Ninos and Ninor Mansor

January 25, 2023

Reflections On Contagion
& The Rebirth Of Crypto
Infrastructure
The second half of 2022 represents the greatest deleveraging event in crypto history, filling the
graveyard of the 2020-22 market cycle with the bodies of failed exchanges, market makers,
protocols and funds. How did infrastructure built over a cycle collapse in a few quarters?

We take this opportunity to publish Edessa’s first long-form report and:

Build a fundamental framework for the collapse of 2022;

Outline a path forward for the rebirth of crypto market infrastructure.

Over the years in crypto, one principle continues to re-emerge. While onlookers dismiss the
space as entirely speculative following a systemic collapse, the seeds of innovation are
planted in real time, motivated by the collapse. The market’s most potent shifts happen after
its most severe failures, with one cycle’s hubris becoming the call for future innovation and
progress.

PLEDGE TO
 Contents
Disclosure 3
Ancient Bull & Bear Markets 4
Part 1: Framework For Collapse 6
-----Ideal Market Structure: Originator Independence 6
-----The Commingled Reality 8
-----Three Fundamental Causes Of Contagion 10
----------(1) Originator Roles 10
----------(2) Feedback Loops 11
----------(3) Strategy Creep 11
-----The End Of The Paper Empire 12
-----Parallels To The Mother Of All Blowups: 2022 v 2008 13
Part 2: Rebirth From Ruin 14
-----One Cycle's Failures Are The Next Cycle's Muse 14
-----The Seven Pillars Of Infrastructure Rebirth 16
----------(1) Infrastructure Unbundling 16
----------(2) The Self-Custody Spring 17
----------(3) Decentralized Derivatives 18
----------(4) Decentralized Scoring: Onchain Identity & Collateral Rating 19
----------(5) The Rebirth Of CeFi Market Makers, Lenders & Exchanges 20
----------(6) UX-Forward Mass Market Products 20
----------(7) Zero Knowlege Information Sharing 20
-----The Future Of Open Markets 21
-----The Risks Ahead 22
Conclusion: The Infrastructure Rebirth 23

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 2

 Disclosure
This research paper, authored by the founders of Edessa and its affiliates (“Edessa”), is
intended for informational purposes only. The information contained in this paper is
based on data and information that the authors believe to be reliable, but no
representation or warranty, express or implied, is made as to its completeness or
accuracy. The authors are not providing any advice or recommendation to invest in any
specific cryptocurrency or related investment product. The information contained in
this paper has been prepared in good faith, to the best of the authors' ability, and is
believed to be accurate as of the date of publication. The information in this paper may
be subject to change without notice, and the authors assume no responsibility to
update this paper or to advise on further developments relating to the subjects
discussed.

The authors and contributors of this paper have financial interests in the cryptocurrency
space in general, and the contents of this paper should not be considered as an
endorsement or a recommendation of any particular investment. The authors and
contributors of this paper have not been compensated for its production and may have
a financial interest in the companies or cryptocurrencies discussed in the paper.

This paper includes forward-looking statements, which are based on current

expectations and projections about future events. These statements are not guarantees
of future performance and involve known and unknown risks, uncertainties, and other
factors that may cause actual results, performance or achievements to be materially
different from any future results, performance or achievements expressed or implied by
the forward-looking statements. This paper is not a solicitation, and should not be
considered as an offer, or the solicitation of an offer, to buy or sell any securities or
related investment products.

The authors of this research paper provide this information as-is with no warranty or
representation of any kind and expressly disclaim any and all liability for any errors or
omissions in the information provided. The information in this paper should not be
considered as an endorsement or a recommendation of any particular investment, and
should not be relied upon as the basis for any investment decision.

Investing in the cryptocurrency industry is highly speculative and involves a high

degree of risk, including total loss. Cryptocurrency prices can fluctuate widely, and
investors should be prepared for the possibility of losing their entire investment.
Potential investors should carefully consider their own risk tolerance and financial
situation before investing in any cryptocurrency or investment vehicle. Investors should
consult with their own financial and tax advisors before making any investment
decisions.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 3

 Ancient Bull & Bear Markets
Through millennia of imperial expansion and karmic collapse, Mesopotamia came to be
known as the “cradle of civilization”. Its rise was far from linear, defined by the bull and
bear markets of the ancient world. The story often began with city states born out of
desolation–tempered by war and scarcity. Pragmatic rulers built on the ruins of fallen
empires with new forms of administration and property. Soon enough, the humble
Mesopotamian king had enough resources to industrialize his scrappy army and
transition from a city-state to an imperial model.

Conquest became the empire’s credit line and fuelled advancements in science,
mathematics and state technologies. Vassal states stretched from Egypt to Anatolia.
Ancient kings plugged the holes of a multi-ethnic balance sheet through force and the
deportation of conquered peoples. This was imperial leverage at its finest, funnelling
spoils back to the capital cities which hosted the greatest palaces, royal art and
expansive literary works the world had ever known.
“Assyria soon discovered that empires are like Ponzi schemes… [They]
must continue to expand if they are not to collapse.”
Paul Kriwaczek, Babylon: Mesopotamia and The Birth of Civilization

As administrative complexity ballooned, the unwind of an overconfident empire would

soon begin. High-conviction city states devolved into elitism and luxury while tensions
simmered across the landmass. Time and time again, the Mesoptomians suffered
the ultimate strategy drift: they forgot the desolate age that brought about their
initial success. They became overleveraged and oblivious to contagion–whether the
fuse came from uprising, invasion or natural disaster.

Crypto is similarly consumed by these rise and fall sagas. High-conviction teams are
born in an era starved of credit and search for humble success. The tempered gains of
the “true believers” attract a new batch of bull market participants who push the
bounds of mainstream adoption. They catapult themselves into crypto royalty and build
a makeshift empire of leverage and domination. And so the karmic reversal begins:
tides turn, enemies rebel, and the market destroys the royal palaces as quickly as they
were assembled.

Once again setting the stage for true believers who find themselves in a desolated city.

The Palaces of Nimrod. James Fergusson, 1853 (top left).

Images 2-4 generated with MidJourney.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 4

 An Ancient Cycle
Individual hubris was not fatal in its own right, but collectively, each transformation
compounded to produce the most levered market in crypto history.

PARTICIPANT BEAR MARKETS BULL MARKETS

Founders raise to execute on a very Fundraising becomes an end in and of

FOUNDERS specific thesis with clearly-defined runway itself, with teams gunning for dream
targets. valuations.

Wizkid managers with limited track

FUND Capital allocators shy away from new
records raise large funds while existing
players scoop up LP demand into
MANAGERS managers.
“megafunds”, arguing the case for growth
investing.

Users prioritize self-custody, and As users grow complacent and less

EXCHANGES exchanges focus on catering to sophisticated, exchanges employ
sophisticated participants increasingly predatory tactics

They become a hodgepodge of VC,

MARKET Trading firms start the cycle as delta-
directional trading, lending and token
neutral shops focused on specific HFT
MAKERS strategies.
market making, raising “growth capital”
for what started a prop trading model.

As FDVs balloon, treasuries stop viewing

PROTOCOL Treasuries are conservative with token themselves as startups and instead
TREASURIES runway in bear markets. become fiduciaries of growth and
ecosystem branding.

Crypto Market Cycles: From Disinterest to Mania (16-18; 20-22)

Stage4 Stage1 Stage2 Stage3 Stage4 Stage1 Stage2 Stage3 Stage4 100%
Exhaustion Public Private Institutional Exhaustion Public Private Institutional Exhaustion
& Disinterest Market Market Mania & Disinterest Market Market Mania & Disinterest
Mania Momentum Mania Momentum
$80
Cumulative Private Market Funding (B)

16-18 Cycle 20-22 Cycle 80%

$60
60%
Dominance

Halving 2016 Halving 2020

$40
40%

$20 20%
Cumulative Private Market Funding
BTC Dominance
ETH Dominance
$0 0%
2016 2017 2018 2019 2020 2021 2022 2023

Expanding on a chart we initially published in 20191, the cycle of public and private market
funding repeated itself in 2020-22. Innovation happens when faith in crypto is at its lowest
and destroyed when faith is at its highest. Data sourced from DefiLlama2 and CoinMarketCap3.

1
https://twitter.com/ByteSizeCapital/status/1087905293583798272
2
https://defillama.com/
3
https://coinmarketcap.com/

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 5

 Part 1: A Framework For Collapse
How did market infrastructure built over years fail in a few quarters? We break down
the collapse at a structural level by exploring the role of different market participants.
In our framework, there are five fundamental types of participants and each is an
“originator” of some kind:

(1) Consensus Originators (COs)

This category encompasses public blockchains, decentralized protocols built on top of
them and stakeholders like validator networks, public miners and protocol foundations.
Their chief role: provide public infrastructure.

(2) Asset Originators (AOs)

These entities create crypto-native assets which become collateral. They fall into two
camps: (1) asset minters; (2) asset wrappers. The minters are miners, stakers and token
issuers (i.e. projects).

The wrappers financialize these minted assets by issuing derivative assets. Examples
include Lido issuing stETH as a staking derivative or Grayscale issuing GBTC as a BTC
equity wrapper. While in theory they should trade at parity, wrapped assets are softly-
pegged as there are no mechanisms for arbitrage.

(3) Equity Originators (EOs)

This is crypto’s capital base, representing new equity capital. This class includes
institutions like venture funds and hedge funds that raise LP capital and deploy across
the market. Other sources of equity origination are self-funded individuals,
independent investors and family offices. EOs can take on debt, but their business
mostly relies on capital accumulation and fundraising. Their role is principal risk-
taking–investing at risk of total loss.

(4) Debt Originators (DOs)

These are lenders who build crypto’s credit infrastructure, matching counterparties
willing to borrow and lend assets against a range of interest rates (fixed or floating);
durations (short or long, callable or non-callable) and collateralization profiles. A
healthy DO is constantly managing the risk of their loan book. Are short and long term
loan obligations aligned? Is the pledged collateral adequate security? Are
counterparties solvent?

(5) Trade Originators (TOs)

This class of participants facilitates trading infrastructure. They include centralized
exchanges, OTC market makers and DEXs.

Ideal Market Structure: Originator Independence

Before we dive into 2021-22, what does a healthy universe of originators look like?

Equity Originators are the lifeblood of the market. They provide fresh capital to
Consensus Originators for ownership in underlying companies or networks. They run
validators, stake assets, build mining farms or provide DeFi liquidity for rewards. They
provide capital to Asset Originators by buying issued tokens or minting softly-pegged
wrapped assets (i.e. GBTC), managing their own exposure.

Debt Originators are at the epicenter of risk. They take collateral from COs, AOs and
EOs and issue loans based on internal risk management. COs, AOs and EOs lend their
excess crypto-assets to DOs to earn a market rate.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 6

 DO integrity depends on minimizing duration, collateral and counterparty risk. If
they receive “good collateral” from solvent and liquid counterparties, no single
bankruptcy should impact their entire loan book.

The Ideal World: Siloed Originator Risk

DOs, COs, EOs and AOs trade with third-party Trade Originators. TOs are siloed from
the risks of other categories–they don’t originate equity, debt, consensus or
assets. Their role is simple: allow users to continuously (anytime) or discretely
(predetermined times) match orders and withdraw their assets 1:1. No bankruptcy
across this chain of participants should impact TO solvency.

In the ideal market structure, risk is siloed. Lending desks (or protocols like Aave)
facilitate loans between counterparties who manage their own exposure. Exchanges do
not become lenders–they remain third-party venues. Equity capital flows into private
market companies and protocols at the risk of total loss. AOs (i.e. Grayscale) do not
directly or indirectly overlap with DOs (i.e. Genesis). As a result, the system doesn’t
contain feedback loops or “daisy chains” of potential insolvency.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 7

 The Commingled Reality
In reality, the crypto ecosystem became one of the most opaque markets in history with
the commingling of most of its major institutions. Take FTX as the most extreme
example: what was meant to be a Trade Originator ended up a DO (“lending” to
Alameda), an AO (minting FTT), an EO deploying capital (FTX Ventures) and a CO
creating consensus (Serum). There was a general plague of “sister companies” and
“intercompany loans”, reinforcing this commingling.

While this obfuscation was difficult to achieve on-chain, DeFi stayed a small
percentage of trading and lending volume. DEX trading never exceeded 1/5th of total
volume 4 while behemoths like Genesis originated the lion-share of loans, frequently
greater than $10B within a single quarter 5:

Genesis Active Loans By Quarter

BTC

$14 ETH

USD

$12 Other

$10
Active Loans (B)

$8

$6

$4

$2

$0
2018 Q3

2019 Q1

2019 Q3

2020 Q1

2020 Q3

2021 Q1

2021 Q3

2022 Q1

2022 Q3
Quarter

The Lending Behemoth: Genesis Loan Origination.

Active loans originated by Genesis by quarter and denomination6.
Not only did exchanges become their own issuers and lenders, the debt origination
business was rife with moral hazard. Mostly centralized, lending became so risky that it
crowded out risk-savvy participants. A small number of lenders extended leverage to a
growing pool of counterparties who pledged increasingly illiquid collateral and took
every imaginable risk.

It is difficult to describe the extent of the resulting interdependence except by attempting

to visualize it:

4
https://www.theblock.co/data/decentralized-finance/dex-non-custodial/dex-to-cex-spot-trade-volume
5
https://genesistrading.com/insights/quarterly-reports
6 https://genesistrading.com/insights/quarterly-reports

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 8

 The Commingled Reality: Crypto Market Infrastructure in 2021-22.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 9

 Three Fundamental Causes Of Contagion
Insolvent entities projected a facade of balance sheet strength as long as the wind
didn’t gush in their direction. Ultimately, we argue that there were three fundamental
causes of contagion which accumulated over years and created this house of cards.

(1) Commingled Originator Roles

The first fundamental cause was the incestuous nature of market infrastructure. Every
business that could be aggregated was aggregated. Entities supposed to be
originating trades (like FTX) were secretly originating debt (lending user deposits),
transforming equity capital (users) into an additional source of credit.

Institutions printed or wrapped their own assets and borrowed against them to take on
more principal risk. The two clearest examples of commingled origination: (1) the
creation of FTT, taken as collateral by lenders or closely-related entities and fuelling
investments across the space; (2) the minting of softly-pegged derivatives like GBTC
which were taken as collateral and motivated a debt creation machine. DOs and TOs
merged into one.

The moral hazard of asset origination fuelled this environment. AOs issued illiquid
assets backed by credible investors, encouraging DOs to assume excessive risk by
accepting them as collateral. They, along with all other originators, accumulated a web
of toxic relationships over time–represented by the dashed lines below:

The Real World: Commingled Originator Risk.

Toxic relationships represented as dashed lines.

Another framework to understand the health of these relationships is tight versus loose
coupling. Tightly coupled entities are codependent. The collapse of one inherently
cascades to the other. These relationships crumble when market conditions reverse.
One example is a lending desk accepting illiquid collateral as security for a loan,
leaving them stuck with bad debt in the event of default. When relationships are
loosely coupled, one entity can unwind without damaging the other. They are highly
robust. In this case, the lending desk takes liquid collateral as security and executes an
orderly liquidation upon default. By nature, most DeFi-based relationships are loosely
coupled.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 10

 Since most trading and lending took place on CeFi and illiquid collateral
dominated lending agreements, in 2021-22, most systemically important entities
became tightly coupled and collapsed as soon as macro conditions reversed.

(2) Feedback Loops

This commingling created feedback loops. One bankruptcy would therefore trigger an
entire chain. Two examples:

1. The flow of toxic debt origination. Alameda pledged to Celsius and Voyager, who
lent to 3AC, who pledged to Genesis, who lent to Alameda. Any single default or
collateral downgrade disrupts the entire loop. To make matters worse, 3AC and
Genesis deposited and traded on FTX, who was “lending” user deposits to
Alameda.

Toxic debt origination loop.

1. w

2. The dangers of mixing debt and asset origination. Institutional Investors deposited
crypto assets to Grayscale, minted trust shares, pledged these shares to Genesis,
who then lent to Institutional Investors. The collapse of the Grayscale premiums
forced a string of insolvencies. Leverage was the foundation of these
relationships: Institutional Investors borrowed from Genesis to buy GBTC and
then pledged these shares with Genesis for additional loans.

Toxic asset and debt origination loop.

(3) Strategy Creep

Much like the Mesopotamians, the market suffered from strategy creep. FTX began as a
decent exchange and ended as a delusional conglomerate of everything–from politics
and philanthropy to venture investing. Companies start with a basic competency and
end with dozens of strategies. From the city-state model to the imperial model:

Entrepreneurs lending out VC-funded treasury to generate yield

Fund managers participating in high-FDV “discounted” treasury rounds
Exchanges running fractional reserves, trading operations and VC funds
Market makers transitioning from HFT to directional risk-taking.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 11

 The End Of The Paper Empire
The market wasn’t based on real balance sheets, but on paper attestations. The
irony is that paper subsumed a market historically opposed to rehypothecation–a
market which lived through the collapse of Mt Gox’s fractional reserve in 2014. While
FTX’s paper market was not new, this rehypothecation machine was more sophisticated
than anything seen previously.

The Mesopotamian rulers merged the priestly and political class. Kings believed in their
own divinity until outside forces put them to the test. In addition to SBF’s philanthropic
declarations, the FTX royalty expressed its divinity via Alameda’s exemption from
auto-liquidations. The casino didn’t just have better odds–the casino was on “God
mode”, protected from liquidation with an infinite well of capital.

$65 Billion Artificial Collateral

Exempt from

Exchange

Auto-Liquidation
Auto-Liquidation
Customers can trade on margin

only up to posted collateral

Greater than $0 4,000

Credit Limit

$1 Million to $150 41

Million $65 Billion 1

Alameda’s divinity – a $65B credit line funded by users, as

discovered by the FTX bankruptcy team 7.

Deluded rulers hauled up in luxurious palaces never expect God Mode to suddenly
end, but it does, triggered by unified invaders.
“Angered by the hubris of Naram-Sin, the gods supposedly unleashed the barbaric Gutians to
descend out of the highlands and overwhelm Akkadian towns.”
Robert C. Allen, The Collapse of Civilization in Ancient Mesopotamia

It was a matter of time before the market sniffed out Alameda’s insolvency and tested
SBF’s paper empire. CZ delivered the final coup de grâce in early November:

The final collateral downgrade 8.

CZ delivered the final downgrade. Just like in 2008, the collapse began once the
market realized it was accepting -D collateral as +AAA.

7
https://restructuring.ra.kroll.com/FTX/Home-DownloadPDF?id1=MTQzODU1NQ%3D%3D&id2=0
8
https://twitter.com/cz_binance/status/1589283421704290306?s=20&t=y5EvIZXsVRPHwOBNN_23_Q

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 12

 Parallels To The Mother Of All Blowups: 2022 v 2008
In 2021, we wrote a paper 9 exploring TradFi
market structure and crypto CeFi. We now
have a clear case study. The analog between
08 and 22 is as simple as replacing
instruments, counterparties and catalysts:
"Below we examine the blowup of 2008 (the
Global Financial Crisis), but we first encourage the
reader to ask the following questions. In TradFi:
• Is there a way to reliably verify counterparties and
their credit history?
• Can we quantify their debt obligations?
• How can we quantify system leverage?
• In the presence of rehypothecation, can we trust
these measures?"
The answer to these questions in 2008 and
2022: No.
“One of the most extraordinary aspects of 2008
was the relationship between opaque financial
products and unquestioned risk-taking. Seduced
by the hunt for yield, nobody understood what
they were buying and very few knew what they
were selling.”
The most extraordinary example of this
relationship was how exchanges, VCs and
trading firms were so confident in unrealised
PnL they borrowed against paper gains to
place more venture-style bets.
“Banks repackaged and retranched risk, using
CDOs as collateral – CDO2 – making it impossible
for lenders to not only redeem collateral upon
default, but identify their counterparties
altogether. Who are the borrowers? What is their
credit risk? Do they even have any collateral?”
The banks were CeFi exchanges like FTX,
lenders like Genesis and yield providers like
Celsius who focused on repackaging crypto
yield.
"Sudden downgrades descended upon the
market. Imagine believing your position was safe
and overcollateralized, only to realize that your
AAA collateral was the furthest thing from AAA.
Over 31% of downgrades involved AAA-
collateral. It would be like thinking leveraged long
was collateralized by Bitcoin only to realize it was
truly collateralized by Dogecoin – or Safemoon.
9
https://www.arringtoncapital.com/blog/the-space-race-for-open-markets-vega/
Reflections on Contagion: The Rebirth of Crypto Market Infrastructure
Put another way, an institution may have thought
its balance sheet was 10x levered, only to discover
that they needed to multiply that number by a
factor of five.”
Each downgrade revealed how much leverage
actually existed in crypto, starting in Q2 and
climaxing with the collapse of FTT.
"Crypto inherits many of the failings of TradFi
microstructure, but because of the unique nature
of crypto collateral, none of the corresponding
failsafes. It is like getting the worst of both worlds,
redlining the market’s engines and threatening
collapse with each liquidation event...
Supercharged collateral is incredibly powerful, but
when combined with a naive implementation of
legacy markets, it is arguably net worse than
TradFi’s closed markets."
Crypto is 24/7, has no circuit breakers and no
lender of last resort. This is why CeFi
infrastructure needs to be even more robust
than TradFi’s venues (and arguably why DeFi
digested the contagion in a more orderly
fashion).
"Our takeaway is a lesson not of history, but of
hindsight: centralized markets suffer from the
obfuscation of risk and no amount of government
regulation will change this reality. What we need
instead is a properly designed, robust and
transparent financial system where the game
theory of the system encourages honest
behaviour. In the transition from closed to open
markets, what we need are rules without
corruptible and flawed rulers."
If 08 was not enough, the rise and fall of crypto
market infrastructure again highlights the
opaque nature of centralized financial markets.
"If a system is transparent by design – by code –
then counterparties can always be identified,
collateral can always be verified and system
leverage is something the layman can determine
without the rubber stamp of an apparently
omniscient institution. We are of course pointing
to decentralized financial markets…"
Breaking the perpetual loop of contagion,
whether once every decade in TradFi or once a
year in crypto.
edessa.capital 13
 Part 2: Rebirth From Ruin
There is no doubt that Mesopotamian accomplishments were numerous from the
invention of written language to modern statecraft. And yet they found themselves in
the same situation again and again: reduced to ruin, wondering how.

Almost as consistent as this hubris and collapse was persistent survival. Civilizations
may have fallen but their ideas had strong continuity with rulers thousands of years later
viewing themselves as modern revivalists of Mesopotamian knowledge. Outsider
civilizations may have overran the capital city but they often failed to become the
dominant cultural force. Culture was constantly reborn from ruin, migrating beyond the
capital cities or returning to them centuries later and forging new civilizations built on
the memories of predecessor accomplishments and failure.

Crypto lost its ethos in 2021-22 and became the abyss it claims to stand against. In this
section, we imagine the crypto rebirth–how can the industry rebuild going forward? In
the same way COVID accelerated the shift towards digital transformation, we believe
that the collapse of FTX could accelerate the rebirth of crypto market infrastructure.

The rulers of ancient Mesopotamia obsessed with the ancient knowledge of their
forefathers. One of the last Assyrian kings went as far as seeking out every clay tablet in
the fertile crescent and curating them into the greatest library the world had seen.

The Royal Library of Ashurbanipal.

Generated with Midjourney.

One Cycle’s Failures Are The Next Cycle’s Muse

Many have now concluded that crypto failed to deliver on its promises. In our view, this
is mistaken: (1) the events of 2022 showcase the fragility of CeFi, not crypto; (2) this
view misunderstands how infrastructure is born across cycles – the failings of one era
are the muse for another.

This theme is consistent. The collapse of the ICO boom left behind a generation of
“useless” ERC20 tokens. They failed. However, eventually, the liquidity of these
surviving tokens bootstrapped Ethereum DeFi in 2020. They failed as individual
projects, but the remnants left behind were important for the launch of Uniswap and
Compound which spawned the DeFi stack, which ultimately spawned DeFi across
multiple blockchains.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 14

 Crypto Market Cycles: From Disinterest to Mania (16-18; 20-22)
100%
Stage4 Stage1 Stage2 Stage3 Stage4 Stage1 Stage2 Stage3 Stage4
Exhaustion Public Private Institutional Exhaustion Public Private Institutional Exhaustion
$80 & Disinterest Market Market Mania & Disinterest Market Market Mania & Disinterest
Mania Momentum Mania Momentum 80%
Cumulative Private Market Funding (B)

$60 60%
$40 40%

Dominance
$20 Halving 2016 Halving 2020 20%

$0 1st Gen L1s

0%
ICO Boom & Bust

$-20 2nd Gen L1s -20%

The Growth Of CeFi Derivatives & Aggregators
Birth Of ETH DeFi

$-40 Cumulative Private Market Funding

DeFi Summer -40%
Multichain DeFi
BTC Dominance
ETH Dominance
-60%
CeFi Unwind

2016 2017 2018 2019 2020 2021 2022 2023

The Crypto Cycles of Birth, Destruction and Rebirth.

One cycle’s failures are the next cycle’s muse.

What springs from 2021-22? Our thesis is as follows: the most compelling themes
revolve around the rebirth of transparent market infrastructure and systems that
“can’t be evil”. The CeFi collapse came at great cost, but it also gives crypto a fresh
calling to rebuild infrastructure that not only makes the errors of 2022 unlikely, but
impossible.

At this point in time, most market infrastructure has been wiped out to the point that we
are genuinely unsure if CeFi credit even exists. The market continues to prod at
surviving conglomerates with the spectrum stretching from bundled giants like Binance
to narrow venues like Bitstamp and Kraken.

The origination activities of major CeFi venues (as far as we know).

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 15

 The Seven Pillars Of Infrastructure Rebirth
We imagine seven themes driving a sustainable rebirth. These themes each
encapsulate new companies and verticals in their own right but also come together to
form a new vision for robust infrastructure.

(1) Infrastructure Unbundling

Infrastructure Unbundling should be a core driver in 2023 and beyond. Unbundling is
the segregation of originators. Through both regulatory and market forces, we likely see
a clearer separation between these participants–crypto’s Glass-Steagall moment10. The
“ratings agencies” qualifying collateral should be independent of the trading
firms, just as lenders should be independent of exchanges–and all the way down
the stack.

This is a lesson already known to traditional financial markets which separate custody,
execution, clearing and settlement. While unbundling is often driven by political and
regulatory forces in TradFi, it is a natural consequence of the composability of open
protocols. The learnings of the past cycle could motivate existing incumbents to slowly
unbundle themselves and ring-fence their businesses as they are pressured to
institutionalize. Specialized DeFi protocols and CeFi counterparties become experts at
taking and siloing one type of risk.

Unbundling will be pioneered by the merging of DeFi protocols and self-custodial

technology with centralized order books, matching engines and lending operations.
Why are centralized crypto-depository institutions like exchanges entirely
custodial with omnibus accounts? Instead, segregated asset management should
become the norm. Users should maintain some ownership of their assets (through
multi-sig or MPC solutions) and delegate assets to exchanges for margin, collateral or
staking.

An unexpected winner in the unbundling wave could be the OTC desk. OTC desks
allow institutional clients to keep their keys while outsourcing trading venue
counterparty risk. They are naturally better at assessing these risks than (say) a venture
capital firm. The only exposure clients have to manage is the delta between executing
and settling a trade, limiting risk compared to housing coins on the venue itself.

As of days before publishing this report, we are interested to note that, while a far cry
from the complete vision for “infrastructure unbundling”, behemoths like Binance are
already making efforts to separate custody from trading. These recent developments
capture the essence of infrastructure unbundling and how it will shift even the most
aggregated organizations to reshape operations:

Early signs of CeFi infrastructure unbundling11.

10
https://www.federalreservehistory.org/essays/glass-steagall-act
11
https://www.binanceinstitutional.com/support/announcements/article/204448334901952512

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 16

 Before we move onto the next theme, we wanted to note the counterargument to
unbundling. Several institutional traders we have spoken with remain strong
proponents of vertical integration, believing it will survive with the right regulatory
oversight, proof of solvency requirements and the emergence of crypto insurance.
Does unbundling maximalism throw the baby out with the bathwater?

Our view is that vertical integration will still struggle to keep up with the supercharged
nature of crypto collateral and post-2022 vertical integration will remain a band-aid for
what is ultimately a technical problem. We would rather see the space forgo some
efficiency gains in the short run if it means forging antifragile technical infrastructure
over the long term.

Nonetheless, this is an important perspective and one we will continue to follow,

especially if institutional demand for vertical integration persists. There is also a world
where (as we see with Binance’s Mirror service) vertically-integrated CEXs unbundle
operations and governance without necessarily unbundling corporate structure and
liquidity.

(2) The Self-Custody Spring

The Self-Custody Spring is a thematic shift of crypto’s talent pool away from
financial engineering and toward non-custodial innovation. The space needs new
technologies that can leapfrog the value and accessibility of self-custody as users
demand products which protect their assets. So far, looking just at Bitcoin, there has
been a significant shift toward cold storage on most exchanges, predominantly the
likes of Coinbase, Kraken and Huobi, while others, like Binance and Bitfinex, have
continued to consolidate their reserves:

Exchange BTC Reserves

Binance
Okx
Huobi Global
Kucoin
Bybit
800,000
Bitmex
Coinbase
Bitfinex
Kraken

BTCUSD Exchange Rate

Bitstamp $10,000
600,000 Deribit
BTCUSD Exchange Rate
BTC

400,000

200,000 $1,000

0
2016 2017 2018 2019 2020 2021 2022 2023

Besides leading market “One Stop Shops” like Binance and OKX, exchange BTC reserves are on a
multi-year downtrend. Data sourced from CryptoQuant12.
Today crypto has an all-or-nothing attitude towards self-custody. Experimentation in
wallet infrastructure can make key management more dynamic, informed by real-time
risk factors. One team we met described this as the rise of ”programmable wallets” and
account abstraction, solutions allowing users to customize wallet policies and create
natural stopgaps through velocity limits and multi-party computation.

The self-custody spring is rooted in DeFi growth but can also reshape CeFi. Here is a
basic example for how access control can diversify CEX risk. Imagine a ⅔ multisig
(or MPC scheme) with one key owned by a user, one by an exchange and one by a
neutral settlement agency. Liquidations happen when the agency and exchange ask for
access, but the exchange can’t assume control over assets on their own. Similarly,
withdrawals happen when the user initiates a transaction, and either the
12
https://cryptoquant.com/

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 17

 exchange or agency approve the transfer.

In the above scenario, users don’t lose access to their assets even in the case of
exchange failure. Could a custodial layer this simple have prevented FTX? In
today’s all-or-nothing world, one entity needs to be corrupted. In the self-custody
spring, multiple genuinely independent institutions need to be corrupted.

CeFi lives in the void of wallet infrastructure. A strong era of self-custodial

innovation could take power from CeFi while increasing the quality of mainstream
onboarding, albeit slowing its pace. This tooling has strong institutional use cases
(think of a “decentralized Fireblocks”), fostering capital efficiency without surrendering
key management.

Just a few days ago, 1inch announced a proprietary hardware wallet13, validating the idea that
even existing DeFi protocols can contribute to the Self-Custody Spring.

(3) Decentralized Derivatives

Decentralized derivatives are one of the most important growth categories over the
next 2-5 years. Open interest (OI) migrating onto on-chain, performant orderbooks
would be a leapfrog for market transparency. The collapse of 2022 was a crisis of off-
chain and hidden leverage, built and cleared on centralized venues. With truly
decentralized derivatives, no one class of positions can take priority. God Mode is
impossible. The system clears debt regularly and catches feedback loops early in the
chain without discretionary margin calls. DeFi derivatives ultimately incentivize
responsible counterparties. It is telling to think that while 3AC, Celsius and Alameda
defaulted on their CeFi agreements, they repaid most of their DeFi obligations.

We believe that sustainable cross-margined trading can only occur on credibly neutral
and decentralized venues. Cross-margining was one of FTX’s most important value
propositions. The exchange allowed users to cross-collateralize across spot, futures
and options positions. While improving capital efficiency, cross-margining in CeFi
incentivizes moral hazard. Exchanges are incentivized to overstate the collateral value
of illiquid assets and allow risky parameters to persist for longer than otherwise
possible.

Cross-margining is a tricky problem, but its dilemmas should be fleshed out by open
protocols. The market will find and eliminate systems which produce bad debt and
collateral.

Parameters must be carefully selected, lest they are subject to economic exploitation
as was the case for Mango Markets.

13
https://cointelegraph.com/news/1inch-launches-proprietary-hardware-wallet-as-self-custody-trend-grows

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 18

 The economic attack14 of Mango Markets15, an onchain cross
collateralized derivatives platform.

It will take time to build liquidity on these decentralized venues, but this is a worthy
effort: in the long run, the UI and liquidity of the on-chain CLOB should trend
toward the look and feel of CeFi without surrendering self-custody.

(4) Decentralized Scoring: Onchain Identity & Collateral Rating

Onchain Identity
On-chain identity serves an important role in the transition away from centralized credit
scoring. In less than a week, the market went from believing FTX was completely
solvent to discovering a $8B hole. Why did so many counterparties get it wrong? With
more activity on-chain, we should see better tools for assessing entity solvency and
credit as a whole.

In the status quo, undercollateralized credit assessment relies on off-chain identity and
other declarations (e.g. financial audits), but these are limited for two main reasons:

1. Non-transferable – Identity must be reinstated with each counterparty

2. No interconnectivity – Each declaration is not tied to current or previous
declarations.

In our view, the magic of on-chain credit scoring will be in anonymous and
pseudonymous designs. The key to unlocking on-chain identity – and thus risk-
minimized undercollateralized lending – are NFTs which serve as unique identifiers in
open markets. These identifiers could take the form of:

1. Anonymous, free market NFTs — popular collections, like Crypto Punks or BAYC,
serving as anonymous identifiers, with reputations that can be bought, transferred
and sold
2. Pseudonymous, regulated NFTs – issued by regulated KYC providers,
embedding encrypted data, allowing DeFi protocols or CeFi providers to
immediately and uniformly check the identity and credit worthiness of a
counterparty, without necessarily revealing KYC information to the public.

Both of these types of identifiers capture “on-chain personhood” and introduce

historical behavior associated with the current owner of the NFT. These NFTs can serve
as social collateral in DeFi protocols or as proof of history with CeFi providers. By
leveraging NFTs in this way, the credit score transforms from a “soul bound” property of
a counterparty to a composable asset and open marker of creditworthiness. This
enables “social slashing” via markers of bad credit (like missed payments), impairing
the value of the NFT identifiers.
14
https://twitter.com/avi_eisen/status/1581326197241180160
15 https://twitter.com/mangomarkets/status/1580053215919607810

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 19

 Collateral Rating
Just as on-chain identity tracks the creditworthiness of counterparties (whether they
are a person, company or public key), rating agencies will ensure consistent, market-
wide assessments of collateral. These ratings agencies could be decentralized
networks or centralized companies–ultimately keeping Debt Originators accountable
and building a better picture for credit risk in real-time. Without more transparent
credit rating, the fox watches the hen house–the same entities rating the
collateral are issuing the loans. These roles, just as in counterparty identity
verification, should be unbundled from other market infrastructure to eliminate bias in
collateral rating.

(5) The Rebirth Of CeFi Market Makers, Lenders & Exchanges

The first of their kind, the last generation of CeFi institutions was born reactively.
Crypto-native lenders, exchanges and market makers each had their own prisoner’s
dilemma. Lenders felt pressure to originate loans and accept new types of collateral–if
they didn’t offer the leverage, somebody else would. Exchanges rushed to launch naive
venues that didn’t account for the unique nature of crypto collateral while market
makers confused balance sheet growth for trading genius and transformed from
liquidity providers to prop traders and venture capitalists.

Who is left in CeFi? There is blood in the water across these companies and an
opportunity for responsible players to build good practices from day one and learn from
their competitors’ demise. Moreover, how can these firms reimagine themselves
with the unbundling and self-custody ethos in mind? Centralized institutions like
market makers should operate in ways that maximize client control while continuing to
simplify how users interact with trading technology. Can non-custodial wallet
infrastructure make these institutions less fragile? In an environment where users are
skeptical of CeFi operators, we could see more innovations from these businesses as
they try to become more robust.

(6) UX-Forward Mass Market Products

In the long run, UX is the only way to break the loop between bull and bear
markets. Centralized institutions make it easier for new entrants to participate but
create fragility and set the space backward when they fail. We are bullish on UX-
forward teams that bring self-custody to the masses in unique, gamified and genuinely
creative ways.

These teams take the technical innovations of a Self-Custody Spring and introduce
them into seamless products. Paranoid cryptographers pioneer wallet solutions, but
product-centric teams bring these to the masses. In the past, we see one cohort
without the other–the hardcore Bitcoiner running a cold machine or the fully-fledged
CeFi operator who builds good UI but disregards self-custody completely.

The bridge between these two worlds are good products people want to use, whether
they are games, marketplaces or collections–pushed by teams who transform self-
custody from a daunting experience into one that is alive. Breaking this loop should be
one of the most important goals of any future cycle.

(7) Zero Knowledge Information Sharing

If lenders knew how exposed their counterparties were to other lenders, would they
have extended as much credit? The answer is no. The challenge with intercompany
information sharing is similar to Schrödinger's cat: revealing information about one’s
positions, loans, and counterparties influences the outcome of a trade. Would a trading
firm want to indiscriminately reveal a long or short position? Clearly not, as this
information would spread and eventually hurt their position.

What if they could share a cryptographic attestation of solvency without revealing their
exact positions? Markets need mechanisms for sharing accurate information about
solvency without revealing the details of exposure, positions, leverage or balance sheet
specifics. Such a system would function as a zero-knowledge information network,
where
Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 20
 where counterparties reveal discrete details of creditworthiness and exposure without
giving up proprietary information. We believe such a system would silo originators
across each core market function without building hidden risk.

One of the major challenges to this idea is ensuring the private data shared with the
network is truthful. Unless an entity operates entirely on-chain, we will still need
auditors to oversee part of this process (the same reason why CEX proof-of-reserves
are hard to rely on).

The Future Of Open Markets

So far in this report we have created a framework for every type of Originator emerging
over the last cycle. We concluded that the three ultimate causes of crypto market
collapse were commingled origination, feedback loops and strategy creep.

We believe the seven pillars of market reform instantiate a way forward for improving
market integrity and transforming crypto’s infrastructure into a system that “can’t do
evil”. Just as each pillar of opacity compounded on the other to produce more risk,
each pillar of market transparency reinforces the other. Ultimately, this will mean the
market does not have to hope for honest behavior, but can rely on systems that
incentivize honest behavior.

The graphic below illustrates how each of these seven pillars come together to reinvent
market infrastructure.

(7) ZK INFO
SHARING

Bringing the seven pillars of market integrity together.

Users enter crypto through UX-friendly self-custodied wallets and interact with
segregated Trade and Debt Originators (centralized or decentralized lenders, exchanges
and OTC desks).

Decentralized information sharing fuels a network of ratings agencies and feeds the
market accurate data about entity solvency while keeping positions private. This data
feeds back into Trade and Debt Originators via on-chain identity and collateral ratings,
while banking infrastructure, rating agencies and user wallets also provide data to this
network. This loop of transparency combined with unbundled market infrastructure makes
it difficult for institutions to keep secrets and play intercompany games.

We believe DeFi activity will grow as a percentage of the overall market, but even CeFi
infrastructure can reorient around these core pillars. Combining all of these pillars
together, we begin moving toward a system built with market integrity at the forefront.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 21

 The Risks Ahead
While we hope the contagion of 2022 inspires a sustainable rebirth of market
infrastructure, this future is not certain and there is still a world where crypto repeats
the mistakes of recent history. Principally, we believe there are two risks ahead: (1)
CeFi is rebuilt with lip service to the mistakes of 2021-22 but the incentives for vertical
integration and commingling again prove too strong; (2) the market embraces DeFi as a
catch-all alternative without tackling its unique risks.

The incentives for vertical integration are incredibly strong because CeFi
businesses thrive on economies of scale. CeFi is an AUM business. With low fees,
entities are incentivized to grow assets at all costs. The economies of scale as one type
of originator become a launchpad for the next: the market maker becomes the
exchange, which becomes the lender, and so on. At the same time, CeFi businesses
are simply giving the market what it wants. Counterparties enjoy the convenience of
all-inclusive offerings.

The main risk for CeFi going forward will be the temptation to again cave to the fallacy
of economies of scale–fuelled by AUM efficiencies and client demand. In good times,
these pressures can prove too strong. Can the unbundling thesis survive another
mania? Or will the market again capitulate to “efficiency”? We can see a world where,
comforted by regulatory changes, CeFi history repeats.

The danger of complacency is also true for DeFi. While 2022’s collapse vindicates
the DeFi thesis, DeFi is not a catch-all solution to centralization. While an individual
protocol like Compound or Aave can be entirely unbundled and specialized as one type
of originator, the protocol is still dependent on middleware and base layer
infrastructure which can become centralized. The economies of scale (and thus threat
of centralization) can form at every layer of the protocol stack: the oracles feeding price
data; the miners extracting MEV; the staking-as-a-service providers running
blockchain nodes; the auditors verifying smart contract code.

In the swing toward DeFi, will the market be too easily seduced by DeFi narratives? The
incredible resilience of DeFi in 2022 in the face of a CeFi unwind, while impressive,
could also lull users into a false sense of security and set the stage for yet another
systemic collapse. DeFi’s ability to successfully unwind debt does not eliminate
the potential for systemic risk and centralization going forward. These risks have
to be addressed.

In our view, failing to address these two risks could set the stage for an even
broader existential threat: total capture by TradFi incumbents and draconian
regulation. If this happens, then crypto has failed.

As we think through these economies of scale, our takeaway is focused on the long
game: it is better for the market to grow slowly, and even develop in a somewhat
fragmented manner, than to embrace explosive and aggregated growth. It is better for
crypto infrastructure to risk fragmentation, take longer to generate meaningful liquidity
and traction, but remain insulated from commingling and centralization risk. This
harkens back to the very ethos of crypto: the self-custody spring is a rejection of
aggregation and is antithetical to economies of scale, instead premised on self-
sovereignty.

Reflections on Contagion: The Rebirth of Crypto Market Infrastructure edessa.capital 22

Conclusion: The Infrastructure Rebirth
Mesopotamian civilizations were the most advanced of their time yet they continued to
fall victim to their own success. The rise and collapse saga continued for thousands of
years until these cultures ultimately failed to regain supremacy and were permanently
subsumed by outside civilizations. Crypto finds itself in a similar conundrum–an
industry with some of the smartest people in the world, guided by a vision for
transparency and financial sovereignty–yet frequently caught in the imperial drama of
individual hubris that mirrors the system crypto claims to oppose.

Centralized financial markets failed crypto just as they failed TradFi in 2008. If
unchecked, the hydra heads of rehypothecation grow uncontrollably whether the
collateral is a mortgage-backed security or an illiquid altcoin. Crypto’s originators
became commingled and abused their scale. In the most extreme example, one market
maker launched its own exchange, which then issued its own collateral and used this
collateral to “borrow” client assets and redirect them to the market maker who traded
against clients while exempted from losses.

Once the contagion began, the market was engulfed by a string of insolvencies unlike
anything the space has ever seen. This collapse of market infrastructure, while
unprecedented, is also the reminder that crypto desperately needed. The reminder
that crypto infrastructure has to reflect the ethos of the space or crypto will
ultimately fail.

The only way to tame the animal spirits is to build infrastructure that “can’t be evil”, not
to hope that crypto participants learn, but build technology that segregates origination
and fosters realistic tools for market integrity. Crypto now has a very strong rallying
cry–to build unbundled, self-custodial and transparent infrastructure. This is a muse to
not just bounce back from collapse, but use failure as inspiration for decentralized
technology. The idea of fundamentally rebuilding financial markets–TradFi or crypto–
will likely take many years, but the events of 2020-22 could ultimately be remembered
as a major catalyst to this end.

It is time for the humble city state to be born from desolation. We are excited about the
environment to come, which will self-select for “true believers” driven by the
fundamental values of crypto rather than the allures of a bull market–values more
important to our civilization today than ever before.

“Time and time again we read such accounts of the total destruction of great
Mesopotamian cities, and yet after a relatively short interval they appear to
have risen again as if nothing had happened.”
Paul Kriwaczek, Babylon: Mesopotamia and The Birth of Civilization

Special thanks to Andrew Kangpan (Two Sigma Ventures), Avi Felman (GoldenTree Asset
Management), Paul Kremsky (Cumberland DRW), Jordy Fiene (Skynet Trading), Michel Dahdah
(C3 Protocol), Barney Mannerings (Vega Protocol), Robert Alcorn (Clearpool), Ryan Berkun
(Teller Finance), Derek Yoo (Moonbeam), Andy Bryant (Vektor Finance), John Clarke (AlgoFi),
Austin Wilshire (xBacked), Bo Zhang (Fyde Treasury Protocol) for their valuable feedback and
contributions.
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