Reliable, secure, on-chain self-custody of funds will help drive market maturity in the digital asset space. One hopes that this conversation is one for the bygone era of Mt.Gox and Quadriga-esque tomfoolery and fraudulent nonsense. Yet, the disintegration of some of the best adopted and most prolific CeFi crypto platforms has shown the need for discernment on the user’s side has never been greater. Platforms that leverage secure self-custody solutions leave their users provably reassured that their funds are theirs, and only theirs. Responsible disclosure of positions ensures user confidence that their deposited funds aren’t being used to buy into highly leveraged positions by firms basically incapable of professional risk management. The industry currently needs to rebuild investor confidence in light of the very possible sale of retail funds to cover irresponsible financial decisions, such as those made by one of the most prominent CeFi crypto companies, Celsius.

Planning for Bear Markets - Expecting the Expected

Designing systems that can withstand all market conditions is a reasonable aspiration. At a minimum, we must build solutions which don’t break when the market isn’t consistently going up. There are a plethora of projects in DeFi that aren’t designed to elegantly weather a liquidity crisis. Some of the most popular and best capitalized projects have been designed to only be viable so long as the market moves up and continues to do so, as was the case with Terra Luna; the implosion of which we wrote about recently

While not quite as self-referential in its value proposition as Luna, Celsius purported to offer its users yields as high as 18% APY, paid weekly (apparently market conditions withstanding). As of May 2022 Celsius held over $11 billion in customer funds. Celsius recently made a series of decisions which suggest they are insolvent, with reports of their legal counsel suggesting they file for chapter 11 bankruptcy. While Celsius are of course not alone in suffering during a bear market, it is remarkable that they appear to have mismanaged risk catastrophically. There is rampant speculation that Celsius have been selling their stETH holdings. If such speculation is true, then Celsius have indeed made some poor decisions; decisions any discerning user would not have bought into had their positions been made public. 

If a user deposited their funds with Celsius (regardless of whether or not they were in “earn” mode accruing interest) then they had agreed to be legally treated as “unsecured creditors”. Depositing funds into an account with Celsius is functionally indistinguishable from loaning them the money. In contrast a “secured creditor” would be someone who is owed money while the borrower has some collateral, which can be used to compensate the lender in the worst case scenario. Loans to unsecured creditors usually involve higher interest rates than those to secured creditors, since they carry more risk. 

In the event that a company goes bankrupt, they will prioritize refunding their secured creditors over their unsecured creditors. Even if this isn’t something the bankrupt firm intends to do, they will have their hand forced by repossession agents coming for whatever collateral is available. Unsecured creditors are, almost definitionally, the last priority of firms settling accounts following filing for bankruptcy. This is not least because they do not have any claim on the assets of the borrower.

On June 12th Celsius stopped allowing customers to withdraw their funds. In a “memo”, a blog post on Medium, Celsius announced that they would be pausing all withdrawals, swaps and transfers between accounts (though customers would still continue to accrue rewards, despite their eventual redeemability certainly being in doubt). The stated reason was that Celsius would be better equipped to “honor, over time, [Celsius’s] withdrawal obligations”. It might be prudent to read this as something closer to “in the unlikely event that we have any of your money left over after paying the people that we actually have legal obligations to, we might consider throwing you a bone, though you probably shouldn’t count on it”. 

“Not your keys, not your crypto'' has been an adage of the crypto community for a decade yet there have been few experiential lessons, as painful as those of Celcius’s customers, motivating this wisdom. More than a million people use, or used, Celsius. Needless to say, Celsius is not insured similarly to retail banks in the U.S., which are insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC was created during the Great Depression as a means of encouraging trust in the banking system. If the bank loses money you’ve deposited then the FDIC will make you whole once more (up to $250k). Despite Celsius’s branding decisions and unfortunate tweets comparing themselves to banks, this is a rather inconvenient differentiator. 

Celsius had major exposure to stETH, an ETH derivative issued by Lido. stETH is issued on the basis of a one-to-one backing with ETH, which has led a surprising number of industry participants to call this a ‘peg’. It is nothing of the sort. There is no mechanism enforcing the price of ETH to be that of stETH. There are sensible arguments to be made that stETH should trade at a discount relative to ETH in virtue of a delay before redemption is possible. Holders of stETH, via Lido’s liquid staking solution, are afforded a liquid token (stETH) that they can use while their ETH is staked on Ethereum’s Beacon Chain and earning validator rewards. Celsius was among Lido’s largest clients, taking user deposits of ETH and depositing them with Lido, while passing on a portion of the validator rewards (yield) onto users. It is quite possible that through this strategy Celsius exposed themselves to a risk: should stETH stop trading one-to-one with ETH then this practice of passing rewards on becomes untenable. If Celsius sold large quantities of their stETH position, they would push the value of stETH down further and put themselves in an even worse position. Hence any sale of stETH is a major concern. 

There has also been speculation that Celsius had positions on Anchor protocol (of UST  infamy), which would explain how they were able to, even temporarily (in a bull market), offer users yields of ~17%. This position likely cost them severely and should have been considered a massively risky position with proportional corresponding hedges. While Celsius were unfortunate to lose tens of millions of dollars in a couple of high profile security incidents, the above speculation is sufficient to motivate significant skepticism of the team’s professionalism and competence. Further, holding hundreds of millions of dollars worth of positions in BTC and having them at risk of liquidation in market conditions not exactly unusual for crypto is similarly discrediting, at least insofar as it pertains to Celsius’s possible insolvency. 

The Path Forward

Irresponsible rehypothecation of retail user funds does not have a place in the long term future of the digital asset markets. Ensuring users have custody of their funds is critically important since it removes the need to trust a third party with one’s funds, instead the business logic is visible on-chain for anyone to see. Third party security audits of these contracts are also a significant step in the right direction. All that said, the correlation between risk and potential reward needs to be understood by the end-user and Celsius’s presenting as a bank served to underrepresent the risk users were taking, to put it politely. 

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