Crisis in crypto lending shines light on industry vulnerabilities

Leading crypto lending firms and hedge funds have run into trouble due to the market turmoil but more so because of their unchecked reckless decision-making process.

The crypto market has entered a bearish phase as prices of major cryptocurrencies have fallen to a four-year low. The current downturn in the crypto market has driven several crypto firms to go out of business, while many have made severe job cuts to remain afloat.

The crypto market crisis began with the Terra debacle that saw $40 billion in investors’ money vanish from the market. At the time, the crypto market showed good resistance against such a massive collapse. However, the after-effects of the collapse had a greater impact on the crypto market, especially crypto lending firms, which many believe are responsible for the current bearish phase.

The lending crisis began in the second week of June when top lending firms started to move their funds to avoid liquidations on overleveraged positions, but the heavy selling that put bearish pressure on prices led to a further downfall.

Ryan Shea, a crypto economist at the institutional digital asset service provider Trekx, said that the lending model makes it vulnerable to volatile markets like crypto. He told Cointelegraph:

“Asset price reversals are particularly challenging to crypto lenders because their business model is very much like that of a regular bank, namely, it is based on liquidity transformation and leverage, which makes them vulnerable to bank runs.”

“During such episodes, customers spooked into thinking they may not get their money back rush to the bank and seek to withdraw their deposits. However, banks do not keep their clients’ money in liquid form, they lend out a large portion of those deposits to borrowers (illiquid) in return for a higher yield — the difference being their revenue source,” he added.

He said that only those customers who act quickly are able to withdraw their money which is what makes liquidity crises such dramatic affairs, “which the collapse of Lehman Brothers and more recently Terra — the crypto equivalent — aptly demonstrates.”

Drawbacks of unchecked leverages

Celsius Network, a crypto lending firm that has been under regulatory scrutiny over its crypto-interest offering accounts, became the first major victim of the market crisis as it froze withdrawals on the platform June 12 in an effort to remain solvent.

The liquidity crisis for Celsius began with a massive drop in Ether (ETH) prices and by the first week of June, the platform had only 27% of its ETH liquid. Reports from different media outlets in the last week also suggested the Celsius Network has lost major backers and onboarded new attorneys amid a volatile crypto market.

Securities regulators from five United States states have reportedly opened an investigation into crypto lending platform Celsius over its decision to suspend user withdrawals.

Similarly, Babel Finance, a leading Asian lending platform that had recently completed a financing round with a $2 billion valuation, said it is facing liquidity pressure and paused withdrawals.

According to previous data from Babel, as of the end of last year, the loan balance reached more than 3 billion US dollars, the average monthly derivatives transaction volume was 800 million, and the issuance of option structured products reached more than 20 billion US dollars.

— Wu Blockchain (@WuBlockchain) June 17, 2022

Later, Babel Finance has eased some of its immediate liquidity troubles by reaching debt repayments agreements with some of its counterparties.

Three Arrow Capital, also known as 3AC, one of the leading crypto hedge funds founded in 2012 with over $18 billion worth of assets under management, is facing an insolvency crisis as well.

people think Celsius is the biggest stETH dumper but its 3AC and it isnt relatively close, they are dumping on every account and seed round address they have, most looks like its going to payback debts and outstanding borrows they have pic.twitter.com/9bZnmTXQzj

— moon (@MoonOverlord) June 14, 2022

Online chatter about 3AC being unable to meet a margin call began after it started moving assets around to top up funds on decentralized finance (DeFi) platforms such as Aave to avoid potential liquidations amid the tanking price of Ether. There are unconfirmed reports that 3AC faced liquidations totaling hundreds of millions from multiple positions. 3AC reportedly failed to meet margin calls from its lenders, raising the specter of insolvency.

Apart from the top lending firms, several other smaller lending platforms have been adversely affected by the series of liquidations as well. For example, Vauld — a crypto lending startup — recently cut its staff by 30%, firing nearly 36 employees in the process.

BlockFi acknowledged they had exposure to 3AC, and it couldn’t have come at a worse time, as it’s been struggling to raise a new round even when it’s at an 80% discount to the previous round. BlockFi recently managed to get a $250 million revolving credit line from FTX.

David Smooke, founder and CEO at Hackernoon, told Cointelegraph:

“For cryptocurrency to reach the trillions, it was necessary and expected for traditional institutions to buy and hold. The young industry often follows old business models, and in the case of crypto lending firms, too often that meant companies becoming loan sharks. Companies that promise unsustainably high returns for simply holding reserves will do exactly that — not sustain.”

Are market conditions to blame?

While from a distance, it might seem like market conditions were the primary reasons for the crisis for most of these lending firms, if one looks closely, the issues seem more concerning with the company’s day-to-day functioning and the spiral impact of the bad decision making.

The insolvency crisis for Celsius brought out several of its misdeeds from the past, with the likes of Swan Bitcoin founder Cory Klippsten and Bitcoin influencer Dan Held warning about shady business practices from the lending platform. Held in a Twitter thread on June 18, they listed a series of issues with Celsius operations since the start that had gone unnoticed until now.

Held highlighted that Celsius has misleading marketing tactics and claimed it was insured while the founders backing the project had a dubious background. The firm also hid the fact that its chief financial officer Yaron Shalem was arrested. Held said, “They had too much leveraged, got margin called, liquidated, leading to some losses for lenders.”

4/ Continued…

– Had a former 24-year-old pornstar as their head of institutional lending
– The founders made dubious claims about their background
– The CFO was arrested for fraud pic.twitter.com/hEHBE90pi4

— Dan Held (@danheld) June 17, 2022

Similarly, 3AC was heavily invested in the Terra ecosystem — the firm had accumulated $559.6 million worth of the asset now known as Luna Classic (LUNC) — the now-forked Terra (LUNA) — before its eventual collapse. The value of 3AC’s half-billion-dollar investment currently sits at a few hundred dollars.

Dan Endelbeck, co-founder of the layer-1 blockchain platform Sei Network, told Cointelegraph about the key issues with 3AC and why it’s facing insolvency:

“Three Arrows Capital is a trading firm that is very opaque with their balance sheet and where they are borrowing and deploying capital. We believe that lack of transparency affected their lenders’ risk assessments and led to this market downfall. These circumstances can create extreme risk, especially in times of market volatility. What happened here is a strong signal that DeFi will continue to grow and bring about more transparency and accountability in this space.”

Market rumors indicate that 3AC used heavy leverages to make up for the LUNC losses that didn’t go as planned.

3AC Backs Terra Luna

Before the Terra collapse last month, 3AC spent $559.6 million to buy Locked Luna.

It’s now worth roughly ~$670.

There is SPECULATION that the massive losses of Luna caused them to use more leverage to earn it back.

Also known as „Revenge trading“

— The DeFi Edge ️ (@thedefiedge) June 16, 2022

Dion Guillaume, head of communications at cryptocurrency trading platform Gate.io told Cointelegraph:

“Celsius and 3AC both suffered because of their irresponsibility. Celsius saved itself from the LUNA crash, but they got badly burnt by the stETH depeg. They seemed to use their users’ ETH funds in stETH pools to generate their yield. This led to insolvency. In 3AC’s case, they lost around nine figures due to the LUNA debacle. To make back their losses, they traded on heavy leverage. Unfortunately, the bear market made their collateral worthless, and they failed to answer multiple margin calls.”

Simon Jones, CEO of decentralized finance protocol Voltz Labs, believes the current crisis brought upon by the crypto lending projects is quite similar to the 2008 recession. Where lenders had extremely high-risk assets on their balance sheet in the form of collateral and these high-risk assets were overvalued or at risk of sudden (large) changes in value.

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The overvaluation of these assets meant lenders thought they had sufficiently capitalized lending books. When the asset prices corrected, lenders were suddenly at risk of having undercollateralized positions. To try to maintain solvency, collateral had to be sold. However, because of the vast quantities trying to be sold at the same time, it contributed to a downward death spiral in the value of the assets — meaning lenders could only sell for pennies on the dollar. Jones told Cointelegraph:

“We should be building a financial services sector that is open source, trustless and antifragile. Not one that’s closed source and taking highly levered bets on retail deposits. This isn’t the future of finance and we should be ashamed to have allowed this to happen to retail users at Celsius. Three Arrows Capital is a hedge fund – so they will never be open source — but better risk management, in particular attention to systematic risk, should have been applied by the lending firms.”

Yves Longchamp, head of research at SEBA Bank, believes regulation is the key to redemption for the crypto market. He told Cointelegraph:

“Recent operational decisions by unregulated crypto service providers in the industry reflect a need for greater transparency and regulation in the industry. By doing so, we can ensure that businesses and users can operate with confidence in the sector. While regulation is coming across more jurisdictions, with both the U.S. and EU at advanced stages of developing frameworks on digital assets, it should be considered a matter of urgency by regulators.”