Cryptogram - 17 June 2022

Celsius crash: What you MUST learn from it

17 June 2022

In this issue

Hello, If we were the auspicious type, we would really wonder about the timing of the launch of Cryptogram and ask, what’s the fault with our stars? Ever since we started, we have been writing to you with bad news after bad news, even if only to help you make sense of it. As we write to you this Friday, we are all coming to terms with yet another phenomenal crash - that of crypto lending platform Celsius Network.

But good for you, we are the rational type. Team Cryptogram is yet again going to turn a terrible situation into a teaching moment for you. There is an important lesson amidst this billion dollar wealth meltdown: don’t lose control of your crypto assets in the hopes of “high yields” with idle money. Your keys, your coins.This week, we give you our honest take on the 15% interest rates offered by a few DeFi platforms like Celsius. This is going to get a bit heavy, so take your time with it.

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  EXPLAIN, PLEASE 

Demystifying the world of cryptocurrency

We usually start with The Big Story, but this week’s explainer is crucial to you understanding the lede piece, so we are going to begin with that. This week, we explain AUTOMATED MARKET MAKERS.Let’s say you have created an awesome new financial product. A new type of mutual fund or exchange-traded fund which can offer your customers great returns. What do you need first, to get going? A market. You need buyers and sellers, in a market, who use your financial product. But you are just starting out, and there aren’t enough “natural” buyers or sellers willing to use your product. So, you decide to give the market a jump start and some stability, and reach out to a few whales. These are high-volume investors who are convinced of your financial product, and are willing to pump in capital and use your financial product by quoting to buy and sell assets at the same time. This ensures that someone is available to buy or sell an asset if there are no natural buyers or sellers, and there is liquidity in the market. This liquidity ensures that the market is not too volatile, and when natural investors buy or sell, they can do so with relatively lesser risk of price fluctuations. For ensuring this stability through liquidity, the market makers are rewarded with profits from the spread between bid (buy) and ask (sell) price - they buy at a lower price and sell at a higher price. This is called arbitrage. That’s one of the ways brokerage firms made their money.

Before the 90s, market making was done manually by brokerage firms using manual trades. Then came the digital revolution in finance, and manual market makers were replaced by computer codes which could do this process automatically - Automated Market Makers. With crypto, we went one step further - Decentralised Market Making. Now, almost anyone can become a market maker. We will explain more about this in the lede piece below. 

THE BIG STORY

High-yield DeFi platforms, the crypto sandcastles

Time is money. Try leaving a stack of cash untouched for a year and see how much wealth has been eroded from it. An LPG cylinder that cost INR 750 in 2021 costs around INR 1050 now. That’s inflation working against you. So, the idea of letting idle money to work for you is a concept that has been preached for decades and is central to building wealth.  In Traditional Finance (TradFi), you can build wealth from idle money by just depositing it in the bank. Banks take deposits from customers at lower interest rates and lend that money as a loan to other customers and businesses who need money.  Some of the interest generated from those loans is kicked towards you. That’s how FDs work.The main difference between TradFi and Decentralised Finance (DeFi) is that banks get replaced by a computer code. Practically speaking, DeFi also made the markets a lot more participative - you don’t have to be a brokerage firm or big investor to be a market maker. Now think back to our explainer above on Automated Market Makers and arbitrage. With Decentralised Market Making in Decentralised Cryptocurrency Exchanges, even you can make money passively through arbitrage. You, along with several other strangers, can be market makers providing the crucial liquidity and stability to a crypto market. More than $40 billion is locked in DeFi currently.

YIELD FARMINGIn the crypto world, this way of making money passively is called “yield farming”, and there are several ways to do it.

  • As a liquidity provider: Users deposit two coins to a decentralized exchange (powered by AMMs) to provide trading liquidity. Exchanges charge a small fee to swap the two tokens which is paid to liquidity providers. This fee can sometimes be paid in new liquidity pool (LP) tokens as a reward too. 

  • As a lender: Coin or token holders can lend crypto to borrowers through a smart contract and earn yield from interest paid on the loan.

  • As a borrower: Farmers can use one token as collateral and receive a loan from another. Users can then farm yield with the borrowed coins. 

  • As a staker: There are two methods of staking in DeFi. The main method is on proof-of-stake blockchains like Cardano (ADA), where a user is paid interest to pledge their tokens to the network to provide security. The second is to stake LP tokens earned from supplying a DEX with liquidity. This allows users to earn yield twice, as they are paid for supplying liquidity in LP tokens which they can then stake to earn more yield.

Decentralised applications (dApps) like Uniswap are built with attractive features to make crypto investors use their dApps. Uniswap is an automated bank where users can buy and sell crypto from. It is built around pools of two tokens.But all of these methods work beautifully and generate great returns, until they don't. CELSIUS, LUNA, AND SANDCASTLESThat’s what happened with Celsius Network. They indulged in such “yield farming” practices, took investors’ money and promised fixed interest rates up to 18% an annum.To give a 18% annual return, a platform must outdo those in the open market with its investments. That means, usually, they take higher risk with customers’ capital. They will use some of the strategies mentioned above to earn yield. But when things go south, they go down pretty deep.We saw this with LUNA. UST was the stablecoin of the LUNA ecosystem. Luna promised 20% interest on US dollar-pegged stablecoins like UST, making it an attractive product advertised as virtually risk-free. But when markets began to shake, the mechanism to hold the token at $1 failed, leading to a death spiral and the failure of a $40 billion protocol backed by venture capitals like 3AC. This collapse has sent shock waves to the entire crypto ecosystem raising concerns on the so-called high interest yields that dApps aspire to offer. For Celsius, the problems began early on. According to data firm Nansen, Celsius was already exposed to LUNA collapse as they had invested upwards of $100 million into UST (with promise of high interest rates on stablecoins to its customers). Interestingly, they have reportedly (observed from their wallet accounts) contributed to the UST de-peg event by removing liquidity, although at a loss. Celsius also promised 6-8% interest on Ethereum (ETH) deposits. A lot of it is likely earned from the staking rewards on the proof-of-stake Ethereum Beacon chain. On the Ethereum Beacon chain (next new upgrade), the assets are completely locked up and no one can ‘unstake’ for now. So, Celsius has failed to isolate the risks associated with LUNA-UST collapse and also locked ETH in the beacon chain. As prices of crypto assets continue to drop, customers demand to withdraw their crypto in hurry. In this scenario, Celsius is facing a liquidity crisis, one in which price downtrend makes it harder and harder to match liabilities (the deposits) with assets (whatever the platform holds on chain). Hence, Celsius shut down crypto withdrawals this week.They were all building sandcastles in the air, and the average investors are having to pay for it now. Celsius customers are now unable to unlock their assets and are forced to hold on to a dropping knife. What’s worse is if Celsius is liquidated because of market conditions, customers will not be able to recover their assets.If you are one of those customers… 

There is a popular phrase among crypto old timers - “not your keys, not your coins”. When you allow a third party to access your crypto, essentially you partake of the control of it. And when things go wrong, it will go horribly wrong. Ironically, Celsius promoted this as their product peg initially.

That didn’t stand the test of time, did it? Many platforms and products that were popular in the 2020-2021 bull markets are struggling to stay afloat today. Logically, yields in a bear market like the one now, can’t exist. There is no way for a platform to support more than 10% interest rates on crypto.  As an investor, you must be modest about such expectations and take control over all your crypto assets. Reduce all counterparty risks and exposure to unproven DeFi products. Invest in custodial wallets (hardware wallet or software wallet) and store your assets safely.  When this bear market ends, the DeFi platforms that survive would ideally be the ones that were careful about their exposure and risks. DeFi will continue to evolve into a trustworthy giant in the future – but for now, your keys, your coins.

  THE TOP FIVE 

Stories from this week you cannot miss

So, that’s it for this week’s newsletter, see you next week!If you have any questions or feedback for us, write to us at [email protected]. You can check out the previous issues here.