#27 The Context: The Long March
It’ll be a long walk out of the morass for DeFi’s damaged
Hi there, hope you've had a good week. This week we look at efforts by DeFi companies in trouble to dig themselves out, as well as putting them in the broader and longer-term context of old fashioned bankruptcy, litigation and regulatory scrutiny. We also take a look at another Achilles heel of crypto, namely cybersecurity: It might not be kindergarten but it’s not rocket science either.
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. Huge thanks to Roslyn Tear, Sam O'Donohoe and Ruby Wu for their contributions, and in particular for taking the tiller while Jeremy was indisposed.
Feedback is as always welcome. Ping us at thecontext@yapglobal.com. Old newsletters can be found here.
[tl;dr]
Celsius is recovering collateral, Three Arrows Capital is MIA
None is likely to avoid bruising litigation, bankruptcy and regulatory scrutiny
DeFi might be full of smart folks, but we still seem to fall for some old-school hacks
[Visible and Invisible: Celsius and 3AC]
Consolidation is a phase in any crash and recovery, and DeFi is no different. As mentioned last week, there are various moves afoot. But how it plays out, and whether it follows or deviates from more traditional iterations, isn’t yet clear. The first step is declaring bankruptcy, then hiring folks to sort out the mess and recover what can be recovered, process any lawsuits and investigations, and then, if there’s anything left, share it around creditors and (if they’re lucky) depositors. (Here’s an interesting exploration of deposits, looking in particular at Voyager).
Acquisition can shorten or even bypass some of this process. So there's always an eye out for a white knight. Crypto lender Nexo, for example (a YAP client), has hired Citibank to explore acquisitions, and talked last month of buying out Celsius; it may also be buying Singapore-based rival Vauld, which disclosed a $70 million shortfall. Whether these buyouts are bailouts, or both, or neither, is up for discussion. In some ways it's similar to a rapid consolidation, where the strong acquire assets, talent and market share on the cheap. But some of the deals are, at least initially, lines of credit to battered players raising questions about whether it's wise to save companies that may simply not be viable.
What may distinguish the companies that are worth saving from the rest are the lengths they go to to satisfy creditors and users whose funds have been frozen.
A visible plan: Celsius for its part is reportedly working with restructuring experts from advisory firm Alvarez & Marshal and also hired Citibank for advice on financing options. This process has included reducing its debt to DeFi protocols, reclaiming higher sums held as collateral for the loans. Celsius has now paid off more than $800 million of debt to DeFi apps, according to The Block.
What is less clear is where this money is coming from, according to Cryptonews, and the implications for those investors unable to access their funds after Celsius suspended withdrawals in June. Celsius paying these debts while freezing withdrawals raises questions about who should get paid what, according to Bloomberg’s Yueqi Yang and Olga Kharif. And for the broader ecosystem, two questions stand out: will this save Celsius or merely delay the inevitable, and what impact will this unwinding of positions have on prices? (Celsius filed for bankruptcy protection on Wednesday.)
A less-than visible plan: Three Arrows Capital has kept a lower profile, frustrating creditors. 3AC went into liquidation on June 27, and filed for bankruptcy in the US on July 1. Creditors have secured an emergency hearing after the usually voluble founders “have not yet begun to cooperate". Lawyers involved in the liquidation proceedings of Three Arrows Capital’s British Virgin Islands fund said their current location is unknown, and in documents filed in the U.S. Bankruptcy Court for the Southern District of New York, said the founders of the fund “have not yet begun to cooperate with the [proceeding] in any meaningful manner.”
An important debate about this is which parts of DeFi, and which of centralised finance, or CeFi, fared better; in short, was the crash a problem with DeFi itself, or with its more centralised components? Zac Prince of BlockFi, for example, opined that "I love DeFi and think that it has a lot of promise - but it's not perfect and doesn't address certain things (credit extension, term lending) that CeFi does.”
[Embracing the inevitable litigation]
It’s the litigation that may prove the most damaging, and drawn-out, part of the play, as previously invisible, or obscure relationships and dependencies come to light.
Venture fund DeFiance, for example, is considering legal action against Three Arrows Capital, a partner after the latter incubated DeFiance. Cryptocurrency exchange Blockchain.com stands to lose $270 million from lending to 3AC, and its CEO has accused the VC of having “defrauded the industry," and that Blockchain.com intended to "hold them accountable to the fullest extent of the law.”
And Celsius is being sued for allegedly being a Ponzi scheme by KeyFi Inc, a DeFi staking software company which says Celsius had refused to honour the terms of a 2020 agreement whereby KeyFi helped manage up to $2 billion of Celsius’ funds. (CEO of KeyFi is Jason Stone, better known in crypto as crypto whale 0x_b1. The 32-page complaint is here (PDF). See Reading for more on Celsius and Jason Stone.)
One thing is clear: This won’t shelter Celsius and others from regulatory scrutiny. Two US states are looking carefully into Celsius and another troubled crypto lender, Voyager, according to Bloomberg. The states, Texas and Alabama, are said to be examining whether Voyager and Celsius fully disclosed information on their loans and the creditworthiness of borrowers. Voyager filed for Chapter 11 bankruptcy protection in New York on July 5, halting withdrawals after counterparty hedge fund Three Arrows Capital failed to repay a $650 million loan.
When the dust does settle, the landscape of jurisdictions presenting themselves as crypto hubs may also look quite different. A Reuters piece explores how Singapore's crypto aspirations have been shaken by the Three Arrows collapse. If Singapore does become more hawkish, the piece says, that might well prompt its Southeast Asian neighbours to follow suit. A possible beneficiary? Hong Kong, which has been more cautious about crypto in the past year.
[Poor cybersecurity - Ronin]
A consistent theme from both bull and bear DeFi has been its vulnerability to hacking attacks, both sophisticated and unsophisticated. In the first six months of 2022, web3 projects have lost more than $2 billion to hacks and exploits — more than all of 2021 combined, according to research by blockchain auditing and security company CertiK. And while some attacks are specific to DeFi — leveraging flash loans, for example, which led to more than $300 million lost in Q2, against $14 million in the previous quarter -- common or garden phishing is still rife.
Ronin, the Ethereum-linked sidechain that underpins play-to-earn game Axie Infinity, lost $540 million in crypto to an exploit in March. While the US government later tied the incident to North Korean hacking group Lazarus, it was down to a simple piece of social engineering, according to The Block, whereby a senior engineer at Axie Infinity was duped into applying for a job at a company that, in reality, did not exist.
Hackers have stolen at least $8 million worth of ETH via a phishing attack impersonating Uniswap’s website, luring users to approve transactions that were in fact malicious. The solution, therefore, is as much about educating users about such attacks — that users may long have been familiar with in ordinary life, but which might be less expected and harder to spot in DeFi — as it is about building more secure DeFi systems themselves.
[Tidbits]
Where is all the web3 hardware? We (still) hear a lot about web3 and its revolutionary potential, but mostly it’s been about software and networks. But we haven’t heard so much about hardware, and in particular devices, and whether those too, will look and behave different. At least since HTC’s blockchain phone. There are some glimpses: Polygon has partnered with phone maker Nothing to embed simpler access to apps, payments and zero-knowledge proof-based ID. Solana has launched a web3-focused smartphone called Saga, which it turns out is a rebranded OV1, the planned flagship phone of OSOM, which itself emerged from the ashes of the Essential PH1 phone, a prototype in 2019 that turned heads for its slender (read: long and thin) screen. Whether these devices help make web3 feel a bit more, well, real, is up for grabs. The Saga won't be available until early 2023.
The United States is playing whack-a-mole trying to close down all crypto avenues that Russia might be using to evade sanctions. The latest, according to Reuters, Japanese crypto miners. US diplomats have asked Tokyo to focus on halting cryptocurrency mining operations based in the Irkutsk region in Siberia, favoured for crypto mining operations because its relatively low temperatures require less cooling and because of the availability of cheap hydroelectric power.
Sports and web3 haven’t given up on each other. Crypto exchange OKX has paid more than $20 million to sponsor Manchester City's training kit. Last last month the FT reported that ageless footballer Cristiano Ronaldo signed an NFT deal with crypto exchange Binance. But generally the trend is the other way: FTX and other crypto firms have been ditching sports deals, according to the New York Post.
[Reading]
Stablecoins: a useful overview and deep dive by Apollo Capital
A report on Celsius (and Jason Stone) by Arkham Intelligence (PDF)
A deep dive from Bloomberg about how Three Arrows Capital fell apart
[DeFi Definitions]
An occasional segment exploring one particular aspect of DeFi.
This week: “Collateralisation” by Sam O’Donohoe.
Given recent events with the implosion of crypto lenders in Celsius, 3AC, and Voyager, lending is front and centre in people’s minds.
Collateralisation is a central mechanism for securing loans, whether it’s crypto or traditional finance. It involves the provision of assets that act as security, otherwise known as collateral, to ensure the lender doesn’t lose out on the valuation of their loan if the borrower were to default on their repayment.
In most traditional loans, the borrower is required to provide collateral that exceeds the sum of the loan (over-collateralisation). However, some DeFi protocols use smart contracts to reduce the value of collateral below the sum of the loan (under-collateralisation), without impeding the integrity of the loan.
In the case of Celsius, the crypto lending platform sanctioned loans with assets that they themselves borrowed from DeFi protocols. Think of it as paying off the debt of a credit card with another credit card. This model worked during the bull market when asset prices ballooned, with the market cap of the crypto lending system reaching unprecedented heights of $110 billion in November 2021. Now, it is proving to be an unsustainable model, with many crypto lenders facing liquidation and struggling to pay off their debt.
More reading: