Dragonfly Managing Partner Haseeb: In-depth Review of the Major Collapse of the Crypto Market in 2022 and Its Insights

Speaker: Haseeb Qureshi

Video Title: "2022 in Review: the Year of 'Collateral' Damage"

Compiled by: Qianwen, ChainCatcher

In 2022, we had many painful experiences. We spent a lot of time trying to analyze and understand them, figuring out why they happened, the specific processes involved, and the people involved, but I have yet to see anyone truly attempt to view them from a more macro perspective, integrating them together.

What do all these events have in common? Why did they happen, and how can we avoid them in the future? This will be the focus of my talk today. I will discuss what we experienced over the past year in chronological order: quantitative tightening, the P2E model, the collapse of Luna, the Three Arrows Capital and FTX incidents, and think about them in a specific context.

1. Event Overview

First, let's go back to January 2022, when interest rates were at zero and inflation was just beginning. In most cases, risk assets performed well, peaking in November, and everyone was making a fortune. At that time, the entire industry was booming and full of energy for both the industry and risk assets.

So I will review the past year from two aspects: the first part is cryptocurrency, and the second part is the macro economy. The above chart shows the trends of BTC and the federal funds rate. Overall, it was stable, with Bitcoin showing a downward trend. When the federal funds rate reached 1%, it was the Federal Reserve's second major interest rate hike, which coincided with the first major collapse of the year—the collapse of Terra.

Essentially, Terra was a leveraged bank that accepted funds and then issued liabilities worth one dollar. However, it did not keep all the funds deposited by users but instead took the funds out to pay its equity holders, namely those who owned Luna, hoping that UST holders would not want to withdraw their funds.

It was a bank that did not reserve all its funds, and when many people wanted to leave the bank, it collapsed. This is somewhat similar to the Silvergate incident, but their methods of leveraging were different.

The next major collapse was Three Arrows Capital. It was a leading fund in Singapore and was extremely leveraged. The aftermath of the Terra collapse affected Three Arrows Capital, leading to its collapse, which immediately triggered a sharp drop in cryptocurrency prices.

Then came the Federal Reserve's 75 basis point rate hike, shortly after which Axie Infinity experienced a significant drop, plummeting 90% from its peak. This P2E model was no longer effective; for instance, players in the Philippines were now earning less from this game than their minimum wage, whereas before, they had earned much more than the minimum wage. This may sound harsh, but it was a Ponzi scheme disguised as a game.

People thought there would always be others speculating on AXS, so there would always be a market to sell tokens, but when all of this stopped, when people no longer wanted to buy AXS, the game suddenly came to a halt. This model of making money from playing games could no longer operate, and this Ponzi scheme came to an end. After that, interest rates continued to rise and would keep climbing, leading to the major event in November.

In November, FTX collapsed. FTX was a leveraged exchange, but you could also say it was a Ponzi scheme disguised as an exchange. You can look at it in different ways, but fundamentally, FTX was leveraged. It was somewhat like running a Ponzi scheme, which ultimately led to a massive collapse.

Then there was the major collapse in lending, Genesis. It was the largest lender in cryptocurrency. They themselves were leveraged while providing leverage to many players, which was actually the reason for their eventual downfall, so they were both a leveraged borrower and a lender providing leverage.

So that basically sums up what happened over the past year. The current interest rate is maintained at 4.5%, and as interest rates rise, cryptocurrency shows a downward trend, and when the collapse occurs, prices drop significantly.

2. The Story Behind

If you only look at the surface, you might think 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 their trends are almost identical 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. This sounds strange, doesn't it? Because both FTX and Genesis collapsed after that.

Let’s tell this story from a macro perspective.

This was a year of liquidation—due to inflation, interest rates rose, and inflation soared in November, after which the Fed quickly raised interest rates in an attempt to catch up with inflation and bring it down. In fact, we are just beginning to reach a level of decline.

Why does rising interest rates affect asset prices? This starts with the value of assets. We believe an asset has value because it can bring us returns in the future, especially considering that these assets cannot provide immediate returns. Most of the cryptocurrency assets we hold are the same; it's a story about the "future."

So why do interest rates affect asset prices? When telling this story about the future, you must consider how long it will take to receive returns in the future to discount the value of the asset.

You can think of interest rates as the time you need to wait; if you have to wait longer to get returns, you must discount the price more. If the interest rate is zero, it means that whether you pay today or in ten years, your returns are the same. But if the interest rate becomes 5% per year, meaning you have to wait a long time, then its value today will decrease significantly.

This is why interest rates are important for cryptocurrency. When interest rates rise, cryptocurrency prices fall, and when prices drop, people get liquidated because they have loans.

But traders are not the only ones being liquidated; leveraged companies and leveraged protocols can also be liquidated. When the latter happens, it gives the impression that everything is in chaos. People feel that someone is the culprit, causing everything to end.

However, when a trader is liquidated, people may not react as strongly. As we just saw in the chart, the way companies and traders collapse is the same. We can narrate from different angles; it can be a moral story, "someone did something wrong that led to everything happening," or it can be a macro story.

So these Ponzi schemes and leveraged protocols are products of zero interest rate policies. When interest rates are zero, you can wait indefinitely for a Ponzi scheme to work, and you can expect leverage to bring growth. But when you suddenly have to prove that this growth, that today's policy plan is effective, you find that you simply don't have time to prove it, and everything ends like that.

Of course, you might think this story is too simplistic, absolving too many individuals of personal responsibility. So let's first look at the parts that performed well. For example, MakerDAO, AAVE, Compound, Uniswap—DeFi has performed well in the past. Of course, people have lost trust in large exchanges like Coinbase and Binance, but they clearly have not reached their end.

3. How Can We Interpret This?

One interpretation is that zero interest rate policies led to massive improper investments. People poured money into almost any investment because they were so eager for yields that they made irrational investments, only to later realize they had made incorrect decisions.

Another interpretation is that CeFi is bad, and DeFi is good (of course ignoring that Terra is DeFi). But not all CeFi has failed, so I don't think this is a reasonable explanation, even though it is a very convenient story.

But you can look at it from another angle. Most of these failures were actually failures of collateral. There was some form of collateral in the system, but it was insufficient: Three Arrows Capital did not have enough collateral to cover all their loans, and Terra did not have enough collateral in the system to support all outstanding UST. They were essentially lending in a state of bankruptcy, which basically meant their collateral was insufficient. So perhaps the problem lies in the lack of collateral.

Now, when we say insufficient collateral, we can use credit to represent it. You can think of credit as a loan with insufficient guarantees; when there is not enough collateral, bad outcomes will occur.

Another way to view credit is that credit is secured by reputation, because you do not have enough collateral to support the entire loan, so what remains is the value of your reputation. Therefore, if you default on a loan, you will lose your reputation—if I intend to extend credit to you, I must understand how your creditworthiness is. When reputation is stable and valuable, credit will work. This is why we have credit scores; when you default, your reputation is affected. So your reputation should have enough value for your credit limit.

So what are the collaterals for Terra and Axie Infinity? First, there are the obvious collaterals; for Terra, it was LFG and Bitcoin, but in reality, there was not that much collateral. Therefore, you can look at Terra from another angle: the collateral for Terra was the confidence in the reputation of Terra, LFG, and the Terra Foundation.

But these collaterals were not ideal. It turned out that when we allowed Terra to leverage, we overestimated the value of that collateral.

The same goes for Axie Infinity; the credit came from trust in the game designers' reputation. You thought this game was sustainable, only to find out it was super leveraged, a super Ponzi scheme, but even so, you still hoped these designers and their organization could take actions to turn the situation around, so that was your trust in them.

Therefore, another way to view what happened last year is that we had an incorrect estimation of the reputational value of these people. Some specific individuals and organizations' reputations were overly trusted and guaranteed.

Think about who the so-called heroes of 2022 are that have not fallen from grace.

4. Lessons from the Story

These individuals we chose continuously disappoint us, but that does not mean that reputation no longer has value. This does not mean that you should not value people's reputations; I think that is incorrect.

If we do not trust institutions, teams, and foundations, it will be difficult to build cryptocurrency. We have a lot of work to do, and this work will be done by individuals, organizations, and groups.

Therefore, I think the lesson from the story is that cryptocurrency should not abolish trust. I think this is an overly simplistic reaction—blaming trust in others for the mistakes, so we no longer trust others, only using MakerDAO or only using Uniswap, hoping that no more bad things will happen. This idea is wrong. We have too much to do, and we need to trust the teams that will build the next generation of applications, exchanges, and custodians.

Before people build real trustless and decentralized bridges, we cannot say no to trust.

The real lesson of the story is that we need to think carefully about how to choose trustworthy people. The biggest lesson people need to learn is that we have created a kind of idolization and fanaticism about certain individuals in the past, and this needs to change so that cryptocurrency does not repeat the mistakes of 2022.