Blockchain Industry Overview
Three main events in 2022 were key for the future of the blockchain industry and will shape the space in both technological and regulatory aspects. These consisted of the Terra-Luna network collapse, which involved the loss of all financial value inside the Terra ecosystem; the Ethereum Merge, where the Ethereum blockchain transitioned from a proof-of-work(PoW) to a proof-of-stake(PoS) consensus mechanism; and the fall of FTX, in which the second largest company in crypto, FTX, filed for Chapter 11 Bankruptcy. I will now go over the three events and explain in detail what happened in each case.
Sergio Verdugo, a Computer Science and Artificial Intelligence student at IE University participates in the Impact Xcelerator as a School of Science and Tech Student Fellow and also a Foundation fellow. He is also a co-founder of Bproto and a team member at Cortex Network and App, innovating in decentralized content through Web3 domains.
Terra Luna Collapse
The cryptocurrency market has been known to experience dramatic swings, with rapid price increases and crashes being a common occurrence. One such crash occurred in May 2022 when LUNA, a popular cryptocurrency, experienced a sharp drop in value. The crash, which wiped out billions of dollars in value, left many investors reeling and questioning the stability of the crypto market.
LUNA is the native cryptocurrency of the Terra network, a blockchain platform that uses stablecoins to facilitate cross-border payments and other financial transactions. The platform has gained popularity in recent years, with a growing number of users and a high-profile partnership with the South Korean government. LUNA has also seen a significant increase in value, reaching an all-time high of $119.18 in April 2022.
However, the bubble soon burst, and LUNA’s value plummeted by over 99% in a matter of days. The crash was triggered by a number of factors, including a broader instability in cryptocurrency prices with most of them having decreased since November 2021 although it is important to point out that LUNA had thrived in this environment due to the adoption of UST, the network's stablecoin. Stablecoins are tokens that are pegged to 1 dollar. This value is maintained through different mechanisms. USDC is a stablecoin issued by the company Circle and is backed with a 1:1 ratio through bank deposits and other assets. UST was what is known as an algorithmic stablecoin and, as the name itself infers, it maintains the dollar value through a series of algorithms executed by arbitrators that profited through maintaining this price.
Why is this important to know? Well, this was the main reason behind the collapse because both tokens, LUNA and UST, were connected through these arbitrage algorithms so for UST to maintain its price, LUNA had to be bought or sold depending on how the price of UST varied. This system had never before shown any weaknesses previous to the collapse but it is important to remember that this system had only been tested in a market with increasing prices.
One of the most important concepts in crypto is liquidity pools. These allow you to trade one token for another and determine the new price of the currency after the transaction happens. Previous to the 7th of May 2022, Do Kwon, founder of Terra, had announced that on that day, all the liquidity of UST would be moved from one pool to another in order to improve the liquidity and backing of the stablecoin. When he withdrew the liquidity, a third party inserted a massive and sudden selling pressure that appeared on the main Centralized Exchanges which caused a de-peg of the dollar value that could not be supported by arbitrators. Suddenly, the price of UST was not 1 dollar and investors started selling LUNA out of fear. This third party also put a short position on LUNA, Bitcoin and UST which resulted in a profit of over 800M dollars. Three Arrows Capital was allegedly the company behind this and interestingly enough, it went bankrupt only a few months later due to insolvency. This would explain why they resorted to these bad praxes.
The LUNA crash had very negative consequences for the whole industry as massive amounts of people lost their savings due to UST's price going to zero and caused a great loss of confidence among investors that now were increasingly reticent to invest in other DeFi projects. The industry how regulatory scrutiny increased after this with rumours of new strict regulations being passed that would limit innovation and hurt DeFi.
Ethereum Merge
Following the Terra Luna collapse, there was a major development in the industry since Ethereum, the main smart contract-enabled blockchain, changed its consensus system from a proof-of-work to a proof-of-stake. Proof-of-work is the system Bitcoin uses and it is the one in which transactions are validated through computing power ensuring that there are no fraudulent transactions that go through. In order for this to happen, a single entity would have to own over 50% of all the Bitcoin nodes (mining computers) in the network, which is practically impossible. Proof-of-stake is a system in which validators put at risk their cryptocurrency in order to validate a transaction. They are therefore encouraged to act in an honest manner because otherwise, they will lose their coins.
This had a series of consequences for Ethereum. The most significant one was the 99.95% decrease in energy consumption which meant the efficiency of the network vastly improved due to it. One of the issues that people contrary to blockchain used to point out was the high energy consumption therefore this complex network update was a step further towards creating an energy-efficient financial system.
However, not all consequences were positive. Lots of proposed bills in the USA congress that ended up being unsuccessful put PoS in the bullseye as they aimed to strictly regulate these types of blockchains therefore now, Ethereum could be heavily affected by new regulations and consequently, the greatest innovation hub in the blockchain industry would be seriously limited.
FTX Fall
One month later, the second biggest company in the blockchain industry, FTX, collapsed after Sam Bankman-Fried, the company’s CEO, stole customer funds to pay off debt from Alameda Research. Alameda Research was FTX’s venture arm and the main reason for its horrendous balance sheet was the fact that they collateralized their loans with the exchange’s token, FTT, which was not even liquid at that time. This balance sheet was leaked and the price of FTT instantly plummeted making Alameda insolvent. It was here when Sam took the money from the users to pay the debts.
This was seen by the mainstream media as something that severely hurt the whole industry as one of its giants had fallen; however, it was an event that proved the necessity of decentralization and blockchain technology. At the end of the day, FTX was a completely centralized entity and this would never have happened with smart contracts and decentralized exchanges. Another positive impact of this was that companies within the industry are now required to have a higher standard than previously. In the exchanges’ case, users will not deposit any crypto on them unless they have public proof of reserves. Exchanges are the banks of crypto, therefore having complete proof of reserves is much more reliable than traditional banks as these rely on fractional reserves. This means that if everyone wanted their money back, the system would collapse as we saw in Cyprus and Greece some years ago.
What will the future look like?
In the future, it is very likely that we will see new surges in price and new bull markets which will most likely coincide with a stable macroeconomic situation and a reasonably good performance of the SPX. Institutional investors keep entering the space and every day we see news related to the real-world adoption of this enthusiastic technology. The industry is in its early stages and these unfortunate events are part of its maturing process where there will also be regulation coming out that establishes a framework for these assets in the USA and EU.
There are several events to be excited about like the Bitcoin halving or the advancements on ZK-rollups for Ethereum Layer 2 solutions. The innovation occurring in the space is mindblowing; however, in order to consolidate, companies need to start focusing on the UX/UI of the tools they are building as this is the biggest barrier to adoption. Operating on the blockchain is too complicated at the moment and it is quite intimidating for new users. Fortunately, NFT technology has been positively welcomed by big companies like Meta, Adidas and Starbucks which are starting to implement it themselves and we can expect this growth to continue during the next few years.
This is what most projects should be focusing on, user-friendly applications that add value and leave the complicated backend technology right where it should be, hidden from the user. When this happens, we will start to use crypto much more in our daily lives.