Counterparty Risk

or Ugh, Celsius! Oh no, Voyager! Damnit FTX!

I have written previously about how I trusted the system. I trusted that the stocks that I purchased and were held in custody at my traditional brokerage were still going to be there when I wanted to sell them. I believed that the online crypto exchanges could be trusted in the same fashion. I am very sad to report that I was wrong.

I started writing this in September 2022, but was hesitant to discuss how much my losses are at these exchanges. This draft has been in limbo for months. I will share that it is ‘a lot,’ but have decided not to disclose amounts. I will say that what happened this summer has caused a lot of reflection, and financial and marital stress. FTX blew up this week, and even more people have been wrecked. If you read no further than this, please self-custody your assets.

Celsius hurt me, and I use that business name in my writing, but this point applies to Voyager, FTX, BlockFi, Gemini, etc.

Cryptocurrencies and digital assets are a new form of investment. This newness presents some perils. A peril that I have known existed, and I suspect you have as well, is the possibility of computer hackers. This risk is legitimate, and not negligible. I recommend using multi-factor authentication for your traditional platforms and different passwords for every platform. I anticipated this risk, and used multiple platforms to lower the risk of being hacked. All of the platforms I have used and have recommended have multi-factor authentication (this is superior to SMS message authentication because attackers can trick your cell service provider to send the messages to a duplicate SIM card). Also, I believe that in today’s world, a hack of an exchange is very unlikely. The companies are actively working to prevent this. The hacks that you hear about nowadays tend to be individual wallet or chain hacks/exploits, not hacking and withdrawing coins from an exchange.

A peril that I did not expect was that the platform would grossly mis-manage my crypto. In emergency medicine we sometimes talk about the unknown unknown. In other words, you don’t know what you don’t know. An example might be a nurse or midlevel not considering a spinal epidural abscess as a cause of a patient’s back pain. If you, as the health-care provider, do not know that such a problem exists, you will not look for it and will never find it in your patient. In summary, this is a product of training. If you are trained to think about these things, you are more likely to look for them.

I didn’t look for the counter-party risk of the company that I trusted to hold my bitcoin and ethereum and stablecoins would mismanage my coins and not have them when I wanted them back again. Sadly for me, this is precisely what happened to the assets I stored at Celsius.

To break-down Counter-Party Risk more plainly, essentially I was relying on another party to handle my coins. There is an old adage in the bitcoin space: “Not your keys, not your coins.” To my knowledge, this was started by Andreas Antonopolous years ago

, although perhaps he got it from someone else. What this means is that if you are not the person, and the only person, that holds the private key to your digital wallet, then you are inviting risk by allowing another party to do so.

I had heard of Mt. Gox being hacked in 2013, and thought that we, as a cyber-security industry, had advanced so much since then that such a large-scale hack would never happen again. Then, a few years ago, there was a Canadian exchange called Quadriga and the CEO was the only person that held the keys and he died/disappeared. I thought that Celsius, and Voyager, and BlockFi were big enough firms, with multiple employees, and licenses, and oversight that I was not at risk of these types of exploits.

All three of these firms are ones that I have used, and I had recommended them previously. They all had products where I could place my crypto into their custody, and they were lending it out, and paying me interest for storing the wealth with them. Each platform had various pros and cons. BlockFi had to settle with the SEC early this year because they used language that did not appropriately disclose the risk that the customer had. In a gross oversimplification, the SEC felt that the word interest was not allowed because the reward or yield was based on a riskier asset than the products in traditional banking. All of the platforms were careful to call the returns we were getting reward or yield after this although many platforms were calling it that beforehand as well. In retrospect, were these businesses selling unregulated securities? Certainly that is possible, I definitely was sold the idea that my assets were being lent out with no risk to me.

Celsius told its customers (us) that they were taking our coins and loaning them out to institutions that wanted to trade, but needed liquid capital. The story told us was that the borrower would post collateral that was worth more than what was borrowed. In theory, this protects the lender, because even if the borrower defaults, the lender has the collateral that was worth more than what was lent away. Indeed, Celsius customers could take loans against their crypto and get access to capital without incurring a taxable event. If I had sold my bitcoin at $69K, I would have paid capital gains on the difference from the original purchase price. Since I posted the bitcoin as a loan, and borrowed $USD, I did not incur a taxable event. I managed to time the peak pretty well, inadvertently, and entered into a loan agreement in Nov 2021.

Around April 2022, Celsius had grown to around $20 Billion in Assets Under Management. It seemed like a very solid lending platform. I interacted with some of the employees when I went to Bitcoin Miami 2022. I took a selfie with the Celsius CEO, Alex Mashinsky. It felt like we were at the beginning of the new wave of finance. The loan I took out was the fastest and easiest loan I have ever done. It took minutes, not hours. The platform of course knew what coins I had to post as collateral, and they wired $USD to my checking account. Of course, I no longer had access to the crypto, and I was no longer earning interest on the crypto, because it was now listed as collateral.

Bitcoin and other crypto are volatile assets. I was again comfortable with the price gyrations. I remain confident in the long-term success of Bitcoin. I can handle the short-term price fluctuations. These assets will remain volatile until a substantial majority of the population desires them. I do not have any idea how long that is going to take, but it is years, not months. I was not expecting the Terra/Luna ecosystem to blow up, or the effects of that to ripple across the digital space and wreck other institutions. That blow-up happened in early May. In early June, Celsius halted withdrawals. Voyager paused withdrawals in July. FTX started bankruptcy and contagion in November.

It may take months or years to fully understand how Celsius managed to lose or mismanage the crypto collateral, but there are a few unquestionable facts:

1- They do not have the assets that they claim they have, and have filed Chapter 11 bankruptcy to reorganize.

2- Right up until the withdrawal freeze, the company was reassuring us that everything was fine–The CEO did a weekly YouTube show on Friday where he said such things.

3- Celsius had staked coins into smart contracts on DeFi platforms and they paid all those back before filing for bankruptcy.

On a personal note: Celsius halted withdrawals as prices were falling such that I did not feel safe adding to my collateral. The loan had a liquidation threshold–basically if the value of the collateral I had given them became worth less than a certain dollar value, the loan was terminated and they kept the collateral. I was aware of this when I initiated the loan, and knew that the prices were moving towards the margin threshold, where the platform wanted me to add collateral towards my loan. This would have looked like transferring in more crypto. In real time while this platform had locked withdrawals I was afraid of ‘throwing good money after bad’ and I was not comfortable adding collateral to my loan. In retrospect, I believe this turned out to have been the best course of action.

I spent weeks upset that Celsius had taken my bitcoin. To be fair to them, they took it in accordance with the rules I had agreed upon when I initiated the loan. But I was sad that I lost the bitcoin. I did spend the $USD on real estate, and could not rapidly get the $USD back. If I did, or if I had the $USD today, I actually could have bought back the bitcoin at a lower price, and would have been able to lower my cost basis for the bitcoin. Alas, I didn’t have a pile of cash.

Remember the DeFI thing from a couple of paragraphs back. Distributed Finance or Decentralized Finance is ‘the new finance,’ which creates ecosystems of borrowing and lending capital based only on math and code. Ethereum and other smart contract cryptocurrencies allow conditional execution events to occur. In DeFi there are not greedy/corruptible humans making bad decisions, there is only code: If this, then that. This is why Celsius had to close all their DeFi positions. They were not able to negotiate with anyone to try and get a better deal after the deal had been struck (ie the code had been written). (Be careful, because sometimes there ARE greedy humans creating the cryptocurrencies.)

Traditional finance (TradFi) is being challenged by technological innovation (FinTech). DeFi is the future of finance, but right now we are still in the Wild Wild West. DeFi is FinTech on the blockchain. Celsius promoted themselves as CeFi (Centralized Finance), where they were acting as a bridge into the world of DeFi. Personally, I had heard of 20%APY or more returns in DeFi, but didn’t have the time to learn about all the different protocols and risks and rewards. I was trusting Celsius to do this for me. They got to take a cut (Celsius advertised that they took 20% of the profits and gave 80% to the customer). I was good with this arrangement.

In the bankruptcy filings, Celsius has released documents suggesting they have dramatically less crypto than they are supposed to have on behalf of their customers/depositors. As of now, it appears they have somewhere in the 20-40% range of what they are supposed to have to give back to customers. 😢 My own personal silver lining here is that I have a new asset instead of 20-40% of the bitcoin that was used in that loan.

Back to Counterparty Risk and Not your Keys, Not your Coins. After Celsius paused withdrawals, I started pulling assets from all the other platforms. Unfortunately, Voyager lowered their daily withdrawal limits, and I was not able to get all my crypto off Voyager’s platform before they also paused withdrawals.

Voyager didn’t wait as long to file for bankruptcy protection after they halted withdrawals as compared with Celsius. I can only presume that this is because they are publicly traded and were more responsible(?!?) than Celsius. I say that somewhat incredulously because it appears Voyager gave Three Arrows Capital an unsecured $650Million loan. This is an egregious level of risk that should have been managed by corporate counsel or the investment department.

These two platforms have taught me a painful and expensive lesson in counterparty risk. Bitcoin was the first asset created that essentially eliminates counterparty risk. The OG bitcoiners have been saying for years to get your coins off exchanges: Not your keys, not your coins. You can put your bitcoin into a wallet and no one can take it from you.

I am telling you all this, not because I want you to feel sorry for me. I am telling you so you don’t have to experience this pain. In retrospect, I put my crypto at risk to earn around 5% interest per year, but in reality I may have lost 100% of it. At this point, I have no idea how or when I will get any of the assets I held at Celsius and Voyager. In the 20/20 vision of hindsight, the risk is not worth it. Unfortunately, the early reporting is that FTX may have even more customers than Celsius, and has lost even more of their assets. 😢 😢 😢

So please, friend, learn about self-custody. Trezor and Ledger are the two most popular hardware wallets. You will not go wrong with an investment in one of these. You can also use paper wallets and hot wallets, and you can use a combination of all of these. Protect your seed phrase or your private key. Record it somewhere safe. There are numerous online guides for this. Read more than one. Here's a comprehensive one from CZ at Binance.

Another lesson from this is the immutability of DeFi. That code is going to execute if the parameters are satisfied. No human is there to mess with it, or change the terms, or make bad decisions after the fact. DeFi doesn’t have the best user experience/interface right now, but that is a matter of time and programmer energy. Those things will improve.

I think the self-custody thing sounds imposing. It's just another facet of understanding Bitcoin. I have learned this lesson the hard way. I really hope you do not. Take your time and do the work, and get your crypto off exchanges.