Celsius and the Three Arrows Crisis: The Lehman Moment
Last week, the panic continued to spread in the market, one of the reasons was that Three Arrows Capital (3AC), one of the most active and influential VCs in the industry, was facing liquidation. 3AC is one of the largest customers of global lending, and it borrows large amounts of funds from major CeFi platforms (such as BlockFi, Genesis, Nexo, Celsius), of which Celsius is 3AC’s largest creditor. If the 3AC does collapse, the institutions that lend to the 3AC will take huge risks. A series of chain reactions ensues:
- The first is that the CeFi platform cannot recover the loan, and the funds are recovered by liquidating the collateral, and the CeFi platform shall bear the difference between the liquidation and the loan.
- When the panic occurs, the CeFi platform faces the pressure of user redemption. The CeFi platform further withdraws credit from the system to protect itself. The same amount of assets, the money is less, and the asset price drops accordingly. When liquidity is withdrawn, the overall balance sheet of each participant shrinks, the ability of market makers to provide liquidity decreases, and bid and ask spreads widen.
- For funds , as volatility increases, they need to deleverage to maintain the same VaR.
- The fall in asset prices has led to the liquidation of a large number of institutions’ collateral assets, the sharp contraction of the credit scale of the entire market, and continued deleveraging.
- Given the heightened risk, LPs will redeem liquidity in preparation for thunderstorms like UST and Celsius.
According to Deflama data, the TVL of the entire DeFi has plummeted from $200 billion before the UST collapse to $74 billion now, a drop of 63%.
During the subprime mortgage crisis in 2008, Lehman Brothers was caught in a liquidity crisis due to its rapid expansion, highly leveraged operation and wrong judgment of the situation. In the end, it collapsed with a huge debt. Then market confidence collapsed out of control. In an environment where the macro economy is not clear, interest rates are gradually rising and the US Federal Reserve is tightening water, it is difficult for cryptocurrencies as risk assets to stay safe. This time, the thunderstorm crisis of large institutions has already laid the groundwork when the UST collapsed. Investment institutions and market makers suffered heavy losses in the UST collapse. The sharp drop in mainstream asset prices became the last straw that broke the camel’s back. High leverage has triggered a series of liquidations, and subsequent thunderstorms may continue, which is why Celsius and the Three Arrows crisis have been compared to the Lehman moment in the currency circle.
What pulled the trigger of the serial liquidation
As an insider, we may not be able to get a glimpse of the reasons for the collapse and serial liquidation of the crypto market, but we can get a glimpse of the leopard through some excellent viewpoints in the market. At present, there are roughly the following types of mainstream voices about the liquidation in the market:
1. Global financial markets fall as the Fed raises interest rates in response to high inflation
The crypto market has peaked since the Fed’s announcement of Tapper last November. After entering May, US President Biden, the Secretary of the Treasury and the Secretary of Commerce and others have frequently spoken out on the issue of inflation. Fighting inflation as the primary issue of the current US economy has reached a general consensus at the US policy level, and the market has experienced a slow decline. When the US Labor Department announced on June 10 that the CPI index reached a 40-year high of 8.6%, exceeding the expectations of all economists surveyed, the market tumbled. To tame inflation, the Federal Reserve on Wednesday announced its biggest interest rate hike in nearly 30 years, raising rates by 0.75 percentage points. Although market expectations have been met through media briefings in advance, when the boots landed, financial markets were still affected by the more pessimistic economic outlook and continued to fall. Amid the U.S. interest rate hike, the decline in global financial markets, and the expectation of an economic recession, market liquidity will weaken, and funds will withdraw from emerging markets and turn to more stable investment targets.
2. After the Luna incident, institutions were damaged, market liquidity weakened, and institutions’ ability to resist risks weakened
After the Luna incident, several super-large crypto market makers were severely damaged, and many investment institutions also suffered heavy losses. Whether they were providing liquidity to UST or allocating assets to UST and Luna, they all suffered heavy setbacks. These market makers used to be important maintainers of the liquidity of the crypto market. Since the crash of Luna, the liquidity of the entire crypto market has become much weaker. When an institution suffers a run or debt request, there is not enough liquidity in the market to guarantee the full exchange of assets, which will cause the institution to suffer greater losses in the process of selling.
3. Institutions actively or passively deleverage
Proper leverage is a normal business strategy when the market is on an upswing. At the moment of global liquidity crunch, cryptocurrencies continue to decline in the interest rate hike cycle, and high leverage has become a reminder of the previous aggressive expansion behavior. Suffer from liquidation passive deleveraging.
4. The operation of a large number of centralized institutions in the encryption industry is not transparent
Although DeFi uses anonymity to overcome the problem of information asymmetry that has always existed in the financial market, the underlying assets invested by centralized institutions are not transparent enough, and there will be potential risks such as fund pool term mismatch and misappropriation. The lack of timely and full understanding increases the risk of sudden market collapse and panic. In the past, Celsius lost more than 70 million US dollars in funds due to the theft of the stakehound, but it has been kept secret, and it was finally revealed, which led to a crisis of confidence. There are also DeFi projects Stablegains embezzled customer funds to deposit funds to Anchor to earn interest margins, and the collapse of UST caused customers to suffer massive losses.
5. Heavy reliance on on-chain collateral (crypto assets)
The Bank for International Settlements (BIS) believes that DeFi relies heavily on the characteristics of on-chain collateral (crypto assets), which not only fails to protect the field from the market “boom-bust” cycle, but also falls into a liquidation spiral.
To ensure lenders are protected, DeFi platforms set a liquidation ratio relative to the borrowed amount, the BIS explained. For example, a collateralization rate of 120% may be accompanied by a liquidation rate of 110%, if the collateral is liquidated below this threshold. The smart contract stipulates that at this point anyone can act as a liquidator, confiscate the collateral, repay the lender, and pocket a portion of the remaining collateral. The profit drive ensures adequate supply for liquidators and mitigates potential credit losses for lenders.
“Overcollateralization is prevalent in DeFi loans due to the borrower’s anonymity,” the BIS noted, pointing out that in order to avoid forced liquidation, borrowers typically submit crypto assets above the minimum required, resulting in higher effective collateralization rates. Considering the “boom-bust” cycle of the crypto market, in fact, “over-collateralization and liquidation ratios do not eliminate the risk of credit losses. In some cases, the value of the collateral fell rapidly, and borrowers did not have time to unwind before they fell in value. Loans, causing lenders to suffer losses.”
6. The market lacks reasonable supervision and safety pads
Celsius is not registered with the U.S. Securities and Exchange Commission (SEC), which means it is virtually immune to risk management, capital, and disclosure rules, and it also means that regulators are less willing to bail out when major financial risks arise. powerful.
In addition, qinbafrank believes that the 4 circuit breakers in the US stock market in March 2020 were considered a soft landing, and the market fell by 40% in the end. The circuit breaker is a protection mechanism formulated by supervision for the market. There is no regulation and no circuit breaker mechanism in the encryption market, so we have witnessed the moment when the pie is cut in half overnight.
The recent strong deleveraging is talking about the Lehman moment of the crypto market. Looking back at the 2008 financial crisis, although the US government did not rescue Lehman from bankruptcy, it also rescued many financial institutions, including the subsequent big water release that brought the financial system from The brink of collapse was pulled back. It can be imagined that if there is no external assistance and related mechanisms, the US capital market will be even worse in 2008 and March 2020. From this point of view, the strong deleveraging of the crypto market is also self-clearing without any market mechanism under supervision. Qinbafrank believes that this is a classic interpretation of the market mechanism.
The boom and crisis of DeFi nesting dolls
The biggest value proposition of DeFi is that it is interoperable. Our financial system can interact with the larger ecosystem, which means that anyone can combine two protocols (such as Aave and Synthetix) to create new products and innovate user experiences. Good products will soon have network effects, as liquidity is also transferred to each other, which will completely disrupt the traditional financial industry.
– Stani Kulechov, founder and CEO of Aave
DeFi was born thanks to smart contract technology, which makes complex financial products easy and simple for anyone to use. It is also composable, that is, the application interacts with the protocol in a permissionless manner. While improving capital utilization, each new DeFi application can also be connected to existing applications to enhance its functions and practicability.
After users lend assets or provide liquidity in DeFi, they will receive voucher tokens. For example, Compound’s cToken, Yearn’s yToken, and Uniswap’s LP Token. In order to further improve the utilization of funds, some platforms began to accept these derivative tokens as collateral, and then issued another token for the collateral, and the nesting doll was born. As liquidity mining detonates DeFi Summer, users can also get platform governance tokens as rewards, and the potential value of governance tokens further motivates users to “mock dolls”. A user’s sum of money may generate various other coins one after another, and the concept of governance coins has pushed the “dolls” to a climax. The DeFi market is getting bigger and bigger, and the participants are getting more and more benefits. In a bull market, that’s true.
The prevalent “doll” model of DeFi is very similar to the subprime mortgage of Wall Street in 2008. The “Matryoshka” model deeply binds various DeFi platforms together. And ETH is the bottom collateral of most assets. If ETH falls, a chain reaction will occur.
The Three Arrows Capital Crisis has made people find that one of the most popular strategies among institutions is to borrow ETH at a low interest rate of about 2%, and pledge stETH on Lido to generate a yield of about 4%, and then use stETH as a Collateral, revolving lending and borrowing ETH on Aave, increasing leverage in this seemingly low-risk way. Celsius had nearly 450,000 stETH at its peak, and the platform would deposit these stETH into Aave as collateral and lend stablecoins or ETH to meet users’ redemption needs. It is not difficult to see the pattern of “Matryoshka + Revolving Loan” if you look closely.
DeFi combination greatly enriches the ecology, but this composability is actually a “double-edged sword”. The multiple compounding of smart contracts and capital pools adds more complexity and brings more loopholes. Oracles, which provide an interface with external data, also become potential targets of attack. Such as using flash loans to manipulate or destroy prices. Even if there are no technical loopholes, the “doll + revolving lending” also increases the risk of financial systemic.
Posted by:CoinYuppie，Reprinted with attribution to:https://coinyuppie.com/looking-back-at-the-beginning-and-end-of-the-encrypted-lehman-moment-what-pulled-the-trigger-of-the-serial-liquidation/
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