From Celsius to Three Arrows Capital, major industry players have lost to the 2022 crypto crash. Although the market appears to be stabilising now, the cascading effect of the LUNA/UST crash is still being felt by companies today.
Previously, Zipmex announced on July 20 that customers wouldn’t be able to withdraw their crypto holdings until further notice. The company cited reasons “beyond its control” such as volatile market conditions and the resulting difficulties of key business partners.
While it’s true that Zipmex couldn’t have predicted the market volatility, it certainly could’ve been better prepared for it. In reality, it’d seem the platform’s difficulties are a result of mismanaged funds — a decision which Zipmex was always in control of.
To understand this, let’s connect the dots between Zipmex and the LUNA/UST crash.
Key problem: over-leveraged positions
At the beginning of the LUNA/UST crash, crypto lending firm Celsius was heavily exposed to a token called Lido Staked ETH (stETH), which had its value pegged to Ether (ETH).
The company accepted ETH deposits from its client and staked them in exchange for stETH. These deposits offered an interest rate of around four per cent. Next, Celsius used the stETH as collateral to borrow more ETH. Finally, the ETH was staked in exchange stETH, and the cycle would repeat.
To illustrate, say you have 100 ETH, which you stake in exchange for 100 stETH. At this point, you can expect a return of 4 ETH per year.
Next, you use the 100 stETH as collateral to borrow 70 ETH, and stake that as well. Now, your return goes up to 6.8 ETH per year. You also receive 70 stETH which you can use to repeat the process.
By doing so over and over, you take on an increasingly leveraged position. This is how Celsius was able to offer high returns to its clients for their ETH deposits.
As one might expect though, as leverage increases, so does risk.
Going back to the example, you currently have a loan of 70 ETH collateralised by 100 stETH. The loan issuer maintains that at any given point, your loan can’t be worth any more than 80 per cent of your collateral.
So, if the value of 100 stETH were to drop below the value of 80 ETH, you’d either have to top up your collateral, or your position would be liquidated. If you were leveraged further, it’d become even more difficult to maintain your position, because you’d be required to top up a larger amount in case of volatility.
Celsius’ position was contingent on the stability of the peg between ETH and stETH. The company didn’t hedge against a scenario where this peg would be broken.
As it turns out, that’s exactly what happened. The panic resulting from the LUNA/UST crash caused stETH’s value to drop below that of ETH. If Celsius didn’t provide enough collateral, its entire position would be liquidated, meaning the company would lose a significant portion of its clients’ funds.
This forced Celsius to halt withdrawals. Since the platform was using its funds to hold on to an over-leveraged position, it no longer had the liquidity to fulfil withdrawal requests from its customers.
On July 13, Celsius announced that it had filed for bankruptcy.
This example of overleveraged trading isn’t a one-off case, nor is it limited ETH/stETH. It’s the key reason behind the cascading fall of crypto firms, which we are seeing today.
How does this tie in with Zipmex?
Zipmex offered its users annual rewards of up to 10 per cent on crypto deposits. The company generated these rewards by loaning the crypto out to other platforms.
At the time of the LUNA/UST collapse, Zipmex had lent out US$48 million to Babel Finance and US$5 million to Celsius. Both companies were exposed to over-leveraged positions, as a result of which they were forced to freeze withdrawals when the market crashed.
Zipmex, now unable to collect on these loans, was forced to freeze withdrawals as well. As it stands, the company has written off its loan to Celsius, but is working with Babel Finance on recovering customer losses.
The market crash has brought to light the interdependency between different firms in the crypto space. The collapse started with large companies managing billions in funds, and now the consequences are spiralling down to smaller firms which had invested with them.
How can retail investors avoid such risks?
By asking the right questions.
If a crypto exchange is offering 15 per cent interest rate on a coin, where are these returns coming from? It’s important to realise that while crypto can offer attractive investment opportunities, it doesn’t generate money out of thin air.
With centralised exchanges — such as Zipmex — it’s not always clear how your holdings are being used for further investments. As apparent over the last month, this creates the risk of inaccessibility if the company faces liquidity issues.
To ensure your funds are protected, it’s best to use an exchange which is regulated by the Monetary Authority of Singapore (MAS). While a lot of crypto exchanges are based in Singapore, many haven’t been licensed yet and are only operating under exemption.
Buying crypto through a licensed exchange ensures that you can seek legal recourse if the company mismanages your funds.
Using decentralised wallets and managing your holdings personally is another option.
From a long-term industry point of view, most DeFi builders, advocates and commentators actually believe that the breakdown in centralised platforms is a bull case for DeFi, where users want self-custody of assets. As the saying goes, ‘not your keys, not your assets’.– Imran Mohamad, Head of Marketing, Kyber Network
Lending crypto and earning interest through DeFi protocols allows you to be fully aware of the risks you’re taking on and prevents losses stemming from third-party mismanagement.
Decentralised exchanges (DEX) allow users to earn returns for providing liquidity. For example, say you deposit your ETH and USD Coin (USDC) holdings in a liquidity pool. Whenever someone converts between the two cryptocurrencies using the DEX, you’ll earn a portion of the transaction fees which they’re charged. In this case, it’s very clear where your returns are coming from.
“These are organic, sustainable, and are not guaranteed,” explains Mohamad. “You would see some of these pools with less than one per cent APRs and some with more than 100 per cent APRs, and these occur due to the supply and demand of the market, not propped up by outside funding.”