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June 27, 2022

Ember Nuggets #37 | The Fallout of CeFi Crypto Platforms 📉

Nugget #1: Fallout of CeFi Crypto Platforms

Bitcoin launched in the aftermath of the collapse seen in 2007-2008. The thesis (and I am extrapolating to make a point), no single entity should have so much concentrated control or impact on a system. With crypto, we have been focused on a trustless system that is decentralized and spread out across many. However, we have seen some of the same risks seen in traditional finance play out in crypto and the aftermath will be interesting, especially how we grow from this.

So what has happened?

The Terra ecosystem collapse in early May was the beginning. The wipeout of a $40B+ ecosystem has had lingering effects that have brought down many large institutional and retail players in the space. The news is rapidly evolving and there is much we still do not know, but what we do is the following.

Celsius, which had $11.8B in AUM in May with 1.7M users, froze account withdrawals and transfers. The entity which calls itself a DeFi platform is basically a centralized entity that was acting as an intermediary to DeFi for its users. Celsius provided borrowing/lending with attractive yields that led to retail demand (the platform peaked in October with over $25B in AUM). In essence, many could call it a bank without the traditional regulations and controls in place.

Celsius would generate yield in many ways, some were by lending to other entities with under-collateralized loans via Anchor (which blew up), and depositing/borrowing via on-chain protocols like AAVE and Maker. The Terra collapse led to the first of many dominoes to fall that have put the platform in a liquidity crisis. Celsius was the key seller of stETH that led to the de-peg and general price decline of ETH over the past many weeks. This was, in essence, done to cover loans and lower the margin call threshold. However, it doesn’t seem like they are out of the woods yet. Celsius has been bringing on bankruptcy advisors over the past few weeks - as it seems investors are not keen to bail out the entity that abused its risk parameters and could lose customer funds.

Another impacted by the fallout is 3AC, also known as Three Arrows Capital, a highly respected fund in the space. 3AC was levered-long across various tokens, protocols, and entities, so much so that the fallout of Terra and the general crypto pullback has led to margin calls on many of their positions. The destruction of crypto valuations is breathtaking from a $3T peak to a recent low of $900B. The recent events show “contagion” events as many of these large institutional players and retail protocols are intermingled. 3AC liquidity crisis has impacted Voyager (the publicly traded entity that is similar to Coinbase) and BlockFi (which liquidated 3AC overcollateralized loan when it hit margin call).

3AC is complex and evolving, and the most shocking. 3AC was not only levered-long across the ecosystem with little risk management in place, they were leveraging treasuries of portfolio companies (money they invested in startups) to make bets elsewhere. This will be a great HBS Case Study and we are likely to learn a lot in the coming months as investigations heat up, but one thing is for certain - we need regulation because there is systemic risk in the space and greed is blinding many basic tenets of risk management.

The fallout of 3AC and Celsius has impacted other protocols like LIDO, Maple Finance, and Babel to name a few. But many, including myself, see this as a blessing as a lot of leverage has been flushed out of the system and we are likely near the bottom (at least the bottom driven by institutional selling to cover their margins).

Nugget #2: Web3 Cell Phones are coming

Solana announced a phone yesterday and today we saw the announcement of Nothing Phone (by the founder of OnePlus). The thesis is simple. There are only a few million crypto wallet holders, but everyone owns a cellphone. The goal is to bring Web3 to the masses directly with hardware and software that provides security while making it easier for the average person to engage with Web3.

It is too early to see what this may do for the ecosystem, especially since many crypto apps exist on both android and Apple app stores. Some hardware manufacturers and platform designers have already been working to incorporate crypto rails (natively) in their products/services. For example, Apple has already been working toward incorporating crypto with Apple Pay.

Our main takeaway is to wait and watch - how do these phones and developer ecosystems make Web3 apps more accessible and convenient for the masses.

Nugget #3: Macro Market Update

Bitcoin and Ethereum have seemed to have found some footing with Ethereum holding above $1K and Bitcoin above $20K after recent weeks of selloffs driven by large institutions trying to stay afloat. All happening while the Fed raised interest rates by 75bps and has now shifted dialog towards aggressive hikes to curb inflation and that they may be unable to prevent a recession with their recent actions. Macro equity markets remain jittery with choppy trading over the past few weeks, but the fundamentals of the market remain strong. Ultimately, we think this may be near the bottom for many, but recession and geopolitical risk remain that could be catalysts towards larger moves in the coming months.

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