DeFi Short Squeeze

Short Squeezes in DeFi and how Euler enables trading them.

In this article we’ll discuss:

• Wild short selling squeezes in the stock markets and what causes them
• How we’re about to witness the same phenomenon play out in the digital asset space
• How one could capitalise on that
• How Euler enables it for both retail and institutional traders through unique innovation

Let me tell you a Short Story

Remember the GME short squeeze?

I do. There I was, putting in ridiculous bids for GME, NOK and AMC call options in an environment where you could drive a truck through the bid ask spread and market makers would show up like Viennese cafe waiters, i.e. whenever they pleased. As a matter of fact, footage of me trying to request prices from Interactive Brokers in the first 10 minutes of the trading session:

Suddenly, I saw Nokia (NOK) 10 strike April expiry calls options trading at 0.30 USD (note: they were trading at 0.05 USD the day before) and I managed to buy stupid size at that price.

The next few days were history: a bunch of Wall Street Bets apes basically beat millionaire hedgies and market makers with hundreds of Ivy Oxbridge PhDs into brutal submission. GME, NOK, AMC and whatever was being shorted by the market skyrocketed as shorts sellers were trying to buy back the shares and mitigate losses.

My NOK options opened at 1.14 USD vs 0.30 USD the day before and we immediately hit a circuit breaker. Then 1.70 USD and another circuit breaker… then 2.00 USD until someone actually dealt at 5.25 USD. Given I was managing decent size for me and 3 other degens, hadn’t slept for 24+ hours and had a full-time job at the same time, “fun” was one way of putting it.

At the end of the day, we left some money on the table but it was worth the effort and fun.

But the real winner was Roaring Kitty: “20 million profit”

Why did buying GME work?

Mid-December 2020, my fellow market operator Jan noticed something: Gamestop (GME), a video game retailer, was significantly undervalued. The market was pricing imminent death of the franchise due to COVID lockdowns, whilst completely discounting positive developments within the company. And crucially, everyone, and I mean everyone on the street was shorting GME:

As a quick refresher, short selling means betting that a given asset will go down in price. In theory, you ask someone who is holding GME shares if you can borrow these shares subject to interest. Should they agree, you sell GME shares for cash. If GME price halves, you can use half the cash you’ve received upon selling GME earlier to buy GME back at a lower price and return it to the lender. The other half of cash is your profit.

Now in reality, this is done through your retail broker or prime broker like Goldman Sachs if you’re an institutional investor. Goldman would act as the intermediary between a large pension fund sitting on a bunch of stocks and hedge funds. Additionally, Goldman would loan the hedge fund money to be able to borrow more stocks than they can afford for leverage.

Why would someone keep shorting a stock that’s trading so low? Why not just cash in and leave? The reason is that hedge funds often fulfil a specific investment mandate like long/short equities. In theory, you are long a basket of good stocks like Berkshire Hathaway, Apple and Google whilst shorting a basket of scum stocks like Gamestop, AMC, Deutsche Bank etc. on a constant basis. This way, your investors are only exposed to the difference between the two baskets and don’t care what the general market is doing overall. You might close some of your profitable positions from time to time, but at the end of the day, investors are paying you for being long AND short.

This is where the apes come in.

Redditors picked up on Roaring Kitty’s pitch and started buying GME en masse. As they pushed it higher, some weak short sellers went underwater and decided to close their positions by buying GME. That pushed the stock even higher which emboldened the apes. The apes bought more, shorties covered, GME up, apes bought more… you get the idea: a feedback loop of victorious degeneracy. The apes smelled blood (and opportunity to move out of their mums’ basements), but they wanted more. So they started buying EVERYTHING that was heavily shorted: AMC, NOK, BB, MAC etc.

Melvin capital, a multi-billion dollar hedge fund that was shorting these names, lost half the AuM, Robinhood had to ban buying and that got Congress involved, AOC and Ted Cruz agreed on something… it was mayhem. And I won’t lie, I deeply enjoyed it especially because I used to work in institutional finance. Smug bankers got beaten at their own game by a bunch of degens, what’s not to like?

The point of this story is, you can make a lot of money by understanding market positioning. Sometimes, it’s good to be short because you think the intrinsic value of something ought to be lower. But sometimes, when everyone is short for the same reason… you can make a killing by taking the other side and going long. At some point, even a tiny uptick in price will cause an avalanche of buying and who knows, maybe you’ll get out of your mum’s basement too someday!

Back to Crypto

The digital asset space has been maturing. It has become a trillion dollar asset class with billions of dollars exchanged every day. That hasn’t been left unnoticed by the institutional trading crowd.

Now that the liquidity is there, multi-billion dollar hedge funds fulfilling various mandates like macro, long/short, volatility etc. are setting up crypto desks as we speak. Remember that long/short strategy in stocks we talked about? That’s coming to crypto, which means soon we’ll see traders doing spread trades between good tokens vs bad tokens which leads to short-selling volume.

These wild swings in equities you’ve seen above…

Are coming to the digital asset space with institutional involvement.

Euler

Euler is a permissionless lending protocol that enables anyone to create a lending/borrowing market on any token. Want to earn interest on your $FWB token? No problem. Lend it via our protocol, receive eFWB which entitles you to the deposited $FWB + interest.

What if you think their community is massively overvalued and will hit a snag soon? You could first lend (deposit) some eligible collateral like ETH etc. and receive your eETH. With that in your wallet, the protocol will allow you to borrow an asset subject to borrowing requirements.

For eg, if you deposit 100 USD worth of ETH, you can only borrow 20 USD worth of FWB. If you’re really certain it will collapse, why not lever up? Sell that FWB you borrowed for ETH, lend the ETH, get more eETH, borrow more FWB etc. until you hit the max allowed borrowing limit. Should FWB collapse, you’ll make a pretty penny as you’re leveraged.

If you’re an institutional trader, your job is also to think about risk management at all times. Basic risk management would be something like: “if FWB/ETH goes up against me by 20%, I want to be out of the trade with a loss of 1mio USD”.

You don’t want to stay short FWB/ETH as it’s going up >20% without being liquidated. FWB/ETH could easily surge by 100% meaning you’ll lose 5x your predetermined loss and probably get fired for lousy execution. This is the entire reason you have dedicated prime brokerages at banks like Goldman, JPM etc.

In legacy finance, it would look something like this:

Say you shorted FWB/ETH at 1 but the pair is approaching 1.15, you call up your prime broker and ask for a price.

Goldman: “Bid/offer is 1.18/1.22”

You: “Mine at 1.22”

“Mine” meaning “I buy at 1.22” in trading floor jargon (selling would be “yours at 1.18”)

Effectively, you’ve lost a bit more than 1mio USD as you’ve exited at 22% above entry price level instead of 20%, but given liquidity conditions, it was a decent price. Next minute you see some desperate short seller actually lifting an offer (“bought” in trading floor jargon) at 1.90 to cover his position. Phew, that was as close as it gets to arranging an interview with McDonalds!

Euler = Risk management

This isn’t legacy finance. To make sure you get liquidated reliably, we have technology!

At Euler, we have implemented mechanisms like stability pools and Dutch auctions to make sure liquidators have a huge incentive to liquidate your positions reliably. These aren’t just “nice to haves”, as predictable execution is crucial to drive institutional adoption and hence higher utilisation and higher volumes. Through these innovations we are putting Euler at the forefront of this inevitable trend.

You can read more about these mechanisms here.

Trading scenarios Euler enables

Imagine you’re a serious crypto trader (just for a minute) and you’ve been following the hypothetical rockbuyerDAO that invests in NFTs depicting rocks. Their token is trading around 5 USD and so far, their investments have played out well.

Then, you notice someone brought forward a proposal to outsource the investment research to a third party provider: Oakton Stratmont Investment Research. Governance passes the motion almost unanimously and Oakton is paid 5 mio USD per year in USDC.

Unlike rockbuyerDAO governance members, you are aware of the fact that Oakton is a scam. Their previous head of research was convicted of fraud and the people listed on the website don’t even have LinkedIn profiles.

You put on a huge short position vs ETH expecting imminent collapse.

Days pass, and the price keeps grinding higher against you. You add collateral to short more. It keeps moving against you and you’re very frustrated.

As you analyse onchain data, you realise that you’re not the only smart kid on the block. 10 other addresses have put on a combined short position of 12 mio USD and they’re all bleeding. This could quickly become a massacre, especially since average daily volume is circa 1 mio USD, i.e. they’d struggle to cover.

You start digging more diligently this time and schedule a call with Oakton under the pretence of seeking their services. The new head of research seems like a very knowledgeable guy with serious credentials, and furthermore tells you that he turned the entire place around just recently after the previous head was convicted.

You make a few calls and realise that he has real pedigree and has already done some high quality work for previous projects as an independent advisor.

This is big.

Immediately, you cover your short at a slight loss and buy rockbuyerDAO token in size. Oakton’s first investment proposal is an absolute killer and the token jumps by 10%, forcing some short sellers to cover their shorts and to buy the token. As the buying pressure pushes the token higher, more people are forced to get out, creating a vicious loop akin to what happened to GME.

You on the other hand are balling because you’ve:

1. Understood market positioning
2. Done deep due diligence
3. Cut your losses early and flipped.

All of this was enabled by Euler and its underlying technology, which will create permissionless markets on any token and crucially, liquidate you reliably when you are on the wrong side of the trade.

Risks

If what was described above fits your trading style, it’s important to understand the risks.

Liquidation: while we believe our innovations are a game changer, there is no guarantee that you’ll be liquidated. Which is why it’s important to understand things like:

1. Liquidity of your token (market cap, average volume, size of the liquidity pool)
2. Volatility (especially during tail scenarios)
3. Size of your position (also combined size of all short sellers) versus average volume
4. Idiosyncratic risks of the token (smart contract risk, centralisation risk, auditing etc.)

Luckily, we’re diligently analysing these things through our risk framework and will be publishing our views on specific tokens. Nevertheless, one should always do his/her own research.

Interest rate risk: when you borrow a token, you are paying variable interest. The more people borrow, the higher the utilisation rate, and the higher the interest rate. Higher accumulated interest owed results in higher debts, which may lead to unwanted liquidations.

Additionally, should most lenders withdraw their tokens from the lending pool, utilisation will skyrocket leading to increased borrowing rates.

Note: we are planning to cap interest rates in worst case scenarios to prevent massive liquidation spirals.

Lending risks: If you’re on the lending side, you’re at risk of not being able to immediately withdraw your tokens from the lending pool. This may happen if any of your tokens are used for borrowing purposes. Hence, it’s important to understand your share of the lending pool and withdrawal risk.

Conclusion

There is a plethora of trading strategies waiting to be deployed in the digital asset space beyond mere hodling, and we are excited to roll out our protocol to enable that. Through innovations like stability pools, Dutch auctions and many more things to come, we will support a resilient environment capable of accommodating traders of all sizes, from your average trader to hedge fund whales.

About Euler

Euler is a capital-efficient permissionless lending protocol that helps users to earn interest on their crypto assets or hedge against volatile markets without the need for a trusted third-party. Euler features a number of innovations not seen before in DeFi, including permissionless lending markets, reactive interest rates, protected collateral, MEV-resistant liquidations, multi-collateral stability pools, sub-accounts, risk-adjusted loans and much more. For more information, visit euler.finance.

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