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July 12, 2022

Ember Nuggets #38 | Dear CeFi, stop giving Web3 a bad name. Sincerely, DeFi ✍️

As many of you know, the crypto world has been impacted by an ever-growing debt crisis that has spread across various CeFi entities like wildfire. Driven by bad debt outstanding at 3AC, a conversation for another day, and a sharp drop in crypto asset prices have impacted many lenders.

Let’s first establish some basic jargon being thrown around in the news.

CeFi – is centralized finance and represents financial entities acting on/off-chain but in a controlled, centralized manner where company governance controls the actions of the firm, its deposits, and the ability to deposit/withdraw. In this scenario, you don’t own your keys and thus any capital deposited could be at risk at the entity level. CeFi platforms include Coinbase, Binance, Huobi, Celsius, and Voyager (to name a few).

DeFi – is decentralized finance and represents protocols that live completely on-chain. These protocols act as a proxy between parties that may be interacting with the protocol for its specific use case. In this scenario, the protocol owns/operates the smart contract that users interact with, however, users control their funds (and keys). The risk is at the smart contract level (represents security risk) and less likely centralized authority risk (primarily if audited). DeFi platforms include Uniswap, AAVE, and Compound. Risk remains but more so technical, smart contract risk, but your keys, your crypto.

Celsius touts itself as a crypto retail bank telling customers that it offers services with no fees, “fair” yields, and quick settlement times. Celsius leveraged “juicy” yields to attract customers' funds and in early 2021, it became the first platform to cross $20B+ in AUM, primarily driven by retail. By all means, Celsius was just a centralized entity that presented itself as a wrapper on top of DeFi – making it easy for everyone to invest…but it was the furthest thing from DeFi.

Celsius generate revenue in a few different ways:

  • Spreads – profiting when they are able to generate higher rate on lending than what they pay customers on deposits (i.e., if Celsius was able to loan out assets and get 10% and then offer 5% to customers, it would net 5% as a spread).

    • Celsius made two types of loans:

      • Retail Loans: Customers could leverage their deposits and take out loans.

      • Institutional Lending: Lending customer deposits to institutions and other counterparties, usually off-chain.

  • DeFi – depositing capital on chain with protocols like AAVE, Maker, BadgerDao, and others to generate yield.

  • Trading – it seems Celsius was using customer funds to trade in the market, one such example is KeyFi, which recently sued the company.

As you can see, there is a problem with a lot of this and it all starts with customer deposits. Customer deposits are where everything starts and stops – it is a core part of traditional banking, but there is a big difference. Traditional banks are heavily regulated and further supported by customer deposits being insured via FDIC. Ignoring the insurance, most banks are very picky about lending and their counterparty risk, have robust risk management departments and have painfully inefficient capital requirements since the Great Recession (good for us). And if all else fails, they will likely get bailed out by the US Government. Now, these things are almost non-existent in crypto.

Customer deposits fall through the cracks, there is no FDIC insurance, and these entities are able to do whatever they want (at least so far, let’s see what comes next). Here is how Celsius defines customer deposits:

Your Celsius Account is not a deposit or checking account, and Celsius does not hold any Digital Assets on your behalf. All Eligible Digital Asset balances on your Account represent Digital Assets are either loaned from you to Celsius or held by it as collateral, and therefore, owned, held and/or controlled by Celsius (under the applicable Service, as further detailed herein), and Celsius’ obligation to deliver such Digital Assets back to you upon the termination of the applicable Service.

When a user deposits money on Celsius – this gets transferred to a pool of assets that everyone on the platform has deposited. The UI will show your funds, but for operational purposes, the funds are actually in the pool and in the hands of Celsius employees. The deposits themselves become a liability on Celsius’ balance sheet and what they “owe” the customer. The customer in this scenario, from my understanding, is an unsecured lender to Celsius. Doubt that if the marketing materials had said that, we would still deposit our funds there (talking about us, the public).

Now, what probably happened?

Well, Celsius had no proper risk management systems in place and basically lent out 75% of its assets to other institutions. The firm was acting as a hedge fund (buying/selling tokens), investing in protocols, and lending out parties like 3AC (which have since defaulted on their loans). Rumors have it that since May 2022 when Celsius had roughly $12B in AUM, almost $8B (75% of their book) was lent out.

With poor risk management and running rampant in the market, there are many ways Celsius started piling up the losses. Celsius was heavily involved in Anchor (Terra protocol offering 20% yield), lost $100Ms in various hacks on-chain where they had deposited customer funds, margin/liquidation issues on leverage, and then bad loans to borrowers that began defaulting like 3AC. Again, we don’t have hard facts but the downturn likely led to a $2B+ hole in Celsius’ books that will likely lead it to bankruptcy. No customer was likely expecting Celsius to take their deposits and run rampant in the market opening positions on altcoins, taking leverage and increasing the risk even more, and then to top it off, likely pumping/dumping tokens to counter-trade their customers.

On-Chain data shows that Celsius was one of the largest players of DeFi depositors and borrowers – opening large positions in various tokens including CEL, BTC, stETH, and ETH. The sharp downturn in price in early June led to Celsius freezing withdrawals. This was likely driven by the need to take liquid deposits (that would’ve allowed withdrawals) and utilize them to prevent margin calls on-chain. On-Chain activity shows Celsius depositing $750M+ to prevent liquidation on protocols like Maker, AAVE, and Compound.

Unlike CeFi, DeFi activity is transparent, trackable, and abides by rules, not emotions. Any loan from AAVE or others requires over-collateralization (if I want to borrow $100, I need to deposit $150). To prevent liquidation, Celsius repaid loans and deposited additional wBTC and ETH to lower the margin threshold. Over the past week, Celsius has repaid many of these loans and taken the collateral back but the damage is done and likely there is a mismatch of assets and liabilities – leading to the likely bankruptcy filing in the upcoming weeks. We expect additional downward pressure on price in the crypto market driven by Celsius selling the collateral that it pulled from DeFi protocols and sent to exchanges. Bankruptcy proceedings typically require remaining assets to be held “safely.”

The troubles and revelations will continue to escalate for the firm. Celsius was recently sued by a former employee and operator of the infamous Twitter account 0xB1. Celsius brought on a firm called KeyFi and funded them with $534M to trade on-chain, at one point the infamous address was the 3rd largest on-chain, dabbling on various on-chain protocols and behind only Justin Sun and Alameda. 0xB1 created a 113% return for Celsius and returned the funds in early 2021. The lawsuit stems from the lack of payment from Celsius to the party that operated and generated the return on the funds.

Through the lawsuit, we are able to ascertain, based on claims, how poorly Celsius was managing risk and mismanaging customer funds. The state of Celsius's finances is bad – FTX walked away from a deal and investors want the company to go through bankruptcy to solve its issues.

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