Paradigm Letter to Investors: Embracing New Beginnings Amidst the Collapse

Original Title: 《LP Letter Excerpt --- July 20th, 2022》

Written by: Matt Huang, Paradigm

Compiled by: Deep Tide TechFlow

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

Overall, you can interpret this as a psychological massage for LPs, using simple and understandable language, shared for everyone to enjoy together.

Original text:

The year 2022 is characterized by macroeconomic uncertainty and a brutal global sell-off, which has impacted technology, cryptocurrencies, and other markets.

Bitcoin and Ethereum have fallen by 49% and 58% respectively since the beginning of the year, while other crypto-related assets have been hit even harder, such as COIN (down 71% year-to-date). This massive sell-off has exposed the entire crypto ecosystem built on unhealthy leverage, triggering a series of dilemmas and bankruptcies.

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

Despite the market being shaken, 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, the speculators who came for a brief visit have exited. We believe that the next 12-24 months will be a very productive period for building and investing in cryptocurrencies.

What Happened?

A complete description of the ongoing crypto deleveraging requires hindsight.

Currently, based on what we understand, it is clear that certain crypto entities accumulated a large number of unsustainable positions under the implicit assumption that asset prices would continue to rise.

In 2020-2021, the market was filled with enthusiasm, and companies and funds felt invincible, with risk constraints becoming obstacles to chasing scale and returns, leading to the accumulation of both explicit and implicit leverage. The external shock of the global downturn served as a reality check; although these events are clearly negative, we optimistically believe that the lessons learned will translate into a healthier cryptocurrency ecosystem in the long run.

Terra, LUNA, 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 UST stablecoin pegged to the dollar that is built on it.

The peg of UST is maintained through a two-way redemption process with LUNA: when UST drops below $1, you can "burn" $1 of UST to "mint" $1 of LUNA, and conversely, when UST rises above $1, you can "burn" $1 worth of LUNA to "mint" $1 of UST. Theoretically, this process would keep UST around $1… as long as confidence in the system remains strong.

Like many previous "algorithmic stablecoins," if confidence in the value of UST and LUNA is lost, the design of UST is susceptible to a potential negative spiral, leading everyone to rush for the exits.

In fact, the design issues of algorithmic stablecoins are numerous, and perhaps the most interesting question is not "Why did UST collapse?" but rather "How did UST become so large before its collapse?" This is a question we have been asking ourselves from the sidelines during the meteoric rise of LUNA/UST.

While it is difficult to pinpoint the root causes accurately, a charismatic founder (Do Kwon); many prestigious investor supporters (including the now-bankrupt 3AC); an Anchor protocol that offered an impossibly good 20% yield on UST; a glamorous attempt to acquire large amounts of BTC as collateral; and many other factors combined to fuel retail and institutional fervor for the underlying asset LUNA and the seemingly low-risk 20% UST yield.

The rise in the value of LUNA led to greater confidence in the stability of UST, while more UST deposits led to greater confidence in LUNA.

This positive feedback loop was very powerful during the rise, but during the decline, the negative feedback loop became even stronger. Currently, LUNA has fallen from over $100 in April to less than $0.01 today. The UST stablecoin broke its $1 peg and is now worth nearly $0, with over $18 billion in UST deposits and $40 billion in LUNA market cap having vanished.

As the air escaped from LUNA and UST, the sell-off in cryptocurrencies accelerated, and problems began to appear elsewhere in the crypto market.

3AC and Crypto Lenders

Three Arrows Capital (3AC) started in 2012 as a traditional forex arbitrage fund and then expanded into the crypto market through arbitrage and directional strategies. The founders of 3AC (Su Zhu and Kyle Davies) grew their initial capital of less than $1 million to over several billion dollars over a decade.

From any perspective, this is an incredible feat. However, it is precisely this performance record achieved without regard for risk that can be said to have paved the way for 3AC's demise.

Entering 2022, 3AC's inflated overconfidence dangerously combined with the crypto lending ecosystem, which was very willing to provide unhealthy leverage to increase loan books in search of higher yields.

Incredibly, a crypto lender, Voyager Digital, seemingly provided 3AC with up to $350 million in USD and 15,250 BTC (worth over $1 billion as of March 30) with no collateral at all. Such a large loan without any collateral clearly indicates poor judgment but also suggests fierce competition among lenders to increase assets and their relative comfort in working with large, reputable funds like 3AC.

Not all lenders were so reckless. Loans from Celsius and Genesis appeared to be partially collateralized, while BlockFi's loans seemed to be over-collateralized.

Overall, 3AC was able to accumulate billions in debt against billions in assets, which was largely related to the continued rise in cryptocurrency asset prices. Once the market sell-off and the subsequent LUNA/UST collapse occurred, what happened next was inevitable.

3AC transformed from billions in net assets to over $1 billion in net debt, collapsing and blowing a large hole in the balance sheets of crypto lenders.

While 3AC caused the largest losses, crypto lending institutions also made various other mistakes. Some engaged in risky trading strategies with customer assets (e.g., the so-called "yield farming" across DeFi protocols). Others locked capital in seemingly low-risk arbitrage trades (e.g., betting that GBTC and BTC prices would converge), implicitly assuming a long-term bull market that did not match the short-term nature of customer deposits. For the surviving crypto lending institutions, risk management seems poised 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. Such an ambitious process is bound to be chaotic. Every failure is a learning opportunity, and we optimistically believe that the cryptocurrency ecosystem will become smarter and more resilient.

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

In 2014, MtGox was the largest Bitcoin exchange, handling over 70% of global trading volume, and a hack resulted in the loss of over 7% of all circulating BTC.

In 2016, a smart contract application called "DAO" was hacked, holding nearly 15% of all ETH supply.

At the time, both events seemed catastrophic. Fear was widespread, and asset prices followed suit. However, based on our experience, such events ultimately did not stop the fundamental momentum of cryptocurrency progress: developers and entrepreneurs committed to building the future.

These crises also catalyzed positive change. The decline of MtGox paved the way for safer and better-run exchanges like Coinbase and spurred the development of fully decentralized exchanges like Uniswap.

The DAO hack raised awareness of the security of smart contracts. We hope that the collapse of LUNA/UST will lead to a broader understanding of the risks surrounding algorithmic stablecoins, and that the explosion of 3AC and crypto lending institutions will lead to better risk management.

A little-known 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, have been able to liquidate collateral through preset mechanisms when margin limits are reached, maintaining solvency. These systems are on-chain, transparent, and verifiable by anyone, leaving little room for unhealthy leverage to accumulate. DeFi has a long way to go to match the existing financial system, but some of its fundamental advantages are beginning to emerge.

Amid the gloomy headlines, our optimism has not been diminished by recent events. Not a day goes by without encountering a talented student or an experienced tech executive considering building their careers in the cryptocurrency space over the next 5-10 years.

Crypto infrastructure and developer tools are maturing. The opportunities for new DeFi protocols, especially after this CeFi unwind, are enormous. We see many emerging green shoots in consumer areas such as gaming, digital art, and social networks. Progress and opportunities abound, largely unaffected by asset prices and ongoing deleveraging.

Looking ahead, we will continue to focus on the decades-long opportunities in cryptocurrencies. Our team and the entrepreneurs we support find it easier to concentrate on substance in a quieter environment without distractions. The speculative tourists have left, and valuations are beginning to rationalize. Strong companies are finding it easier to hire top talent.

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