Crypto End Game Goes Through DeFi’s Black Box

An already dire situation in the cryptoverse took another ominous turn Saturday, when Bitcoin dropped below $20,000 for the first time since 2020.

A abrupt downward lurch saw “digital gold” trade near $18,700, with a market cap of around $361 billion. At the highs in November, Bitcoin’s market cap was $1.27 trillion.

Saturday’s swoon was the 12th straight on Bloomberg’s data, according to which Bitcoin is mired in its worst streak of daily losses on record. Of course, pricing varies across platforms, which in some cases means unequivocal statements of “fact” aren’t possible in crypto. Regardless, the move below a psychologically significant round number marked the latest blow to sentiment after a week full of them.

Notably, ~$20,000 was the high point during Bitcoin’s breathtaking 2017 ascent (figure below). So, we’re back to the bubble peak seen just before 2018, when Jerome Powell took the reins at the Fed. By the end of that year, the combination of rate hikes and balance sheet runoff pushed equities to the brink of a bear market and contributed to considerable consternation in credit, not unlike what’s happening right now in traditional assets.

Bitcoin is down around 30% this week alone, bringing the drawdown to 72%. It’s traded every bit like the risk asset it is during this year’s broad market malaise.

It’s important to note that the stakes are much higher this time versus previous “crypto winters.” Tentative adoption by institutional investors, the proliferation of crypto hedge funds and a mania in alt-coins, let the proverbial genie out of the bottle.

Meanwhile, the rapid construction of a multi-hundred-billion dollar ecosystem around Ethereum created a mind-boggling array of cross-holdings, which I suggested in March would be impossible to disentangle when the dominoes started to fall.

Market participants got a preview of that in May, when TerraUSD, a popular algorithmic stablecoin, lost its peg, dragging Luna, its floating balancer token, into oblivion. That shook the decentralized finance (DeFi) ecosystem to its core. I’ve argued that ecosystem is now in the process of imploding.

Ethereum, which functions a bit like DeFi’s reserve currency, fell below $1,000 on Saturday (figure below).

Its market cap has collapsed from $570 billion in November to just $130 billion. If you’d bought at the highs — or, relatedly, sold something for Ethereum in November but didn’t convert the proceeds to dollars — you’ve lost 80%.

Ethereum’s ongoing collapse is very significant for reasons that aren’t well understood by the vast majority of casual market watchers.

Although DeFi isn’t synonymous with Ethereum, it’s entirely fair to say that on a day-to-day basis, DeFi sentiment is by and large a function of Ethereum’s price and the assumed stability of stablecoins. If the former is falling rapidly and the latter isn’t a given, it’s a problem.

A broad measure of the dollar value of bets across DeFi platforms and protocols stood at $71 billion on Saturday (figure above). That’s down from a peak of $250 billion.

The red dot gives you some context for the most recent value destruction, vis-à-vis that triggered by Luna’s collapse and the associated selloff and panic withdrawals (pink dot).

In the figure (below), the first shaded area corresponds to the collapse of Terra Luna. The second is a function of the current selloff across crypto and the panic associated with the Celsius problem.

Again, note that the charts are in dollar terms.

The Celsius story, even more so than the Terra debacle, is the quintessential example of the underappreciated risks embedded in DeFi. Last week, Celsius suspended withdrawals, swaps and transfers citing “extreme market conditions,” a decision that contributed to the rapid deterioration in crypto sentiment seen over the past several days.

Celsius’s problems speak (loudly) to my contention that the labyrinthine nature of DeFi and the impossibly convoluted network of underlying cross-holdings makes the entire ecosystem seem like a black box full of dynamite.

In essence, users staked their Ethereum (I’ll switch to “Ether,” to separate the coin from the chain) on Celsius to earn interest, and Celsius deposited that Ether with another platform, Lido, in exchange for a higher yield and another token, “staked Ethereum,” or stETH.

I implore you: Stick with me. This is tedious, but it’s just as important as it is laughably absurd. Even if you don’t think you’d be affected by the implosion of Web3’s attempt to replicate Wall Street, you’ll nevertheless get an incredulous chuckle out of the sheer blatant audacity inherent in the setup.

In theory, stETH is redeemable one-for-one with regular Ether upon completion of a wildly-hyped upgrade during which Ethereum will transition to a more energy efficient system for transaction ordering by merging with the proof-of-stake “Beacon Chain.”

Whenever transactions are enabled on Beacon, Lido users can redeem their stETH for regular Ether along with their accumulated rewards “directly,” as Lido puts it. In the meantime, that stETH is transferrable and tradable, which Beacon-chain Ether isn’t.

So, as is the case with tokens offered by a number of other DeFi platforms, Lido’s stETH can be traded and lent across the ecosystem. You stake your regular Ether with Lido, receive stETH (and yield) while you wait on “the Merge,” and in the meantime, you can deploy that stETH to earn still more yield. Lido spells this out. One of its “goals” for stETH is to create “a building block for other applications and protocols [including] as collateral in lending or other trading DeFi solutions.”

Let me emphasize: That self-referential dynamic is pervasive in DeFi. Lido will tell you all the ways it’s different, but the larger point is that there are myriad platforms which allow users to “deposit” one coin in exchange for yield and another coin, which is itself tradable and can be used as collateral elsewhere. It’s like shadow banking, only with Chuck E. Cheese tokens.

Celsius allows users to deposit funds, which it then stakes across a variety of other DeFi protocols. It arbs the difference between the yields it earns from those staked positions (and, one assumes, any trading activity and knock-on lending and staking) and what it pays out to its own depositors.

Researcher Nansen identified a wallet it says belongs to Celsius. That wallet appears to show hundreds of millions of stETH as collateral for stablecoin loans denominated in USDC, the fully-reserved token widely viewed as the safest stablecoin in all of crypto.

This week, stETH began trading at a discount to regular Ether. That discount was around 6% on Saturday. If loans across DeFi are collateralized by stETH, that collateral could be liquidated forcibly, driving the price still lower. The longer the “the Merge” is delayed, the more problematic this could potentially become.

stETH isn’t actually “pegged” to Ether, but the assumption of a generally stable 1:1 relationship likely underpins all manner of borrowing and lending across DeFi, just as the assumption that TerraUSD was 1:1 to US dollars was accepted as a given. By some measures, stETH accounts for a third of all staked Ether. If Ether is falling rapidly (which it is) and stETH’s discount to Ether is widening (which it was), the implications for layer upon layer of rehypothecated ETH, WETH and stETH collateral are potentially momentous. And that’s to say nothing of the sentiment hit for other coins generally associated with Ether selloffs. Those coins are likewise staked, locked, deposited, pledged and re-pledged.

Not to put too fine a point on it, but there’s an elevated chance that the kind of domino-style collapse I’ve predicted unfolding over 12-24 months is unfolding right now. Just days before Celsius suspended withdrawals, I again cautioned investors that DeFi is a house of cards. And a wobbly one at that. The Celsius drama, the Lido connection and the unfolding margin call on Three Arrows (one of the world’s largest crypto players), are emblematic.

In my opinion, it’s just a matter of time before this black box explodes. The self-referential dynamics described above are a feature of DeFi, not a bug. It’s a labyrinth of leverage built on nothing.

Imagine a totally opaque, global rehypothecation scheme where the vast majority of the collateral is worthless, not because the assets went bad, but rather because they were never assets in the first place.

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