The Great Unwinding

Last month, we called the current market situation, “The Great Reset”, which meant resetting pricing, portfolio allocation, risk management, and generally how to buckle up and sit around a little bit while the dust clears. Well, things got shaken up a lot this month when multiple institutions fell. The root cause here was poor risk management, with many institutions levering up and not preparing for a large market downturn, or mismanaging customer funds for greater gains and losing them.

In a sense, the leveraged bets on crypto caused its market cap to rise faster and to more unreasonable valuations. Say the true market valuation of crypto should be $1T, but hundreds of millions of dollars were borrowed to purchase more and more crypto. In fact, some DeFi protocols even allowed this, you could borrow against positions you purchased or you could swap liquid token assets and re-borrow against them again. This is what happened in Celsius’s situation

Celsius, the second domino

Ironically last month we just mentioned Lido’s product staked ETH, which allows you to stake your ETH to swap for a dividend earning asset stETH. Because this ETH has been locked until after the merge, it should in theory be an illiquid coin, however with stETH, Lido gives people a voucher they can use to swap it with any other asset. In theory, the stETH is ALWAYS going to give you back the equivalent ETH, we just don’t know what time frame.

On June 13th, a month after the Terra collapse, Celsius sent a notice out to pause all withdrawals. Even CEO Alex Mashinksy tweeted, “We need the community to help build the next Celsius”, where I responded with, “what do you mean next?” – the CEO’s tweet was deleted.

(The infamous blog post)

Even leading up to June 13th, speculation was that Celsius was going insolvent, we had posted several warning signs, especially their massive stETH wallet. Users who were staking it would not be able to transfer it back to the same amount of ETH back. The peg between stETH and ETH had broken after a few mystery wallets and Alameda (a fund from FTX folks) dumped their holdings. At one point, it would be an 8% hit to swap back to ETH. The other point was that the curve pool, similar to when UST collapsed, was severely imbalanced; there was no way for Celsius to convert user’s staked ETH back at the same rate. At this point also, Celsius had a whopping 73% of its ETH locked up!

And that’s not all, upon further examination, there were more losses. Celsius lost tens of millions in the Stakehound and BadgerDao hacks (possibly hundreds of millions), and then on chain analytics point to Celsius being a major holder of UST as Terra collapsed, possibly losing around $80M in that process too. As users started catching on and withdrawing, Celsius had no choice but to pause withdrawals, since it would be unable to fulfill them all at one point. Meanwhile, multiple Celsius liquidations almost hit, as Celsius sold user funds to add collateral to prevent their holdings from being taken away.

Terra’s collapse was the first domino to fall. Celsius was the second. It wasn’t too long before contagion took place, and Celsius wasn’t the first to get affected.

Lessons learned

  1. Not your keys not your crypto, if you hold your funds somewhere centralized, you are trusting them with what happens to it
  2. Remember to never go all in or put all funds in one place (unfortunate if you were also in Terra)
  3. As an institution, you should never risk your customer funds as a deposit/staking service
  4. Or, if your service does invest on behalf of the customer, at least be completely transparent about it
  5. Crypto is missing the caliber of risk management hires that are in traditional finance
  6. Remember withdrawing from any liquid staking service might cost mere dollars, the trade off is losing 100% vs. < 1% for when you hear these kinds of rumors and think you should move your funds somewhere safe. We were posting about Celsius issue in our news channel a few days before withdrawals were paused Domino 3(AC)

3 Arrows Capital (3AC) was one of the top hedge funds in crypto, with over $10B in holdings, amazing early investments, and making aggressive market calls (though sometimes to manipulate markets). It was simply one of the most respected names in the space, Su Zhu, the head honcho, became a crypto celebrity. He had a popular podcast and was one of the voices people listened to.

Shortly after Celsius’s downfall, something strange happened. Su Zhu removed all the coins off his profile except for BTC, and he sent this tweet:

(Notice this was literally the next day after Celsius)

Meanwhile, Crypto Twitter was already speculating that 3AC could be underwater. After all, crypto is all visible on the blockchain. Different holdings were being transferred to USDC and various wallets were in danger of getting liquidated from various DeFi protocols. Market makers that allowed liquidity to 3AC noticed money missing, institutions noticed that their margin calls were not being filled. The biggest news that day was a $5M margin call for a $1B position, and 3AC was unable to fulfill.

Crypto markets tanked, people were monitoring each liquidation target. For every target hit, it would force loans to sell back to USDC. Logically markets front ran those numbers, selling ahead of the targets. ETH fell from $1700s to below $1k as people checked off each liquidation target one by one. Not only was 3AC in danger of being liquidated, so was Celsius! This was some of the craziest events in crypto, and that was only 1 month after THE craziest event of crypto (Terra collapse).

Finally, ETH bounced off of $850. I still remember the feeling, I was sick to my stomach at the thought that crypto could go to $500 in the same night. That feeling is what led me to buy some more ETH. Remember, the more uncomfortable you are at how pricing looks, the more likely it is a good buy (assuming you understand the market context). I have since sold the position on this latest bounce up to $1200.

The fallout from 3AC is still uncertain today. We know they have borrowed hundreds of millions, if not billions, from various institutions. All of those institutions could be taking huge write offs and facing massive losses right now.

Lessons Learned

1. Again, risk management, if you are overlevering yourself to make or break a bet, that’s obviously not going to always work out

2. Institutions lending to 3AC shouldn’t have been loaning out funds that were customer owned, or funds that were needed to keep the company solvent