Obfuscation, Rehypothecation, Capitulation: Monday’s Volatility — VegaX Flash News Report June 2022
There is a saying in the digital asset space along the lines of
“If you cannot determine the source of the yield that you’re receiving, then YOU are the yield.”
Similarly, in poker, the saying goes that if you sit down at a table, and are unable to determine who the “sucker” is within 15 minutes, the sucker is you.
These adages are not being shared to scare our readers, but rather to illustrate a consistent point across poker, investing, and the life: if something seems too good to be true, it is.
This piece will attempt to cover the many aspects contributing to Monday’s capitulation in the digital asset, equity, and credit markets. As VegaX is a digital asset investment firm, we will frame our analysis through the lens of the digital asset industry but will touch on factors/situations in other markets for broad contextualization.
The Rehypothecation Shell Game
Investopedia defines rehypothecation as “a practice whereby banks and brokers use, for their own purposes, assets that have been posted as collateral by their clients.” Generally speaking, financial institutions rehypothecate client funds if they believe they can generate additional income in a safe manner while keeping liquidity levels high enough to honor redemption requests. The last part is crucial: you can have an edge in the market, but if you are leveraged — and a rehypothecation is a form of leverage — your position is at the mercy of liquidation factors, redemption requests or even outright bank runs.
The article goes on to note that, since this is an inherently risky practice, clients must permit a bank/brokerage to rehypothecate their funds and the firm would offer a lower cost of borrowing or rebate on fees. Rehypothecation was a common practice until 2007, but hedge funds became much warier about it in the wake of the Lehman Brothers collapse and subsequent credit crunch in 2008–09.
Those who remember the global financial crisis of 2008–09 might see similarities between the systemic risk of sub-prime mortgages (rehypothecation of collateral) and recent catastrophic meltdowns in the digital asset space. It comes down to appropriate risk management, and in the case of Celsius, many in the industry have been trying to inform the public of Celsius’ lack of transparency for some time.
In a CoinDesk article from July 2020, Celsius founder Alex Mashinsky was quoted as saying that the firm “does not do non-collateralized loans…. Celsius will not do that because that would be taking too much risk on your [clients] behalf.” Later in the article, Anastasia Golovina, a spokesperson for Celsius at the Ditto PR agency, confirmed the company does indeed make uncollateralized loans: “Celsius’ total uncollateralized loans are less than a fraction of 1 percent out of tens of thousands of loans issued since 2018.”
Critics of Celsius’ unsustainable yields and lack of transparency to their users have also cited that Celsius’ terms of use stipulate “you grant Celsius the right … to pledge, re-pledge, hypothecate, rehypothecate, sell, lend or otherwise transfer or use any amount of such Digital Assets … for any period of time.” That’s not all — Celsius has, at times, even been known to rehypothecate user deposits and/or borrower collateral for hyper-risky operations such as perpetual future swap contracts.
Illiquid or Insolvent?
Celsius works in much the same way an ordinary bank or brokerage does but deals solely in digital assets. The firm collects deposits from users seeking yield on their assets and collects collateral from borrowers looking to leverage their positions. An advertisement on Celsius’s site as of this writing offered an 18.63% APY on crypto deposits. However, unlike a bank, Celsius doesn’t have FDIC government insurance that protects people in case of a bank failure.
Based on the warning signs outlined above, it should come as no surprise to savvy readers that late Sunday evening, Celsius announced in a public memo that it would be pausing all user withdrawals for the time being. In the memo, Celsius said that the company’s “ultimate objective is stabilizing liquidity.” It did not give a date for when customers might expect to be able to withdraw again, warning that “this process will take time, and there may be delays.”
The staking, the lending platform is now in muddy waters as chain-watching market participants claim that the company unstaked $247 million worth of Wrapped Bitcoin from DeFi lending protocol Aave and sent it to FTX exchange. Those looking into on-chain addresses also alleged that apart from moving WBTC, Celsius has also moved 54,749 Ethereum worth $74.5 million to FTX — more than likely to be sold in an effort to curtail the firm’s liquidity crisis.
On top of all of this, Celsius is suspected to own a ~$278m leveraged position of the stablecoin DAI on the Maker protocol. The position is collateralized with 17,919 WBTC and is at risk of liquidation if the price of bitcoin falls below ~$17k.
Suboptimal Business Model
Amid the chaos following the release of Celsius’ public memo, rival lending platform Nexo issued a statement early Monday morning announcing that the firm had contacted Celsius’ management team with a Letter of Intent to purchase some or all of Celsius’ outstanding collateralized loan receivables. While this sort of capitulation would be utterly embarrassing and likely end Celsius, it is a brilliant strategic maneuver for Nexo.
At first glance, it appears that Nexo is “kicking Celsius while they’re down,” however, this proposed acquisition might be the only chance that Celsius’ users have to recuperate their deposits or collateral positions. From Nexo’s point of view, this move would spare retail investors from maximal pain, reduce bad press at an industrial scale, and best of all, would allow Nexo to absorb the majority of its rival’s client base.
In the public memo, Nexo states that its “underlying sustainable business model has allowed it to maintain financial stability in any market circumstances and as a result, the company is in a solid liquidity and equity position to help mitigate the consequences of Celsius’ distressed state.”
Let’s review how Nexo’s business model differs from that of Celsius. To start, Nexo makes every effort to be transparent with the source of their lending yields and with the solvency of their reserves.
The firm’s website links to another platform called TrustExplorer where anyone can at any time download an attestation of Nexo’s reserves (updated on a daily basis), which is completed by third-party accounting firm Armanino. Unlike Celsius’ management team, who appear to be either disorganized or malicious in their obfuscations, Nexo’s management is transparent as to where their yields come from. Along these lines, in a Cointelegraph article from May 2022, co-founder and executive chairman Kosta Kantchev stated with reference to yields on his platform “the eyebrow-raising rates are often available either with Nexo Tokens through our loyalty program or for some of the newer coins for which we can generate such impressive yield.”
With the digital asset industry in a relatively nascent stage, a firm’s reputation is crucial to its long-term success — and we are currently seeing a scenario play out with firms at both ends of the reputational spectrum. Where Celsius is scrambling to remain solvent, Nexo is positioned to potentially be a lifeboat for affected users. Note that Nexo’s offer to purchase outstanding loan receivables does expire on June 20th at 7 AM UTC.
DeFi: State of the Market
Near record-breaking inflation numbers, strained supply chains, and an array of public DeFi disasters have led to widespread uncertainty in the digital asset markets. While cryptocurrencies still remain correlated to traditional financial markets, the $45bn collapses of Terra sent shockwaves around cryptocurrency markets and proliferated wider sell-offs across numerous digital assets.
The current landscape is composed of innovative projects that provide decentralized capabilities to earn yield, invest and spend funds all while managing your own private keys. The majority of these innovations are brilliant in theory, but during tumultuous times or drastic market downturns, the cracks in these theories are revealed. The issue with the majority of unsustainable protocols is their lack of solving for necessity and instead focusing on replication.
Recently, TRON’s algorithmic stablecoin, USDD, has suffered a de-pegging event and is currently hovering around 98 cents. USDD is a carbon copy of Terra’s infamous UST which has investors and researchers fearful of the ramifications if USDD were to plummet in value similarly UST. TRON founder, Justin Sun, has deployed over $650m USDC to defend the peg but ultimately a metaphorical run on the bank may already be unavoidable.
Ethereum currently has roughly 65% market dominance over DeFi with other chains like Binance Smart Chain, TRON, Solana, and Avalanche lagging further behind. Ethereum is still the most expensive chain to engage with due to its high gas fees, yet has managed to retain a robust share of the market. This is due to innovations built on Ethereum such as Compound, AAVE, Lido, Maker, Uniswap, and dydx. These protocols empower users to jump hurdles that were previously impossible and have made the transition to DeFi a seamless experience. The future of decentralized finance is contingent on more groundbreaking innovations in a number of institutional-focused categories — Lending and Borrowing, Structured Products, Derivatives, and Cross-Chain Infrastructure. While the current state of the DeFi market may look bleak, there have already been some groundbreaking protocols released in beta that have the potential to onboard traditional financial institutions.
The Macro Storm
The capitulation seen in the digital asset markets Monday was not unique, similar moves in the global commodity and equity markets were uncorrelated but similarly painful. Throughout 2022, long-time asset managers and macroeconomic analysts have cited geopolitical conflicts, stressed supply chains, excessively volatile weather patterns, and frantic central bank policies as catalysts for consistent market downtrends.
In a public post on substack, Quadriga Asset Managers Managing Partner, Diego Parrilla shared his firm’s thoughts on the current macroeconomic horizon. He notes that in the immediate short term, in the face of rampant inflation, central banks have no choice but to raise nominal rates. However, given that the global financial system is increasingly a system of interconnected risk, Parrilla does not believe that the Fed will be able to curtail demand levels AND manage to not “spook” markets, generally speaking. Something’s got to give, as the saying goes, and Parrilla believes that credit markets will invariably be stressed as a result of quantitative tightening.
Quadriga’s Managing Partner concludes his thesis by proposing that real rates (nominal rates minus inflation) will remain negative for the foreseeable future — Monday’s sell-off in the bond market seems to agree with Parrilla’s thesis, as the US 10yr rate jumped to 3.39%, the biggest single-day move since March of 2020.
In the US, the change in YoY inflation is a product of a basket of goods and services, but a lesser-known fact is that this basket is not static, in fact, governments across the globe routinely manipulate the components of baskets to reflect a more positive outlook. From a US point of view, a more accurate indicator of economic sentiment is the University of Michigan’s Consumer Sentiment Index — which recorded an all-time low this past Friday. Investor Lyn Alden notes that consumer sentiment and equity prices both tend to front-run official recession periods, which are declared in hindsight.
Conclusions
These are precarious times: investors all over the world are selling assets at a loss in order to cover margin calls, operating costs, and even daily expenses. Some of the pain is avoidable: with regard to the contagion in digital assets, there were clear indications that Celsius was rehypothecating user deposits and borrower collateral into extremely risky endeavors. This is an opportunity for those burned to learn from this painful episode, additionally, for the digital asset community to come together and more aggressively call out those protocols that are effectively ticking time bombs.
What’s more, the macroeconomic landscape continues to look bleak. Deeply negative real rates driven by central banks’ unsustainable monetary policy and rapidly collapsing global supply chains are concerning regardless of one’s tenure as an investor. However, there are steps one can take to insulate one’s portfolio as much as possible.
In large part, this protection comes from putting the requisite amount of effort into due diligence processes when making investment decisions. As we’ve seen with the TerraUSD/LUNA and Celsius implosions, understanding the source of an investment’s yield may be more important than the amount of return promised. Rest assured that at VegaX, we take our time when constructing investment products, making sure that our clients’ principal is safe while sourcing yield in a sustainable manner. We are committed to putting our clients’ interests first, providing thoughtfully designed products and high-quality educational material.
Thank you for reading, we hope this piece was informative and that your portfolio is in good hands. If you are looking for a good-faith investment solution provider, head over to our website https://vegaxholdings.com/ and check out our offerings.
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