The Struggle Between Retail Investors and Whales: The Dilemma and Future of Decentralization Exchanges

In 2021, retail investors in the United States engaged in a fierce battle with Wall Street short-selling firms over GameStop stock. Now, a similar storyline is playing out in the cryptocurrency industry. On March 26, a wealthy investor nearly caused the DEX "Hyperliquid" to incur a loss of nearly $230 million.

This event is not just a simple technical failure; it reflects the challenges faced by the concept of Decentralization, the compromise between ideals and reality, and the intense conflicts of interest among various parties in the crypto trading ecosystem.

Let us review the ins and outs of this event, think about who the real winner is, and what impact this will have on the future of the industry.

Whale Approaches, Hyperliquid in a Dilemma

The JellyJelly token surged by 429% in just one hour, putting immense pressure on Hyperliquid. The platform took over a trader's short position after closing, facing over $12 million in floating losses at one point.

The situation is critical: If the price of JellyJelly rises to 0.15374, the $230 million funds of Hyperliquid will face the risk of total loss. As funds continue to flow out, the liquidation price of JellyJelly will further decrease, creating a vicious cycle.

This attack precisely exploited four main vulnerabilities of the Hyperliquid system:

1. Lack of effective position limits for illiquid assets
2. The oracle manipulation prevention mechanism is not perfect.
3. The automatic position inheritance system carries risks.
4. Lack of necessary circuit breaker mechanisms

This is not just a simple trading operation, but rather a meticulously planned attack on the system's vulnerabilities. Hyperliquid faces a dilemma: either watch $230 million in funds face liquidation risk, or violate the principle of Decentralization and take emergency intervention measures.

Market sentiment reached a boiling point in an instant, with numerous retail investors joining this "encirclement" action. Some influential industry figures even called for large Centralized Exchanges to participate. A well-known executive from an exchange responded to community members' suggestions to launch JELLYJELLY, triggering further fluctuations in the price of the token.

Just when retail investors thought victory was in sight, Hyperliquid took emergency action. The platform initiated a validator emergency vote to completely delist the JELLYJELLY token. This decision reached "consensus" in a very short time. Hyperliquid then released an official statement announcing that the governance committee had intervened and delisted the related assets, demonstrating the platform's determination to "stabilize the market" and forcibly quell this short squeeze.

The Test of Decentralization Ideals

The Hyperliquid event revealed significant challenges currently faced by decentralized exchanges (DEX). This incident exposed a serious vulnerability in the platform: it allowed the opening of extremely large positions on low market cap and low liquidity tokens, for which the market could not find enough counterparties during liquidation. In other words, the market depth is far from sufficient to support trades of such scale, and once a short squeeze occurs, liquidity collapses immediately, rendering the liquidation mechanism ineffective.

Hyperliquid was supposed to play a neutral platform role, but in this incident, it not only got involved but also changed the rules of the game when the situation turned unfavorable. The market's confidence in decentralized exchanges has been severely impacted. The "consensus" passed in just two minutes allowed the governance committee to arbitrarily change rules and close trading pairs, even faster than many centralized exchanges' responses. This inevitably raises the question: is the so-called "decentralization" only effective when the market is stable, and once it spirals out of control, does it turn into "arbitrary actions"?

If a DEX can also "force delist" assets, then what is the true meaning of decentralization? Is a centralized exchange more reliable, or is a decentralized platform more trustworthy?

The Contradiction Between Decentralization Ideals and Efficiency

On the surface, DEX seems safer because users' assets are always under their own control, eliminating concerns about misappropriation by centralized institutions. The automated market maker (AMM) mechanism ensures the feasibility of decentralized trading, but its drawbacks are also evident: insufficient liquidity, high slippage, and impermanent loss, leading to a poor user experience. Most people use DEX either for long-term holding or to participate in airdrop activities, as the daily trading experience is not ideal.

In contrast, centralized exchanges are convenient to use, have sufficient market depth, and powerful features, providing a smooth experience for both contract trading and spot trading. However, this convenience comes with risks: once funds are deposited into the exchange, users lose direct control over their assets. Past incidents such as the hacking of Mt.Gox and the collapse of FTX have made people wary of the next exchange that could potentially have problems.

The Hyperliquid event is a typical reflection of this dilemma: there is an inherent contradiction between the idea of decentralization and capital efficiency. The pursuit of absolute decentralization will inevitably affect capital efficiency; while the pursuit of the highest capital efficiency often requires a certain degree of centralized control.

This is an ethical dilemma similar to the "trolley problem": Should we adhere to the principle of Decentralization, accepting potential systemic risks and capital efficiency losses, or sacrifice some Decentralization when necessary to ensure system security and capital efficiency? Hyperliquid chose the latter, taking emergency measures to protect the protocol in the face of significant losses, but this also drew harsh criticism.

Interestingly, many critics have faced the same dilemma in similar situations themselves. Some critics took similar emergency measures during the market turmoil on March 12, 2020, when inaction could have had catastrophic effects on the entire cryptocurrency industry. This fact highlights the complex relationship between ideals and reality.

The Future Development Direction of the Crypto Market

Looking ahead, decentralized exchanges may develop towards a "partially decentralized + transparent rules + intervention when necessary" direction, rather than pursuing the extremes of "fully decentralized + market laissez-faire" or "fully centralized + opaque operations + intervention at any time."

In seeking a balance between maintaining the spirit of crypto culture and improving capital efficiency, the new generation of decentralized exchanges will strive to preserve sufficient on-chain transparency and user control, while effectively protecting system security and user assets in times of crisis. This balance is not a betrayal of ideals, but a pragmatic response to reality.

Centralized exchanges are also facing transformation pressure. In response to users' concerns about asset control and competition from decentralized exchanges, centralized exchanges are undergoing a strategic transformation centered on Web3 wallets. Whether it's industry-leading exchanges, established exchanges, or emerging exchanges, they are all trying to adopt the "Centralized Exchange + Web3 Wallet" model, balancing the convenience of centralized trading with the security guarantees of decentralization:

• A well-known exchange has not only expanded its business scope by actively developing its wallet services but has also successfully consolidated its market position as the second in the industry.
• Another large exchange acquired a well-known wallet as early as 2018, but only began to truly value its Web3 wallet business after the rise of the decentralized exchange market posed substantial competitive pressure, significantly increasing its R&D and marketing investments.
• Some established exchanges are also keeping up with the trend by building their own Web3 wallets, and they have specifically set up innovation zones to introduce popular Meme coins and emerging projects to meet users' trading demands for high-risk, high-return assets.
• Recently established emerging exchanges have proactively launched fully functional Web3 wallets and have taken the lead in connecting to multi-chain ecosystems. This layout not only provides users with more flexible asset management options but also enables them to achieve differentiated positioning in the increasingly fierce competition among exchanges.

This transformation is not only a response to user demand but also an adaptation to the logic of industry development. By integrating Web3 wallet functions, centralized exchanges retain the depth and efficiency of centralized trading while providing users with the choice to independently control their assets—users can decide when to place their assets in the exchange's custody for convenience and when to transfer them to their own wallets for security.

As the industry matures, we may see more solutions that coexist with "bounded decentralization" and "transparent centralization." In this new stage of integrated development, participants who can find the best balance between transparency, security, and efficiency will stand out in the increasingly competitive market.

Combining the efficiency of a Centralized Exchange with the transparency of a DEX, this may be the next development stage of crypto trading—it's not a contradiction of ideas, but a fusion of advantages.