The Twilight and Revival of the Crypto Market

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 FTX, a series of negative events cast a shadow over the entire industry.

In the face of these challenges, blindly insisting is not a wise move. We should instead learn from these events and make reasonable predictions about the future of the industry.

Recently, several senior practitioners in the industry conducted in-depth discussions on hot topics such as the FTX incident, covering analyses of multiple black swan events, changes in the decision-making processes of centralized institutions, future market trends, and more, providing us with valuable insights.

Three Black Swan Events Impacting the Exchange Landscape

In 2022, the crypto market faced a significant turning point. The destructive power and impact of the black swan events involving Luna, 3AC, and FTX far exceeded previous years. Tracing back, the seeds of the crisis had already been sown: the problems at FTX can be traced back to the collapse of Luna, and recent internal disclosures also confirm that FTX’s losses originated from an earlier period.

The rapid collapse of Luna is a typical Ponzi scheme: abnormal market conditions triggered a swift run, causing the multi-billion dollar market value of Luna to drop to zero in an instant. Many centralized institutions were poorly prepared for market risks, leading to excessive risk exposure. For example, 3AC quickly transformed from a risk-neutral hedge fund into a one-sided gamble.

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

The FTX incident has exposed several thought-provoking issues:

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

2. The quantitative and market-making teams can also suffer heavy losses in extreme market conditions. A sudden market crash leads to a depletion of liquidity, forcing many teams to convert high liquidity assets into low liquidity assets.

3. The asset management team is also facing challenges. They have accumulated a large amount of lending assets and derivatives, which can easily trigger a chain reaction during institutional failures.

These issues directly point to the operational risks of centralized institutions. The FTX incident marks the twilight of centralized exchanges. There is extreme panic globally over the opacity of centralized exchanges and the potential chain reactions they may trigger. On-chain data also shows a significant number of users transferring assets in the past month.

Before dusk, the private key lost in the game against human nature. Over the past 10 years, centralized exchanges have lacked a reasonable third-party custody mechanism to manage user assets, making it ineffective to counteract the weaknesses of human nature in management, which has led to exchanges occasionally touching user assets.

In the future, the industry needs to learn from traditional finance and find suitable ways to ensure that centralized exchanges no longer simultaneously take on the triple roles of trading, brokerage, and custody. At the same time, technical means are required to ensure that third-party custody and trading activities are independent of each other, and regulation should be introduced when necessary.

Other centralized institutions also need to make changes in response to the major changes in the industry.

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. One important reason for their crisis was the neglect of counterparty (, especially the risks of centralized exchanges ). “Too big to fail” was once the impression people had of FTX.

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

This is a double-edged sword. The benefit is that it accelerates the collapse of harmful bubbles; the downside is that it leaves almost no opportunity window for insensitive investors.

In such a market environment, the role of centralized exchanges may gradually degrade to that of a bridge connecting the fiat world and the encryption world, addressing issues such as KYC and deposits through traditional means.

In contrast, the more open and transparent operation method on-chain has greater prospects. With the development of blockchain performance and underlying private key management technology, on-chain decentralized finance (, including decentralized derivatives exchanges ), will gradually emerge.

For centralized institutions, the cornerstone of reconstruction is still to master asset ownership. Using MPC-based wallet technology solutions to interact with exchanges is a good choice. Institutions can maintain their own asset ownership and secure asset transfers and transactions through third-party coordination and exchange co-signing, limiting transactions to a short time window to minimize counterparty risks and chain reactions triggered by third parties.

Decentralized Finance: Finding Opportunities in Crisis

With a large amount of capital flowing out of the encryption world and the macro environment of interest rate hikes, decentralized finance ( DeFi ) is facing significant challenges. Currently, the overall yield of DeFi is lower than that of U.S. Treasury bonds, and investing in DeFi also requires attention to the security risks of smart contracts. Considering the risks and returns comprehensively, DeFi is not optimistic in the eyes of mature investors.

However, the market is still brewing innovations. Decentralized exchanges around financial derivatives are gradually emerging, and innovations in fixed income strategies are rapidly iterating. As public chain performance issues are gradually resolved, the interaction methods and implementation forms of DeFi are expected to further innovate.

However, the current market is still in a delicate stage. Black swan events have caused crypto market makers to suffer losses, leading to severe liquidity shortages, and extreme price manipulation occurs from time to time. Assets that initially had good liquidity are now easily manipulated. Due to the large number of combinations between DeFi protocols, price manipulation can unexpectedly affect many entities.

In this environment, investment operations may become more conservative. Some teams prefer to look for stable investment methods, such as obtaining 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.

Expecting Market Reversal: Both Internal and External Factors Are Indispensable

The last round of market fluctuations was largely due to the entry of traditional investors in 2017. Due to the large scale of assets they brought with them, coupled with a loose macro environment, this jointly drove a bull market. Currently, it may take a certain degree of interest rate cuts and the return of hot money to the crypto market for the bear market to reverse.

In addition, estimates show that the total daily cost of the entire encryption industry (, including mining machines and practitioners ), ranges from tens of millions to one hundred million USD. Currently, on-chain capital flows indicate that daily capital inflows are far less than the estimated costs, thus the market remains in a stock game phase.

The tightening of liquidity combined with the stock game, as well as the unfavorable external environment both inside and outside the industry, are external factors preventing the market from reversing. The upward internal factor in the encryption industry comes from the growth point brought about by the explosion of killer applications.

Since the last round of the bull market, several narratives have gradually quieted down, and the industry has yet to clearly identify new growth points. The introduction of layer two networks such as ZK has improved the performance of public chains, but there are still no clear killer applications. We are still unclear about what application forms can lead to the influx of assets from large-scale ordinary users 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.

However, the reversal of market trends also needs to match the inherent cycles of the encryption industry. Considering the Ethereum merger event in September this year, as well as the upcoming next round of halving for Bitcoin in 2024, there is not much time left for breakthroughs in applications and the eruption of narratives within the industry.

If the external macro environment and internal innovation rhythm cannot keep up, then the existing cognition of a four-year cycle in the industry may also be broken. Whether the bear market will become longer across cycles remains to be seen.

When both internal and external factors for a market reversal are indispensable, we should gradually accumulate patience, timely adjust our investment strategies and expectations, to cope with more uncertainties.

As participants in the encryption industry, we should be solid builders rather than bystanders who miss opportunities.

Selected Q&A Session

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

A: There are mainly two major directions:

1. Performance ( TPS ) issues. Currently, the ZK solution has the greatest potential in the second-layer network, but it may still take at least two years for final implementation and use.

2. The balance issue between the security of the underlying private key and the application. This directly affects user experience and access thresholds. A keyless wallet based on MPC may be a better balance solution.

These two directions are the core issues that the entire industry must address.

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

A: Currently, it is a bear market state of stock game. Compared to history, asset drawdowns are around 80%. It may be in the bottom range now, but the specific duration and status still need to be observed.

Possible turning point:

1. The interest rate hike cycle has ended. According to historical experience, it will take at least until mid-2023.
2. New growth points and triggers have emerged in the industry.

From the miner’s perspective, a typical bottom cycle signal has emerged - the mining costs have become difficult to cover the marginal costs. However, due to special circumstances, the hash rate may only decline slightly.

Currently at the bottom range, it is a good time for individual investors to gradually build positions. The short term may be 1-2 years, while the long term may be 3-5 years.

Q: What is the future development direction of centralized exchange (CEX)?

A: CEX may face the following changes in the future:

1. Regulation is tightening, and there may be a requirement to split multifunctional services.

2. The competition in decentralized exchanges (, especially in derivatives ), will intensify.

3. The core role of CEX may shift to:

   • Provide traditional financial investors with solutions to understand and recognize encryption assets
   • As a channel for deposits and withdrawals between fiat and encryption currencies

4. Its existing core trading functions (, especially derivatives trading ), may gradually be replaced by decentralized exchanges or coexist with them.

Q: How can institutions prepare to enter the DeFi space?

A: DeFi mainly has 4 major directions:

1. Stablecoins - Some innovations may emerge in the near future, such as AAVE and Curve stablecoins.

2. Lending - After experiencing extreme market conditions, on-chain lending performed relatively well, but it also exposed some issues, and there will be new iterations in the future.

3. DEX - Relatively mature, with the launch of ZK technology, the order book model may be further improved.

4. Derivatives and Risk Management - Relatively early, but after the FTX incident, on-chain futures and options trading volumes surged, potentially becoming a new growth point.

For institutions:

• First, you need to establish awareness.
• Build internal workflows for DeFi
• You can use decentralized interaction tools like Cobo Argus.

For individual investors:

• Currently, it is difficult to obtain stable high returns in DeFi.
• You can focus on single coin staking, which has relatively lower risks.
• You can try with small funds to observe new growth points and directions.
• Reviewing the story of the last bear market to prepare for the next round.
• Observe more, operate less, learn more.