The Twilight and Rebirth of the Crypto Market

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

In the face of these impacts, blindly adhering to beliefs is not a wise move. We should instead learn from it and make rational judgments about the future of the industry.

Recently, a private meeting attended by industry veterans discussed hot topics such as the FTX incident, covering important issues like the correlation of multiple black swan events, changes in decision-making by centralized institutions, and future market trends. Below is a summary of the main viewpoints from the meeting:

Three Major Black Swan Events Impacting Exchanges

In 2022, the crypto market experienced a huge turnaround. The destructive power and influence of the three major black swan events involving Luna, 3AC, and FTX far exceeded previous years. To trace it back, the seeds of the crisis had actually been planted long ago: the issues with FTX can be traced back to the collapse of Luna, and the latest leaked internal documents also confirm that FTX's shortfall has been long-standing.

The rapid collapse of Luna is a typical Ponzi scheme. A sudden market movement triggered a swift run on the asset, causing Luna, worth hundreds of billions of dollars, to drop to zero in an instant. Many centralized institutions were unprepared for this, holding massive risk exposure, such as 3AC quickly turning from a risk-neutral hedge fund into a one-sided gambler.

In June, a large number of institutions held high-leverage one-way positions, blindly believing that certain price points would not be broken, leading to mutual borrowing among institutions and ultimately triggering the 3AC incident. In September, after the Ethereum merger, the market showed signs of recovery, but the unexpected collapse of FTX once again triggered panic.

From the perspective of Binance CEO Zhao Changpeng, this may just be normal business competition. However, it unexpectedly triggered market panic, revealing Sam Bankman-Fried's financial black hole, ultimately leading to the rapid collapse of the FTX business empire.

The three Heitianpeng incidents exposed some issues worth pondering:

1. Institutions can also go bankrupt. Many large institutions in North America have misconceptions about risk management and the crypto market, leading to a chain reaction. The risk of unsecured credit among institutions is extremely high.

2. The quantitative and market-making teams will also suffer severe blows during extreme market conditions. When the market experiences violent fluctuations, capital flight leads to a serious lack of liquidity, forcing many market-making teams to convert high liquidity assets into low liquidity assets, facing the dilemma of being unable to withdraw.

3. The asset management team is also facing challenges. They need to find low-risk returns in the market to reward investors. Achieving α returns mainly relies on lending and token issuance. During the operation process, a large amount of lending assets and derivatives were accumulated, and once institutional defaults occur, these assets will face a chain reaction.

This reminds us of the development history of traditional financial markets. The crypto market has completed a journey of over 200 years of traditional finance in just over a decade, achieving both remarkable successes and replaying issues seen in the history of traditional finance, such as the misuse of client funds that occurred in the FTX incident.

The FTX incident marks the twilight of centralized exchanges. Worldwide, people are in a state of extreme panic regarding the opacity of cryptocurrencies, especially centralized exchanges, and the potential chain reactions that could result. Data also confirms this assessment, as there has been a significant amount of on-chain user asset transfers in the past month.

In this crisis, private keys have been defeated in the struggle against human nature. Although the ownership of crypto assets is guaranteed by private keys, centralized exchanges have lacked suitable third-party custodians to help manage user assets over the past decade, addressing the human weaknesses of exchange managers, which has always given exchanges the opportunity to touch user assets.

Sam Bankman-Fried, the founder of FTX, has always been a restless person. He often works late into the night and does not allow himself or his funds to remain idle. During the DeFi boom, Sam frequently transferred large amounts of funds from the exchange's hot wallet to participate in various DeFi project mining.

When human nature craves more opportunities, it is also difficult to resist temptation. A large amount of user assets are stored in the exchange's hot wallets, and it seems reasonable to use these assets to obtain risk-free or low-risk returns. From Staking to DeFi mining, to investing in early projects, as the returns grow larger, the behavior of misappropriation may become more rampant.

These black swan events have provided profound insights for the industry: regulatory agencies and large institutions should learn from traditional finance and find appropriate ways to prevent a single institution from simultaneously acting as an exchange, broker, and third-party custodian. At the same time, technical means are needed to ensure that third-party custody and trading activities are independent of each other, with no conflicting interests. Regulatory oversight can even be introduced when necessary.

In addition to exchanges, other centralized institutions also need to make changes amid the dramatic changes in the industry.

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

The black swan event not only affected exchanges but also impacted related centralized institutions. The reason they were hit hard is largely due to the neglect of counterparty (, especially the risks associated with the exchange ). The perception of "too big to fail" was once a common impression of FTX.

In May, Luna collapsed. In November, it was FTX's turn.

The traditional financial world has a lender of last resort system. When large financial institutions face a crisis, there are often third-party organizations or even government-backed entities that perform bankruptcy restructuring to mitigate the risk impact. However, there is no such mechanism in the crypto world. Due to the underlying transparency, people can analyze on-chain data through various technical means, resulting in the rapid spread of crises.

This is a double-edged sword. The benefit is that it accelerates the burst of bad bubbles, allowing problems that shouldn't exist to disappear quickly. The downside is that it hardly gives less sensitive investors any reaction time.

In such a market environment, the FTX incident marks the arrival of dusk for centralized exchanges. In the future, they may degrade into a bridge connecting the fiat currency world and the crypto world, addressing issues such as KYC and deposits through traditional means.

Compared to traditional methods, the more open and transparent operations on the chain are more promising. As early as 2012, the community was discussing on-chain finance, but it was limited by technology and performance at that time. With the development of blockchain performance and private key management technology, on-chain decentralized finance, including decentralized derivatives exchanges, will gradually emerge.

The game has entered the second half, and centralized institutions need to rebuild in the aftermath of the crisis. The cornerstone of rebuilding is still grasping asset ownership.

Therefore, using the currently popular MPC-based wallet technology solutions to interact with exchanges is a good choice. Institutions can retain ownership of their assets and securely transfer and trade assets through third-party custodians and exchange co-signatures, limiting the trades to short time windows to minimize counterparty risk and potential chain reactions triggered by third parties.

Decentralized Finance: Finding Opportunities in Crisis

When centralized exchanges and institutions suffer heavy blows, is the situation of DeFi any better?

With a large amount of funds flowing out of the encryption world and the macro environment facing interest rate hikes, DeFi is under significant pressure. From the perspective of overall returns, DeFi currently does not outperform U.S. Treasury bonds. In addition, investing in DeFi also requires attention to the security risks of smart contracts. Considering the risks and returns, DeFi is currently not optimistic in the eyes of mature investors.

Despite the overall pessimistic environment, the market is still brewing innovations. For example, decentralized exchanges around 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, the interaction methods and possible forms of DeFi will also enter a new iteration.

However, this kind of update and iteration does not happen overnight, and the current market is still in a delicate stage. Due to black swan events, crypto market makers have suffered losses, leading to severe liquidity shortages 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 stages are now easily manipulated. Once the price is manipulated, due to the presence of a large number of combinations among DeFi protocols, many entities may inexplicably be affected by the price fluctuations of third-party tokens, creating liabilities innocently.

In such a market environment, investment operations may become more conservative. Some teams prefer to seek stable investment methods to obtain asset increments through Staking. At the same time, a system for real-time monitoring of on-chain anomalies has been developed to improve overall operational efficiency through ( semi-) automated methods.

As industry veterans gradually adopt a cautiously optimistic attitude towards DeFi, we are also curious about when the entire market will see a turning point.

Anticipating Market Reversal: Both Internal and External Factors are Essential

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 need to understand where the wind is coming from.

The previous round of market fluctuations likely stemmed from the entry of traditional investors in 2017. Due to the large scale of assets they brought, coupled with a loose macro environment, a bull market was created. Currently, it may be necessary to wait until interest rates are lowered to a certain extent, and hot money flows back into the crypto market, for the bear market to reverse.

In addition, previous rough estimates show that the total daily cost of the entire encryption industry, including mining machines and practitioners, is between tens of millions and 100 million USD. Currently, the on-chain capital flow indicates that the daily capital inflow is far less than the estimated expenditure cost, therefore the entire market is still in a stock game phase.

The tightening of liquidity combined with the existing competition, along with the poor external environment within and outside the industry, can be seen as external factors preventing the market from reversing. The internal factors contributing to the upward development of the encryption industry come from the growth points brought about by the explosion of killer applications.

Since multiple narratives have gradually quieted down after the last bull market, we still have not clearly seen new growth points in the industry. As second-layer networks like ZK are gradually being introduced, we vaguely sense the changes brought by new technologies, with public chain performance further improving. However, we have not yet seen a clear killer application. From the user perspective, we still do not know what kind of application can lead to a large-scale 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 growth point.

But 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 of this year, as well as 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 in 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 also gradually accumulate patience and adjust our investment strategies and expectations in a timely manner to face more uncertainties.

Things are never smooth sailing. I hope that every participant in the crypto market can be a solid builder, rather than a bystander who misses opportunities.

Appendix: Selected Q&A Session

Q1: What are the main innovation directions for the future of the crypto market?

A: There are mainly two major directions:

1. Performance ( TPS ) issues. Multi-layer networks are the solution, among which the ZK Layer 2 network has the most potential, but it will take at least two more years to implement.

2. Balancing underlying private key security and application. This is a core issue that hinders the industry from attracting a large number of new users. MPC-based keyless wallets may be a better balancing solution.

Q2: How do you view the current market situation, and what are the future trends?

A: Currently at the bottom of the bear market, but the duration is difficult to determine. Possible turning points:

1. The interest rate hike cycle has ended, and it will take at least until mid-2023.

2. The industry has new growth points and triggers.

From the miners' perspective, bottom signals have appeared - mining costs have become difficult to cover marginal costs. However, due to the special circumstances of North American miners, hash power may only decline slightly.

The price of second-hand mining machines has fallen below production costs, which is a signal of surrender. For individual investors, this is a good time to accumulate positions, but there needs to be a readiness for long-term holding.

Q3: Signature Bank plans to sell 10 billion encryption