DeFi Dominoes

Jun 24, 2022

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Domino effects and tense macro conditions

Micro and macro conditions led to a +70% decline in total crypto market cap since its peak in November 21. On the macro side, global events such as war and pandemics have impacted economies, disturbing energy and food supply chains, resulting in increased inflation. Central bank monetary policies have reinforced these symptoms by increasing the money supply. To tame inflationary dynamics, interest rate hikes have increased the cost of money and catalyzed risk-off environments where cash reigns king. Crypto assets do not rest in isolation from such macro conditions, as prices have decreased due to increased sell pressure. This market sell-off exposed how much credit and leverage was inherent to the crypto ecosystem since it triggered domino effects that resulted in significant liquidations, illiquidity, and insolvencies of on-chain DeFi markets, and off-chain entities such as Centralized Finance (CeFi) platforms, crypto venture capital funds, and trading firms. Some of the major events leading to the current market sentiment are depicted in Illustration 1.

Illustration 1: Total crypto market cap in light of recent events
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SOURCE: TRADINGVIEW, BITCOIN SUISSE RESEARCH

In May and June, massive deleveraging events followed the already heavy market conditions induced by macro events. The first domino stone to fall, the LUNA/UST collapse was a massive disruption wiping out $40b in value and affecting major players involved in crypto. Since these players are often inextricably linked in the crypto space, domino effects are hard to avoid. Even if major liquidations have already happened, on-chain data suggests that there is still a lot of leverage left to be unwound, see for example Table 1.

Table 1: Current positions to watch with respect to important liquidation thresholds
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SOURCE: MILES DEUTSCHER, BITCOIN SUISSE RESEARCH
The domino players

A lot of players joined the crypto space while crypto was on a bull run.

In recent weeks, a multitude of them such as Defiance Capital, Babel Finance, Celsius, 3AC, Finblox or Voyager were affected by domino effects as yields promised by the majority of these entities came from a daisy chain with several cross-dependent intermediaries that ended up in a hedge fund trading style with ever-increasing risk. Celsius and 3AC represent two of the most important entities with around ~$10b and ~$18b in assets respectively, that have been highly entangled in these liquidation cascades. As a result, the centralized lending platform Celsius froze customer assets while the position of the Singapore-based crypto hedge fund 3AC was liquidated by FTX, Deribit, and BitMex after facing a loss of over $200m due to itsTerra exposure.

Celsius in a nutshell

Centralized Finance (CeFi) platform Celsius announced Sunday, June 12, that they had halted all withdrawals, swaps, and transfers between accounts due to “extreme market conditions”. Shortly after Celsius’ announcement, Alabama, Kentucky, New Jersey, Washington, and Texas opened investigations into Celsius’ decision to suspend customer redemptions. Before halting withdrawals, wallets linked to Celsius moved $320m of assets from e.g. Aave to FTX. Celsius is used by more than 1.7m users and offers a native platform token CEL, offering increased rewards, which fell >70% after the firm’s announcement. Like Nexo or BlockFi, Celsius custodies digital assets on behalf of investors and offers attractive interest rates via rehypothecation, see Illustration 2. Celsius does not explicitly disclose the protocols and strategies it employs to give its users up to 20% yield though.

Illustration 2: How Celsius generates yield on behalf of their clients
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SOURCE: COINMETRICS, BITCOIN SUISSE RESEARCH

According to their terms of use, this grants them the right to “use or invest such digital assets in Celsius’ full discretion” and as these operations are not isolated from risk, deposited assets “may not be recoverable” if Celsius is unable to meet its obligations. In order to offer competitive or even outstanding yields, Celsius actively manages and deploys their customers assets across DeFi protocols that offer a spectrum of risk. Like in traditional finance and investment, there is no free lunch. In order to realize these yields, Celsius utilizes a combination of various protocols and smart contracts. Thus, the exposure to smart contract bugs, exploits, and flawed mechanisms is magnified and yields are highly unpredictable. Moreover, depeg scenarios with higher loan-to-value ratios pose liquidation risk. With that, Celsius lost funds in the $120m the BadgerDAO exploit, has been impacted by the Luna collapse, and faces further risk due to ongoing stETH-ETH depeg. Due to the recent market downturn, their $225m DAI debt position in Maker was at risk of liquidation before they topped up their vault and paid back debt bringing the new liquidation price to ~$13’600 per BTC, see Table 2.

Table 2: Recent operation history of Celsius’ WBTC vault
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SOURCE: MCD STATE, BITCOIN SUISSE RESEARCH

As prices approach liquidation levels, borrowers can contribute capital held elsewhere or repay some of the outstanding debt, both increasing the collateralization ratio and reducing the liquidation price. With Celsius holding now 83.7% debt share of the WBTC-A vaults and the sheer size of the position, market participants observed Celsius’ actions with concern. If Celsius failed to avoid liquidation, the majority of their collateral, 23’963 WBTC, would have faced liquidation via Maker’s collateral auction. Maker automatically liquidates borrowers’ collateral when the protocol-set collateralization ratio for that vault is not being maintained. For the WBTC-A vault, the liquidation ratio is currently set at 145%. Besides the collateral price, the actions taken to avoid liquidation impact Celsius’ collateralization ratio and can be traced on-chain, see Illustration 3 where the OSM price, a delayed price value ensured by the Oracle Security Module (OSM), is plotted versus the collateralization ratio.

Illustration 3: Impact of actions and price on the collateralization ratio of Celsius’ WBTC vault
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SOURCE: BLOCK ANALITICA, BITCOIN SUISSE RESEARCH

Even after more than 10 days now, it remains unclear if Celsius halted platform activity due to cash flow insolvency with redemption demand exceeding their liquid reserves or balance sheet insolvency as a result of mismanaging funds. As they still hold open positions, more downside in markets and a further depeg of stETH-ETH poses liquidation risk with serious size in a market that’s already shaken up. According to wallets labeled to Celsius, they are highly exposed to stETH ($420m on Aave) and WBTC ($490m on Maker). Moreover, of their ~$10b in assets, only ~$1.7b was successfully traced on-chain. It is opaque where the remaining assets rest.

3AC

3AC is a crypto-focused trading firm with ~$18b in assets. With the recent market sell-off, they have faced massive liquidations on e.g. Genesis, BlockFi, FTX, Deribit, and BitMex after they suffered from closely linked exposure to the LUNA-UST collapse and the stETH-ETH depeg. One wallet tagged as 3AC seemingly was forced to sell +60k stETH to pay off loans and debts, contributing to the stETH-ETH depeg and bringing even more entities in trouble. According to Ryan Selkis, founder of Messari, 3AC might have $1.0-$1.5b in net liabilities, with lenders like BlockFi and Genesis having likely already liquidated their positions. At the time of writing, Voyager announced a $650m exposure towards 3AC, likely being an unsecured or undercollateralized loan. Also, Finblox, a CeFi company, is pausing reward distributions because of 3AC's involvement and the current market volatility. The problems of 3AC might also lead to contagious domino effects as they borrow from almost every major lender such as FTX, Celsius, BlockFi, Nexo, and Voyager and if 3AC is unable to repay loans, some of these lenders inevitably take a hit. Not only lenders might be affected by 3AC’s liquidity and insolvency problems. As they were early investors in several protocols such as Avalanche, Near, or Solana, upcoming token unlocks might create sell pressure as 3AC might sell these tokens to meet liabilities. With a lot of positions being on the brink of liquidation and the risk of lenders being affected by 3AC positions, major credit might leave the ecosystem, overall shrinking balance sheets. This might lead to market makers having more difficulty providing liquidity resulting in a widening bid-ask spread. The first domino falling for 3AC again was the LUNA-UST collapse as they supposedly build a 9-figure UST position borrowed off investors and multiple funds to deposit them into Anchor to yield ~20%. One can calculate how much this position is worth with UST trading close to zero.

The domino stones

There were several domino stones these entities fooled around with. The two most important ones of them with massive contagion due to adoption and the sheer amount of wiped out value are stETH-ETH and LUNA-UST. Besides, there were several protocol exploits leading to unrecoverable losses and miscalculations regarding GBTC arbitrage. In 2021 crypto yield services leveraged GBTC arbitrage and the massive contango to secure yield that was perceived as “risk-free”. In recent months, GBTC increasingly traded at a discount. With entities such as 3AC pledging it as collateral, its discount volatility and liquidity put lenders under even more pressure.

stETH-ETH

Lido is the largest liquid staking platform (~35% of total staked ETH and supply +4m ETH) offering the synthetic asset stETH in return for staked ETH and promises a 1:1 redemption after the PoS transition. The ETH staked on the beacon chain is therefore currently frozen until the post-merge Shanghai hard fork. Instead of staking on your own, stETH offers liquidity and enables utility in DeFi to either yield farm or pledging it as additional collateral in order to increase leverage. A depeg from ETH poses not only problems to stETH collateralized positions as these hit the liquidation ratio even earlier but also to players exposed to stETH that are forced to sell their position at a discount to meet liabilities. This also accounts for one reason of the recent stETH-ETH depeg, as depicted in Illustration 4. Besides that, fear of the Ethereum merge being postponed yet again, market uncertainty, and the fact that no arbitrage is possible all induced stETH to trade considerably lower than ETH despite being backed 1:1.

Illustration 4: stETH-ETH depeg
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SOURCE: DUNE, BITCOIN SUISSE RESEARCH

Given the lack of arbitrage and the liquidity mismatch between stETH and ETH in Curve pools, stETH is still being sold at a discount to reduce risk or realize capital calls. A discount that followed the LUNA-UST collapse and might therefore work as a proxy for financial stress in the crypto ecosystem.

LUNA-UST

The LUNA-UST case was the key domino stone falling in may leading to huge contagion within the whole crypto ecosystem. UST was the most famous algorithmic stablecoin along with its sparring partner LUNA until they collapsed to $0 in May 2022, see Illustration 5, after UST’s flawed peg mechanism resulted in hyperinflating LUNA from ~300m to ~6t circulating supply within hours. UST began depegging on May 7, as large withdrawals from e.g. Celsius began on Anchor. For more insights into the LUNA-UST case, we refer to the last Decrypt on (Un)stablecoins. and the corresponding Weekly Wrap.

Illustration 5: Price development induced by hyperinflating Luna
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SOURCE: TRADINGVIEW, BITCOIN SUISSE RESEARCH
Defying CeFi

If risk is managed properly, DeFi offers great benefits compared to traditional finance. In a market sell-off, it is helpful to know counterparty risk and liquidation levels of big players as these drive prices down even further. Since DeFi is transparent due to the underlying decentralized systems, blockchain analysis enables calculation of liquidation ratios. Besides transparency, DeFi is more libertarian than traditional finance as there aren’t social safety nets. It accelerates the evolutionary dynamics of business as only the fittest survive. Without bureaucracy, markets evolve and optimize impressively fast. DeFi loans are overcollateralized and with that, there is almost no risk of bad debt given that the protocol executes based on smart contracts.

As mainly closed CeFi platforms that claimed to provide safety were flushed out, the current situation might offer an opportunity for DeFi to build more user safety and trust. Despite crypto introducing new types of risk, especially CeFi platforms have to implement proper risk management with risk-adjusted yields and credit analysis that benefits from DeFi’s transparency. At the time of writing, CeFi yields on Nexo or BlockFi are outperforming top DeFi yields across stablecoins. One has to ask where this yield is really coming from and if the risks are justified. SEC’s Gary Gensler is warning about high APYs.

Conclusion and Outlook

While risk assets suffered from various macro-related developments, various micro-events within the crypto ecosystem have amplified the macro shadow. Domino effects triggered by the $40b LUNA-UST collapse led to serious contagion among various entities. The falling dominos reminded us of a plethora of things. CeFi remains opaque while DeFi offers full transparency given wallets are labeledcorrectly. This transparency improves risk estimates for market participants and increases awareness of counterparty risk yet may invite position hunting to trigger liquidations. Even highly overcollateralized, leveraged positions remain dangerous, especially in highly volatile markets that are affected by a risk-off environment. As the headlines have proven, very high APYs correlate with very high risk. The issues might be a wake-up call to CeFi users being blinded by high APYs. Self-custody, reliable custody partners, and diversification help to mitigate these risks.

Looking at the bright side, the DeFi and Ethereum ecosystem have passed another stress test. Aave is still facilitating loans, Uniswap is still swapping coins, MakerDao is still minting DAI, and Curve is still providing low slippage on stablecoins. There was no major outage and every system operated as intended. Overall, the current flush-out and deleveraging of credit from the last couple of bullish months might offer a healthy reset to the ecosystem and enable a repositioning towards sustainable yield.

Summing up: if you don’t know where the yield is coming from, you are the yield.

Bitcoin Suisse