#23 The Context: It’s Cold Outside
Celsius freezes, lowering the temperature across DeFi
Hi there, it’s been an interesting few of weeks and we’re feeling the chill despite it being June. Bitcoin is around $22,000 at the time of writing; the last time it was there was October 2020 which is eons in crypto-time. This week we look under the hood of the Celsius crash; Three Arrows Capital happened a little too late for us to dive into but we’ve put links to the latest developments below. It’s times like this which offer an opportunity to find out what really works and what doesn’t, and how. Hopefully some of the stuff below might help on that.
The usual disclaimer: This newsletter collates the main themes and headlines of the week in DeFi/crypto/metaverse/web3/NFT land and tries to provide unbiased context. It’s aimed at anyone who wants to keep an eye on the space but isn’t following it too closely, or is on the hunt for story ideas and angles. It’s put together by a team at YAP, and doesn’t contain any promotion of our clients (if one is mentioned, we’ll flag that).
This was put together by a team led by founder Samantha Yap, and Jeremy Wagstaff, formerly of the journalism parish. Thanks to Ruby Wu, Roslyn Tear, Becky Corbel and Delon Chans for contributions, Joey Wu for production. Your feedback is as always welcome. Ping us at thecontext@yapglobal.com. Old newsletters can be found here.
[tl;dr]
Celsius Networks is the latest to stumble, with some blaming it for unhelpful opacity.
Is there a solution to these kinds of collapses? Yes, but you might not like them.
Lobbying is getting more popular in crypto, but that raises its own questions.
[Always Crashing in the Same Car?]
Things ain't pretty in most markets at the moment, but any doubt that crypto wasn't heading for another winter have likely been lain to rest. Inflation is stalking the markets -- raising fears that the U.S. government might increase interest rates -- and crypto is not perceived as an antidote, hence the falls. A decision by Celsius Network, a kind of crypto bank which borrows and lends cryptocurrencies, to pause withdrawals and transfers triggered a precipitous drop in its CEL token.
So why Celsius? On paper it exhibits all the traits of a sober, quasi-centralised shop for consumers to have trusted access to crypto services. It had raised $864 million from VCs and at one point was custodian of funds theoretically worth more than $28 billion for more than 1 million customers. In short: a sort of TradFi-friendly DeFi play. So what went wrong?
A number of things:
One was in the structure itself: The problem was that it in order to deliver on its promise of high yields for deposits and low rates for borrowers, it used its deposits to buy a token, stETH, that was linked to Ethereum (ETH) which can earn more yield but which cannot be redeemed for ETH for up to a year after Ethereum goes through the Merge (an upgrade to the Ethereum blockchain which has yet to happen.) The result: Celsius was effectively insolvent. (Check out this thread: jonwu.aztec on Twitter. And here’s a piece on CoinDesk about the Terra/Celsius crash: (Lido Finance is a YAP Global client) Crypto Market Chaos: No, Lido Is Not ‘the Next Terra’)
This complexity may have been enough to cause a collapse. But it was aggravated by the company's opacity, according to Henrik Andersson, chief investment officer at Apollo Capital, in a (subscription only) newsletter. "The recent actions of Celsius and the opacity of its CeFi (Centralised Finance) infrastructure have caused uncertainty for its users," he wrote. "If this transparency existed, users would've been able to quickly assess the health and solvency of the platform in real-time." This opacity extended beyond merely the technical: Celsius had declined to confirm that their CFO had been arrested last November until journalists started reporting it. Bitcoin Magazine looks deeper into Celsius' white paper and public pronouncements in its analysis of what went wrong.
This is all good analysis, but the point with crypto is that it shouldn't be possible to be so opaque. Every transaction should, in theory, be available to anyone who wants to check things out. At least, that's the theory. Henrik's point appears to be that it’s the CeFi elements of Celsius that are problematic, because they don't adhere to DeFi's principles of transparency and decentralisation. In reality, of course, for most of us is that transparency is not in itself enough; the increasingly complex nature of derivatives and tokenomics in DeFi mean it's not easy to investigate deeper into the thicket to work out what is really happening.
That's why we're heavily reliant on sleuths like Mike Burgersburg, a pseudonymous writer who has been making detailed allegations about Celsius for at least a year:
He has presented what he says is evidence that a founder of Celsius had been advisor to (and beneficiary of) two other crypto projects that ended in rug pulls. (This post was written in April; the original allegations were made in January, but didn't attract more than a few retweets.)
He has cited what he says was Celsius' exposure to a year-old case where staking solution company Stakehound announced they had lost the keys to some 38,000 Ether. Burgerburg alleged in early June that Celsius had sent more than 35,000 Ether to Stakehound.
There are quite a few lessons to draw from this, but the Celsius collapse is now part of a bigger drop in crypto that we almost certainly haven't seen the end of yet. As we've mentioned in previous newsletters, the heroes in these incidents are often pseudonymous researchers skilled and experienced in digging into transactions. Though we shouldn't ignore their willingness to pose tough questions to the right people when the opportunity arises.
(Here’s a deep dive by the FT team, and a WSJ piece on the company reaching out to restructuring attorneys for help.)
[A solution to the problem?]
Given a significant part of the problem is that crypto players lack credible collateral, is part of the answer to look for more old-world collateral? JPMorgan's Tyrone Lobban says the financial giant plans to do just that by bringing trillions of dollars of tokenized assets to DeFi. Despite the current jitters, or maybe because of them, connecting DeFi and TradFi assets to each other is a goal both sides are working on. Given the levels of VC and institutional interest in crypto, and the growing numbers of TradFi professionals moving over to DeFi, it's more a question of when and how this would happen. JPMorgan's plan, for example, involves converting U.S. treasuries and shares in money market funds to tokens, which could then be used as collateral in DeFi pools. Some of this is already happening, but with a strong TradFi bent: JPMorgan has a private blockchain-based collateral settlement system which uses a token representation of BlackRock's money market fund shares as collateral. The goal is to leverage a wider range of assets -- both traditional and decentralised -- through this process of tokenisation.
Companies like IBM have been talking up blockchain for a few years now, and are talking more and more about "hybrid networks" which embrace both permissioned and permissionless blockchains. These approaches are usually seen as using the wrong tools to do the job.
Another interpretation of 'hybrid' is for governments to launch their own digital currencies, inheriting some features of crypto but leaving out the bits they don't like. The Kansas City Fed has drawn up a useful summary of the state of play in the adoption or not of retail CBDCs. It doesn't try to land on either side of the debate, but it does point out that "the motivations and scenarios will likely vary across countries, as each country has a unique set of opportunities and challenges in its economy and payment system." (If you like the weeds, here is an interesting speech from Lorie K Logan of the New York Fed talking about, inter alia, the potential of wholesale CBDCs from a central bank's point of view.)
But these attempts to bridge the TradFi and DeFi world may hide a misperception: does DeFi do what TradFi does, only better? Or is it doing something else? There's an argument, for example that there is a basic philosophical difference between the traditional financial system and the cryptocurrency system, and that is TradFi is really about the extension of credit, while crypto is not, at least not wholly. A stablecoin -- one that is, er, stable -- is the closest analog to money. In which case, what is Bitcoin? And so if crypto is trying to do away with credit risk, then does that make it less risky? The past couple of months (OK, last few years) would suggest not.
Indeed, credit is extended all over crypto; it's just that in most cases the loans are collateralised, or overcollateralised. So that only benefits those who already have assets, but want to keep those assets in place and borrow assets in other forms or denominations to do something else with them. This is all done because crypto's hallmark is anonymity, which is anathema to KYC and other methods to extend credit to those who don't already have significant assets. So the debate is now around some form of self-sovereign identity that preserves anonymity while allowing it be a verifiable credential that could allow users to borrow without the need for equal or extra amounts of collateral. Check out this longish paper by Molly White on an increasingly relevant topic, should crypto ever really deliver on its promise to help the unbanked.
[Our man in Washington?]
This leaves DeFi in something of a quandary: on the one hand it wants to stick the middle finger to TradFi, CeFi and BigGov. After all, the point of crypto is to build a financial system that isn't part of the Financial System, and which does things differently. But on the other hand it can't satisfy its ambitions without in some way connecting to all three. The main focus is for those companies big enough to spend money on lobbyists, so they can have a seat at the table when it comes to regulation. BlockFi is the latest to hire lobbyists to streamline talks with policymakers.
Then there's a more aggressive tack, funded by the heart and soul of DeFi: Coin Center is a non-profit advocacy group funded by venture capital names like Andreessen Horowitz and some big crypto names like Ripple, Coinbase and Ethereum. It has worked with legislators on draft legislation and files amicus briefs. Last week it filed what may be its first lawsuit alleging the U.S. Treasury Department and Internal Revenue Service presenting a constitutional challenge to the Tax Code passed last summer. It says the so-called 6050I amendment, which would require individuals and businesses who receive $10,000 or more in crypto to report to the government not just the name of who sent them the funds, but that person’s date of birth and Social Security number as well, is unconstitutional. "If the amendment is allowed to go into effect," the suit say, "it will impose a mass surveillance regime on ordinary Americans.”
[Tidbits]
BitMEX co-founder Benjamin Delo sentenced to 30 months probation. The sentencing closes a legal chapter that began in the fall of 2020, when the US accused Delo and co-founders Arthur Hayes and Samuel Reed of "evading US anti-money laundering requirements." Hayes evaded jail time, but received six months home detention as part of a two-year probationary period. Hayes will be permitted to travel to his home in Singapore for the remainder of his probation once the six-month home detention sentence is served in the US.
India is still mulling whether it's a crypto nation, but tellingly it's taking advice from the World Bank and International Monetary Fund, neither of which are big fans of DeFi (although they have dabbled with blockchain and some of their number have expressed interest in crypto's potential. For now, the to-and-fro is further to the side of skepticism: the government's chief economic adviser has warned about the dangers of crypto without regulation.
We have mentioned in a previous newsletter about Adobe's embrace of NFTs; now it has released an open source toolkit, designed to reduce misinformation and fakes in images and videos.
Gaming DAO Merit Circle, YGG ‘Terminate Relationship’: more developments in the thorny domain of DAO governance, brought into sharper focus by the falling earnings from ‘play-to-earn’ games.
[Reading]
The New York Times peers inside crypto exchange Kraken: Inside Kraken’s Culture War Stoked by Its C.E.O. “[E]ven in the male-dominated cryptocurrency industry, which is known for a libertarian philosophy that promotes freewheeling speech, [Jesse] Powell has taken that ethos to an extreme.” Molly White takes a closer look on a Twitter thread at the overhaul documents and offers some comments of her own.
[Media corner]
On The Record: Here's the latest in a series of YAP Global interviews with journalists in the space. This week, we feature our conversation with Tom Farren of Cointelegraph. He says “I’m really trying to look for the projects with genuine utility”. Past interviews are here: On The Record Archives. (Let us know if you’re up for an interview. It really helps us understand how we can better help journalists, and hopefully helps other journalists understand the space better.)