The ’22 bear market post mortem

Reflections on the current state of crypto: the hype, the doom & what's here to stay

I don’t post often, but when I do make sure to not miss out!

It is July 2022 and the crypto markets have been in a massive downtrend over last couple of weeks. It's very easy to feel depressed after the whole space lost half its market cap since the beginning of the year. For me, writing is one of those things that let me separate the facts from the emotions and learn for the future. I hope I can give you an idea of my thinking at the moment, and the things I have learned over the past few months.

Crypto technology is incredibly young and therefore things are in constant flux. Hype and doom sometimes seem just a few days from each other. When Bitcoin hits a new all-time high, people expect it to go to infinity - and it never does. Likewise when it hits a bottom, people expect it to go to 0 - and it never does.

In this article we’ll talk about what crypto cycles are, take a look at some of the innovations of past cycles and finally conclude with the big trends from the past ~2 years. My goal is help you understand the nature of the still largely unregulated space and see for yourself what interesting projects and ideas have been emerging.

I'm not a financial advisor so as always: do your own research, I could be completely wrong about some things. This blog might be called “All In BTC” but that’s definitely not true - sound financial planning is always a matter of risk mitigation and time horizons. What works for one person does not work for another.

Intro: What is a crypto cycle?

For those less familiar with the term: a cycle is usually a period of time in which certain patterns repeat. To take an example from traditional investing: agricultural produce like wheat usually trades in yearly cycles as the expected harvest season depends on the weather conditions of each season.

In crypto, cycles have largely been playing out over the programmed 4-year Bitcoin halving cycles. Those “halvings” are the four-yearly events, when the bitcoin mining reward get cut in half, effectively cutting Bitcoin’s new issuance in half. This supply reduction has been coinciding with Bitcoin’s massive price increases over the months following this event (known as crypto summer), followed by a sharp price decline and stagnation usually starting about half way to the next halving event (also known as crypto winter - which we have just entered in May/June 2022).

Although Bitcoin’s volatility has been decreasing over time, it’s still important to understand that those swings aren’t about to end anytime soon. As crypto is hard to regulate, people are free to speculate on questionable coins with extreme amounts of leverage. In other words: they gamble with money the don’t have on assets that are designed to pump the price in the short term and implode in the long run (see my section on scams later in this article). 

When prices go down rapidly, things get ugly quickly: people are forced to sell because those gambles fall apart or they panic sell when prices are crashing. In crypto, those things happen on a global scale which makes the impact even wilder. In this cycle, the failure of the LUNA token (and the associated UST token) triggered a cascade of collapses (Celsius, followed by 3 Arrows Capital, followed by BlockFi, Voyager,…).

The detailed dynamics of those sell-off’s are beyond the scope of this article - the point here is that crypto is risky for exactly those reasons. Even though US and European regulators are stepping in to make crypto safer for everyone, their regulatory powers only reach to crypto exchanges in their jurisdiction. Everything beyond - essentially everything that’s decentralised - will continue to allow for reckless gambles for everyone who’s well versed with technology.

Every cycle in crypto brings new, exciting innovations. As we’ll see later, also new scams and pyramid schemes innovate in tight lockstep.

The big cycle trends

I’m borrowing this idea from Chris Dixon of Andreessen Horowitz, as I think it provides a great outline of the big innovations that have happened in crypto since it’s inception in 2010 (https://a16z.com/wp-content/uploads/2020/05/Chris_Dixon-What_Are_Blockchains_And_What_Are_They_Good_For-1.pdf):

The first wave/cycle (~2010-2012) marked by the launch of Bitcoin itself. Prices were in the sub-cent area back then, nobody knew if BTC would even survive the next year(s). The second cycle (2012 - 2016) gave us - most notably - Ethereum, the most popular smart contract platform nowadays (plus a couple of Bitcoin clones). The third cycle (2016-2020) ignited a wave of further smart contract platforms and the first decentralised finance apps, such as DyDx, Maker, Uniswap, Aave, and of course NFTs. Those are some quite big names/themes in crypto nowadays, but each of those technologies and protocols were unclear to even work in the beginning (and a lot of them failed and disappeared).

Innovation also happened on an infrastructure level. During the first crypto cycles there had been countless Bitcoin clones that basically copied (= forked) the Bitcoin code, made 1-2 adjustments and launched as a new coin. In the last cycle, there have been countless attempts to build a next generation Ethereum competitor to achieve faster, higher bandwidth at lower transaction cost.

It remains to be seen which of those new chains will prevail as Ethereum remains the most popular smart contract platform and is in the early stages of migrating to a proof-of-stake consensus model. Which brings me to the first major innovation of this cycle: Proof-of-stake blockchains.

Proof-of-stake consensus

Currently, the Ethereum network still works with a proof-of-work consensus algorithm similar to Bitcoin, which sacrifices throughput for security. As Ethereum is a Turing complete smart contract blockchain, it’s hosting a multitude of applications: different coin projects (so called ERC20 tokens), decentralised finance, NFTs, gaming, and so on. At peak times throughput has already become an issue, which is why Ethereum has planned, implemented and has started migrating to a proof-of-stake consensus algorithm.

To explain consensus in simplified terms: In proof-of-work consensus, the processing power of all the computers participating in the network is used to verify transactions on the blockchain. Pro’s: It’s highly secure and there’s a low barrier to participate (democratic). Con’s: It’s power intense, has limited throughput and is expensive in peak times. 

In proof-of-stake, validators put up their own capital to secure the network. While less democratic - more capital means more voting power - this approach needs less processing power, energy and allows higher throughput. While Ethereum is still on its way to move to such a proof-of-stake consensus mechanism, a couple of other blockchains have already launched their proof-of-stake networks successfully: Solana, Avalanche, Cardano or Near, to name a few.

Not too long ago it has been unclear wether Proof-of-stake is a feasible mechanism to reach the necessary security standards. But, good news: those chains work relatively well and they still work even in the current turbulent market conditions.

Keep in mind that many of those chains currently are still in beta development stage (eg. Solana and Cardano). Every chain has so far experienced their fair share of growing pain.

Regardless, Proof-of-stake is here to stay.

Decentralised Stablecoins

Even though Luna’s stable coin’s collapse tipped the whole crypto market into a bear market, I think that decentralised stable coins are one of the major innovations that happened in the crypto space recently. This is too interesting of an engineering problem and too lucrative of a problem to solve.

To break things down, stable coins track the value of a real world asset (most popular are US dollar coins, but there is one for Euro, Yen or Gold). The technology exists in an iron triangle: stability (how well is the underlying currency tracked), decentralisation and capital efficiency. 

To illustrate this issue: USDC - the stable coin issued by Circle, a US company - is the “gold standard” of Dollar stable coins. Circle is a regulated US company, and every USDC that exists is backed by an equivalent dollar on a bank account. Very stable, very efficient (put in a Dollar, get one Dollar coin) but also very centralised. Circle can basically ban any wallet they want.

On the other end of this spectrum is for example Maker: Every DAI, their US dollar coin, is backed by crypto assets like Bitcoin, Ethereum, etc. It works like this: You deposit 1 Bitcoin and receive 80% of its value in DAI Dollars. In case Bitcoin’s price falls by 20% you either have to put up some more assets, pay back the loan or the position gets sold (= liquidated) to protect the 1 DAI = 1 Dollar “peg”. DAI is stable, decentralised but not very capital efficient (you have to give up 80% of your asset’s present value).

There is many different approaches to decentralising stable coins, and there is no shortage of failed experiments in the past year (Luna, Neutrino, Deus or Titan). And it remains to be seen whether any of the current projects will survive. 

Contrary to common opinion I think there will at some point be decentralised stable coin projects that work. I also want to link Rawson Haverty’s extensive stable coin research document here. It really got me excited about the topic.

NFTs

Non Fungible Tokens have experienced rapid growth in the past 2 years. The technology went from a proof of concept (CryptoKitties in 2017) to a fully fledged industry with billion Dollar valuations. According to Alex Atallah (OpenSea Founder), there were more NFTs in existence in March 2022 than websites online in 2010. This statistic might be a little flawed as some NFT projects mint 10’s of thousands of items at a single launch.

Still, the hype can’t be disregarded. For a while, Bored Ape Yacht Club had a comparable valuation to Star Wars’ intellectual property when it was sold to Disney. Just to put this into perspective: Star Wars excited fans for decades, any movie immediately grosses millions of dollars, and there are theme parks, merchandise and shops. Bored Apes? Had a burger joint.

Even if those projects are overvalued a lot, the underlying tech is extremely promising. NFTs fix many of the problems the art market faces (verifiability, illiquidity, transferability). The medium is new as well: Art is not “buy once and forget” anymore, but the best NFT projects create journeys and fun experiences. Some are even used for access to real world parties and gatherings.

In know from my own experience that digital art has been particularly hard to monetise outside of the advertising or big movie industry. NFTs give artists a global market to find their audience and sell their art.

From my perspective, we have just scratched the surface of NFT technology - we will discover many more use cases and ideas. Pictures are just the tip of the iceberg. The technological expertise required will continue to decline while the technology will move towards the main stream even more. Most importantly, NFTs will have to lose their speculative image and move towards real utility for end users.

For my Austrian/German audience: I’m also hosting a podcast about NFTs with my friend Thomas where we discuss the latest developments and projects in Web3.

Bridges

As explained earlier, different blockchains follow different approaches and therefore have different advantages and disadvantages. Naturally, the technology to move (some) assets across chains has been chased by a lot of smart minds and has been a hard problem to solve. Essentially, it needs a system - usually a couple of nodes - that allows agreement of a transaction simultaneously on 2 chains. For that reason an attack is comparably easy: only a handful of nodes need to be attacked and not the whole network.

The most popular and exciting example is ThorChain, which bridges the Bitcoin, Ethereum and Cosmos networks in a decentralised fashion. Soon after launch their network got exploited and it took them almost a year to get the service back online again. Nowadays Thorchain seems to run smoothly.

Other hacks in the past months (eg. Ronen & Wormhole bridge hacks), have shown how difficult it is to design a secure bridge between systems that rely on different consensus architectures.

From a technological perspective, bridges like Thorchain are groundbreaking - bridging 2 networks that are so fundamentally different as Bitcoin and Ethereum is an exciting achievement. I’m sure there will be many more attempts to bridge chains and hacks that come with that, as we are driving towards a path of more stability.

Scams & questionable developments

One of my favourite topics is the increasing sophistication of scams. Since the user interfaces in crypto are still rather complicated and the technology is rather difficult to understand, it’s still far too easy to sell worthless stuff to people. Although all blockchain parameters are transparent, the average users needs help evaluating the quality and economics of different projects. Here is a couple of the latest scams that have surfaced in crypto:

Influencer scams

Since NFT projects are cheap to launch and some reach sky-high valuations, it’s easy for people with a big audience to monetise their followers. While this is a great innovation for some genuine artists, it’s also been a tremendous opportunity for some influencers to scam their fans for no value returned (a so called “rug pull”). Some examples? Kim Kardashian and Floyd Mayweather face ongoing lawsuits about promoting Ethereum Max, a scam coin. In addition, Floyd has been scamming his audience with a couple of NFT projects (eg. Bad bunnies, Mayweverse,…) and ran away with the money. This is not good for the reputation of crypto in general and should (and will) be legally prosecuted. In case you are interested in further exploring those scams, I want to recommend ZackXBT’s Twitter account for in depth analysis.

Liquidity mining

If something sounds too good to be true, it probably is. Everyone, who has dipped their toes into DeFi in the past year has probably noticed some sky high promised rates of return (something to the extend of “stake your coins and earn 100%+ APR”). The main question in those cases should always be: where does this yield come from?

It’s very easy for projects to “print” more tokens that dilute the supply. If some project like Ohm, Hex,.. promise to double your staked capital in a certain time, they will probably dilute the whole token supply by that exact amount.

It should be logical: you can’t sustainably pay someone a 20-30% interest rate without a highly profitable operation or diluting the token supply.

Miner Extractable Value

Did you know that big hedge funds get themselves their own server in the server rooms of big stock exchanges, so that they can execute trades milliseconds faster than their competition (including everyone of us)? This is called arbitrage trading, where those funds are able to make some money on slight market inefficiencies, eg. buy Stock A in NY for 0.99 cents and sell it in Frankfurt for 1 Dollar.

On Ethereum a similar war is going on. The order transaction are processed is defined by the “gas fee” which is paid the user. There is a possibility to “front run” a trade by simply paying a higher gas fee.

It works like this: If I want to trade some USDC for some ETH on Uniswap, I have to define how much I’m willing to pay for that ETH - eg. the current price + 1% maximum. Front running is, when someone sees this order on-chain and pays a higher gas fee to quickly buy some ETH cheaper before me, and then sells it back to me for the +1% defined earlier.

Since Ethereum miners (people who validate the Ethereum transactions) decide which transactions get processed in which order, they have an incentive to make some money on the side leveraging this: 314 Million Dollars in ~2020 according to Flashbots research.

To be clear: this is a bad development for Ethereum. Front running does not add any value to the network, but rather contributes to congestion, higher network fees and higher prices paid by end users. It’s even likely that Ethereum’s security is impacted negatively.

Concluding remarks

In times of market distress everything looks bad. However, blockchains’ key features (permissionless, immutable & transparent transactions) are still valid and working. The major innovations I outlined above have the potential to give everyone access to financial services they could never imagined before.

Here is the thing with crypto: other than traditional means of transactions, it’s an organically evolving, digital system. Of course, many things are still very experimental (and some outright scams of course). However, organically evolving systems get better over time, especially because they promise high rewards for those who build great products that last.