The Disillusionment of the Eternal Bull Run

The market in July is digesting the extreme volatility of the previous two months, and the focus of investors' debate has shifted to whether a cyclical bottom is forming. We also have time to review the impacts brought by DEFI technology, the collapse of centralized financial institutions, excessive leverage, and liquidity cycles. Before each crisis, there are always those who believe "this time is different," but in fact, we have been repeating history. In the face of cycles, technological advancements may only boost economic expectations and cannot suppress greed and fear. We have witnessed the destructive power of leverage and the rapid bursting of bubbles. If there is anything to learn from the past two months, it is certainly a reverence for market rules and a reflection on speculative psychology.

There is no difference; what has changed is that investors have learned more, and the frenzy and noise have been eliminated by the market.

The Crashing Market

Ethereum's monthly token price changes over the past five years show that the market performed poorly from April to June 2022. In June, ETH experienced a decline of 45%, and by the end of June, the price of ETH had dropped 78% from last year's historical high of $4808.

The reason for discussing Ethereum rather than Bitcoin is that this crisis is more related to liquidity. Although various layer 1s have flourished in the past two years, since the emergence of DEFI, Ethereum has remained the largest smart contract platform, carrying a large number of users, funds, transactions, and innovations, like a gravitational field continuously absorbing large amounts of liquidity. During the bull run cycle that started in 2020, the price of Ethereum rose, and the total value locked (TVL) across the network surged to (, reaching a peak of about $25.3 billion in December 2021. Subsequently, due to the rapid collapse of a batch of game finance projects at the end of 2021, the market experienced a downturn, until it quickly surged to $22.8 billion in March-April 2022, after which the overall amount of funds truly and without any rebound plummeted.

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At the same time, the supply of stablecoins on the ETH chain has also changed. Unlike the rapid decline in Ethereum's market value from November 2021 to January 2022, which occurred during the last drop, this time the decline was accompanied by a contraction in stablecoin supply, which did not happen at the end of 2021. The supply decreased from a peak of $16.1 billion on April 3, 2022, to $14.65 billion on June 30, with a total outflow of $1.45 billion exceeding the total supply of DAI. During this period, the supply of USDT decreased, while USDC seemed to become a "safe-haven" stablecoin, experiencing a certain degree of increase.

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This series of price crashes, TVL contraction, and stablecoin supply decrease seem to indicate that this market turbulence is more severe 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 the direct driving force behind a thriving market.

It should be noted that liquidity has two meanings in macroeconomics: first, the ease of asset realization at the micro level, and second, the abundance of market funds at the macro level. The liquidity mentioned in this article refers to the latter.

Looking back at the crash process from April 2022 to now, it can be roughly divided into three stages:

The first phase is from April 4 to May 6, and the market decline is mainly due to concerns about the macro environment. The Federal Reserve's tightening expectations continue to strengthen, with the market basically confirming a 50 basis point rate hike at the May FOMC, and the annual rate hike expectation reaching as high as 275 basis points. US Treasury rates continue to surge close to 3%, the US dollar keeps strengthening, with the exchange rate against the Chinese yuan rapidly appreciating from 6.37 to 6.5, and various commodity markets are hitting new highs. The Bitcoin market shows a close correlation with traditional markets, the crypto market is starting to weaken, and Bitcoin has fallen below $40,000. Ethereum's market cap and TVL have begun to decline in sync, and this relatively mild decline seems to indicate that smart money is just expressing expectations of liquidity tightening.

The second phase was from May 7 to May 14, during which the market decline was mainly influenced by the extreme events surrounding LUNA. In just a few days, the market value of two digital assets, )LUNA and UST(, evaporated nearly $40 billion in investor value. On May 7, UST began to decouple, and by May 9, it had dropped to $0.35, while LUNA was trading at around $60, nearly halving from its historical high of $119). In the next 36 hours, the price of LUNA fell below $0.1, and UST fluctuated between $0.30 and $0.82. This led to the redemption mechanism of the LUNA-UST protocol running at high speed, causing panic among some and greed among others, all exchanging 1 UST for LUNA worth $1, which increased the supply of LUNA and further depressed its price. Soon, the once-glorious South Korean "national currency" LUNA was nearly worthless. The Bitcoin holdings of Luna Foundation Guard (LFG), which had attempted to link UST with the entire Bitcoin market since March, were completely depleted in just one day on May 9, as they tried to defend the peg of UST to the dollar, but ultimately failed.

The third phase is from June 8 to June 19, during which the market experienced a sharp decline mainly due to the collapse of various centralized financial institutions. The on-chain DEFI market is on the verge of collapse, and the impact of LUNA is more far-reaching than imagined, even affecting LIDO, where stETH also experienced a decoupling. Strictly speaking, there is no anchoring relationship between stETH and ETH; stETH is merely a futures contract of ETH. Celsius was the first to be affected and was forced to suspend all withdrawals. Subsequently, news emerged that Three Arrows Capital was in crisis. As a major supporter of LUNA and a major holder of stETH, they faced over $400 million in loans that needed to be repaid. To make matters worse, it was reported that the founders of Three Arrows Capital leveraged their reputation to "desperately borrow from nearly all institutional lenders in the industry," including Voyager Digital, Babel Finance, and BlockFi. Three Arrows Capital had heavily leveraged their debt to purchase the majority of their assets, with a very small collateralization ratio. In no time, off-chain exchanges, lending institutions, and hedge funds were all affected, unable to repay debts, lacking liquidity, or facing liquidation during this crisis. Other affected institutional investors or individuals also chose to withdraw liquidity to protect themselves. On June 18, Bitcoin fell below the $20,000 high from 2017, reaching a true low of $17,708.

History is just repeating itself

Roger Lowenstein's book "When Genius Failed: The Rise and Fall of Long-Term Capital Management" chronicles the rise and fall of Long-Term Capital Management (LTCM), and contains a quote: derivatives are new things, but panic is as old as the market.

That year was 1998.

The derivatives we are familiar with, including options and futures, still belonged to the category of financial innovation that year.

LTCM was founded in 1994 by the legendary Wall Street firm Salomon Brothers' bond trading chief, engaging in highly leveraged arbitrage in the bond market. Its board members included Myron Scholes and Robert C. Merton, who jointly received the Nobel Prize in Economic Sciences in 1997 for their development of the famous BS options pricing model.

At that time, the highly popular LTCM employed a strategy that seems quite simple now: mean reversion, betting that the market would return to average levels to gain returns, which inherently assumed that the market would not deviate from "normal" for too long. For many years, this was indeed the case when the market operated normally. In its first three years, LTCM delivered annualized returns of 21%, 43%, and 41% to its investors, attracting all bankers on Wall Street. The fund signed thousands of derivative contracts, with almost all banks at the time being their creditors, covering risk exposures worth over $1 trillion.

However, the strategy of betting that the betting market would always return to "normal" has failed. It should be noted that before the collapse of LTCM, they did not wait for the market to return to normal. The black swan event still occurred. The global panic caused by the Russian financial crisis led investors around the world to sell everything, and the yield spread 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. The fund was forced to liquidate, exacerbating the systemic risk for all investors.

Many people compare the crisis of Three Arrows Capital to the collapse of LTCM back in the day.

Although the scale of Three Arrows cannot be compared to that of LTCM, it was reported that at its peak, Three Arrows had only $18 billion in size, which is far from LTCM, but a closer look at the context reveals some similarities.

LTCM bet on mean reversion, widely borrowing debt to operate its strategy with high leverage. However, when a black swan event occurred, the strategy failed, leading to an inability to repay debts, liquidity being squeezed, market pricing distorted, and a collapse of faith.

Three Arrows Capital bet on LUNA and stETH, borrowing debt widely with low or even no collateral and operating with high leverage. When LUNA collapsed, stETH was also impacted. To minimize losses, Three Arrows had to sell stETH. Faced with widespread inability to repay debts, this caused significant losses to companies such as Voyager Digital, BlockFi, and now Genesis. Even many investors unrelated to LUNA and stETH chose to withdraw liquidity, and the market is experiencing "de-leveraging" and "hard landing" in a collapsing manner.

In 1998 and 2022, there is a gap of 24 years, and the development process is almost identical. Not to mention the internet bubble in 1990 and the global financial crisis triggered by the subprime mortgage crisis in 2008, history seems to be repeating itself.

When accumulating leverage, has no one reflected on it, has no one consulted history?

It must be.

But this voice was drowned out by the soaring asset prices, and optimists shouted, "This time it's different."

In 1998, Wall Street was obsessed with derivatives and the aura of Nobel laureates. During the internet bubble, people firmly believed that this communication technology could open a new chapter in the world. In 2008, the invention of subprime loans seemed to liberate all of humanity.

The innovations brought about by technology have led investors to be optimistic about the current situation, while enthusiasm has fueled a widespread speculative mentality, constantly eroding the boundaries of risk. The accumulated leverage has resulted in false promises of high returns, and at the moment the dominoes fall, nothing is different.

The Essence of Technology and the Leverage Cycle

The winner of the "Schumpeter Prize", 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 with each other, while recursion refers to directional, optimal cloning.

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

This is the main reason why DEFI has been in high demand since its inception. The essence of DEFI technology is the stacking of Lego blocks. This stacking shortens the innovation cycle, and we are always standing on the shoulders of giants. Imagine how difficult it would be to build a ve(3 from scratch if OHM were not open-source and curve had patent protection. It is precisely because of its grammatical composability, protocol reusability, and tool compatibility that we have witnessed its rapid development in the crypto space since Uniswap ignited DEFI Summer. We do not have to start from scratch; we just need to focus on the areas that need technological breakthroughs the most.

Review how dominoes are quickly set up and fall down.

The LUNA-UST algorithmic stablecoin protocol has been under constant controversy since its inception, with many accusing it of being just another Ponzi scheme, while others criticize the mechanism as merely stepping on one's own feet. It represents a completely new narrative and a technical method of maintaining peg, achieving a 1:1 exchange with the US dollar through algorithms, discarding the asset-backed guarantees upheld by USDC, USDT, and even DAI. Delphi even created a DEFI paradise called Anchor for this narrative, offering a "no-risk" return of 20% to support the direction of these artificially created assets.

No endorsement, decentralized, algorithm, protocol, just as the Bible says, this is a new heaven and a new earth, and there is no more sea.