Paradigm Letter to Investors: Crash and Rebirth Belief

On July 20, Matt Huang, founding partner of well-known crypto VC Paradigm, sent a letter to LPs, explaining the internal reasons and implications of the recent collapse of the cryptocurrency market. He believes that although the market is destroyed in the short term, in the long run , the lessons learned during this crisis will translate into a healthier crypto ecosystem. The next 12-24 months will be a good time to build and invest in cryptocurrencies . 

In general, you can interpret this as a psychological massage for LPs, which are all simple and easy-to-understand vernacular, share with everyone, and massage together.

original:

2022 will be marked by macroeconomic uncertainty and a brutal wave of global sell-offs that have implications for tech, cryptocurrencies and other markets.

Bitcoin and Ethereum are down 49% and 58% year-to-date, respectively, with other crypto-related assets being more severely affected, such as COIN (down 71% year-to-date). The big sell-off exposed the entire crypto ecosystem on unhealthy leverage, triggering a series of woes and bankruptcies .

Crypto headlines and sentiment have turned noticeably negative, reminiscent of the bear markets of 2018 and 2015, but these events are now playing out alongside cryptocurrencies on a larger stage.

Despite the market shock, our long-term belief in cryptocurrencies as a technology and asset class remains strong. The quality of talent entering the crypto market has never been stronger. Meanwhile, speculators on short tours have withdrawn. We believe that the next 12-24 months will be a very productive period for building and investing in cryptocurrencies .

what happened?

A full description of the ongoing crypto deleveraging requires hindsight.

Currently, based on what we know, it is clear that certain crypto entities have accumulated large unsustainable positions under the implicit assumption that asset prices have been rising.

In 2020-2021, the market was full of enthusiasm, companies and funds felt reassured, risk constraints became barriers to the pursuit of scale and yield, and explicit and implicit leverage was built up. The extrinsic shock of the global crash is a reality check, and while these events are clearly negative, we are optimistic that the lessons learned will translate into a healthier cryptocurrency ecosystem in the long run .

Earth, MOON, UST

The first domino to fall was the Terra blockchain. In short, Terra is known for its native blockchain asset LUNA (similar to Ethereum’s ETH) and the dollar-pegged stablecoin UST built on it.

UST’s peg is maintained through a two-way redemption process to LUNA: when UST falls below $1, you can “burn” $1 of UST to “mint” $1 of LUNA, and vice versa when UST grows to $1 Above $1, you can “burn” $1 worth of LUNA to “mint” $1 of UST. In theory, this process will keep UST around $1…as long as confidence in the system remains strong.

Like many “algorithmic stablecoins” before it, if confidence in the value of UST and LUNA is lost, the design of UST is subject to a potential negative spiral that will cause everyone to run to the exit.

In fact, there are so many questions about algorithmic stablecoin design that perhaps the most interesting question is not “Why did UST crash?” but “How did UST get so big before it collapsed?  ” /UST has been asking himself questions from a bystander’s perspective during his meteoric ascent.

While it’s hard to pinpoint the root cause, a charismatic founder (Do Kwon); many reputable investor backers (including the now bankrupt 3AC); a too good one offering 20% ​​UST yield Anchor protocol at high rates; flashy attempts to acquire large amounts of BTC as collateral, and a combination of many other factors fueled a frenzy of retail and institutional speculation on the underlying asset LUNA and the seemingly low-risk 20% UST yield.

An increase in the value of LUNA leads to greater confidence in the stability of UST, while more UST deposits lead to greater confidence in LUNA.

This positive feedback loop is very strong during the ascent, but the negative feedback loop is even more powerful during the descent. Currently, LUNA has dropped from over $100 in April to less than $0.01 today. The UST stablecoin broke the $1 peg and is now worth close to 0, with over $18 billion in UST deposits and $40 billion in LUNA market cap gone.

The sell-off in cryptocurrencies was accelerated as air fled LUNA and UST, and problems began to appear elsewhere in the crypto market.

3AC and cryptocurrency lenders

Three Arrows Capital (3AC) started as a traditional foreign exchange arbitrage fund in 2012 and then expanded into the crypto market through arbitrage and directional strategies. The founders of 3AC (Su Zhu and Kyle Davies) used their own capital to grow their starting assets of less than $1 million to more than a few billion dollars in 10 years.

An incredible feat from any angle. However, it was this track record of ignoring risk that arguably paved the way for the demise of the 3AC.

Heading into 2022, the 3AC’s inflated overconfidence is dangerously combined with the cryptocurrency lending ecosystem, which is more than willing to provide unhealthy leverage to grow the loan book in search of higher yields.

Incredibly, one cryptocurrency lender, Voyager Digital, appears to have provided 3AC with as much as $350 million in USD and 15,250 BTC (over $1 billion in total as of March 30), completely unsecured. Such a large loan, without any collateral, clearly shows bad judgment, but it also hints at the intense competition among lenders to grow their assets and how they are working with a large and reputable fund like 3AC feel relatively comfortable.

Not all lenders are so flippant. The loans from Celsius and Genesis appear to be partially collateralized, while the loans from BlockFi appear to be over-collateralized .

Collectively, 3ACs are able to accumulate billions in debt on billions of assets that have a lot to do with the continued growth of cryptocurrency asset prices. Once the market sold off and the subsequent LUNA/UST crash, what happened next was inevitable.

3AC morphed from billions in net worth to over $1 billion in net debt, went out of business, and blew a hole in the balance sheets of cryptocurrency lenders.

While 3AC caused the biggest losses, cryptocurrency lenders also made various other mistakes. Some engage in risky trading strategies (e.g., so-called “yield farming” across DeFi protocols) with client assets. Others lock up capital in seemingly low-risk carry trades (such as betting on GBTC and BTC prices converging), implicitly assuming a long-term bull run in the market that doesn’t match the short-term nature of customer deposits. For surviving crypto lenders, risk management seems likely to gain new prominence internally .

lessons learned

The cryptocurrency ecosystem is rebuilding money, financial systems, and Internet applications based on new technological and economic foundations. A process so ambitious is bound to be messy. Every failure is an opportunity to learn, and we are optimistic that the cryptocurrency ecosystem will become smarter and more resilient.

This is not the first crisis for cryptocurrencies, and certainly not the last .

In 2014, MtGox was the largest Bitcoin exchange, handling more than 70% of the world’s trading volume, and a hack caused a loss of more than 7% of all BTC in circulation.

In 2016, when a smart contract application called “DAO” was hacked, it held close to 15% of all ETH supply.

At the time, both events appeared to exist. Fear is widespread, and asset prices rise with it. However, in our experience, events like this do not ultimately stop the fundamental drive of cryptocurrency progress: developers and entrepreneurs committed to building the future .

These crises also catalyzed positive change. The decline of MtGox made way for more secure and well-run exchanges like Coinbase, and spurred the development of fully non-custodial exchanges like Uniswap.

The DAO hack has brought more attention to the security of smart contracts . Hopefully the LUNA/UST debacle will lead to a broader understanding of the risks surrounding algorithmic stablecoins, and the explosion of 3ACs and crypto lenders will lead to better risk management.

An underreported fact is that decentralized finance (DeFi) protocols have performed relatively strongly compared to centralized finance (CeFi) lenders and funds .

DeFi lenders, such as MakerDAO, Compound, and Aave, are able to maintain solvency by liquidating collateral when margin limits are reached through a preset mechanism. These systems are on-chain, transparent, code that can be inspected by anyone, with little chance of accumulating unhealthy leverage. DeFi has a long way to go before it can match the existing financial system, but some of its fundamental advantages are starting to emerge.

Amid the gloomy headlines, our optimism remains unaltered by recent events. There’s not a day where we don’t meet a talented college student or an experienced tech executive considering the next 5-10 years to build his career in cryptocurrency.

Cryptographic infrastructure and developer tools are maturing. The opportunity for new DeFi protocols, especially after this CeFi unwind, is huge. We see many emerging green shoots in the consumer space, such as gaming, digital art and social networking. Progress and opportunities abound, largely unaffected by asset prices and continued deleveraging.

Going forward, we will continue to focus on the multi-decade opportunity for cryptocurrencies. Our team and the entrepreneurs we support find that in a quieter environment, it’s easier to focus on the substance without getting distracted. Speculative tourists have left, and valuations are starting to rationalize. Strong companies are finding it easier to hire great people.

Overall, we are optimistic that the next 12-24 months will be a good time to build and invest in cryptocurrencies .

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/paradigm-letter-to-investors-crash-and-rebirth-belief/
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