Greed vs Risk. Celsius and Three Arrows Capital

Yikes Y'all. What an awful month we have experienced in the Crypto Market, and also the stock market as well. I have been trying to gather up all the information I could about what happened to cause such a dramatic drop in prices, as well as the conditions at Celsius. I have previously been a proponent of Celsius. I have a considerable amount of my personal portfolio at the company. In case you were not previously aware of the company, essentially you could store your crypto assets at Celsius, and they would lend it out to other people, earn a return on what was lent out, and pay you the return. This is what the large traditional finance houses do as well (Fidelity, Schwab, JP Morgan, etc). The traditional finance, the institution holding stocks in my 401K is lending out my stock to traders, and I do not get any return or benefit from that. When you borrow or trade on margin at these brokerages, you are using shares owned by other people until you cover or close that position. I thought Celsius was doing this same thing, but sharing the benefit with me. In theory, Celsius was using the same sort of risk management for this lending that the traditional finance houses did. I may be wrong, but I do still think that was the original mission, and that Celsius probably DID actually do this.

​ De-Fi is Decentralized Finance. Basically think of this as software-based asset pools. There are algorithms and ratios to let you do something like stake 100 units of token Y and borrow 80 units of token X (or sometimes even token Y). You could also place your assets into the pool without withdrawing any, and earn yield by simply putting them into the pool. On this side of the equation, you are supplying liquidity to be the market maker.

However, it seems that Celsius probably did more than this. They also placed some of the crypto stored with them into DeFi pools to earn yield. This isn't necessarily wrong. But they may have taken undue risk by doing some Recursive Borrowing. Here is an example. Take 1 Ethereum and stake it at Lido. You are given 1 stEth (staked eth). You then take that stEth and place it into a lending pool at Aave, which will let you borrow 0.8 Ethereum against that 1 stEth. Then you take your newly borrowed. 0.8 Ethereum, and stake it at Lido, get another 0.6 stEth out, place that over at Aave again, get out 0.4 Ethereum and so on. Now, you can understand that if the price of Ethereum were to drop, you may not be able to pay back or add collateral to those loans at Aave. Ethereum peaked just under $5,000 last fall, and dropped to $2000 recently, and then down to $1100 this week. It is not difficult to imagine that people or institutions using leverage on their position would have a difficult time covering their margin calls.

Ethereum is probably a fine protocol. It is certainly the cryptocurrency with the most financial transactions. I know there are a lot of Bitcoin Maximalists that think everything other than Bitcoin is garbage, but I am not of that mindset--at least, not yet. However, I will say that this recent price crash has me reconsidering my position. For the time being, though, I think we can live in a multi-coin future. I am typing this to you on my Mac computer. I grew up gaming on and building Windows PCs. I think Linux is a fine operating system. Even though MOST of the world uses Windows, we now have a lot of computers using Google Chrome--probably because it is free and easy. It also runs on lightweight processors and doesn't require a lot of storage space, so these computers can be built easily and cheaply. My point is, the world today is working fine with numerous operating systems that interoperate on a daily basis, but do different things and have different use cases. This is why I think there will not be 'one coin to rule them all.' That being said, I do think Bitcoin will likely be the money of the internet and our digital future. But I digress, back to Celsius.

So, Celsius's whole business model is to entice users (me) to put my crypto there, which they could then lend out, and earn both of us yield. They bragged they would give me 80% of the yield and keep only 20% to run the company. Different crypto assets had different rates of yield. (Yield is an important word here, as BlockFi got in big trouble with the SEC because they called this return Interest. I'm pretty sure this is semantics, because when I earn interest at Bank of America they are generating it in the same way--by lending out assets. However, laws have semantics.)

I have been hearing for years from the Bitcoin community 'Not your keys, not your coin.' This means that if you don't self-custody your bitcoin, someone else could mis-handle it. There was a huge hack of Mt.Gox in 2014, the first large crypto exchange and users lost all their coins (840,000 bitcoin). Then, there was a huge loss of coins by Canadian exchange Quadriga in 2018, where the owner of the company died and no one else had access to the private keys. (The dude was a bit unusual, and there is skepticism if he really died or absconded with the crypto.)

I watched Celsius for a long while before I thought they seemed safe enough to store crypto there. I saw this opportunity to return up to 5% of my bitcoin if I stored it there. It did not at all seem like this company, in 2020, was at risk for one of those hacks. It was too big, and too public for one of those hacks. I was not at all concerned about losing my crypto in the same way as what happened with Mt.Gox and Quadriga. In the same way, I have not been worried that Merryl Lynch or Charles Schwab were going to have my stocks stolen. I heard Michael Saylor in interviews talking about not wanting to take the additional risk of putting his MicroStrategy bitcoin into lending protocols. I thought it would be fine to risk my much smaller pile and earn the 5%. It seemed worth the risk at the time. I now look back on my decision as being motivated by greed. A lot of the reporting in the media about Celsius right now is that they had returns up to 18%. A more honest description is that different coins yielded different return, and only one (Synthetix, I believe) had return that high. Most were around 3-5%, although I could get 8% on the stablecoin I put there.

So, why am I so down on myself for this decision? Well, Celsius may have been doing some of that recursive borrowing, and taking outsize risk. We don't know, yet, why, but a week ago Celsius locked up all users funds. No users can move crypto within their ecosystem or out of it.

One of the other things Celsius let you do is take a loan against your crypto. I had used Ethereum and Bitcoin last fall as collateral for a loan and take out a USD loan against my position. I used the USD to purchase a house, which seemed like a way to safely leverage my position without realizing a capital gains tax. I also thought this was a good way to hedge/diversify, and put some of this accumulated wealth into real estate. Celsius allowed a 25% Loan-to-Value interest-only loan and charged 1% APY on it. I thought this was a great move at the time. Inflation was heading towards 5% and I thought this loan was GREAT! Plus, it was super easy. By far the easiest loan I ever took out, I did it all within the app. Also, if you are thinking the same way I was when I first discovered this option, no you don't earn any interest on the crypto you post as collateral for the loan.

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I think we have enough background on Celsius and my position there. After the Terra/Luna ecosystem blew up last month, crypto prices across the board started to fall. Positions were getting liquidated, users were scared (rightfully so) and withdrawing their assets. At the time, one of my friends said this made it 'ripe for regulation.' Although Celsius has not been transparent about where their assets were, and what assets fell in price, or what they had to liquidate, it seems like they were over-exposed to the stEth position. There is concern that they may have been doing some of this recursive borrowing. I'm not sure, yet. The nice thing about the blockchain being public is that people can sleuth this out.

What I do know is that a lot of Bitcoin Maximalists were disparaging Celsius. At first, it seemed to me that this was largely about custody of the keys. Remember the 'not your keys, not your coins?' This is a HUGE mantra of the Bitcoin community. Celsius responded with the position that it is OK to live in a world where some users do not want to be responsible for their private keys. Again, I think there will be a world with both options, and maybe some bitcoin holders do both.

In response to the combination of the market conditions, the attacks by the Bitcoin Maxi's, and the loss of asset prices, Celsius went from having over $20 Billion in assets under management during the winter to $11B on May 17. Today is June 17, 2022 and they have not updated this figure in over a month, so I do not know how low it is, but the number is definitely lower than $11B. It is probably half that. In hindsight, however, it looks like there may have been fire where there was smoke, since Celsius froze all user withdrawals in order to 'secure the assets.'

This is bad. I am not sure, yet, how this is going to unwind, but there is no future where Celsius doesn't come out severely tarnished. If users do not have the confidence that the company is going to return the assets stored there, no users will store assets there. It may be that Celsius goes bankrupt and my assets and others are used to pay off the company debts or positions. That is my worst-case scenario, and I do not think that is going to happen. Gosh, I certainly hope that is not going to happen, but my reasoning behind why I think that is not going to happen is there are companies and funds in this world that are good at buying and financing distressed assets. Best-case scenario is that Celsius secures outside financing and opens up transfers again.

Of course, the minute that happens, most users are probably going to transfer all their assets off the platform, which will likely put Celsius right back where they are. My guess is the solution will be somewhere in-between and that they slowly allow users to withdraw assets over time.

Three Arrows Capital is a multi-billion dollar crypto hedge fund that has invested heavily in these crypto protocols as well. It seems they have lost a lot in the Terra/Luna collapse. Some cryptic Twitter posts suggests they are facing a crisis much like Celsius is. This is also putting a lot of stress on the crypto market.

ALL of this is happening while the world seems to be on fire. Inflation is the highest ever in Europe and the US. The Fed is raising rates, and is going to have to keep raising rates. I do not believe the pain is over, yet.

I have not lost my faith in Bitcoin. I still believe it is sound money, and it is the future of the global economy. I still believe it is big ask to learn about it. You have to unlearn what you have learned, and see that inflation is bad, and we have been kicking the can down the road with all of this money printing.

I am sorry for anyone I encouraged to place digital assets at Celsius. I never expected this kind of lock-up to occur. I DID expect market volatility (I didn't think we would get this low, although many people still think prices can go lower). I did NOT expect this custodian to fail us. Even as I was typing this blog post out, I knew we were approaching the Friday 1pm weekly YouTube program that Celsius CEO Alex Mashinsky hosts. Sadly, they have cancelled this week, which is only going to add to the fear. I deeply apologize. I was excited that I found a way to earn additional return on my bitcoin, in bitcoin at Celsius. I had bitcoin and Ethereum at BlockFi and moved it over to Celsius as the BlockFi returns dropped.

The price of these digital assets is not the problem. I still have complete confidence that these assets will be worth much more in the future. The price is short term pain with long-term gain. Remember not to put more assets into any investment than you can afford to lose. Bitcoin is still the future. Buy some today at these discounted prices. You can dollar-cost average with no fees on the Strike app. Please recognize that prices MAY go lower before they go higher.

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On the bright side, there are two catalysts I see in the immediate future for rebound in prices:

1- The petition by Grayscale to convert their GBTC trust into an ETF. The SEC has been denying these for years, but last year allowed bitcoin futures ETFs to exist. Other nations (Canada, for example) have bitcoin ETFs, which allow a regular investor to simply by Bitcoin using their traditional brokerage. I believe a spot Bitcoin ETF in the U.S. is inevitable and that the SEC is actually harming investors by only allowing a futures ETF to exist. This is basically trading on 'paper' bitcoin, or the promise of bitcoin at some price in the future rather than holding the asset. GBTC is the single largest holder of bitcoin, with about 3% of all bitcoin. The current petition to the SEC has to be responded to by July 8th. I do not have any insight on the SEC and how this process is unfolding (or not, as the case may be), but Grayscale has indicated they will bring a lawsuit if this isn't approved. Bitcoin is trading around $20,500 right now. GBTC is trading at at 35% discount to spot BTC and I think it is a strong buy. MSTR holds 129,218 bitcoin with a market cap of $1.839B right now, which is $14,231 per bitcoin, which is about 30% discount to spot BTC. Also, MSTR is continuing to add to its position and not charging an annual 2% maintenance fee like GBTC does. OBTC is trading at a 22% discount to spot BTC. I expect all three of these equities to rebound hard once the ETF conversion is approved. If only I had a crystal ball as to WHEN the SEC would approve the spot BTC.

2- The Ethereum merge is probably going to happen this year. Ethereum is the largest smart-contract cryptocurrency and has been trying to evolve into its final form for years. Currently Ethereum is a Proof-of-Work crypto, which means miners have to solve complex math equations in order to create a new block on the blockchain. Ethereum has been planning to migrate to Proof-of-Stake, where users stake their Ethereum to become a validator node. The validators agree upon the formation of new blocks, and are rewarded with more Ethereum for doing so. This is where the staked Ethereum (stEth) I mentioned previously comes into play. As of right now, this is only being staked in preparation for the eventual MERGE of the current Ethereum chain with the Beacon chain (previously called Ethereum 2.0). Any way you slice it, this is apparently a very difficult and complex task because the Ethereum community has been trying to accomplish this for years. Even this past winter it was thought the Merge was going to happen June 2022, but it is no longer forecast for this month. I think the Ethereum Merge also an inevitability, it is just unclear when this will happen. Coinbase Institutional has an interesting forecast for the yield on the staked Ethereum in the 9-14% range (they say 5-10% higher than it is currently). This makes me want to start an Ethereum Validator node. You need 32 Ethereum for a full node, but you can pool funds with other users if you don't have that amount.