Liquidity Crisis and Technological Disillusionment

The cryptocurrency market in July is digesting the severe fluctuations of the previous two months, and investors are discussing whether the cycle bottom has been formed. Looking back at this period, we have witnessed the impact of DEFI technology, the collapse of centralized financial institutions, excessive leverage, and the effects of the liquidity cycle. Before every crisis, there are always those who believe "this time is different," but in fact - history always repeats itself. In the face of economic cycles, technological advancements may only raise economic expectations, but cannot suppress the greed and fear inherent in human nature. We have witnessed the destructive power of leverage and the rapid bursting of bubbles. If this period can teach us anything, it is to maintain reverence for market laws and to examine our own speculative psychology.

There is nothing truly different; the only change is that investors have learned more lessons, and the frenzy and noise have been eliminated by the market.

Market Crash

According to Glassnode data, the monthly price changes of Ethereum over the past five years show a dismal market performance from April to June 2022. In June, ETH fell by 45%, and by the end of June, the price of ETH had dropped by 78% from last year's historical high of $4808.

As the largest smart contract platform, Ethereum has hosted a large number of users, funds, transactions, and innovations, like a gravitational field continuously absorbing a large amount of Liquidity. Starting from the bull market cycle in 2020, Ethereum's price surged, and the TVL( total locked value) skyrocketed, reaching a peak of about $253 billion in December 2021. After that, due to a rapid collapse of a large number of GameFi 1.0 projects, the market saw some decline. In March-April 2022, the TVL rose again to $228 billion, and thereafter the amount of funds began to decline rapidly and continuously, without any rebound.

At the same time, the supply of stablecoins on the ETH chain has also changed. Unlike the sharp decline in Ethereum's market value from November 2021 to January 2022, this drop was accompanied by a contraction in stablecoin supply. It fell from a high of $161 billion on April 3 to $146.5 billion on June 30, with a total outflow of $14.5 billion exceeding the total supply of DAI. An interesting phenomenon during this period was that the supply of USDT decreased, while USDC seemed to become a kind of "safe-haven" stablecoin, with an increase in supply.

This series of price crashes, TVL contraction, and decline in stablecoin supply indicate that this market turbulence is more severe than the adjustment from the end of 2021 to March 2022. After all, the amount of funds, or liquidity, directly reflects market confidence and is the direct driving force of market vitality.

It should be noted that the liquidity mentioned in this article refers to the abundance of market funds at a macro level, rather than the ease of asset realization at a micro level.

The sharp decline since April 2022 can be roughly divided into three stages:

Phase 1 ( From April 4 to May 6 ): Mainly triggered by concerns about the macro environment. The expectation of tightening by the Federal Reserve has been continuously strengthened, with the market basically confirming a 50 basis point rate hike in May and an annual rate hike expectation of up to 275 basis points. U.S. Treasury yields have broken 3%, and the dollar continues to strengthen. The commodity market has reached new highs. Bitcoin is highly correlated with traditional markets, and the crypto market has started to weaken, with BTC falling below $40,000. The market capitalization and TVL of Ethereum have both moderately declined, seemingly reflecting smart money's expectations of tightening Liquidity.

Phase 2 ( May 7 to May 14 ): LUNA extreme event outbreak. In just a few days, the top 10 by market cap LUNA and UST evaporated nearly $40 billion. On May 7, UST decoupled, dropping to $0.35 on May 9, while LUNA plummeted from its historical high of $119 to around $60. Within 36 hours, LUNA fell below $0.1, and UST fluctuated between $0.3 and $0.82. The LUNA-UST redemption mechanism operated at high speed, with some in panic and others in greed, exchanging 1 UST for LUNA worth $1, increasing LUNA supply and further depressing the price. The BTC reserves of Luna Foundation Guard ( LFG ) were exhausted in one day on May 9, attempting to defend the UST dollar peg but failed.

Phase 3 ( From June 8 to June 19 ): Various centralized financial institutions collapsed one after another. The on-chain DEFI market was on the brink, the LUNA incident had far-reaching effects, impacting LIDO and causing stETH to decouple. Celsius was the first to encounter problems and was forced to suspend withdrawals. Subsequently, the market reported that Three Arrows Capital was in crisis; as a major supporter of LUNA and a large holder of stETH, they faced over $400 million in loans that needed to be repaid. Worse still, the founders of Three Arrows Capital leveraged their reputation to borrow large amounts from almost all institutions, using debt to buy assets with a very low collateral ratio. In no time, exchanges, lending institutions, and hedge funds were not spared, facing insolvency, liquidity shortages, or liquidation. Other institutions and individual investors also rushed to withdraw liquidity for self-preservation. On June 18, BTC fell below the $20,000 high from February 2017, hitting a low of $17,708.

History is repeating

Roger Lowenstein's book "When Genius Failed: The Rise and Fall of Long-Term Capital Management" recounts the rise and fall of Long-Term Capital Management (LTCM), in which there is a saying: "Derivatives are new, but panic is as old as the market."

That was in 1998. At that time, the derivatives we were familiar with, such as options and futures, were still considered financial innovations.

LTCM was founded in 1994 by the legendary bond trader of Salomon Brothers, engaging in high-leverage arbitrage in the bond market. Board members include 1997 Nobel Laureate in Economics Myron Scholes and Robert C. Merton.

LTCM adopted a seemingly simple strategy - mean reversion, betting on the market's return to average levels for profit, assuming that the market would not deviate from "normal" for a long time. This was indeed the case for many years. In its first three years, LTCM achieved annualized returns of 21%, 43%, and 41%, attracting Wall Street's attention. The fund signed thousands of derivative contracts, with almost all banks being its creditors, and its risk exposure exceeded $1 trillion.

However, this strategy of betting on the market eventually returning to "normal" has failed - or rather, before LTCM collapsed, they did not wait for the market to normalize. The global panic triggered by the Russian financial crisis led investors to sell everything, and the yield spreads that LTCM bet on did not return to normal as expected, but instead widened. Suddenly, hundreds of billions in leveraged trading strategies were losing money. Funds were forced to liquidate, exacerbating systemic risk.

Many people compare the crisis of Three Arrows Capital to the collapse of LTCM. Although the scale of Three Arrows is far less than that of LTCM, which peaked at only $18 billion, the process is quite similar.

LTCM bet on mean reversion, operating with high leverage through massive borrowing, the occurrence of a black swan event led to the failure of the strategy, inability to repay debts, liquidity squeeze, market pricing distortion, and collapse of faith.

Three Arrows bet on LUNA and stETH, widely borrowing low-collateral or even uncollateralized debt, operating with high leverage. LUNA collapsed, stETH was impacted, and Three Arrows was forced to sell stETH, resulting in widespread inability to repay debts, causing huge losses for many companies. Many investors unrelated to LUNA and stETH also withdrew Liquidity, and the market realized "de-leveraging" and "hard landing" in a crashing manner.

In 1998 and 2022, 24 years apart, the process is almost the same. Not to mention the internet bubble of 2000 and the global financial crisis caused by the subprime mortgage crisis in 2008, history keeps repeating itself.

During the accumulation of leverage, hasn't anyone reflected on this, or consulted history?

Surely someone has done this before. It's just that this kind of voice has been drowned out by the skyrocketing asset prices, with optimists shouting "this time is different."

In 1998, Wall Street was obsessed with derivatives and the halo of Nobel Prize winners. During the Internet bubble, people firmly believed that this communication technology could open up a new world. In 2008, the invention of subprime loans seemed to liberate all of humanity.

Technological innovation brings optimism about the status quo, and fervor fuels widespread speculative mindsets, continuously eroding risk boundaries, accumulating leverage, leading to false promises of high returns. When the dominoes fall, nothing is different.

The Essence of Technology and the Leverage Cycle

"The Schumpeter Prize" winner Brian Arthur believes in his book "The Nature of Technology" that the economy is an expression of technology, and the essence of technology is combination and recursion. Combination refers to the rapid integration of elements, while recursion refers to directional optimization cloning.

The impact of "composability" on technology and innovation is exponential.

This is also a major reason why DEFI has been highly sought after since its inception. The essence of DEFI technology is the stacking of Lego blocks, shortening the innovation cycle - we are always standing on the shoulders of giants. Imagine how difficult it would be if OHM were not open source, and Curve had patent protection, to build ve (3 from scratch. It is precisely because of its combinable syntax, reusable protocols, and compatible tools that since Uniswap ignited DEFI Summer, we have witnessed remarkable developments in the crypto space. We do not have to start from scratch, but rather focus on the areas that most need technological breakthroughs.

Review how dominoes are quickly set up and fall down.

The LUNA-UST algorithmic stablecoin protocol has been controversial since its launch, with some accusing it of being another Ponzi scheme and others criticizing the mechanism as merely stepping on one foot while using the other. This is a brand new narrative and anchoring technology - achieving a 1:1 exchange with the US dollar through algorithms, abandoning the asset collateral guarantees upheld by USDC, USDT, and even DAI. Delphi even created the DEFI paradise Anchor for this purpose, offering a "risk-free" return of 20% to support these assets created out of thin air.

No endorsement, decentralized, algorithm, protocol, as if a new world has been created.

During the continuous rise of LUNA, some people also warned about the risks. As early as 2018, MakerDAO's risk officer Cyrus Younessi pointed out that Terra/LUNA was not feasible, illustrating how similar attempts have been repeatedly rejected by the market.

However, until 2022, the price of LUNA continued to rise, and Do Kwon was even confidently betting with others on Twitter. Time seems to prove that LUNA is different from previous failed cases - this time it's different.

The seemingly different reasons mainly are Anchor and LFG.

The story of DEFI always revolves around liquidity. The three pillars of DEFI: DEX is the liquidity exchange venue, Lending is the liquidity pricing venue, and Stablecoin is the liquidity anchor.

To create a pegged myth, it is necessary to consider the direction of the liquidity created out of thin air. If liquidity is compared to water, the market needs a sponge to absorb and lock it in. Based on this, in July 2020, LUNA created Anchor, and Nicholas Platias described this protocol on Medium.

He envisioned a savings protocol with the following features:

• Principal protection: Implement a liquidation mechanism to protect depositors' principal.
• Instant Withdrawal: Terra deposits can be withdrawn immediately without locking.
• Stable interest rate: Stabilizing deposit interest rates by transferring the variable portion of rewards from collateral assets to depositors.

Ultimately, they set the stable interest rate at 20%.

This yield would raise alarms for anyone with investment education under normal circumstances.

The simplest principle is the Capital Asset Pricing Model ) CAPM (: The relationship between the expected return of an asset and the expected return of the market portfolio indicates that the portfolio return is only related to systematic risk. The 20% fixed return offered by Anchor for UST is clearly much higher than the market risk-free rate of return, implying that this return rate cannot be risk-free.

At its peak, UST's market value reached 18 billion USD, with over 14 billion locked in Anchor, requiring an annual payment of 20% APY. Regardless of the bottom