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Every bear market is a test. Those who fail to pass it are bound to disappear, and those who succeed will have more mistakes to learn from.
Crypto finance is a very young sector, and the previous bear market of 2018 has exposed mostly one very specific side of it that was developed enough – the ICOs. The lesson was valuable, though, and we have learned that ICOs, apart being an innovative way to raise money, can also be a profitable tool for scammers of all kinds. Since then, both the general public and the regulators got wiser, and the ICOs as a notion have deflated from a fraud bonanza to another type of fundraising – just what they were meant to be.
Since then, crypto finance has made immense progress, notably with the advent of DeFi, or decentralized finance: DEX (decentralized exchanges), lending-borrowing protocols, yield protocols, investment DAOs, decentralized stablecoins… Alongside the DeFi, a CeFi has developed – centralized crypto finance operating in a traditional way (keeping clients’ assets under the firm’s control), but generating yield with DeFi and other crypto companies.
Both DeFi and CeFi have had their vulnerabilities exposed in this bear market – and this is a good thing, for we can now learn their lessons.
It is difficult to say if Terra’s developer team knew about its protocol vulnerabilities, and whether the decision to start hoarding bitcoin for its reserves is indicative of such knowledge. What is sure is that the original hypothesis that minting incentives could balance UST/LUNA pool and keep the stablecoin pegged to dollar was not tested against the possibility of a huge inflow of either cryptoasset that would unbalance the pool. And that’s what has happened, of course.
DeFi is generally more reliable than its centralized counterparts because it is free of human judgement and follows its algorithm – except for the creation of the algorithm itself. Protocols being mathematical, it is possible for their creators to build different models, making sure they withstand catastrophic scenarios. That was not the case with Terra and its stablecoin UST, which imploded spectacularly.
A good example of a market-tested decentralized stablecoin is DAI – a dollar-pegged stablecoin issued by MakerDAO. It has had its own set of problems since its launch in 2017, including several brief de-pegs. However, it has worked through its issues, adjusting the stability fee here, reducing the supply there… As of now, DAI has survived two crypto market crashes and it is still pegged to the dollar.
While Terra’s inherent vulnerabilities are to blame for its implosion, it was Anchor that actually triggered it. This DeFi lending-borrowing protocol was holding a staggering 70% of all circulating supply of the UST, Terra’s stablecoin, and when users started massively withdrawing their UST from Anchor, Terra’s UST/LUNA pool got dangerously unstable. Terra’s mint-and-burn system was not ready for such inflow, which led to UST losing its peg and precipitating all Terra’s ecosystem in a death spiral. Such massive concentration of an asset within a single yield protocol was a ticking bomb, and it did not fail to explode.
Another example of a dangerous concentration of an asset is a smaller DeFi lending-borrowing protocol Solend, one of the rare ones built on Solana. It has found itself in a very delicate position recently: a whale has deposited a big amount of $SOL (amounting to 95% of Solend’s deposits), borrowing twice as less in stablecoin. Despite this over-collateralization, the $SOL price has fallen too low, and the account has become at risk of liquidation, where $SOL deposited as collateral would have been sent to a DEX and sold at market price. For a big amount like this, such liquidation would mean sending $SOL prices even lower and putting at risk other Solend clients. The ensuing panic of Solend’s team, its inappropriate handling of a DAO vote to take control over the whale’s account, and the liberating intervention of Binance’s CZ who managed to contact the whale and persuade them to secure and diversify their position across several lenders, were a spectacular way to show the importance of diversification – not only for the investors, but for the financial protocols as well.
DeFi is not magic, and magically high yields should always raise red flags for the whole ecosystem.
The reason why the infamous Anchor protocol gathered such a high concentration of UST was its promise of a 20% yield. When it became clear such yield was not sustainable and it started to decrease, users quite naturally started to withdraw their UST, sending them back to Terra. Some say that it was Anchor’s high yield that incited so many people to mint more UST, inflating its supply for speculative purposes, which has put the stablecoin on a shaky ground.
Other DeFi protocols have been remarkably reliable though. Despite cascading liquidations and panicking investors moving funds all over the place, none of the OG DeFi protocols like Aave (now 3% yield on stablecoins), Compound or Uniswap has suffered any disturbance. On the contrary, they seem to have been doing a good business: in the end of June Uniswap daily fees have exceeded those of the whole Ethereum blockchain, with other DeFi protocols showing the same tendency.
High yields can also come from leveraged trading – a very risky practice, where even the slightest price movement can bring either an important profit, or an equally important loss. Companies and users are massively deleveraging their positions now: since Q1 2022 users have taken off DeFi protocols two-thirds of their locked funds, as per DappRadar’s report.
Chi va piano, va sano 🐢
Celsius was among the first – and the biggest – CeFi companies to halt user withdrawals last month. Since then, its has been joined by BlockFi, Babel Finance, Coinflex, Vauld, and other centralized lending-borrowing platforms, while crypto brokerage firm Voyager Digital has officially filed for bankruptcy.
Specific reasons may vary from technical ones, like over-reliance on synthetic products (Celsius), to purely human miscalculations: undercollateralized loans to friendly hedge funds (BlockFi, Voyager and possibly Babel), maintaining an individual account that went into negative equity instead of liquidating it (CoinFlex), risky financial operations that did not play out (probably most of them)… All these missteps could be put under the general notion of poor risk management.
CeFi is opaque by principle, but we can take our clues from the current situation to pick the best actors who appear to handle the collateral issue responsibly. Celsius’ main competitor Nexo is doing rather well – it even proposed by buy Celsius’ key assets after it froze the withdrawals, and is now in talks with Singapore-based Vauld to explore an all-equity acquisition of the company. Nexo liked to boast about being over-collateralized at all times, with a real-time third-party audit making sure the company always had more assets than liabilities. It is likely this strategy will be the one to help Nexo not only survive the bear market, but use it to strengthen its leading position for the next growth cycle.
However, it is possible that Nexo’s good fortune could also be explained by, well… good fortune that helped it avoid the assets and companies that crashed. We cannot say for sure because it is opaque. And while noone investigates financial operations of a firm that is doing fine, the deceived users of defaulting CeFi companies now have plenty of questions. Some users, for example, say they would have never lent money to BlockFi if they knew it lent millions to 3AC hedge fund 🤷
We believe that this lesson must be not only about quality collateral, but also about transparency and disclosing the firm’s main liabilities to its clients.
The last lesson is not new, but it needs to be repeated in every market crash, for our memory is short. The very reason why crypto has been created is to give its owner the true – non-custodial – ownership over their assets. Confiding these assets to a third party, be it a bank or a CeFi platform, is always risky. Users of Celsius, BlockFi and other distressed companies know it better than anyone, and their example has incited numerous crypto users to withdraw their funds from centralized entities.
A recent Glassnode’s chart shows Bitcoin monthly outflow from exchanges reaching the highest level ever: a whopping 151k BTC left exchanges’ wallets in June.
Beyond the crypto finance sphere, every crypto enthusiast has already learned probably the most important lesson of the all: crypto is young and it evolves in an upward-spiral mode, gaining in strength, adoption, diversification, security and use cases every four years. Bear markets, although painful, help stir this development in the right direction, pointing out flawed practices and encouraging the virtuous ones.
We always learn the hard way.