If Bitcoin was about decentralization, the collapse of some of the biggest names in cryptocurrency tied to decentralized finance, risks pushing the sector ever closer towards centralization.
History may not repeat itself, but it often rhymes. Decades after the end of the Cold War, ancient rivalries and perceived slights are being fought using modern(ish) weapons in Ukraine.
The global monetary system and economy can’t seem to get past a constant cycle of booms and bust and efforts to democratize and decentralize finance often seem to concentrate rather than distribute power and risk.
Nowhere has this been more apparent than the recent implosion of a string of centralized and well-funded cryptocurrency lenders and their possible rescue by a handful of entities (one) that threatens to centralize power and influence in the digital asset space even more than ever.
Tale as Old as Time
While our story begins with the age-old quest of trying to spin copper into gold, by way of the financial alchemy that was the algorithmic stablecoin TerraUSD and its sister token Luna, the revelation that decentralized finance or DeFi, is more similar to centralized finance or CeFi, comes from the multilayered hypothecation of a seemingly endless string of cryptocurrency derivatives, starting with staked Ether, or stETH.
For cryptocurrency luddites, Ethereum is due for a major software upgrade in the later part of this year, which would shift the world’s second most valuable blockchain away from the energy-intensive Proof-of-Work method of securing transactions, to the far more energy-efficient Proof-of-Stake protocol.
To take advantage of this upcoming shift without locking away the use of an investor’s Ether, a DeFi app known as Lido Finance offered something known as “staked Ether” or stETH which is supposed to be redeemable for one regular Ether after the planned Ethereum upgrade known as “The Merge.”
Lido Finance offered investors an interest rate to lock up their regular Ether, allowing them to earn a passive income without having to sell their Ether tokens, but more importantly, stETH was free to be used in trading or other transactions.
In exchange for their regular Ether, Lido Finance issued stETH which could be lent or traded on other platforms, whilst waiting for The Merge.
Right off the bat, this arrangement by Lido Finance ought to have raised several red flags.
For one, the “real” Ether locked into Lido Finance wouldn’t have a fixed date for being unlocked because it was dependent on something that the DeFi platform had absolutely no control over — The Merge, which may or may not ever happen.
The other major issue with Lido Finance’s offer was that stETH, which is notionally as valuable as regular Ether, could be traded and loaned out as if it was as good as the real thing.
An analogue in CeFi would be depositing money in one bank, to take that same deposit slip and loan that same amount of money to another bank and so on and so forth ad infinitum.
If a depositor puts $100 in one bank account, they can’t typically take that proof of deposit and then put it into another bank account with a different bank and earn another round of interest there, yet that is precisely what Lido Finance was offering — for investors to have their cake and eat it, as many times as they wanted.
Complicate This
But the world of DeFi is relatively complicated, requiring some degree of savviness and comfort dealing with Metamask wallets and smart contracts.
Which is why companies like Celsius Network would DeFi on behalf of investors, taking their Ether in return for a smaller interest rate, then locking up that Ether on Lido Network in return for stETH to use in trades and lending to such other counterparties like the hedge fund Three Arrows Capital and arbitrage the spread.
In the case of Three Arrows Capital, the term “hedge fund” is being applied broadly, but it’s beyond the scope of this piece to split hairs on terminology.
Under normal market conditions, stETH ought at worst trade for a small discount to regular Ether — what’s known as a liquidity discount.
Given that stETH held all the same properties as regular Ether, many investors were quite content to value it at a hundred cents in the dollar when it came to the “real Ether.”
But after the implosion of Luna and TerraUSD, excessive selling pressure caused stETH to become unpegged (a really bad thing) from Ether’s price and forcing outfits like Three Arrows Capital to liquidate these positions.
Data from Nansen.ai, a blockchain and data analytics provider, suggests that Three Arrows Capital withdrew over 80,000 stETH from DeFi platform Aave in four transactions and swapped 38,900 of the stETH for just 36,700 “real Ether” or a haircut of about 5.6% in Ether terms alone.
That sudden dumping of stETH liquidity into already skittish markets saw the dollar value of stETH fall by 41% at one point, whereas “real Ether” only lost 39%.
The de-peg of stETH’s price to Ether’s immediately hit Celsius Network.
Celsius Network makes money by taking regular Ether, paying out a small yield on that Ether, and then staking that Ether on platforms like Lido Finance to generate a higher return, which is why the de-peg of stETH and Ether hit the lender hard.
Although the cryptocurrency holdings of Celsius Network are fairly opaque, Nansen.ai has identified that at least one wallet belonging to the lender held more than US$400 million of stETH at one stage.
The longer that stETH was not worth its equivalent in Ether, the more depositors were clamoring to redeem their Ether deposits from centralized lenders— a typical run on the bank.
Not My Problem but Everyone’s
Making matters worse, the fall of stETH wasn’t just a problem for Celsius Network, but DeFi lending as a whole, because of the broader market’s dependence on stETH.
And when the value of stETH as collateral started to fall below certain thresholds, DeFi smart contract loans were automatically liquidated, flooding the market with more stETH and putting even more downwards pressure on the synthetic derivative of Ether.
While DeFi protocols are ostensibly decentralized, venture capital-funded giants like Celsius Network have helped to coalesce single points of weakness, acting like a centralized bank rather than a collection of DeFi smart contracts or algorithms governed by the democracy of token holders scattered across the globe.
The result of course is that when a single point of weakness fails, it’s able to exacerbate losses through unilateral moves such as the freezing of withdrawals, which wouldn’t otherwise be the case in DeFi — depositors can pull their funds at any time directly from smart contracts.
To be sure, stETH is supposed to be 100% backed by Ether, albeit, Ether which has its liquidity locked up until such time that The Merge happens (if ever).
But under difficult market circumstances, such as the present, collateral values, including a liquidity discount on stETH could cause its dollar price to drift far off the price of regular Ether.
And that’s a problem because stETH isn’t locked up, it’s used as collateral throughout the DeFi landscape, creating a contagion risk where none would otherwise have existed, as evidenced by trouble in a string of other centralized lenders including BlockFi and Babel Finance and of course, the hedge fund, Three Arrows Capital.
The full extent of the malaise may take some time to ripple through the entire DeFi ecosystem, with even smaller and lesser-known lenders such Finblox halting withdrawals, likely just the tip of the iceberg.
It’s How You Use it That Counts
In terms of size, Celsius Network was hardly the biggest counterparty out there, with some US$20 billion in assets, compared to TerraUSD and Luna, which saw US$60 billion go up in smoke.
But in terms of interconnectivity and contagion risk, Celsius Network may have an impact far in excess of the US$20 billion in assets on its books.
Where the real danger lies is that Celsius Network freezing withdrawals is akin to the crisis of confidence suffered by financial markets in the 2008 Financial Crisis — no one knew who they could trust and so no one trusted anyone.
The result in the 2008 Financial Crisis of course was that credit markets seized up until the U.S. Federal Reserve intervened.
And while there’s no equivalent central cryptocurrency bank, firms have their lender of last resort, but it comes at a cost — greater centralization.
In some ways, allowing the failure of middlemen in what’s supposed to be decentralized finance could have been a good thing — DeFi could have gotten closer to its raison d’être, which was to avoid centralizing points of weakness which would encourage bailouts and greater centralization.
For all its messaging around “unbanking” the masses, Celsius Network acted very much like a bank and centralized risk within a single entity.
Worse still, Celsius Network increased counterparty risk and contagion by hypothecating assets to orders of magnitude beyond what its deposits were.
Although Celsius Network acted as a quasi cryptocurrency bank, it wasn’t regulated like one, meaning that the firm could invest customer funds as it saw fit, without restrictions, reserve requirements or stress tests.
Whereas DeFi smart contract loans typically require overcollateralization on the part of borrowers, it was entirely possible for Celsius Network to provide riskier soft loans to counterparties it may have had relationships with, in exchange for higher interest rates.
Because depositors with Celsius Network cared more about what they were receiving on their deposits than how the firm ultimately made good on them, they may not necessarily have questioned who the lender’s borrowers were, or indeed, who the firm was borrowing from.
And Celsius Network is hardly the only lender likely to have engaged in such behavior.
But where the true risks to the decentralization of finance lies is in the resolution of this mess — the bailouts.
Too Big to Fail
Just weeks after FTX bailed out ailing cryptocurrency broker Voyager Digital, with a US$485 million cash and Bitcoin package, the Bahamas-headquartered cryptocurrency exchange extended a US$250 million loan to lender BlockFi.
While FTX’s rescue packages are no doubt welcome (the U.S. Federal Reserve would never step in), they also serve to concentrate even more power and influence in the sector into the hands of a few.
By taking on the role of a lender of last resort, FTX is building a pivotal role for itself, akin to the authorities that rescued banks in the aftermath of the 2008 Financial Crisis and indirectly becoming itself too big to fail.
And whereas a central bank would eventually want to dispose of private assets that it’s taken onto its books for the purpose of a bailout, there is no such moral hazard for holding on to them as in the case of FTX.
In the past, large cryptocurrency exchanges, which are hugely profitable, have stepped in to bail out projects or companies that run into trouble, to shore up the ecosystem.
For instance, last year, FTX supplied US$120 million in debt financing to Japanese-headquartered cryptocurrency exchange Liquid, following a hack which saw US$90 million drained from the latter’s coffers.
And this year, the world’s largest cryptocurrency exchange by volume, Binance, led the bailout of Sky Mavis, maker of the popular play-to-earn cryptocurrency game Axie Infinity, which was hacked to the tune of US$600 million.
Where FTX’s more recent bailouts differ is that rescuing centralized lenders that are also engaged in DeFi is a qualitatively different proposition altogether because it doesn’t improve risk management, oversight or decentralization.
Instead, FTX’s bailouts would draw more investors to deposit with these centralized lenders, because they have been bailed out and backstopped before.
If nothing else, by rescuing some crypto lenders and not others, the same way that Bear Sterns got a bailout, but not Lehman Brothers, big players like FTX get to decide who survives and who doesn’t and more importantly, concentrate even more influence, power and assets within a few large entities.
The whole point of DeFi was to self-custody cryptocurrency assets, but because the technology is nascent, interacting with smart contracts and Metamask wallets isn’t as user friendly as dealing with a centralized intermediary lender like Celsius Network.
Millions of depositors were more than happy to accept a lower interest rate than they could have just so that Celsius Network could abstract some of the complexity of DeFi out of yield generation.
For as long as DeFi remains complex, the demand for centralized cryptocurrency lenders will remain.
And for as long as centralized crypto lenders remain, the premise and promise of DeFi will continue to be eroded.
This news is republished from another source. You can check the original article here
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