What do the events of the Great Rout have in common? Why did it happen and how to avoid it?
Speaker: Haseeb Qureshi, Managing Partner, Dragonfly Capital
Compilation: Qianwen, ChainCatcher
In 2022, we have a lot of painful experiences. We spend a lot of time trying to analyze and understand them, find out why they happened, how they happened and who was involved, but I haven't seen anyone really try to take a bigger picture of them and put them together look at.
What do all these things have in common? Why do they happen and how can we avoid them in the future? This will be the focus of my talk today. I will talk about what we have experienced in the past in chronological order, such as quantitative tightening, P2E mode, Luna thunderstorm, Three Arrows Capital and FTX events, and think about them in a specific context.
1. Event sorting
First, go back to January 2022, when interest rates were at zero and inflation was just starting. For the most part, risky assets are doing well, peaking in November when everyone is making money. For this industry and risk assets, the entire industry was in full swing and full of energy.
So I will review the past year from two aspects: the first part is cryptocurrency, and the second part is macroeconomics. The chart above shows the direction of BTC versus the Fed funds rate. The overall trend is stable, and Bitcoin has a downward trend. When the fed funds rate hit 1%, it was the Fed's second big rate hike, which was when there was the first big crash of the year - Terra's crash.
Essentially, Terra is a leveraged bank that takes funds and then issues liabilities worth one dollar. But it does not keep all the funds invested by users, but takes the funds out and pays its equity holders, that is, those who own Luna, and hopes that UST holders will not want to get their funds back.
It was a bank that didn't have all the money in reserve, and when a lot of people wanted to leave the bank, it collapsed. This is somewhat similar to Silvergate, but they are leveraged differently.
The next big crash was Three Arrows Capital. It is a leading fund in Singapore and is also extremely leveraged. The aftermath of Terra's collapse affected Three Arrows Capital, causing the latter to collapse and immediately triggering a sharp drop in cryptocurrency prices.
After that, the Federal Reserve raised interest rates by 75 basis points, and soon after, Axie Infinity experienced a sharp drop, plummeting 90% from the highest point. This P2E model doesn't work anymore, for example, players in the Philippines are now making maybe less than their minimum wage with this game, whereas before, they were making a lot more than minimum wage. It may sound ugly to me, but it's a Ponzi scheme packaged as a game.
People feel like there's always someone else speculating on AXS, so there's always going to be a market to sell tokens, but when that stops, when people don't want to buy AXS anymore, the game suddenly grinds to a halt. This model of playing games to make money can no longer work, and this Ponzi scheme is over. After that, interest rates kept going up and going up, and then came the big event in November.
In November, FTX crashed. FTX is a leveraged exchange, but you could also say it is a Ponzi scheme masquerading as an exchange. You can look at it in different ways, but fundamentally, FTX is leveraged. It's kind of like running a Ponzi scheme and then eventually bringing about a huge crash.
Then came Genesis, the big crash on the lending side. It is the largest lender in cryptocurrencies. They are leveraged themselves and provide leverage to a lot of players at the same time, which is actually why they eventually go down, so they are a leveraged financier and a leveraged financier.
So the above is basically what happened in the past year. The interest rate is now at 4.5%, and as the rate rises, the cryptocurrency shows a downward trend, and when the crash occurs, the price drops sharply.
2. Behind the story
If you only look at the surface, you will feel that the cryptocurrency world is full of Ponzi schemes, fraud and leverage, and its evil veil has been lifted.
But if you compare the cryptocurrency index with the Nasdaq index, you will find that the two trended almost exactly the same until the later Three Arrows capital incident.
After the Three Arrows Capital incident, there were some differences between the two, but they basically maintained a similar trend. Sounds weird right? Because both FTX and Genesis crashed after that.
Let's tell the story from a macro perspective.
This was a year of reckoning - because of inflation, interest rates went up, inflation spiked in November, then the Fed raised rates quickly to try to catch up to inflation and bring it back down, and we're only now starting to get to a level where it's back down.
Why do rising interest rates affect asset prices? It starts with the value of the asset. The reason we consider an asset valuable is what it will bring us back in the future, especially given that these assets don't give you immediate returns. The same is true for most of the crypto assets we hold. This is a story about the "future".
So why do interest rates affect asset prices? In telling this story about the future, you have to discount the value of the asset by taking into account how long in the future it will take to earn a return.
You can think of interest rates as how long you have to wait, if you have to wait longer to get paid, then you have to discount the price more. If the interest rate base is zero, that means that whether you pay today or 10 years from now, you will get the same return. But if the interest rate changes to 5% a year, which means a long wait, it will be worth a lot less today.
This is why interest rates are important for cryptocurrencies. When interest rates go up, cryptocurrency prices go down, and when prices go down, people get liquidated because they have loans.
But traders are not the only ones being liquidated. Leveraged companies and leveraged agreements will also be liquidated. When the latter happens, it gives the appearance that everything is messed up. People feel like someone was the one who started it and it all ended.
But when a trader is liquidated, people may not react as much. Like the chart we just looked at, businesses and traders collapse in the same way. We can tell it from different perspectives, it can be a morality story, "someone did something wrong and everything happened", or it can be a big story.
So these Ponzi schemes and leveraged agreements are all products of the zero interest rate policy. With zero interest rates, you can wait forever for a Ponzi scheme to work, and you can expect leverage to deliver growth. But when you suddenly want to prove this growth and prove that today's policy plan is effective, you find that you have no time to prove it, and everything is over.
Of course you may feel that this story is too simplistic and that it absolves too many people of personal responsibility. So first let's look at the parts that perform well. For example, MakerDOA, AAVE, Compound, uniswap, DeFi have performed well in the past. Of course, people have mistrust of the big exchanges like Coinbase, Binance, but they are clearly not over yet.
3. How can we interpret it?
One interpretation is that the zero interest rate policy has led to large-scale malinvestment. People invest their money almost anywhere because they are so desperate for yield that they invest irrationally, only to wake up and realize they made the wrong decision.
Another interpretation is that CeFi is bad and DeFi is good (ignoring, of course, that Terra is DeFi). But not all CeFi fails, so I don't think that's a very plausible explanation either, although it's a very convenient story.
But you can look at it from another angle. Most of these failures are actually collateral failures. There is some sort of collateral in the system, but not enough: Three Arrows Capital does not have enough collateral to cover all their loans, and Terra does not have enough collateral in the system to back all outstanding UST. They're basically taking out loans already bankrupt, which basically means they're under-collateralized. So, maybe the problem is the lack of collateral.
Now, when we say undercollateralized, we can use credit to mean it. You can think of his credit as an undersecured loan, and when there is not enough collateral, bad things happen.
Another way to look at credit is that credit uses reputation as collateral because you don't have enough collateral to back the entire loan, so all you're left to rely on is the value of your reputation. So if you default on your loan, then you lose your reputation - if I'm going to extend you credit, I have to know how creditworthy you are. Credit comes into play when reputation is stable and valuable. That's why we have credit scores, and when you default, your reputation suffers. So your reputation should be of sufficient value to your line of credit.
So what is the collateral for Terra and Axie Infinity? The first is the obvious collateral, which for Tarra is Lfg, Bitcoin, but in reality there are not so many collaterals. So you can look at Terra from another angle, the collateral of Terra is confidence in the reputation of Terra, Lfg, and Terra Foundation.
But these collaterals are not ideal. It turns out that when we allowed Terra to leverage, we overestimated the value of this collateral.
The same goes for Axie Infinity, credit goes to the game designer's reputation. You think this kind of game is sustainable, and it turns out that it is actually a super-leverage, a super-Ponzi scheme, but even so, you still hope that these designers, its organization, will do something to reverse the ending, so this is your trust them.
So another way of looking at what happened last year is -- we had a miscalculation of the value of these guys' reputations. The reputations of specific people and organizations are overly trusted and vouched for.
Think about the so-called heroes in 2022. Who else has not fallen from the altar?
4. Inspiration from the story
The people we elect keep failing us, but that doesn't mean the reputation is no longer valuable. That's not to say you shouldn't value people's reputations, I don't think that's true.
If we don't trust institutions, if we don't trust teams, if we don't trust foundations, then it will be very difficult to build a cryptocurrency. We have a lot of work to do, and it will be done by individuals, organizations and groups.
So I think the moral of the story is that cryptocurrencies should not abolish trust. I think it's an overly simplistic reaction - blaming the mistake on trusting others, so we don't trust others anymore, only use MakerDAO or only use uniswap, and hope that nothing bad will happen again. This thinking is wrong. We still have so much more to do, and we need to place our trust in the teams building the next generation of applications, exchanges, and custodians.
We cannot say no to trust until people build truly trustless and decentralized bridges.
The real lesson of the story is that we need to think carefully about who we choose to trust. The biggest lesson that people need to learn is that we have created an idolatry and mania about some people in the past, and this needs to change so that cryptocurrencies do not repeat the mistakes of 2022.
