Crypto Hacks and Efficient Markets

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Last week, there was a hack of a blockchain that resulted in the theft of over $600 million worth of cryptocurrency. The hack went mostly unnoticed for 6 days. I say that it went mostly unnoticed because some people did notice it and tried to profit off of this knowledge. Unfortunately for these people, they actually lost money. How is this possible? They had superior information than everyone else? Should they have profited? Does this mean that financial markets are inefficient? Frequent readers of Economic Forces might recall that I think financial markets are efficient (see here and here). So how can we explain this?

The unique thing about blockchains is that they record every transaction. If I buy a coffee from you with some digital token, the transfer of the digital token from my crypto wallet to your crypto wallet will be recorded on the blockchain. If we want to verify that the transaction went through, we can go to the blockchain to see that I did indeed pay you. The thing is, as long as everything goes right, neither of us will probably check the blockchain. We don’t need to check the blockchain. The blockchain is a distributed ledger. The nodes on the network are verifying that these are valid transactions.

However, if you want to check the blockchain, you can. Some people do. In fact, sometimes there is valuable information on the blockchain. When someone hacked the Ronin blockchain (an Ethereum sidechain affiliated with a game called Axie Infinity), it was evident on the blockchain. You can see the hacker’s digital wallet here. There is 175,000+ ether in that digital wallet with a dollar value of about $600 million.

The amazing thing about this hack is that, if you were looking at the blockchain, you could have seen that the hack had taken place. Transactions that consist of 180,000+ ether should raise a red flag. But that is not all. The hacker also took over $25 million in the USDC stablecoin. Again, you can see this transaction on the blockchain.

Yet, despite the fact that all of these transactions were on the blockchain, nobody seemed to notice for 6 days. Or did they?

While the news took days to break, there were some people who were apparently checking the blockchain, but here is where the story gets really wild. The people who noticed that the sidechain had been hacked decided to profit from this knowledge. These enterprising blockchain readers decided to short the digital token associated with Axie Infinity. After all, they knew that there was a hack, no one else seemed to know, and surely this revelation would tank the price.

Easy profit, right? Wrong.

What actually happened is the Axie token rose 25% over the next two days in conjunction with rises in other crypto prices. The people who shorted the token had their short positions liquidated. While the token price did drop 7% immediately on the announcement of the hack, the price is still higher as of this writing than it was on the day of the hack.

I bring up this example because this is the sort of story that gets sent to me as evidence that markets do not work or that financial markets are inefficient. But is that really the lesson?

The short answer is no.

One might expect that the price of the Axie token would collapse when the hack became public knowledge. However, it is not obvious that the price should collapse. The Axie token isn’t a stock. In other words, it is not a claim to the future profits of Axie Infinity. The token is needed to play the game. In addition, the token gives one a say in the governance of the protocol. It is not a claim to the flow of profits of the game. It is not even a claim to the underlying assets owned by Axie. Thus, one might expect the hack to cause the price to fall because the hack reveals insecurities associated with the game, the sidechain, or both. In that case, one would expect the price to decline. However, since the token is not a claim to any of the cryptocurrency that was stolen, it is not obvious that the Axie token is really worth that much less than it was a week ago.

A bigger lesson for financial markets more generally is that arbitrage is almost always risky, even when one has superior information. In this case, people who knew with certainty (it is on the blockchain!) that there was a hack were not able to profit from this information.

What happened here reminds me of a frequently cited example that is supposed to demonstrate the inefficiency of financial markets. It is possible for the same asset to trade in two different places. Maybe you can buy shares of some Japanese company in both the U.S. and Japan, for example. Since these shares are both ownership claims in the same firm, they should have the same price. But sometimes they have different prices. This doesn’t seem to make sense. In fact, many argue that this is a sign of inefficient financial markets. After all, one should be able to earn a risk-free profit by buying the lower-price version of the stock and selling short the higher-price version of the stock. Eventually, the prices will converge.

However, is this really an opportunity for risk-free profit? If it is, why do these differences not get immediately arbitraged away? The answer is liquidity risk. When I short an asset, I am borrowing shares of that asset from someone else and selling them. To close my position, I need to buy shares of that asset and return them. I profit by selling high and buying low. In order to make this trade, I am going to have to post collateral (cash) to make sure that I can close my position. In the event that the price rises, there is a chance that I won’t be able to buy back the shares. Thus, when the share price hits a particular level, my collateral will be used to buy the shares and the shares will be returned. I take a loss on this position.

Now, let’s return to our examples. In the case in which shares trade on two different markets, it might seem easy to make a profit. Buy the low-priced shares and short the high-priced shares. When the prices converge, this yields a profit. It might not be that easy. Suppose that I take these positions and the company announces record earnings. In this case, the price of the stock might rise substantially in both markets. In fact, if there are differences in the transaction volumes in the two markets, the spread between the prices might actually increase. If this happens, my short position could get liquidated at a loss and my long position might not have sufficient gains to cover the losses. What seemed like a risk-free profit turns into a loss.

This is similar to what happened in the Axie case. The people shorting the Axie token had superior information to others. Yet, they not only weren’t able to profit, they actually lost money.

Markets are a discovery process. In financial markets, people are trying to determine what particular assets are worth. As more information is known, this affects people’s perceptions of what the asset is worth. But everyone has different views of what something is worth. This is precisely the reason that people are trading. They think they know what the price should be, the price differs from what they think it should be, and they try to profit from the discrepancy. People like to sound smart and say that price equals fundamental value, but the fundamental value itself must be derived from some model.

There are several lessons revealed by these examples. One lesson in all of this is that not all information is necessarily useful information. It seems like knowledge of the hack would drive down the price of the Axie token. Nonetheless, it is not obvious. Maybe the price is primarily driven by the supply and demand of the users in the game. The fact that the sidechain was hacked might not have much of an effect on those users.

A second lesson is that even when you have superior information, the market can move against you precisely because others don’t have that information. If the market can move against you longer than you can stay solvent, then there is risk involved. Your arbitrage opportunity isn’t risk-free.