Paradigm Letter to Investors: Crash and Resurrection, Faith Does Not Change

Compilation of the original text: Deep Tide TechFlow

Compilation of the original text: Deep Tide TechFlow

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

In general, you can interpret it as a psychological massage for LPs, all in plain language that is easy to understand, share it with everyone, and massage together.

original:

2022 will be characterized by macroeconomic uncertainty and a brutal global sell-off that has affected tech, cryptocurrency and other markets.

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

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

Despite the market shock, our long-term belief in cryptocurrency as a technology and asset class remains strong. The quality of talent entering the crypto market has never been stronger. At the same time, speculators who came for short visits have withdrawn.first level title

what happened?

A full account of the ongoing crypto deleveraging requires hindsight.

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

In 2020-2021, the market is full of enthusiasm, companies and funds feel confident, risk restrictions become an obstacle to chasing scale and returns, and explicit and implicit leverage accumulates. The external shocks of the global crash are a reality check, and while these events are clearly negative, we are optimistic thatfirst level title

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 dollar-pegged stablecoin UST built on top of it.

The UST peg is maintained through a two-way redemption process to LUNA: when UST drops below $1, you can"combustion"$1 in UST comes"casting"LUNA for $1, and conversely, when UST grows above $1, you can"combustion"$1 worth of LUNA comes"casting"$1 in UST. In theory, this process should keep UST near $1...as long as confidence in the system remains strong.

like many before"Algorithmic Stablecoins"In fact,

In fact,With so many problems with algorithmic stablecoin design, perhaps the most interesting one is not"Why is UST crashing?"but"How did UST get so big before it crashed?"This is a question we've been asking ourselves from the sidelines during the meteoric ascent of LUNA/UST.

While it's hard to pinpoint the root cause, a charismatic founder (Do Kwon); many reputable investor backers (including the now bankrupt 3AC); The high-rate Anchor agreement; the flashy attempt to acquire a large amount of BTC as collateral, and many other factors combined to fuel retail and institutional frenzied 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, and more UST deposits lead to greater confidence in LUNA.

This positive feedback loop is very strong on the way up, but the negative feedback loop is even stronger on the way down. Currently, LUNA has dropped from over $100 in April to less than $0.01 today. The UST stablecoin broke its $1 peg and is now worth close to 0, over $18 billion in UST deposits and $40 billion in LUNA market cap have disappeared.

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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. 3AC's founders (Su Zhu and Kyle Davies) used their own capital to grow their starting assets from less than $1 million to over several billion dollars in 10 years.

An incredible feat from any angle. However, it was this track record, achieved without regard for risk, that arguably paved the way for 3AC's demise.

Heading into 2022, the inflated overconfidence of the 3ACs has combined dangerously with the cryptocurrency lending ecosystem, which is all too willing to provide unhealthy leverage in search of higher yields to grow the loan book.

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

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

Collectively, 3AC was able to amass billions in debt on billions in assets that had a lot to do with the continued growth in crypto asset prices. Once the market sell-off and subsequent LUNA/UST crash, what happened next was inevitable.

3AC, which went from billions in net worth to more than $1 billion in net debt, collapsed, blowing a hole in the cryptocurrency lender's balance sheet.

While 3AC caused the biggest losses, crypto lenders have also made various other mistakes. Some engage in risky trading strategies with clients’ assets (e.g., so-called “yield farming” across DeFi protocols). Others locked capital in seemingly low-risk arbitrage trades (such as betting that the prices of GBTC and BTC would converge), implicitly assuming a long-term bull market in the market, which did not match the short-term nature of customer deposits.first level title

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 a learning opportunity, and we are optimistic that the cryptocurrency ecosystem will become smarter and more resilient.

This isn't the first crisis for cryptocurrencies, and it certainly won't be the last.

In 2014, MtGox was the largest Bitcoin exchange, handling more than 70% of the global transaction volume, and a hacker attack caused a loss of more than 7% of all BTC in circulation.

In 2016, a named"DAO "’s smart contract application held nearly 15% of all ETH supply at the time of the hack.

At the time, both events seemed to exist. Fear is pervasive and asset prices rise with it. However, in our experience,Events like this ultimately don’t stop the underlying drive for cryptocurrency advancement: developers and entrepreneurs working to build the future.

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

The DAO hack has brought more attention to the security of smart contracts.Hopefully the debacle of LUNA/UST will lead to a broader understanding of the risks surrounding algorithmic stablecoins, and the explosion of 3AC 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, all have preset mechanisms to liquidate collateral when margin limits are reached, keeping them solvent. These systems are on-chain, transparent, anyone can inspect the code, and there is little chance of accumulating unhealthy leverage. DeFi still has a long way to go before it can match the existing financial system, but some of its fundamental advantages are already beginning to emerge.

Despite the gloomy headlines, our optimism remains unchanged by recent events. Not a single day goes by without encountering a talented college student or a seasoned tech executive considering spending the next 5-10 years building a career in the cryptocurrency space.

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

In general,

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