This Time Isn't Different: Part III
'Tis a racket as old as John Pierpont Morgan himself.
Last time, we saw how the market for UST and stETH started going haywire.
What follows is how that led to a full out financial crisis within crypto!
What Agatha tells Anderton
The chaos in UST and stETH began to cause systemic contagion, hitting key financial institutions in crypto.
One of the biggest dominoes to fall was Celsius.
Celsius is one of the largest centralised cryptocurrency financial service providers. You can trade crypto with it, you can deposit crypto with it to yield interest and you can borrow from it. Although it tends not to describe itself as such, you can think of its business model as a bank. It has a retail-facing commercial banking arm and a retail-and-wholesale-facing investment banking arm, borrowing in the former in order to lend in the latter.
Unlike most banks in tradfi, which earned the difference between what it lent at and what it borrowed at, Celsius stood out by offering wildly above-market yields to depositors as well as the low interest loans to borrowers. How could it possible provide both of these simultaneously?
The trivial answer is that they were making a loss, and returns were partly being paid for by getting in new depositors. however, the more complete answer is rehypothecation and leverage.
Like basically every financial institution, Celsius lends out its depositor’s money. What rehypothecation refers to is that Celsius also lends out the collateral it gets from borrowers. In particular, it had been lending UST on Anchor, yield farming ETH/stETH with Lido and Aave as well as doing the stETH/bETH with Lido and Anchor. This meant that it was exposed to both UST and stETH.
So when UST depegged, they took quite a hit. Alone, this likely wouldn’t have taken down Celsius. However, it had also lost a few hundred million in various hacking incidents during the previous few months, and worst of all, the depositors were starting to withdraw their money in a panic.
This coincided with the stETH break in parity, which caused a huge maturity mismatch. Celsius’s ETH-denominated liabilities had to be paid out immediately, but its ETH-denominated assets were incredibly illiquid. Mostly they were either in stETH or directly locked up in Ethereum 2.0. The problem was that everyone was deleveraging at the same time, so the secondary markets for selling stETH were drying up.
Centralised exchanges (CEX) didn’t have deep enough liquidity, and neither did DEXs like Curve. Liquidity providers (LP) didn’t want to be left trapped and holding a bag full of stETH, so they exited; the stETH/ETH trading pool on Curve had become 80% stETH, meaning there wasn’t enough ETH for Celsius to sell all of its stETH, even if it was willing to do so at a loss. The only way out was with over-the-counter (OTC) trades to brokers, but that meant accepting an even steeper discount. All of this would cause the value of Celsius’s ETH-denominated assets to fall in value when marked to market price, encouraging even more withdrawals.
In a manner not too dissimilar to tradfi bank runs, Celsius got fucked.
Liquor, ladies and leverage
Oh, and then there’s leverage.
In order to further juice up its returns, Celsius borrowed from the MakerDAO protocol. MakerDAO, much like Terra, has two crucial currencies: the equity token Maker (MKR) and the stablecoin DAI which is pegged to the US dollar. Unlike UST, DAI is an overcollateralised crypto-backed stablecoin. This means that for every $1 of DAI Celsius borrowed, it needed to put in $1.50 worth of collateral into the MakerDAO lending protocol, and if the loan-to-value ratio ever went past a certain threshold, it would get seized.
The problem with getting leverage via an overcollateralised stablecoin is that they are natural liquidity drainers. As soon as the UST contagion led to selloffs in the rest of the crypto market, the value of Celsius’s collateral began to get marked down, bringing it closer to liquidation. In the midst of a massive cash exodus, Celsius had to deploy what limited resources it had to stopping a default on its loans.
Doubly fucked.
As Celsius took blow after blow, traders could smell blood in the water. If they sold enough of the asset types which Celsius was using as collateral, they could force Celsius to be liquidated. This would let them buy up Celsius’s stuff at bargain bin prices, and with all of this being publicly viewable on the blockchain, short sellers knew exactly what to target and how much to sell.
Triply fucked.
The result? Celsius gated withdrawals, preventing depositors from taking their money out. The ensuing fear, uncertainty and doubt sent asset prices tumbling, leaving it with even less collateral. At this point, Celsius could have tried to repay its loans, or top up its collateral to prevent liquidation.
For every $1 borrowed, Celsius needed to provide $1 to repay it or $1.50 to have enough collateral. Ostensibly, the former is cheaper. Yet Celsius chose the latter. Why? Because it knew it definitely couldn’t repay its debts, but it would cost pennies on the dollar to top up enough collateral to survive a bit longer. Thus what little remained of Celsius’s liquid ETH was locked in as collateral.
Triply fucked.
In short, Celsius took their depositor’s money as well as their borrower’s collateral, levered it up and bet it all on black at the roulette table. When UST and stETH got depegged and when other assets fell alongside, this house of cards began to collapse. Rather than honouring their customer’s redemptions, Celsius locked up their money. Then they doubled down on their bets and took one last punt, hoping on the off chance that their assets rebounded in price and they could make it all back.
In tradfi, you’d at least get your money back via laws surrounding deposit insurance, but here, none of this applies. Depositors and borrowers have no protection against Celsius using their money and collateral for whatever it deems fit. In the wild west of crypto, there is only one law: if it’s not your keys, it’s not your money. Because of how large Celsius was and how many counterparties it engaged with, this triggered chaos across a whole web of transactions.
Hedge funds that don’t hedge
It wasn’t just the shadow banks that were facing funding pressures. Another victim of this vicious cycle is Three Arrows Capital (3AC), one of the largest hedge funds in the crypto space. Much like Celsius, it was exposed to UST and stETH, thus leaving it in a bit of a bind as the losses cascaded and its collateral went to zero. In fact, it was even more exposed, because it had been one of the main organisations helping to support LFG, buying up Luna in exchange for various other assets in order to capitalise Terra’s crypto reserve. That half a billion dollars went up in smoke virtually overnight.
At this point, the story should be clear. They were levered up too much and got margin called when their collateral fell in value. The big difference is that they basically ghosted everyone, and thus got liquidated by their counterparties. These were some huge counterparties, including centralised exchanges like Bitmex, FTX and Deribit; lenders like Celsius, BlockFi and Genesis; market makers and trading firms like 8BlocksCapital, as well as brokers who had engaged in OTC trades with them.
This is especially concerning for counterparty lenders if they don’t have enough capital buffers on their balance sheets to bear the losses of liquidating 3ACs portfolio. For example, 83% of BlockFi’s loans are under- or un-collateralised. Nor was 3AC just a trading partner; in many cases, it was an investor which also managed assets for its venture bets. This provided another avenue for contagion, with lending platforms like Finblox which had received capital from 3AC having to impose withdrawal limits of their own.
The end of the beginning
As for what happens now? I have no clue.
If the collapse of 3AC we’ve seen in the past couple of days is crypto’s Lehman Brothers, it’s worth remembering that the immediate aftermath of Lehman’s collapse was seen as a triumph of the accountability of free markets against moral hazard. But within a matter of days, people realised this was no controlled demolition. The worst was not over - far from it.
Lehman didn’t mark the end of the crisis back in 2008. It wasn’t even the beginning of the end. At best, it was the end of the beginning. Nor is it over now. It’s not clear what topples next, if anything. Perhaps another stablecoin, like Tether or Magic Internet Money. (Yes, it’s really called that.) Perhaps a financial service provider like Nexo or Babel Finance, the latter of which halted withdrawals much like Celsius. Perhaps one of the many exchanges which has had to liquidate counterparty positions at a loss.
Equally, perhaps we get a knight in shining armour who comes and pumps enough liquidity into the system to calm everyone down. The world of defi might not have a lender of last resort, but that was once the case for tradfi too. Back in the Panic of 1893 and 1907, there was no Federal Reserve. Instead, JP Morgan personally bailed out the US financial system. Twice!
Mamma Mia! Here we go again
By now, the two stories should sound familiar.
Irrational exuberance and a savings glut fuels a demand for safe assets.
Financial institutions restructuring and repackaging new yield-bearing securities until they are treated as safe.
Market actors act as shadow banks, levering up till the system is so fragile a single huff from the Big Bad Wolf can bring it down.
When that arrives, there’s a run on every finnancial institution that even has a whiff of this no-longer-as-safe asset.
This leads to margin calls, liquidations, panic over counterparty risk and contagion, till credit trickles entirely to a close.
In 2008, we learnt a few things after all of this.
Firstly, that the financial system is one that transforms risk, but doesn’t destroy it. By creating safe assets which are information insensitive, it can help reduce idiosyncratic risks. Yet safe assets are at the heart of systemic risk, and even seemingly safe assets like money market mutual funds can go bust.
Secondly, that you shouldn’t mistake leverage for genius. Too often, leverage is used because of greed or moral hazard, rather than because there’s a genuine opportunity.
Thirdly, that counterparty risks matter. When something goes wrong, the opacity of the system determines how badly everything else is hurt. if you have a large shadow banking system, you better make sure they hold enough liquid assets.
The greatest trick
The greatest trick the centralised defi institutions ever pulled was convincing the world they weren’t tradfi. Indeed, the very term itself is a misnomer. The trend of centralisation is unsurprising. In any network, there is a tendency towards having easy-to-use onramps and offramps, especially since decentralisation is naturally subject to adverse selection and a lack of recourse. Can defi be the exception to the rule?
I think this crisis has shown a glimpse of that potential. While some major cedefi institutions might have done badly this time around, the defi protocols and critical infrastructure have weathered the storm so far. The transparency of having everything on-chain helped sound the alarm, which is why more people knew about Terra than Celsius, and more people knew about Celsius than 3AC.
As long as there are transactions off the blockchain, there will be things you cannot audit. With those known unknowns, panic and contagion is almost inevitable. But that’s the point of the entire project: to ensure trustless and transparent transactions via the blockchain and smart contracts. If everything is on-chain, you can prove, beyond a shadow of doubt, that you are or aren’t exposed to the risks people are concerned about.
Of course there will always be some centralisation in crypto. Among tradfi advocates, there are those who think that this reflects the utter folly of the defi project. That once you’ve opened Pandora’s box to fraud, deception and exploits, you can’t close it again. That the increased transparency and tradability means increased volatility. Or that without a central bank, the interconnectedness of defi means it will always be on the verge of teetering. I disagree. When when all is said and done, when everything is over and when the worst has come to pass, there’s still one thing left in Pandora’s Box: hope!