The Crypto Market has been rocked by chaos in the last few weeks.
No, I am not talking about the general crash in prices across the board. Instead, I am referring to the issues that have cropped up in one segment of the Crypto space – DeFi.
One by one, protocols are failing and going under. Some have stopped withdrawals. Some have failed to meet margin calls. Whereas others have suspended the very features that were their USP.
The list is long, but let’s focus on some of the major developments with respect to Celsius, 3AC & Solend.
This article is for anyone interested in better understanding the risk and reward structure of the Crypto markets. Also, it will give you a keen understanding of systematic risk and how Crypto is still not detached from our TradFi world.
1. Define Systematic Risk?
Systematic risk is a risk that cannot be mitigated by holding a well-diversified portfolio. In its simplest sense, it is the risk that emanates from the system in which we operate.
Hence, it can only be absorbed.
Think of interest rates, the fiscal deficit, and estimates of economic growth.
No firm, sector, or market can be spared if interest rates increase, the fiscal policy becomes contractionary and economic growth slows down. Overall business sentiment and performance will suffer.
This will in turn be reflected in the market prices of stocks and other assets.
2. How Does Systematic Risk Impact Crypto?
Notwithstanding the thought-provoking arguments put forward by Bitcoin Maxis, the state of play that exists today is that the Crypto market is heavily impacted by the health of the economy.
With inflation a concern, stocks have taken a beating, and bond yields increased, reflecting an increase in the required return on capital on an inflation-adjusted basis.
With monetary tightening underway, analysts expect the bearish trend in these markets to continue.
When you look at Crypto, the same situation persists. The rising cost of capital, which is becoming increasingly scarce due to higher interest rates, has negatively impacted the markets.
The average individual is concerned about job security and as a result, staying away from the markets. Consequently, liquidity is drying up.
3. The Trigger Event
Whether we would have gotten here still or in this bad shape is an open question, but what really tipped the Crypto markets over their head was the UST depeg.
This is what is characterized as a triggering event – something unpredictable and not modeled easily. More than $40bn was lost as a result of the UST / Luna experiment as the $BTC price plummeted from $40,000 to below $30,000.
It is now marginally up from its bottom of $17,700. No one saw this coming, and if anyone feels that the worst is behind us, the news coming out of the DeFi sector is enough to prove them wrong.
4. Chaos Erupts
4.1. The Celsius Debacle
Earlier this month, Celsius Network, an all-in-one app to trade, borrow, lend & stake cryptocurrency announced that it was pausing withdrawals in light of severely diminished liquidity conditions.
This led to a flurry of accusations about them defrauding their investors (up to US$ 3 Billion). What we now know is that beyond the accusations, there are two reasons for the failure:
Over leveraged positions
The protocol borrowed from liquidity protocols using customer funds to keep borrowing costs low for other customers. A typical swap would be $WBTC (the version of $BTC on the Ethereum blockchain) for $DAI.
There is nothing wrong with this except that the protocol seemed to have followed no asset-liability modeling or accounted for volatility. With the overall market in a strong retracement, the value of the collateral pledged to take on the $DAI loan diminished and forced margin calls.
With the protocol out of a fresh flow of cash given adverse systematic and market conditions and unable to call good on loans made to borrowers (who are barely head above water themselves if not already liquidated), they had no other option but to stop withdrawals and explore bankruptcy.
Exposure to stETH
It is primarily a derivative product and allows investors to earn 8% yields on this staking pool as compared to the 4.2% staking return that one would normally get by staking $ETH.
This is ensured by Lido Staking using $ETH deposits (against which stETH are issued) in additional liquidity provision services on OTC and DEX markets.
The comfort was that each stETH would be redeemed at a 1:1 ratio when Ethereum 2.0 would be launched (stETH could be swapped in DEX markets in the interim) and hence Celsius marketed this extensively to its customers.
However, given the adverse market conditions and the rush to safety, the peg on the DEXs broke & liquidity dried up leading to Celsius, and its customers, holding something that was less than its value and not tradable – at least not immediately.
4.2. Some Worry at 3AC
3AC, short for Three Arrows Capital, is a crypto hedge fund based out of Singapore. As with any hedge fund structure, the Company had investors and deployed large amounts of leverage to generate substantial returns.
Things were hunky-dory until the UST/Luna collapse.
Depending on who you read, the Company suffered a $200mn to $450mn loss from this one position. Messari.io on the other hand estimates it to be $560mn (on top of a 60% drawdown in 27 other assets).
It seemed that the Company survived the trigger event, but was left incredibly weakened.
The continuation of the downward retracement of the overall market led to its leveraged positions being liquidated. At the moment, they are trying to sell everything to close down their levered positions (including selling their NFT collection).
4.3. The Solend Upend
Solend is a yield farming protocol on the Solana blockchain which allows users to deposit, lend and borrow cryptocurrency. The protocol has been in the news since it emerged that a Solana whale has a $21mn SOL position under threat of liquidation.
Their concern was that the said whale was the majority of the protocol’s $SOL holding.
This is significant because, with the price dipping and touching the liquidation point, the concern was that lenders would rush to liquidate the $SOL position, potentially draining Solend of 95% of its $SOL deposits & possibly causing a breakdown of the entire Solana blockchain.
The disaster was averted as the anonymous whale finally responded to public calls for help on Twitter by the protocol. He then proceeded to adjust his position across various other markets.
However, it was comical to see Solend, in the hours before contact was established with the whale, moving to propose a takeover of the account – something that is against the very ethos of DeFi!
5. Lessons in Risk Management
Crypto is a high-risk market, but the fact is that all markets have their own risk and return trade-offs.
What is the distinctive feature of Crypto & DeFi is that it is still a work in progress and with no regulation, there is every chance that innovators will rush their product to the market and make expensive mistakes.
This is not to absolve them of responsibility, but to make you accountable. Protecting your capital is primarily your responsibility. The lessons, as retail investors, that you should take from these developments are:
- Do your own research
- Avoid leverage
- If something is too good to be true, it usually is
- Yield farming is tricky, so don’t dangle with it unless you have the expertise
- Locked staking means locked staking – there is no way you are getting out of it early
Good luck & Stay Safe!