Monthly Market Review - June 2022
For June, we will discuss the recent liquidity crisis the whole digital asset space has experienced and how Defi has reacted.
One of the last bull market's hottest trends was yield-focused start-ups, which all operated like unregulated and under-collateralised banks. These yield platforms would ask investors to deposit fiat or digital assets and promise to pay them a high fixed percentage yield, often exceeding 15% p.a. In turn, these platforms would lend these assets to borrowers trading in the market. During the bull market, these platforms appeared safe and working well. Many of these companies had become established within the digital asset industry. For example, BlockFi raised money at a $3 billion valuation last year. Voyager Digital is publicly listed in Canada, and Celsius Lending had originated over $8 billion in loans. However, as the market began to turn and rates fell, these businesses became more risk-seeking to achieve their advertised yield. After the Luna collapse, rumours about the liquidity of these businesses started to circulate. These rumours intensified when Three Arrows Capital (3AC), an $18 billion crypto hedge fund, blew up in the wake of the Luna collapse. It has transpired that 3AC had taken significant loans from all three businesses, which it has now defaulted on due to falling markets. Rumours became self-fulfilling as most investors on these platforms tried to withdraw their capital, causing 'bank runs'.
Celsius was the first platform to fall when it halted all withdrawals on June 13th. It had a highly risky 19-to-1 assets-to-equity ratio before it ran into liquidity troubles.
Voyager Digital received a $500m loan from Alameda Research (linked to FTX) but eventually halted withdrawals on July 1st. It had lent $665m to 3AC. It's unclear whether it will survive.
BlockFi was offered an emergency loan from FTX, which allows them to be acquired at $275m, including the assumption of the debt. The rumours are they lost $250m due to 3AC so, effectively, they are being acquired for $25m. They haven't paused withdrawals yet.
The contagion of 3AC was significant; the above platforms were just some of the impacted parties. Some exchanges and prime brokerages had also extended credit lines to 3AC; these include Deribit, Genesis Trading and Bitmex. Their losses vary from rumoured hundreds of millions to single-digit millions. The contagion risk has drastically increased the short-term counterparty risk within the space as the crisis works its way through the system. On the DeFi side, investors have also started withdrawing liquidity in a flight to quality. The demand for capital in DeFi has dropped so much that the rates lenders are paid on Aave and Compound are currently c. 0.3% p.a. This is below US T-Bills. Besides the low rates on offer, DeFi has had an orderly unwind financially for the most part. However, community members questioned the decentralised nature of some platforms during the crisis. For example, Solend, a lending platform on Solana, passed an emergency vote to temporarily take over a $100m position on their platform as it was nearing liquidation. The team was worried that the prominent position would cause significant liquidity issues if it was all liquidated at once. The plan was to liquidate this user via OTC and return the remaining capital once Solend had reduced some of the position. The original voting period was 2 hours, and only one user with $500k worth of votes approved the proposal. There was significant community outrage over the decision, and Solend disregarded the vote's result. However, the episode called the value of DeFi and its defined rules into question. There is little value in DeFi if protocols can seize users' funds at will. Hopefully, other DeFi protocols will implement more robust risk management to prevent the need for interventions like this in the first place, or define clear rules about how and when it can step in. Overall, this month has damaged the space as many centralised platforms have been caught out by poor risk management. These platforms were providing retail capital to a risky hedge fund, which blew up.
Liquidity has exited both exchanges and DeFi en masse. However, in time and once the contagion risk overhang has blown through, this painful deleveraging will cause a healthy ecosystem as the irresponsible actors have been washed out.