Disillusionment of the Eternal Bull Market

The market in July is digesting the extreme volatility of the previous two months. The focus of investors’ debate has turned to whether the bottom of the cycle is forming. We also have time to look back at DEFI technology, CEFI thunderstorms, excessive leverage, and the liquidity cycle brings us everything of. Before every crisis, there are always people who believe that “this time is different”, but in fact – we are repeating history all the time. In the face of the cycle, technological progress may only push up economic expectations, but cannot suppress greed and fear. We have witnessed the destructive power of leverage and the rapid bursting of bubbles. If we can learn anything from the first two months, it must be an awe of the laws of the market and an examination of the speculative psychology.

Nothing is different except that our investors have learned more and the frenzy and noise are eliminated by the market.

crashing market

With the help of glassnode, we have counted the price changes of tokens every month in the past 5 years when Ethereum has achieved broad consensus. It can be seen that the market is bleak from April 2022 to June 2022. Among them, ETH dropped by 45% in June. As of the last day at the end of June, the price of ETH has fallen by 78% from the historical high of 4808 last year.

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Figure 1 The monthly price change of Ethereum from June 2017 to June 2022

The reason to talk about ethereum rather than bitcoin is that this crisis is perhaps more related to liquidity. It is undeniable that although various layer1s have competed for each other in the past two years, since the advent of DEFI, Ethereum has been the largest smart contract platform, carrying a large number of users, funds, transactions and innovations – like a gravitational field, constantly Swallowing a lot of liquidity. As shown in Figure 2, gray shows the price of Ethereum, and blue is the TVL change of the entire network. In the bull market cycle that started in 2020, the price of Ethereum rose, TVL soared, and reached the highest value in December 2021, about $253B. Then, due to the rapid collapse of a large number of gamefi1.0 projects at the end of 2021, the market fell back until From March to April 2022, it quickly rose to $228B, and then the overall capital volume really took a nosedive without any rebound.

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Figure 2 Changes in the market value and TVL of Ethereum from June 2017 to June 2022

At the same time, there are changes, as well as the supply of stablecoins on the ETH chain. See Figure 3, the gray part is the change in the market value of Ethereum, the orange line is the overall supply of major stablecoins, and the green, blue, orange, and purple are the supply of USDT, USDC, BUSD, and DAI, respectively. Unlike the last (November 2021-January 2022) precipitous drop in Ethereum’s market cap, this drop, accompanied by a shrinking stablecoin supply, is something that didn’t happen at the end of 2021, by 2022. The high of $161B recorded on April 3rd fell to $146.5B on June 30th, with a total outflow of 14.5B (this figure exceeds the total supply of DAI). What happened more interestingly during this period was the decline in the supply of the stablecoin leader USDT (green), while USDC (blue) seemed to have become a “safe-haven” stablecoin during this crisis, with a certain increase.

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Figure 3 The market value of Ethereum and the supply of various mainstream stablecoins from January 2020 to June 2022

This series of price slumps, TVL crunch and stablecoin supply decline all seem to tell us that this time the market volatility is more ferocious than the decline from the end of 2021 to March 2022 – after all, the amount of funds or Liquidity directly reflects market confidence and is a direct driver of market vigour.

It should be noted that liquidity has two connotations in the macro economy. One is the difficulty of asset realization at the micro level, and the other is the abundance of market funds at the macro level. In this article, we mention The mobility of all refers to the second connotation.

If we go back and look back at how the slump from April 2022 to the present happened, we can roughly divide this difficult period into three stages, as shown in Figure 4, where the gray is the change in the market value of Ethereum, and the blue line is the Ethereum Changes in TVL.

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Figure 4 Changes in Ethereum’s market value and TVL from January 2022 to June 2022

The first phase was from April 4 to May 6, and the market decline during this period was mainly due to concerns about the macro environment. The Fed tightening expectations continued to strengthen, the market continued to strengthen and basically confirmed the FOMC interest rate hike expectation of 50bp in May, and the annual interest rate hike expectation was also as high as 275bp. 6.37 appreciated rapidly to 6.5, and various commodity markets hit new highs. The BTC market showed a side closely related to the traditional market, with the crypto market starting to weaken and Bitcoin falling back below $40,000. See Figure 4. Both the Ethereum market cap and TVL in the gray part have started to fall. This synchronized and relatively modest decline seems to be expressing that smart money is just expressing their expectations for a liquidity crunch.

The second phase was from May 7th to May 14th, and the market decline during this period was mainly affected by the extreme events in LUNA. In just a few days, two of the top 10 digital assets by market capitalization (LUNA and UST) wiped out nearly $40 billion in investor value. On May 7, 2022, UST began to decouple, and on May 9, UST dropped to 0.35, when LUNA was trading at around $60 (nearly halved from the $119 ATH). Over the next 36 hours, LUNA price fell below $0.1, while UST traded between $0.30 and $0.82. This makes the redemption mechanism of the LUNA-UST protocol go into overdrive. Some people are panicking and some people are greedy in the crisis. They exchange 1 UST for LUNA worth 1 USD, which increases the supply of LUNA and further depresses the price of LUNA. Soon, the prosperous South Korean “national currency” LUNA almost returned to zero. Figure 5 shows the BTC holdings of the Luna Foundation Guard (LFG) (orange line), it can be seen that the BTC reserves built by their attempt to tie UST to the entire BTC market since March, on the 9th day of May Depleted within the dollar, they attempted to defend the UST’s peg to the dollar – and they failed.

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Figure 5 Changes in Bitcoin price and LFG’s BTC holdings between January 2022 and June 2022

The third stage is from June 8th to June 19th. The market slump during this period mainly came from the thunderstorms of various CEFI institutions. Rome wasn’t built in a day, but Rome can fall in a day. The DEFI market on the chain is shaky, the impact of LUNA is far-reaching than expected, and even affects LIDO, and stETH has also decoupled (strictly speaking, there is no anchoring relationship between stETH and ETH, stETH is just a futures contract of ETH). Celsius was first affected by this and was forced to suspend all withdrawals. After that, there was news that Three Arrows Capital was in crisis – as the main support institution of LUNA and the super-large account of stETH, they faced more than $400 million in loans to be repaid. To make matters worse, according to a report by Sean Farrell, head of digital asset strategy at FSInsight, the founders of Three Arrows Capital, Su Zhu and Kyle Davies, used their reputations to “borrow against almost every institutional lender in the industry,” including Voyager Digital, Babel Finance and BlockFi, Three Arrows Capital purchased most of their assets through debt and leverage, and the mortgage ratio is very small. For a time, off-chain exchanges, lenders, and hedge funds were all spared, insolvent, illiquid or liquidated in the midst of this crisis. Other affected institutional investors or individuals also chose to withdraw their liquidity during the crisis to protect themselves. On June 18, BTC fell below the 2017 high of $20,000 and reached a true low of $17,708.

History just repeats itself

Roger Lowenstein has a book called When Genius Failed: The Rise and Fall of Long-Term Capital Management, which restores the rise and fall of Long-Term Capital Management (LTCM) in those years. There is a sentence in it, derivatives are new things, but Panic is as old as the market.

That year was 1998.

Derivatives that we are familiar with, including options, futures, etc., still belonged to the category of financial innovation in that year.

Founded in 1994 by the head of bond trading at the legendary Wall Street firm Salomon Brothers, LTCM conducts highly leveraged arbitrage in the bond market. Its board members include Myron Scholes and Robert C. Merton, who shared the Nobel Prize in Economics in 1997 for their development of the famous BS model for option pricing.

LTCM, which was in the limelight at the time, used a strategy that now seems simple — mean reversion, betting on the returns they would get when the market would revert to the mean, with the implicit assumption that the market wouldn’t deviate from it.” norm” is too long. For many years, when the market was functioning normally, that was true. LTCM handed over an annualized 21%, 43% and 41% of satisfactory answers to investors in the first three years respectively, making all Wall Street bankers flock to it. Funds entered into thousands of derivatives contracts, with nearly all banks being their creditors at the time, covering more than $1 trillion worth of exposure.

However, this strategy of betting that the market will always return to “norm” failed – it should be said that they did not wait for the day when the market returned to normal before LTCM collapsed. Black swan events still happen. The global panic caused by the Russian financial crisis has investors around the world selling everything, and LTCM is betting that yield spreads have not returned to normal as they had expected, but instead widened. Suddenly, tens of billions of leveraged trading strategies are losing money. Funds were forced to close their positions, exacerbating systemic risk for all investors.

Many people compare the crisis of Three Arrows Capital to the fall of LTCM that year.

While Three Arrows is incomparable in size to LTCM, which was reported to be only $18 billion at its peak, a far cry from LTCM, a closer look at the context is quite similar.

LTCM bet on mean reversion, widely borrowed debt and ran its strategy with high leverage, but a black swan event occurred, the strategy failed and the debt could not be repaid, liquidity was run, market pricing was distorted, and belief collapsed.

Three Arrows bet on LUNA and stETH, widely borrowed debts with low collateral or even no collateral, high leverage operation, LUNA crashed, and stETH was hit at the same time. In order to reduce losses, Three Arrows had to sell stETH, facing a wide range of insolvency The repayment of debt caused huge losses to companies such as Voyager Digital, BlockFi and now Genesis, and even many investors unrelated to LUNA and stETH chose to withdraw liquidity, and the market achieved “deleveraging” and “hard” in a crashing way. landing”.

1998, 2022, 24 years, the development process is almost the same. Not to mention the dot-com bubble of 1990 and the global financial crisis caused by subprime lending in 2008, history seems to repeat itself.

When the leverage is accumulated, has no one reflected on it, and has no one consulted history?

No, there must be.

It’s just that this voice is drowned out by soaring asset prices, and optimists are screaming that “this time is different.”

In 1998, Wall Street was superstitious about derivatives and the halo of Nobel laureates. During the dot-com bubble, people believed that this communication technology could open a new chapter in the world. In 2008, the invention of subprime lending seemed to liberate all of humanity.

Innovations brought about by technology have led to investors’ optimism about the status quo, the frenzy has fueled a widespread speculative mentality, the constant erosion of risk boundaries, the accumulation of leverage has led to false promises of high returns, and the moment the dominoes fall, Nothing is different.

The Nature of Technology and the Leverage Cycle

“Schumpeter Prize” winner Brian Arthur, in his book “The Essence of Technology”, believes that economy is the expression of technology, and at the same time, the essence of technology is combination and recursion. Composition refers to fast integration with each other, recursion refers to directional optimized cloning.

“Composability” drives technology and innovation exponentially.

I believe this is the main reason why DEFI has been so sought after over the years since its inception. Because the essence of DEFI technology is the superposition of LEGO bricks. This superposition will shorten the innovation cycle – we are always standing on the shoulders of giants. Imagine how difficult it would be to build a ve(3,3) from scratch if OHM wasn’t open source and curve was patented. It is precisely because of the composability of its syntax, the reusability of the protocol, and the compatibility of its tools that since Uniswap ignited DEFI Summer, we have seen its remarkable development in the encryption track. We don’t have to start from scratch, we just need to focus on where the technological breakthroughs are most needed.

Look back at how dominoes are built quickly and fall quickly.

When the LUNA-UST algorithmic stablecoin protocol emerged, there were endless debates. Many people accused it of being a Ponzi in another sense, and another group of people accused this mechanism of stepping on the right foot with the left foot. This is a new set of narratives and a new technical way to maintain anchoring-the one-to-one exchange with the US dollar through an algorithm, abandoning the previous method of asset pledge guarantee that USDC, USDT and even DAI insisted on. Delphi even created a DEFI paradise for this narrative – Anchor, with a 20% risk-free return – to carry these assets created out of thin air.

No endorsement, decentralization, algorithms, protocols, as the Bible says, this is a new world, and the sea is no longer there.

In the process of LUNA’s soaring, many people have suggested the corresponding risks. Back in 2018, Cyrus Younessi, MakerDAO’s head of risk and former research analyst at Scaler, told Scaler why he didn’t think Terra/LUNA would work. He cites the example of Nubits three years ago as proof of how such attempts have been rejected time and time again by the market.

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Figure 6 Cyrus describes the death spiral of terra, the picture comes from Twitter

However, until 2022, the price of LUNA is still higher, and Do Kwon even made a confident bet on Twitter. Time seems to tell that LUNA and Nubits, are different – not this time.

The main reasons for the different looks are: Anchor and LFG.

In fact, from the very beginning, the DEFI story has always revolved around liquidity.

DEFI’s troika: DEX, Lending, stablecoin. Translated with liquidity: DEX is the exchange place for liquidity, Lending is the price tag place for liquidity, and Stablecoin is the anchor for liquidity.

If you’re going to create anchored myths, you need to think about where these flows are going when they’ve been created out of thin air. If liquidity is like water, the market needs to find a sponge that sucks that water in and locks it up somewhere. Based on this consideration, in July 2020, LUNA created Anchor, and Nicholas Platias described the protocol on Medium.

He conceived of a savings agreement with the following characteristics:

  • Principal Protection : Anchor implements a liquidation protocol to liquidate the borrower’s collateral when the loan is at risk, thereby protecting the depositor’s principal.
  • Instant withdrawals : Terra deposits can be withdrawn instantly – no lock-up required.
  • Stabilizing Rates : Anchor stabilizes deposit rates by transferring a variable portion of the block reward from the collateralized assets to depositors.

Ultimately, their stable rate was set at 20%.

This is a yield that, under normal circumstances, would raise alarm for anyone with an investor education.

The simplest of these is the capital asset pricing model (CAPM). For a given asset, the relationship between its expected rate of return and the expected rate of return of the market portfolio can be expressed as, the rate of return of the portfolio is only related to the system related to sexual risk. The 20% fixed rate of return provided by Anchor for UST is obviously significantly higher than the market risk-free rate of return. The implication of this difference is that its 20% yield cannot be risk-free.

When the market was hottest, the market value of UST was as high as 18 billion US dollars, of which more than 14 billion were locked in the Anchor protocol, which required 20% APY every year. No matter how the bottom layer is pledged and borrowed, it cannot achieve this income – the market is like this Simply, without taking the corresponding risk, you cannot get a return higher than the risk-free rate of return. Then, LUNA needs a way to supplement the yield difference.

In January 2022, another mechanism echoing Anchor, LFG was launched. On January 19, 2022, Do Kwon announced the launch of the Luna Foundation Guard, an organization “authorized to build reserves to support the U.S. dollar peg in volatile market conditions” and to “allocate resources to support the growth and development of the Terra ecosystem” through grants . According to estimates, Anchor burned more than $4 million in LFG every day at that time.

In May 2021, according to the mechanism of LUNA-UST, a death spiral has been triggered. LFG (Luna Foundation Guard) injected capital into the market with its strong financial strength, pulling UST back to the anchor position, and also invisible The formation of market consensus has given a boost.

Anchor provides a rate of return that exceeds the market’s risk-free interest rate level, and LFG provides the market with frenzied confidence. People begin to forget the simplest financial principles, and funds begin to leverage: burn LUNA to form more UST, and deposit into Anchor , mortgage the credentials into other protocols (such as Edge), loan out UST, and then deposit this part of UST into Anchor for Loop. Each layer of this nesting doll process is adding bricks to the UST’s flat high-rise buildings.

Individual investors have limited investment opportunities in terms of relatively limited access to capital and information, and sophisticated “arbitrageurs” (CEFI institutions) are better off than individual investors due to greater access to capital and better investment opportunities information on investment opportunities. Leverage allows arbitrageurs to hold more positions. However, even arbitrageurs can face financial constraints due to margin requirements — and in the process, Three Arrows has been incredibly leveraged, and they have even borrowed assets unsecured.

When people began to sum up the success of LUNA and the major public chains raced to imitate, the market gathered an unfounded confidence, and the unsustainable speculation it drove, as the credit bubble grew, speculators appeared and began to frenzy Missionary, swipe twitter a few months ago and you’ll see countless LUNAtic preaching this amazing Holy Grail story to lure later investors into the same spiral.

However, in the event of bad news, the value of the asset falls along with the wealth of the arbitrageur. Leveraged arbitrageurs face margin calls and are forced to sell assets to meet margin requirements. The selling pressure of asset sales further leads to a loss of asset value and wealth for arbitrageurs. Increased volatility and uncertainty lead to more margin calls, which in turn lead to further forced asset sales. The resulting change in profit margins means lower leverage. Therefore, the price falls more than otherwise due to leverage.

Overleveraged in good times and deleveraged in bad times.

The most innovative technology, the strongest financial backing, and the strongest market consensus may also be destroyed in a “black swan” moment, no matter how different the technology and this narrative are from the past, the leverage cycle still dominates everything.

Greed has nothing to do with centralization

When we are in social and economic life, the dilemma we have to face is multi-party distrust, especially financial activities. The way traditional finance solves this problem is to provide “trust services” by notaries, lawyers, banks, regulatory compliance officers, governments, etc. This is an invisible cost added to each participant.

DEFI, short for “Decentralized Finance”, is another solution to the problem of trust between people. Aiming to create a financial world without financial intermediaries, it inherits the spirit of Bitcoin and expands the use of blockchain from simple value transfers to more complex financial use cases. Its connotation can be summarized as follows: censorship resistance, immutability, verifiability, accessibility and social consensus, which translates to: censorship resistance, immutability, verifiability, accessibility and social consensus. It promises an open and permissionless financial future. Anyone can access a variety of financial services, understand the transparent risks involved and trust that their money will not be stolen or frozen.

However, even with the purported benefits of DEFI, cryptocurrency investors are still dealing with CEFI institutions.

Before discussing further, let’s define CEFI first. Here we abandon the traditional centralized financial institutions, such as banks, brokerages, etc., and only discuss the centralized financial institutions in the cryptocurrency field, such as CEX such as Binance, FTX, etc., and lending institutions such as BlockFi.

The reason is that CEFI provides some of the revenue advantages of DEFI, as well as some of the ease of use and security of traditional financial services products. Therefore, even at the risk of counterparty risk, hacking risk, fraud risk and other risks, users still transfer their assets to a black box on the chain controlled by 100% secret keys. In this process, users seem to be weighing, choosing, and surrendering, they surrender 100% of their ownership of their funds in exchange for more convenient and easy-to-use services.

These black boxes, when dealing with customers’ funds, should be based on systematic risk measures to compensate for market fluctuations, such as over-collateralization, such as controlling leverage, such as ensuring liquidity, but when human greed is out of control, it is difficult to have suitable means. Be alerted to these signs in the CEFI black box.

So what about DEFI, which claims to have immutability, verifiability and accessibility, can DEFI restrain human greed and fear?

In 2013, Buterin foresaw the future of smart contracts being used in complex financial applications.

Controlled by software and algorithms that regulate how we interact—“code is law”, code is law—is another form of regulation in which private actors can embed their values ​​into technological artifacts. This brings a variety of benefits, such as legal automation, such as a priori enforcement of rules and regulations that happen automatically. Blockchain technology, the greatest example of this, has opened up many new opportunities to translate law into code. By converting legal or contractual terms into “smart contracts” with guaranteed execution, these rules are automatically enforced by the underlying blockchain network, always as planned, regardless of the wishes of the parties.

As Robert Leshner, who founded the DEFI money market protocol Compound, once said: No human judgment, no human error, no process, everything is instant and autonomous.

Relying on technology as a means of restraining individual behavior, as a means of automatically enforcing rules, sounds yes. Many proponents of “code is law” seem to think that DEFI is entirely outside the legal framework, rather than simply a way to disintermediate financial institutions.

However, just because all of this is happening via the blockchain doesn’t mean centuries of legal process suddenly magically ceases to apply. Because, regulation through code has important limitations and pitfalls that may create new issues related to fairness and due process – code itself, is a reflection of human will, and without stronger binding force, it is hard to imagine anyone Stop your own greed with the confinement of technology.

Let’s mention LUNA again. The arbitrage mechanism of LUNA-UST is completed by code, so as long as the network is not congested, the arbitrage process is automatic, smooth and fast, but this is only a technical progress. In fact, what this mechanism does not solve is the problems other than arbitrage – the problem of risk, the problem of leverage, and the problem of bubbles.

This is a bubble squeezing process faster than any previous hard landing, involving the DEFI protocol on the chain and the CEFI institution off the chain. In less than a month, no one was spared. In the face of the leverage cycle, we The difference or future between DEFI vs CEFI, which has been debated, is better or worse, and who will save who is not worth mentioning.

We are not implying, of course, that constraints on human nature often depend on more universal laws, such as when regulation should act as a gatekeeper, or as classical economics suggests, just as a bell ringer. We just try our best to reiterate the importance of respecting market laws and suppressing speculative psychology. This is not a problem that can be solved by technical means such as DEFI or CEFI. It depends on the overall maturity and progress of the market, and on the common maturity of all cryptocurrency investors. And growth, smooth out excessive leverage cycle. After all, a truly efficient market and a group of rational investors would never allow such a distorted opportunity to exist for too long.

references:

1.https://www.theblockbeats.info/news/30901?

2.https://min.news/en/economy/31b8631378008cf22a291ba7537495b1.html

3.https://www.nasdaq.com/articles/ltcm-and-other-history-lessons-for-crypto

4.https://medium.com/alpineintel/stop-saying-decentralized-a-plea-for-purging-cf4002d96c95

5.https://studio.glassnode.com/dashboards/8a7eca2d-efd9-4260-5554-74dfce400c34?&utm_medium=website&utm_source=defi_analysis_EN&utm_campaign=defi_deleveraging_2022_2022

6.https://insights.glassnode.com/the-week-onchain-week-26-2022/

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/disillusionment-of-the-eternal-bull-market/
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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