Reflection and Outlook at Dusk of the Encryption Industry

The year 2022 was a challenging one for the encryption industry. From the collapse of Luna to the bankruptcy of 3AC, and then to the downfall of the FTX empire, a series of negative events cast a shadow over the entire industry.

In the face of these events, we need to think calmly, learn lessons from them, and make reasonable judgments about the future of the industry. This article will explore the correlation of multiple black swan events, the changes in the decision-making process of centralized institutions, and the trends of future market movements.

Three Major Black Swan Events Stirring the Twilight of Exchanges

In 2022, the cryptocurrency industry faced a significant turning point. The destructive power and influence of the three major black swan events involving Luna, 3AC, and FTX far exceeded that of previous years. Tracing back to the roots, we find that the seeds of the crisis had long been sown: the FTX incident can be traced back to the collapse of Luna, and recently disclosed internal documents also confirm that FTX's losses originated from an earlier period.

Observing the source, anyone familiar with DeFi principles can see that this year's rapid collapse of Luna is a typical Ponzi scheme: abnormal market conditions and a swift bank run led to the instantaneous evaporation of Luna worth billions of dollars. In this incident, many centralized institutions were inadequately prepared for market risks, resulting in excessive risk exposure. For example, 3AC quickly transformed from a risk-neutral hedge fund into a one-sided gambler.

After that, a series of crises unfolded. In June, many institutions held asymmetric positions, using high leverage to go long on Bitcoin and Ethereum, blindly believing that certain price levels would not be broken, leading to mutual lending among institutions. Subsequently, we witnessed the occurrence of the 3AC incident. In September, as the Ethereum merger was completed, signs of market recovery appeared, but an unexpected event triggered the collapse of FTX.

From a business competition perspective, the FTX incident may have been a targeted strike against a competitor's financing. However, the situation took an unexpected turn, causing market panic, as Sam's financial black hole was exposed, leading to a rapid bank run, and ultimately the swift collapse of the FTX business empire.

Among these three major black swan events, there are several key points worth pondering:

1. Institutions can also go bankrupt. Large institutions in North America have misconceptions about risk management and the encryption world, leading to a chain reaction. The transmission of unsecured credit among institutions is extremely strong.

2. The quantitative and market-making teams will also suffer heavy losses in extreme market conditions. The market experiences severe fluctuations, especially during a downturn, leading to a crisis of trust among institutions. A large amount of funds flee, resulting in a severe lack of liquidity. The market-making teams are passively forced to convert high liquidity assets into low liquidity assets, facing the predicament of locked positions that cannot be withdrawn.

3. The asset management team has also been impacted. To provide returns to investors, the asset management team needs to seek low-risk or even risk-free returns in the market. Achieving α returns primarily involves lending and token issuance. The former generates returns by lending market liquidity, while the latter issues tokens to the market through consensus mechanisms, ICOs, and DeFi mining. The asset management team has accumulated a large number of lending assets and related derivatives during its operations. Once institutional defaults occur, lending assets and others will trigger a chain reaction, facing significant impacts in extreme market conditions.

This evokes the traditional financial market. The encryption market has completed in over 10 years what took traditional finance more than 200 years, featuring excellent cases as well as recurring issues seen throughout the history of traditional finance. For example, the large-scale hollowing out of commercial lending by banks reappeared in the FTX incident. These problems seem to point towards operational errors of centralized institutions.

At the same time, the FTX incident also marks the arrival of the twilight of centralized exchanges. Globally, people are in a state of extreme panic regarding the opacity of cryptocurrencies, especially centralized exchanges, and the potential chain reactions that may arise. Data also confirms this assessment, with a significant number of users transferring assets on-chain in the past month.

Before dusk arrives, the private key loses in the struggle against human nature:

Although the ownership of underlying assets in the encryption world is guaranteed by private keys, the lack of a reasonable third-party custody institution to help users and exchanges manage assets over the past 10 years of development in centralized exchanges has led to opportunities for exchange managers to touch user assets, thus combating the human weaknesses of exchange managers.

In the FTX incident, the influence of human nature seems to have been apparent long ago. Sam has always been a person who cannot sit still. He often works overtime and stays up late, never allowing himself or his funds to be idle. During the DeFi boom, he frequently transferred large amounts of assets from the exchange's hot wallet to various DeFi protocols to mine tokens.

When human nature craves more opportunities, it is also hard to resist more temptations. A large amount of user assets are stored in the exchange's hot wallet, and using assets to obtain low-risk returns of ( seems to be taken for granted; from staking to DeFi mining, and then to investing in early-stage primary market projects, as the returns grow larger, the behavior of misappropriation may become more rampant.

The black swan event has shaken the industry to its core, and the lesson is clear: for regulators and large institutions, they should learn from traditional finance and find appropriate ways to ensure that centralized exchanges are no longer managed by a single entity that simultaneously takes on the roles of exchange, broker, and third-party custodian; at the same time, technical means are needed to make third-party custody and trading actions independent of each other, achieving an unrelated interest. If necessary, regulation can even be introduced.

Outside of centralized exchanges, other centralized institutions are facing significant changes in the industry and also need to make adjustments.

Centralized Institutions: From "Too Big to Fail" to the Road of Reconstruction

The black swan event not only affected centralized exchanges but also impacted centralized institutions related to the industry. The reason they suffered from the crisis was largely because they overlooked the risks posed by counterparties ), especially the risks of centralized exchanges (. "Too big to fail" was once the impression people had of FTX. This is also the second time hearing this concept: in some group chats in early November, most people believed that FTX was "too big to fail."

And the first time, it was SuZhu who said: "Luna is big and won't fall, if it falls, someone will come to save it."

In May, Luna collapsed.

In November, it was FTX's turn.

In the traditional financial world, there is the concept of a lender of last resort. When large financial institutions experience severe events, there are usually third-party organizations, or even government-backed institutions, that conduct bankruptcy restructuring to mitigate risk impact. Unfortunately, the encryption world lacks such mechanisms. Due to the underlying transparency, people analyze on-chain data through various technical means, leading to very rapid collapses. A small clue can trigger chaos.

This phenomenon is a double-edged sword, with both advantages and disadvantages. The benefit is that it accelerates the bursting of bad bubbles, allowing things that should not happen to disappear quickly; the downside is that it leaves very little opportunity window for investors who are not very sensitive.

In the process of market development, we maintain our previous judgment: the FTX incident basically marks the dawn of the decline of centralized exchanges. In the future, they will gradually degrade into a bridge role connecting the fiat world and the encryption world, and will address issues such as KYC and deposits through traditional methods.

Compared to traditional methods, we are more optimistic about the more open and transparent operational methods on the chain. As early as 2012, there were discussions in the community about on-chain finance, but at that time it was limited by limited technology and performance, lacking suitable means of support. With the development of blockchain performance and underlying private key management technology, on-chain decentralized finance, including decentralized derivatives exchanges, will gradually rise.

As the game enters the second half, centralized institutions need to rebuild in the aftermath of the crisis. The cornerstone of rebuilding remains the mastery of asset ownership.

Therefore, from a methodological perspective, using the currently popular MPC-based wallet technology solutions to interact with exchanges is a good choice. Mastering the ownership of assets by large institutions, and then facilitating the secure transfer and trading of assets through third-party coordination and exchange co-signing, allows transactions to occur within a very short time window, minimizing counterparty risk and the chain reaction triggered by third parties as much as possible.

Decentralized Finance: Finding Opportunities in Crisis

Will the situation of DeFi be better when centralized exchanges and institutions are severely affected?

With a large outflow of funds from the entire encryption world and the macro environment facing interest rate hikes, DeFi is facing significant impacts: from the overall yield perspective, DeFi is currently worse than U.S. Treasury bonds. In addition, investing in DeFi also requires attention to the security risks of smart contracts. Considering risks and returns comprehensively, the current situation of DeFi does not look optimistic in the eyes of mature investors.

In a rather pessimistic environment, the market is still brewing innovation. For example, decentralized exchanges focusing on financial derivatives are gradually emerging, and innovations in fixed-income strategies are also rapidly iterating. As the performance issues of public chains are gradually resolved, we optimistically believe that the entire DeFi interaction methods and potential forms will undergo new iterations.

However, this iterative update is not achieved overnight, and the current market is still in a delicate stage: due to black swan events, encryption market makers have suffered losses, leading to a severe shortage of liquidity in the entire market, which also means that extreme cases of market manipulation occur from time to time.

Assets with good liquidity in the early stage can now be easily manipulated; once price manipulation occurs, due to the existence of a large number of combinations between DeFi protocols, many entities may be inexplicably affected by the price fluctuations of third-party tokens, leading to their own liabilities without their knowledge.

In such a market environment, corresponding investment operations may become more conservative.

We are currently more inclined to seek robust investment methods, obtaining new asset increments through staking. At the same time, an internal system named Argus has been developed to monitor various on-chain anomalies in real-time, improving overall operational efficiency through the automatic method of ) half (. As industry veterans gradually take a cautiously optimistic view of DeFi, we are also curious about when the entire market will see a turnaround.

Looking Forward to Market Reversal: Both Internal and External Factors are Indispensable

No one will enjoy a crisis forever. On the contrary, we are all looking forward to a turnaround. But to predict when the wind will change, we must first understand where the wind is coming from.

We believe that the previous round of market volatility was largely due to the entry of traditional investors in 2017. Because the volume of assets they brought was relatively large, coupled with a relatively loose macro environment, it created a hot market trend. Currently, it may take a certain degree of interest rate cuts and the inflow of hot money back into the encryption market before the bear market can reverse.

In addition, in our previous rough estimate, we believed that the total cost of the entire encryption industry, including mining machines and practitioners, was approximately between tens of millions and 100 million dollars per day; however, the current on-chain capital flow situation shows that the daily capital inflow is far less than the estimated expenditure cost, therefore the entire market is still in a stage of stock game.

The tightening of liquidity, coupled with the existing stock game and the unfavorable external environment within and outside the industry, can be seen as an external factor preventing the market from reversing. The internal factor that enables the encryption industry to develop upward comes from the growth points brought about by the explosion of killer applications.

Since multiple narratives have gradually quieted down after the last bull market, the industry still has not clearly seen new growth points. As layer two networks like ZK are gradually launched, we vaguely sense the changes brought by new technologies, with public chain performance improving further, but in reality, we still have not seen a clear killer application; at the user level, we are still unclear about what kind of application can lead to a large influx of ordinary users' assets into the encryption world. Therefore, there are two prerequisites for the end of the bear market: first, the lifting of interest rate hikes in the external macro environment, and second, finding the next new killer application explosion growth point.

However, it is important to note that the reversal of market trends also needs to align with the inherent cycles within the encryption industry. Considering the Ethereum merge event in September this year, and the upcoming next halving of Bitcoin in 2024, the former has already occurred, while the latter is not far off from an industry perspective. In this cycle, there is actually not much time left for breakthroughs in applications and narrative explosions within the industry.

If the external macro environment and internal innovation pace do not keep up, then the existing understanding of a four-year cycle within the industry may also be broken. Whether the bear market will become longer across cycles remains to be observed and learned. When both internal and external factors that drive market reversal are indispensable, we should gradually accumulate patience and adjust our investment strategies and expectations accordingly.