way doesn't exist in crypto.

Yeah. Um and this is like some whatever the percentage of their portfolio and they want to kind of see what happens. No. no. Not a chance. That's fascinating. So, but okay, but to to to contrast this, you can deploy your own capital like no problem in DeFi, right? like that you can just directly deploy it.

Okay. Are LPs okay with that risk?

So if you're you have a trading strategy that that that employs like maybe sex or just purely onchain, you know, um some type of arbitrage, it's kind of like case by case. Yeah. Like historically these LPs are also not okay with DeFi. They're kind of okay with it, but they're not okay with it at like some very large size, right? Um so um yeah, that's a totally fair point.

I think the difference is that like the way counterparty risk gets managed is very different and the the kind of true nature of the counterparty risk is different. So the centralized exchange world it will continue to evolve but it like it's now been a while right like FTX we were now several years past FTX and you know the industry was around several years leading up to FTX. Um, and so it evol we it's kind of at the point where like it moves, but it moves slowly and like yeah, it's going to be different in 10 years, but it's not like kind of cutting edge right?

So, this is kind of what it's going to look like. Uh, maybe a little bit different like 10 years from now. And it's not there's no it can't change. There's nothing different about the there's literally nothing different about the tech, the infrastructure or anything. Whereas DeFi, it's less about like changing. I mean the market structure definitely needs to change but I think that people are able it's more about like people will get comfortable with the technology.

Does that make sense? Yeah. It's not so much that like Yeah. So once people understand the tech like once people understand Binance and they understand the industry and they understand you know like the risk profile they're like no this right like it's not an understanding issue. So let me give it's like yeah there's like a hundred billion dollars sitting in this in safe for example there's $10 billion sitting in Morpho everybody can read the code and if anybody including the very well- paid people in North Korea to find a vulnerability they get to keep the money right they're like okay I see okay so let me give a slightly like uh question leading coming from that so how do you think okay so yeah like everybody can read the code it's verifiable And but you you mentioned morpho which is like very different than hyperlquid right.

So how do people respond to for example in your opinion the the hyperlquid handling of of 1010 ADL in general and maybe also just to finish up you can lead into your thoughts on circuit breakers and how you kind of think there are these you know circuit breakers are just not really publicly available especially on on centralized exchanges.

Right. So yeah so Hyperlid is totally centralized. It's no more decentralized than Binance. Now, Hyperlquid what they did differently and they're kind and and is a major contribution to the industry is that they're extremely transparent. So, they're not any more decentralized, but they are like categorically more transparent and I would say like trustworthy on the whole. Now, that's a it's good, but it's also kind of a problem because like you know this, you know, they just stamp like decks on their name.

Like I call it the glue theory, which you can just glue anything to your name. Like that's not going to like work forever. And so that's sort of the issue there. Now, going to like ADLs and circuit breakers. So the problem with so their their transparency is self-reported data, right? And that's like the huge categorical difference from Morpho. Like I don't ever expect Hyperlquid even though they've been incredibly successful to have even a small percentage of the capital that Morpho has on it.