Crypto Was in Crisis, But Crypto WASN’T the Problem

I used to think that you could glean an accurate and well-informed picture from reading the leading business newspapers, especially with regard to financial assets. But since being involved in crypto investing, what has astounded me is just how inaccurate some of the reporting from the leading business information sources is on this subject!

Today, I would like to tell you about how crypto innovations like DeFi (decentralised finance) actually functioned without a hitch through this brutal bear market whereas the ‘crypto’ business casualties we have all been reading about were in fact operating in the more traditional CeFi (centralised finance) structure.

Bankruptcies in CeFi while DeFi emerged Unscathed

Banks, brokers and other financial intermediaries are all part of the centralised finance infrastructure around the world. This system works well most of the time but has some obvious flaws and risks that can come to the fore dramatically in times of deep market turmoil. Who owns what is very opaque and unclear, high leverage can cause not only contagion but in the worst cases, a death spiral of margin calls and forced liquidations. Decentralised finance or DeFi was actually built to mitigate against these risks. Put to the acid test in this bear market, not a single DeFi protocol failed. I just wish the leading business papers understood this!

You’ve probably heard the names of several of the companies that went bankrupt in this market crash including Celsius and Voyager. They are often referred to in the press as ‘crypto’ companies. They weren’t. They operated exactly like traditional banks and brokers. Because they functioned like the other large, centralised institutions we know, they were exposed to the same risks in times of trouble. So it’s important to note that the failure of Celsius and Voyager isn’t the failure of Defi or of crypto for that matter, (as erroneously described in leading business newspapers), it’s instead a pure reflection of the limitations of centralised finance..

“A lot of the collapses that happened during this last round were things that were branding themselves as DeFi but then were actually kind of operating as shadow banks with massive leverage.” David Finlay, Co-Founder of Metamask

DeFi 101

Defi is peer to peer lending using smart contracts on the blockchain. There is now no denying DeFi systems have held up better than centralised lenders in this downturn. Leading DeFi protocols like the Uniswap exchange, Aave and DAI stablecoin have continued to function smoothly and without interruption. Most importantly, these protocols haven’t been destabilised by the contagion of huge losses from loan defaults or declining asset prices, which proved fatal for the centralised lenders.

Arguably the defining characteristic of decentralised finance is their almost complete transparency. DeFi protocols allow near-complete visibility into loans and order books. This notably includes visibility into “liquidation points,” or asset prices at which the collateral for certain loans would be market-sold to cover losses. This transparency is a sharp contrast to services like Celsius, which took depositor funds and deployed them in a wide variety of ways to generate yield. Depositors had almost no visibility into, much less oversight of, how those funds were deployed.

An even more important bit of transparency in DeFi comes from strict policies on loan collateral. One reason Three Arrows Capital blew up is that it had taken out an array of huge loans from funds that were seemingly unaware of Three Arrows’ overall debt levels. In at least one case, a huge loan was issued no collateral at all, apparently based purely on faith in Three Arrows.

While Three Arrows (and traditional funds like Bill Hwang’s Archegos before it) can leverage their reputation to harvest loans all over town, DeFi platforms require collateral for loans, and that collateral must be effectively “locked” within the systems. That prevents the pledging of the same collateral for multiple loans: a form of fraud that is often hard to detect in traditional, centralised financial structures.

Overall, what is important to note is that DeFi removes human subjectivity in financing decisions. Parties agree to conduct transactions openly and transparently on the blockchain, as opposed to backroom deals by opaque, human, potentially conflicted financial actors. What’s more, the rules of engagement are coded into the smart contract. You do not therefore need to trust a counterparty who may be incentivised to twist the truth. The code just executes what both parties agreed to…no matter what! This has a stunningly important implication which I will come to later.

The 3AC collapse: it was just LTCM all over again!

Three Arrow Capital (3AC), a revered Singapore-based crypto hedge fund that at one point managed over $10 billion worth of assets, became one of the most high-profile firms that went bankrupt in this bear market. This downfall led to a deadly cascade that claimed the likes of Celsius, Voyager and many other crypto lending firms with exposure to the hedge fund.

However, again contrary to what the media is saying, the fall of 3AC wasn’t actually a crypto phenomenon. It was just another hedge fund that used their reputation to take on huge amounts of leverage from a variety of sources and then collapsed as markets went against them.

Put simply, the hedge fund made a series of large directional trades in Grayscale Bitcoin Trust (GBTC), Luna Classic (LUNC) and Staked Ether (stETH). Crucially, this was all based upon huge amounts of borrowed funds from over 20 large institutions (often it seems promising the same collateral to several institutions). To make matters worse when the downturn started, 3AC didn’t own up to its mistakes. Like a gambler in the final stages of losing
everything, it then went and borrowed more money, allegedly even using clients’ funds to make bets to try to make their money back. As general market conditions continued to worsen and liquidity dried up, 3AC was exposed as the Ponzi scheme it had become, and the rest is history.

The series of liquidations for 3AC had a catastrophic impact on crypto lenders such as Centralised Finance (“CeFi”) exchanges BlockFi, Voyager and Celsius. Many of these crypto lenders eventually filed for bankruptcy due to their exposure to 3AC. 3AC eventually filed for a Chapter 15 bankruptcy on July 1 owing $3bn with no known whereabouts of the founders.

Sam Callahan, a Bitcoin analyst at BTC savings plan provider Swan, told Cointelegraph:

“Using only publicly available information, in my opinion, the failure of 3AC can really be broken down into two things, 1) Poor risk management and 2) Unethical and potentially criminal behaviour. The first is a classic example of what happens when you use too much leverage, and the trade turns against you.”

History repeats itself, and the financial world is no exception. This series of events is eerily similar to the collapse of other once revered hedge funds like Long Term Capital Management. Not very crypto specific at all if you think about it. 3AC, like LTCM, collapsed due to high leverage, questionable risk management decisions and a complete lack of transparency. In both cases their counterparties overlooked their failings perhaps due to their impressive reputations. 3AC was not a crypto crisis. This was a crisis tied to a lack of
oversight and transparency that can happen in CeFi but which cannot happen in DeFi. Transparency, overcollateralisation and automation all protect users and make decentralized finance a dramatic improvement on traditional financial services.

Most Important thing to Remember: DeFi is not only Less Risky but Gets Paid First!

When you look at what the now bankrupt CeFi companies actually did when faced with dwindling funds, another astounding advantage of Defi becomes apparent: they get paid first!

Centralised finance companies like Celsius and BlockFi did business with counterparties who then invested funds in DeFi protocols. The centralised finance companies knew they were effectively forced by smart contracts to pay back the DeFi protocols. There was no way to back out! So for example Celsius was forced to prioritise paying down its $400+ million DeFi loans on Defi protocols Maker, Aave, and Compound to prevent its collateral from being liquidated. They didn’t have the option to “re-structure” or renege on smart contracts. In DeFi “a deal is a deal” — there is no one to negotiate with. This meant Defi got paid back urgently as the troubles began. Centralised exchanges knew they could always renegotiate or even renege on their CeFi debt obligations. So next time there is a crisis, which lender would you choose to be??

Marius Ciubotariu, the co-founder of Hubble Protocol, believes the 3AC lending crisis highlights the true resilience of the DeFi ecosystem (which includes Maker Dao and Compound). He told Cointelegraph:

“The challenges that faced 3AC are not unique to cryptocurrency nor financial markets as a whole. 3AC crisis has revealed how resilient DeFi protocols actually are. For example, Celsius suffered from lending losses and was being margin called. In fear of on-chain automated liquidations that are visible to everyone, they rushed to pay their MakerDAO and Compound loans first.”

Conclusion

Contrary to what has been widely reported, it wasn’t crypto innovations like DeFi (decentralised finance) that failed or caused the massive downturn we have seen in financial markets. The truth is the brutal bear market that has been hitting all financial assets including Cryptocurrencies this year has — as it does every time — uncovered the downside risk from some pretty outrageous levels of leverage in the financial system (ie in CeFi or centralised finance).

The sell-off is nothing to do with the validity of blockchain protocols but rather proved the soundness of them. Like in 2008, this is a liquidity-driven crisis. And as you can see from the examples mentioned, the problem lies in centralised exchanges, not crypto itself. Even though this collapse is painful, I believe it’s a long-term positive for the industry….The contagion eradicates the bad actors, educates the market on what business models work, and eliminates the weakest projects.

I believe DeFi’s superior performance over this financial crisis may prove to be a pivotal moment. The market has learned an important lesson from this liquidity crisis: you can’t always trust centralised lenders who don’t open their books because you actually don’t have any idea about their overall position. Meanwhile, you have complete transparency on decentralised protocols. This means the risks associated with DeFi are — contrary to popular myth — much lower!

Financial panics and bear markets are part of the investing landscape. It doesn’t matter what asset you invest in… Sooner or later, panic will take hold and crush prices. You can’t avoid them. But we have now seen that DeFi players could be relied upon to conduct their business in the same way before the crash, during the crash, and now in their aftermath, with no pauses in withdrawals or requirements for emergency funding.

All five of the companies that failed were part of the centralised system: just some start-up banking entities that got overleveraged. Nothing new or novel about that. This happens in the centralised system in every downturn. They were not DeFi nor on the blockchain at all. DeFi protocols like Aave, Compound, Uniswap, MakerDAO all functioned flawlessly throughout. This crisis proves the opposite of the common narrative. It proves DeFi works way better than centralised finance in a crisis. You even get paid out first. DeFi will therefore survive and thrive.

PTLIB is co-founder of Dragonfly Asset Management.

DISCLAIMER: This content is for EDUCATIONAL AND ENTERTAINMENT PURPOSES ONLY and nothing contained in this blog should be construed as investment advice. Any reference to an investment’s past or potential performance is not, and should not be construed as, a recommendation or as a guarantee of any specific outcome or profit.