2022 in Review: the Year of “Collateral” Damage by Haseeb Qureshi

so oh here we go perfect oh these lights are very bright so I'm going to be chatting today about looking back over the last year and trying to do a little bit of financial trauma bonding we've all gone through a lot of over the course of 2022 and I think the way we experience or at least the way that I experienced 2022 was a lot of bad things happening over and over again throughout the year and every single thing that happened uh we spent a lot of time trying to analyze and understand them figure out why they happen and and uh you know the the stories and the characters involved but I haven't seen a lot of people really trying to integrate what did all these things have in common why did they happen and how can we avoid them in the future that's going to be the focus of my talk today so you know there's a a lot of themes that we saw last year quantitative tightening there was play to earn there was Luna three arrows FTX there was a lot of pain that ultimately came uh you know to our way as an industry um and so I I want to kind of go through them sequentially and try to contextualize them a little bit more than I think they've been previously uh contextualized so if you go back to when the year started if you remember January 2022 uh interest rates were still at zero we were still in a place where inflation had just begun uh but for the most part risk assets were doing super well the top was November everybody was super rich uh it was a really positive ebullient time for the industry and for risk assets generally okay uh and there were two parts of the story as you're looking back over the year the first part is crypto and the second part is macro and so I'm going to charge the two of them side by side so if you look in the top chart that's BTC in Orange and you look at the bottom that's the federal funds rate that's the the interest rate that uh the FED is setting and you can see things are kind of plodding along Bitcoin is trending down uh and when the federal funds rate hits one percent uh that was the second big jumbo rate hike that the uh that the FED did right then was when we saw the first big collapse of the year which was Tara now what was Tara Tara's often described as a stable coin you know decentralized blah blah blah senior shares fundamentally what Tara was was it was a leveraged Bank it it took in money and then it issued liabilities that were supposed to be worth a dollar but it didn't keep all the money that was put in it sort of took the money out and paid it out to the sort of equity holders which were the people who owned Luna and the people who owned UST were basically hoping that there was never going to be too much demand to get their money back and well certainly that's what we call that as a bank it's a leveraged bank it's a bank that doesn't have all the money in reserves and when a bunch of people want to get out of the bank the bank uh goes goodbye right it collapses uh a little bit what's happening with silvergate today although still forget it's a very different story turns out not to be leveraged quite in the same way um but that was way Terror collapsed Terror collapsed because it was leveraged and so we saw prices really steeply decline after Terror collapse and the next big collapse was three arrows now what was three arrows Capital it was a big head fund run out of Singapore turned out they were super leveraged sensing a theme here okay uh tarot super levers three hours of super levers uh when uh the the the aftermath of Tara found its way that sort of Tremors ended up affecting three arrows they also collapsed and they caused a massive downturn in crypto prices immediately after their collapse and of course right after that you saw another Super jumbo rate hike 75 basis points from the FED uh soon after you saw the downturn of ax Infinity now what is x infinity now this was basically the moment when they were down 90 from their all-time high and the the prices that you could get doing play to earn played earned this idea that you can play a game in order to make enough money to survive or you know have a living or do whatever uh this stopped working basically people in the Philippines were now making less than minimum wage playing x infinity where before that they were making much more than they were making uh in minimum wage and so x infinity this is maybe a an unkind way to represent it but it was sort of a Ponzi scheme macerating as a game right it was this idea that more and more people were going to buy axes they were going to speculate on AXS and because of that you as a player were always going to have a market to sell into but when that stopped when people didn't want to buy AXS anymore and people didn't want to keep buying axes uh then all of a sudden this game stopped working and you know the idea that you could just take some axes and and you know play the game and make some money stopped working and so this Ponzi scheme kind of unraveled it stopped the economics no longer worked now things kind of plotted along for a while interest rates kept going up and at this point it was well understood that interest rates were going to keep climbing and then came the big one in November was a collapse of FTX now FTX of course I mean I don't need to reiterate the story at this point everybody in crypto knows FTX um FTX turned out to be a leveraged exchange but you can also argue that FDX was kind of a Ponzi scheme disguised as an exchange right there are different ways to look at it depending on which Dynamics you focus on but fundamentally FTX was leveraged and it was kind of running a Ponzi scheme uh and that Ponzi scheme eventually collapsed so FTX of course there was a nosedive not as steep as there was with Tara and three arrows and then finally the the really big collapse on the lending side was Genesis Genesis was the largest lender in crypto they facilitated a lot of the financing for these uh for all of everything that preceded it so they weren't one a leveraged financier they provided leverage to a lot of the players earlier in the year and that's actually what ended up being their downfall but also they were themselves implicitly leveraged so they were a leveraged financier and a leverage financier and that led to their own collapse now that's basically been the story of the year that leads us to today interest rates are sitting at 4.5 and you can see as interest rates go up crypto takes downward and that word and uh but with these sort of punctuated equilibria right every time there's this big collapse you see the price goes down a little bit more um now I want to contextualize this a little bit though because if you only look at crypto it looks like wow the story is that crypto was crypto was just full of Ponzi schemes and frauds and leverage and it all kind of Unwound and now we know what crypto really is you know we finally unmasked the villain but if you track crypto against the NASDAQ the NASDAQ is sort of the tech heavy index um you see that actually crypto and the NASDAQ basically tracked each other almost perfectly until three hours collapsed and went through it was collapse there was a moment of Divergence and then they tracked each other almost entirely and actually from before when three hours collapsed to today actually crypto's made up a lot of the difference that seems weird right it seems weird because FTX collapsed after that Genesis collapsed after that but actually crypto has managed to track the NASDAQ since the collapse of three arrows okay now keep this in mind okay so how do we contextualize the story how do we make sense of what happened other than just a series of unfortunate events well you could tell the story from a macro view okay that it was a year of liquidation so here's a story you could tell once where you could tell is that interest rate went up because of inflation so here on the on the right you have the inflation rate in blue obviously it's spiked in November uh and then the FED funds rate the interest rate that the FED charges on dollar deposits went up really quickly trying to chase uh that inflation and bring it back down we're just now starting to come back down um so this is this is a very standard story now it might not be obvious to some of you why it is that the interest rate going up should affect asset prices okay and just very very simply asset prices are uh depend the value of assets is that they're going to give you some value in the future okay that's why assets are valuable especially when those assets are not paying a cash flow to you today okay so you can think of Bitcoin ether you know most of these uh assets that we invested in crypto as being basically assets that are going to pay out someday in the future when Bitcoin becomes digital gold when ethereum becomes you know world scale hyper whatever money right or you know when when compound becomes the the bank of the world or whatever whatever story it is you're telling right it's a story about the future if you're telling a story about the future then you have to Discount the value of that story by how long in the future it's going to take okay when interest rates are zero basically you can think of the the interest rate as the price of waiting if you have to wait longer to get a payout then you have to Discount the price of that more and more if the interest rate is higher and the interest rates have basically gone from zero meaning it doesn't matter if it's going to pay out today or 10 years from now to five percent which means it really freaking matters whether it's going to pay out today we're going to pay out in 10 years because five percent every year for 10 years is turns out a big number so when interest rates climb this quickly that means that a lot of assets that we didn't care how long they were going to take to pay out suddenly we really care how long they're going to take to pay out and if they're going to take a long time then they're worth a lot less today that's why interest rates matter for crypto so interest rate went up and when interest rates go up that means that prices go down okay I just explained why now when prices go down you get liquidations right because you've got people taking loans whatever blah blah liquidations right you guys understand that uh now when Traders get liquidated we kind of struggle we say well you shouldn't have been taken out a loan you know serves you right right so Traders get liquided all the way down and we all understand that there's no story it's just Traders getting liquidated but of course uh Traders are not the only ones who get liquidated they're also businesses that have leverage they're also protocols that have leveraged and when protocols or businesses get liquidated it looks really dramatic it looks really messy it looks like oh there's a story and there's a villain and there's an abnc and there's a beginning and ended conclusion to the story and someone did something wrong but when a Trader gets like whatever's like oh I'm trying to get liquidated you know what are you gonna do um and so in reality when you have this steep of a price decline of course there can be businesses that are implicitly levered and those implicitly lover businesses are going to blow up and you end up getting a shape of a chart like the one we just saw where you know prices go down and businesses explode the same way that Traders explode but you could look at that and say Okay the reason why everything happened was because this person did something wrong then that person did something wrong and that person did something wrong or you could look in and say well of course the the businesses that are levered are going to blow up and the ones that are not level are not going to blow up and that's the same way as Traders and so the stories maybe don't matter so much and we fix it on them because they're recognizable we know that we can see the characters in them we can tell the morality Tales but maybe the way to understand it is purely a macro story okay that's one way in which you could contextualize what happened over the last year um you could say all these things the apology schemes the super leverage protocols they were a product of this zero interest rate zurp which stands for zero interest rate policies meaning that when interest rates were zero you could wait forever for the Ponzi scheme to someday work you could wait forever for the leverage to eventually you know catch up with the growth um but when all of a sudden you've got to prove that growth you're going to prove the policy scheme works today well I don't have time to prove it works today and the thing unwinds so now you could take the micro view you could say okay well that's a convenient story it kind of absolves us of a lot of responsibility but maybe that's a little too simplistic right what's the micro view what happens if you look more into the details of how these things failed and why they failed right so if you look at things that didn't fail you know make it out uh you know Ave compound d-ydx uniswap people have talked a lot about how D5 actually did really well you know ignoring tarot was kind of d52 but let's ignore that um you know do idx intercept these things work well and then of course the big trustworthy C5 players like coinbase Finance if you call them trustworthy right but obviously they've not died yet um so you could you could look this right say okay who survived who failed and you could say ah uh one story is that zero interest rate uh policies led to massive male investment meaning that people started putting money into just about anything because they were so starved for yield they were so star for returns that they tried the stupidest things out there and that set of stupid things included Tara and included the axi infinity and whatever play to earn and all this nonsense uh and now we know ah that was wrong because that stuff doesn't work okay I don't know if that's quite the story uh another story you could tell is that oh C5 is good and D5 is bad we're sorry other way around C5 is bad and D5 is good again ignoring that tarot was D5 but of course not all C5 failed some C5 worked right as we're pointing to um so I don't think that's the story either although it's again it's a very convenient story to tell um another way you could look at this is that most of these failures were failures of collateral there was some kind of collateral in the system that was not sufficient right so three arrows didn't have enough collateral for all of their uh all their loans uh Tara didn't have enough collateral in the system to back all the UST outstanding uh Genesis you know they they were basically making loans when they were already insolvent basically meaning they were under collateralized so maybe the problem is a lack of collateral right and that's the story is that oh you guys were doing crazy you know Financial recursive nonsense and this is a story about you know sort of financially flying too close to the Sun now when we say under collateralized right another way of describing that is that we're basically using credit is when you are you know borrowing money and you don't have enough collateral to back what you're borrowing um and so another way to describe undercoateralized lending is credit people were extended too much credit right um so you could say okay well there's a lack of sufficient collateral there's too much credit we should stop doing credit credit's a bad idea okay that sounds a little harsh credit is a big part of how the world functions um but there's another way you can look at what credit is you can look his credit as under collateralized lending and say the problem why you should never do credit is because there's not enough collateral and when things go wrong bad things happen but another way to look at credit is that credit is using reputation as collateral because you're not you don't have enough collateral to back the entire loan and so the rest of it is the value of your reputation and so if you default on the loan well you're going to lose reputation and the idea is that you know if I'm going to extend you credit I have to understand how good is your reputation relative to the value of this loan and so when reputations are stable and valuable credit works well right that's why we have credit scores we have you know all these different ways of making when you default on your credit card that it ends up affecting your reputation and the idea is that your reputation should be valuable enough for your credit limit right that's how credit works so you could ask them what was the collateral then for Tara what was the collateral for actually Infinity and so there's the obvious collateral which is like in in Terra they had you know lfg they had a big pile of Bitcoin and the Bitcoin was a collateral but there wasn't that much collateral there right um so another way you could look at Terra is that the collateral in Terra was the confidence in dough that was the collateral the collateral was Doe's reputation it was lfg's reputation the Tara foundation's reputation that was the collateral backing Terror and that collateral was not good it turns out we overestimated the value of that collateral when we allow Tara to become so leveraged in the same way x infinity what's the collateral and actually Infinity the collateral and acts Infinity the trust that you're putting in there the reputation is in the game designers it's the idea that yes okay right now it's super leveraged it's super Ponzi nomic but we're going to back into a sustainable way to softly land this airplane right you're trusting the designers to do that because you know if it continues just like this obviously it's going to eventually collapse so somewhere they have to do something and you are trusting them to do something you're trusting people organizations to do something so ultimately one another way to look at what happened last year is that we were wrong about the value of these people's reputations and their specific people specific organizations in whom this trust was placed and specific ways in which their reputations were underwritten inappropriately you just think about how many of the heroes of 2022 are now Dead canceled defenestrated right think about you know there's a there was there was a meme I was trying to find of like the list of all the crypto Heroes who basically got killed of the three arrows guys Andre C uh SPF like almost everybody you can think of who at one point was a hero of the crypto Community has basically determined now no never mind you're a villain and what does that tell us not about them but about us what does it tell us about the people who are choosing as Heroes and the fact that they continually fail us they continually fail the expectations that the crypto Community places in them um and that's not to say that reputations are not valuable that's not to say that you shouldn't be valuing people's reputations and believing that they're going to do something important with the trust you place in them I think that's not correct I don't think there's a serious way that you're going to be able to build crypto without trusting institutions without trusting teams without trusting foundations you're going to have to because this stuff is not done yet there's so much more work to do and that work is going to be done by people by organizations by groups so if I had to give a moral of the story um I don't think it's enough to say that crypto should abolish trust I think that's a an easy reflexive reaction to say like ah the error of our ways was that we trusted people and we got to stop trusting people and if we just only use maker now or we just only use uniswap then nothing bad will ever happen again okay that's that's not going to happen there's there's too much to do there's too much to build and that stuff does require us to place a Nexus of trust into teams that are going to build the next generation of applications of exchanges of custodians Etc but we're not going to be able to say no to trusting people before they build that bridge to true trustlessness and decentralization but rather I think the story the moral of the story that I want to take away is that it's up to us to trust the right people and to think more carefully about in whom and how we place our trust going forward there's no way to say nobody ever deserves trust again you need to do that in order to build something real and build something sustainable um but I think the biggest lesson that that one needs to take away is that um we've learned a lot about the making of idols and the worshiping of Idols about the idea of building Cults of personality around individual people um and that is the thing that needs to change for crypto to ultimately not repeat the mistakes of 2022. that's all for me thank you everybody [Applause]