The Twilight and Rebirth 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 the downfall of the FTX empire, a series of negative events cast a shadow over the entire industry.

In the face of these setbacks, blindly adhering to faith is not a wise course of action. On the contrary, we should learn from them and make reasonable judgments about the future of the industry.

At a recent private seminar, some seasoned professionals engaged in in-depth discussions on topics such as the FTX incident, including the correlation analysis of multiple black swan events, changes in the decision-making processes of centralized institutions, and future market trends. Below is a compilation of some insightful viewpoints from the meeting.

Three major black swan events impact exchanges

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

The rapid collapse of Luna is a typical Ponzi scheme: market anomalies triggered a rapid bank run, causing the hundred billion market value of Luna to drop to zero in an instant. In this event, many centralized institutions were unprepared for market risks, holding a large amount of risk exposure, as 3AC quickly transformed from a risk-neutral hedge fund into a one-sided speculator.

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 inter-institutional borrowing and ultimately triggering the 3AC incident. In September, after the Ethereum merge, the market showed signs of recovery, but the unexpected collapse of FTX once again caused turmoil.

From a business competition perspective, the FTX incident may have originated from targeted financing strikes against competitors. However, this unexpectedly triggered market panic, exposing Sam's massive financial loopholes, leading to a run on the bank and the rapid collapse of the FTX business empire.

These black swan events reveal some thought-provoking questions:

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

2. In extreme market conditions, the quantitative and market-making teams will also suffer heavy losses. The market's distrust of institutions leads to capital flight and liquidity depletion, causing market-making teams to passively hold low-liquidity assets and be unable to withdraw.

3. The asset management team is facing shocks. In order to obtain low-risk returns, the asset management team accumulates a large amount of lending assets and derivatives through borrowing and issuing tokens. Institutional collapses can trigger a chain reaction and suffer shocks in extreme market conditions.

These issues are not uncommon in the history of traditional finance, such as the misappropriation of client funds that occurred in the FTX incident. These problems seem to point to operational issues within centralized institutions.

The FTX incident marks the twilight of centralized exchanges. There is extreme panic globally regarding the opacity of cryptocurrencies, especially centralized exchanges, and the potential chain reactions they might trigger. Data shows that a large number of on-chain users have transferred assets over the past month.

At this twilight moment, the private key has lost in the game against human nature:

Although the ownership of underlying assets in the encryption world is guaranteed by private keys, centralized exchanges have lacked reasonable third-party custody mechanisms over the past decade to help users and exchanges manage assets and resist the human weaknesses of exchange managers, leading to opportunities for exchanges to touch users' assets.

In the FTX incident, the influence of human nature had long been evident. Sam has always been a restless person, often working late into the night and frequently transferring large sums of money from the exchange's hot wallet to participate in various DeFi projects.

When human nature craves more opportunities, it is also difficult to resist temptation. A large amount of user assets is stored in exchange hot wallets, and using these assets to obtain risk-free returns seems to be a matter of course; from staking to participating in DeFi mining, and then to investing in early projects, as the returns grow larger, the misappropriation may become increasingly severe.

These events teach us that regulatory agencies and large institutions should learn from traditional finance to find appropriate ways to ensure that centralized exchanges no longer simultaneously take on the roles of exchanges, brokers, and third-party custodians; at the same time, technical means are needed to make third-party custody and trading activities independent, ensuring that interests are unrelated. Regulatory oversight may be introduced when necessary.

And outside of centralized exchanges, other centralized institutions also need to make adjustments in response to industry changes.

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

The black swan event not only impacted centralized exchanges but also affected related centralized institutions. The reason they fell into crisis is largely due to the neglect of counterparty risk (, especially the risks associated with centralized exchanges ). "Too big to fail" was once the impression people had of FTX. This is the second time hearing this concept: in certain group chats in early November, most people believed that FTX was "too big to fail."

The first time, Su Zhu said in person: "Luna is big and cannot fall; if it does, someone will come to save it."

In May, Luna collapsed.

November, it was FTX's turn.

The traditional financial world has a lender of last resort system. When large financial institutions encounter serious problems, there are often third-party organizations or even government-backed entities that conduct bankruptcy restructuring to reduce risk impact. Unfortunately, the encryption world does not have such a mechanism. Due to the underlying transparency, people analyze on-chain data through various technical means, resulting in crashes happening very quickly. A small clue can trigger panic.

This phenomenon is a double-edged sword. The benefit is that it accelerates the collapse of bad bubbles, allowing things that should not happen to quickly disappear; the downside is that it almost leaves insensitive investors with no window to react.

In such a market environment, the FTX incident marks the twilight of centralized exchanges. In the future, they may gradually evolve into bridges connecting the fiat currency world and the encryption world, addressing issues like KYC and deposits through traditional means.

Compared to traditional methods, the on-chain operations that are more open and transparent are more promising. As early as 2012, the industry was discussing on-chain finance, but at that time it was limited by technology and performance, lacking suitable carrying methods. 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 this rebuilding remains the mastery of asset ownership.

Therefore, using the currently popular MPC-based wallet technology solutions to interact with exchanges is a good choice. Institutions maintain ownership of their assets, and through third-party coordination and exchange co-signing, they can safely transfer and trade assets, conducting transactions only within a short time window to minimize counterparty risk and potential chain reactions caused by third parties.

Decentralized Finance: Finding Opportunities in Crisis

Is the situation of decentralized finance ( DeFi ) better when centralized exchanges and institutions suffer greatly?

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

In this relatively pessimistic environment, the market is still brewing innovation.

For example, decentralized exchanges around financial derivatives are gradually emerging, and innovations in fixed income strategies are rapidly iterating. As the performance issues of public chains are gradually resolved, the interaction methods and possible forms of DeFi will also undergo a new round of iteration.

However, this update and iteration is not achieved overnight; the current market is still in a delicate stage: due to black swan events, encryption 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 existence of a large number of combinations between DeFi protocols, many entities may inexplicably be affected by the price fluctuations of third-party tokens, falling into debt innocently.

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

Currently, we are more inclined to seek stable investment methods, obtaining new asset increments through staking. At the same time, a system called Argus has been developed to monitor various on-chain anomalies in real-time, improving overall operational efficiency through a semi-automated method using (. As industry veterans gradually adopt a cautiously optimistic attitude towards DeFi, we are also curious about when the entire market will see a turnaround.

Expecting Market Reversal: Internal and External Factors Are Both Essential

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

The previous round of market volatility was likely due to the entry of traditional investors in 2017. The relatively large asset scale they brought, combined with a loose macro environment, created a hot market. Currently, it may take a certain degree of interest rate cuts and the re-entry of hot money into the encryption market for the bear market to see a reversal.

In addition, according to rough estimates, the total daily cost of the entire encryption industry, including mining machines and practitioners, ranges from tens of millions to 100 million dollars; however, the current on-chain capital flow indicates that daily capital inflow is far less than the estimated cost, thus the entire market is still in the stage of stock game.

The tightening of liquidity combined with the existing stock game, along with the unfavorable external environment both inside and outside the industry, can be seen as external factors preventing the market from reversing. The internal factors that allow the encryption industry to grow come from the growth points brought about by the emergence of killer applications.

Since multiple narratives have gradually quieted after the last bull market, there is still no clear new growth point in the industry. As Layer 2 networks like ZK are gradually introduced, we vaguely sense the changes brought by new technologies, and the performance of public chains has further improved, but we have yet to see a definitive killer application; on the user level, we still do not know what application forms can attract large-scale ordinary users to flow their assets into the encryption world. Therefore, the end of the bear market has two prerequisites: first, the end of interest rate hikes in the external macro environment, and second, finding the next new killer application that will trigger a growth point.

However, it is important to note that the reversal of market trends also needs to align with the inherent cycles of the encryption industry. Considering the Ethereum merger event in September 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 4-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 gradually accumulate patience and adjust our investment strategies and expectations accordingly to face more uncertainties.

Things have never gone smoothly, but I hope that every participant in the encryption industry can become a solid builder, rather than a bystander who misses opportunities.

Selected Q&A Session

Q: What are the main innovation directions for the encryption market in the future?

Answer: Two main directions:

1. Performance ) TPS ( issues: Multi-layer network solutions, ZK Layer 2 network has the best prospects, but it may take more than 2 years to implement.

2. Private Key Security and Application Balance: has always been a core issue hindering new users from entering. MPC-based keyless wallets may be a better balanced solution.

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

Answer: We are currently in a stage of stock game, with serious capital outflow, clearly in a bear market. Bitcoin has retraced about 80%, approaching the bottom range, but it is difficult to determine exactly when it will hit the bottom.

Two possible turning points:

1. The interest rate hike cycle has ended and is expected to last at least until mid-2023.
2. New growth points and explosive points have emerged in the industry.

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