One day I will write a note about the exciting developments in web3 social, but after Broadway distracted me last week, some of the latest developments in digital asset markets have set up another important discussion in risk management. In traditional markets, when lenders and hedge funds experience liquidity crunches, it’s a big deal because the financial system is deeply interconnected, and most parties carry high amounts of leverage. During previous cryptoasset cycles, institutional involvement was muted. However, as professional investors have become more comfortable with the nascent technologies and their associated tokens, the funds flow has become less retail dominated. The arrival of DeFi lending pools, CeFi Savings & Loan operators, and many former Wall Streeters combined with lots of fresh capital drove substantial innovation and wealth. Yet, markets have rolled over, exposing hubris, inexperience, and greed.
The discussion that follows, is going to examine some critical errors that have resulted in significant losses. Where relevant, I have sampled directly from corporate communications and when I provide an opinion it should be considered my own and not representative of my employer’s view. If, at times, my thoughts come across imbalanced, it’s because they are. I think many of the blunders should have been avoided, but I’m not working with perfect information. However, I do believe what psychologist and author Adam Grant says on criticism:
"Criticizing is easy and fast. Creating is difficult and slow. The two hours you spent on a book or movie usually took two years to produce. Anyone can tear down someone else’s work. The true test of insight is whether you can help them improve it or build something of your own."
At Aquanow, we are building and we’re also here to help guide entrepreneurs or established businesses as they endeavour to provide their clients access to digital assets.
Ok, so what happened?
Unfortunately, we can’t answer this question with precision because the inner workings of digital asset lenders are carried out in a black box fashion. In many ways, this isn’t dissimilar from the traditional banking system. You don’t know what exactly your financial institution does with your deposits, but regulation and insurance provide comfort. In fact, you might even take that for granted.
In developed economies, money markets are generally sound to the extent that, when difficulties come about, central banks and governments step in to stem any widespread fallout. However, the bailouts can’t insulate everyone. Many see their net worths impaired and jobs cut when a crisis hits. The disaster playing out in the digital asset ecosystem is causing similar losses, but there is no central authority to backstop. The pain is exacerbated due to the broader economic slowdown and revaluation of other emerging technologies, too
When UST lost its peg, Luna crashed, and the Terra ecosystem collapsed about a month ago, it seemed as if any broad contagion had been avoided. The projects under development could continue to build on Terra 2.0 or move to another rust-based chain with non-trivial code adjustments. Some investment funds had sustained significant losses and several retail investors were wiped out, but it seemed that there was a collective sigh of relief as stablecoin market cap resumed its growth and the value of assets locked in DeFi protocols stabilized. However, there was a nuanced development that many brushed aside. The value of ETH delegated to validators for the Ethereum beacon chain (we’ll refer to this as stETH going forward – you can read the Cobie link below for more detail) departed from the value of regular ETH.
While stETH and ETH represent the same asset, there’s a notable difference. The former can trade freely but represents a commensurate token which is locked until (at least) the Ethereum mainnet transitions to a proof-of-stake consensus mechanism. This event has been labeled “The Merge” and is anticipated in the fall of 2022 but could be delayed further. A popular trade among Ethereum bulls, has been to stake their ETH to earn rewards, effectively compounding their holdings over time. Lending protocols and liquidity pools listed markets where users could deposit their stETH as collateral to borrow regular ETH and repeat the cycle. Assuming there isn’t a decoupling of the two assets, this provides a way for users to leverage their ETH holdings.
As we saw, the Terra collapse pulled liquidity from the system from price insensitive sellers who needed to raise cash. Unwinding the trade above is tricky because the exchange volumes of stETH are comparatively small and you can’t exchange those tokens for the native asset at the validator level. Cobie explains the situation nicely:
About a week ago, Twitter began to come alive with discussion of potential spillover effects from the fading cointegration of the two tokens. People had created extremely high-leverage positions in stETH/ETH to generate higher yields, but a key tenet of this trade was that the assets would trade in unison and that borrowed ETH wouldn’t be called in too abruptly.
The day after that tweet thread, the popular digital asset lending platform, Celsius halted all withdrawals, swaps, and transfers. Since then, they’ve hired restructuring lawyers, too. If the Terra collapse was “crypto’s Lehman moment” then the newest debacle is reminiscent of Long-Term Capital Management’s (LTCM) failure. LTCM was a hedge fund founded by some of the smartest minds in mathematical finance and Wall Street’s most cunning traders. When the fund launched in 1993, the minimum investment was $10M and many of the top brokerage houses participated. The group’s strategy was initially centered on bond trades that anticipated prices converging to levels that made sense, statistically. In 1998, when the fund began to teeter, its equity value was $5B, but it had borrowed $125B against that; representing a leverage factor of 25x. Does this sound familiar?
The description of events is eerily similar to what’s playing out in digital asset markets today. But here’s an important divergence:
There won’t be a public bailout to shore up the losses from Terra or Celsius, so markets will have to clear themselves and we’re starting to get a glimpse of what that might look like. The prominent hedge fund, Three Arrows Capital, is now facing insolvency and they’re an important borrower across the space. Could BlockFi, Genesis or Nexo be next? This uncertainty is likely to weigh on token prices and balance sheets across the space until something changes the collective psychology.
Who’s got exposure?
Counterparty risk is a chief concern in the financial system. This is a function of all the interbank dealings, leverage, and the fact that banking is a confidence game. When rumors circulate about a client’s ability to pay, then a lender will do what they can to reduce the potential for losses in their book. Sometimes this means transferring risk to an unknowing party or quickly forcing settlement before others come calling too. This results in rapidly mounting losses. For more on this, check out Margin Call – such a good movie – or read about the Archegos calamity of a couple years ago.
In addition to the lack of an imminent central bank bailout, the situation above has another profound difference. The entities that blew up in the historical examples above are investment banks or hedge funds, while Celsius is known and branded as a banking alternative. They’re careful to distinguish that the offering is not a savings account in the fine print, but the “About” segment of the company website says:
This is tough to get my head around and will certainly be addressed in future legislation. An unfortunate circumstance in much of the developed world is that financial literacy is weak. We barely even teach about compound interest, let alone investment risk. Many remain skeptical towards traditional financial institutions following the Great Financial Crisis of 2008. To an extent, comments from bank executives like Bank of America’s CEO, Brian Moynihan a couple weeks ago saying that rates on deposit accounts could go to 11 – 40 bps if the Fed Funds Rate rose to 250 bps aren’t helping this either. Further, the low interest rate environment of the past several years caused a situation where consumers were on the hunt for higher yields. The marketing campaign above seems to lean on all three of these elements. I’m not saying this was done deliberately, but a thoughtful analysis of the message would have uncovered this issue and a regulated entity would not have been permitted to make such assertions.
The quote above is one person’s opinion, and I have no idea if it’s accurate, but it does seem like there were risk management missteps at the FinTech. The effects are causing ripples across the ecosystem, but what might be worse is that there are several companies who make similar assertions about deposits and yield.
Seashell is another digital non-bank, but the CEO is quoted on their site as saying: “we're improving the banking experience to put more money in your pocket… Seashell provides the most simple and secure way to earn high and stable interest.” A consumer reading this assertion might be enticed by such an offering. On the homepage, visitors are greeted with the following:
Here we have another mention of high and stable yields that can compound “while you sleep” with “bank-level security”. Adding reassurance, your money is always available and there are no hidden fees. I’m not sure if the term “security” is used in reference to data integrity or principal protection, but nonetheless, the product seems compelling.
Scrolling further down the page, viewers come across an initiative whereby Seashell will set aside a portion of their proceeds to “support green initiatives that protect our world's oceans and water supply.” This is a noble endeavour and would certainly appeal to the environmentally conscious Millennial and GenZ consumer. A bit further down, we come across the following:
A billionaire is “strongly” suggesting that customers use this product to protect their savings against the threat of inflation – if they’re smart. Celebrity endorsements can be powerful marketing tools and towards the bottom of the page, we learn that Mr. Cuban is an investor in this project. On the one hand, this might signal his commitment and belief that this is a sound business, but it also has elements of moral hazard, since he’s promoting something that is tied to his own financial benefit.
Next up, we have the first quantification of what Seashell means when they refer to “high & stable yields”:
The implied return in the figure above is a 5% compound annual rate, which compares to other high-interest savings accounts with FDIC coverage at 0.75% - 1.75%. The difference in savings would be $11,910 - $9,283, which is remarkable. Further, the smoothness of the line does suggest that this return is “stable”. How do they achieve this?
Clicking on the “Learn more” link, we see that the firm intends to “place your money into a diversified strategy, partially investing into safe haven assets like gold and partially investing into dollar-pegged digital assets...” Maybe I’m getting caught up on semantics here, but the standard deviation of gold prices over the past five years is over 14% and that doesn’t seem very stable. The yellow metal is often considered a way to beat inflation, which may help depositors “beat rising prices” but Seashell’s starting to sound a lot more like an investment product than a savings account.
In addition, the Aquanow DeFi Funding Rate, is an index that tracks the prevailing return associated with lending asset-backed stablecoins on decentralized platforms and it hasn’t traded much above 2% for some time, so I’d be curious to see how the company intends to achieve the stated 5% CAGR.
What happens next?
I’m not saying that Seashell is making fraudulent claims or that the model is broken, but the communication is opaque and from my perspective, some of the risk/return assertions are questionable. If an aggregate of the most institutional-grade lending pools is sitting at less than half of your return target, then in order to achieve the desired results, you’d likely have to increase your risk.
It’s alleged that Celsius had ventured into more speculative projects to reach their goals, which resulted in hundreds of millions in losses from DeFi exploits and the UST collapse. As we’ve seen, they’re not the only ones with a similar business model. Along those lines, leading lending products are currently offering USDC lending rates between 5% - 12% and the token’s sponsor, Circle, has an indicative 1-month yield of 4%. How are the projects achieving these results? They may have superior acumen for generating returns in a safe manner. I don’t have intimate knowledge of these businesses and they could be formidable operators who should be viewed as trusted partners. However, if these groups are engaged in risk-seeking behaviour, then we might find out soon as the continued market weakness weighs on returns across the space. As always, it’s important to conduct thorough research before buying or selling
Alternatively, new regulations could shed light on these opaque business models. U.S. Senators Kirsten Gillibrand and Cynthia Lummis introduced the Responsible Financial Innovation Act about a week ago and it is by far the most thoughtful approach to regulating these nascent markets I’ve seen. The entire text is an awful read, but you can listen to the pair discuss the bill with CoinDesk or check out this summary.
It’s unfortunate that the necessary changes to the digital asset space are going to be forced on it from the outside. Sadly, I think we’ll lose some of the grassroots feel through the institutionalization, but it seems necessary. If we want web3 to be the next phase of the internet, then it’s important to have guardrails in place to protect and educate a massive userbase. People exploring web3 should be provided products and services with clear disclosure and whose sponsors are held accountable to misrepresentation. There are certainly shortcomings in traditional markets too, but the rules provide a basis for prosecution.
My favourite parts about digital asset markets are the innovation and communities. Those don’t go away in a regulated environment and if anything, the latter needs to step up the self-enforcement and hold projects to a higher standard. I’m all for pushing back on incumbent institutions – the competition will make everyone better - but the solutions we provide have to actually benefit users. LFG.