20% profit in CeFi, DeFi lives on

PARIS — Celsius and Voyager Digital were once the two biggest names in crypto lending because they offered incredible annual returns to retail investors, sometimes approaching 20%. Both are now bankrupt as the collapse in token prices, coupled with liquidity erosion following a series of Fed rate hikes, has exposed these and other projects promising unsustainable returns.

“$3 trillion of liquidity is likely to be withdrawn from markets around the world by central banks over the next 18 months,” said Alkesh Shah, global strategist for cryptocurrencies and digital assets at Bank of America.

But easy money laundering is being welcomed by some of the world’s top blockchain developers who say leverage is a drug that attracts people looking to make a quick buck, and it takes a systemic failure of this magnitude to eliminate unscrupulous players.

“If there is anything to be learned from this explosion, it is that you have to be very careful of people who are very arrogant,” Eilon Aviv told CNBC on the sidelines of EthCC, an annual conference that attracts developers and cryptographers to Paris for a week.

“This is one of the common denominators between them all. It’s kind of like a God complex: “I’m going to build the best thing, I’m going to be awesome, and I just became a billionaire.” continued Aviv, who is the head of Collider Ventures, an early-stage blockchain and cryptocurrency venture fund based in Tel Aviv.

Much of the turmoil we’ve seen in the crypto markets since May has to do with these multi-billion dollar crypto companies with centralized front men who set the tone.

“Lack of liquidity has impacted DeFi returns, but a few irresponsible central players have made things worse,” said Walter Teng, Digital Asset Strategist at Fundstrat Global Advisors.

The death of easy money

When the Fed’s base rate was practically zero and government bonds and savings accounts were paying out nominal returns, many people turned to crypto lending platforms instead.

During the boom in digital asset prices, retail investors could earn incredible returns by staking their tokens on now-defunct platforms such as Celsius and Voyager Digital, as well as Anchor, which has been the flagship lending product ever since. failed US dollar-pegged stablecoin project called TerraUSD which offered up to 20% annual percentage returns.

The system worked when cryptocurrency prices were at an all-time high and borrowing cash was practically free.

But as research firm Bernstein noted in a recent report, the crypto market, like other risky assets, is closely tied to Fed policy. Indeed, in the last few months bitcoin along with other major capitalization tokens are falling along with this Fed rate hike.

In an effort to contain rising inflation, the Fed raised the base rate another 0.75% on Wednesday, raising the fund rate to its highest level in almost four years.

Technologists gathered in Paris tell CNBC that sucking up the liquidity that has been sloshing around in the system for years means the end of the days of cheap money in cryptocurrencies.

“We expect more regulatory protection and required yield-supporting disclosures over the next six to twelve months, which will likely dampen DeFi’s current high yields,” Shah said.

Some platforms invested client funds in other platforms that also offered unrealistic returns, in a kind of dangerous scheme where one breach could turn the whole chain upside down. One report based on blockchain analytics discovered that Celsius had invested at least half a billion dollars in the Anchor protocol, which offered customers up to 20% APY.

“The domino effect is like interbank risk,” explains Nick Bhatia, professor of finance and business economics at the University of Southern California. “If credit was given that was not properly secured or reserved, failure will begin failure.”

Celsius, which managed $25 billion in assets less than a year ago, is also at risk. accused of using a Ponzi scheme paying out early contributors with the money received from new users.

CeFi vs. DeFi

So far, the implications in the cryptocurrency market have been limited to a very specific corner of the ecosystem known as centralized finance or CeFi, which is distinct from decentralized finance or DeFi.

While decentralization exists across the spectrum and there is no binary designation separating CeFi platforms from DeFi platforms, there are a few distinguishing features that help to classify the platforms into one of the two camps. CeFi lenders typically use a top-down approach, in which multiple influencers dictate the financial flows and how different parts of the platform work, and often operate in a kind of “black box” where borrowers don’t really know how the platform works. In contrast, DeFi platforms cut out middlemen like lawyers and banks and rely on code to enforce compliance.

A big part of the problem with CeFi crypto lenders has been the lack of collateral to back the loans. Celsius’s bankruptcy filing, for example, shows that the company had over 100,000 creditors, some of whom borrowed the platform in cash without being entitled to any collateral to support the agreement.

With no real money behind those loans, the entire arrangement depended on trust and a constant flow of easy money to keep it all afloat.

However, in DeFi, borrowers post more than 100% collateral to support the loan. Platforms require this because DeFi is anonymous: lenders don’t know the borrower’s name or credit score, and they don’t have other real metadata about their cash flow or equity on which to base their lending decision. Instead, the only thing that matters is the collateral the customer can host.

With DeFi, instead of centralized players, the money exchange is managed by a programmable piece of code called a smart contract. This contract is written on a public blockchain like ethereum or solanaand it is executed under certain conditions, eliminating the need for a central intermediary.

Consequently, the annualized returns advertised by DeFi platforms like Aave and Compound are much lower than what Celsius and Voyager once offered clients, and their rates fluctuate with market forces rather than remain fixed at volatile double-digit percentages.

The tokens associated with these lending protocols have surged over the past month, reflecting the enthusiasm for this corner of the crypto ecosystem.

“Gross yield (APR/APY) in DeFi is derived from the prices of the respective altcoin tokens that belong to various liquidity pools, the prices of which, as we have seen, have fallen by more than 70% since November,” Fundstrat’s Teng explained.

In practice, DeFi loans are more like complex trading products than a standard loan.

“This is not a retail or family product. You have to be quite advanced and have an understanding of the market,” said Otto Jacobsson, who worked in debt capital markets for three years at a bank in London before moving into crypto.

Teng believes that lenders that have not issued aggressively unsecured loans or have not since liquidated their counterparties will remain solvent. Michael Moreau of Genesis, for example, stated: they have reduced significant counterparty risk.

“The rates offered to lenders will and have been squeezed. However, lending remains a hugely lucrative business (second only to stock trading) and prudent risk managers will survive the crypto winter,” Teng said.

In fact, Celsius, although a CeFi lender, has also diversified its holdings in the DeFi ecosystem by staking some of its cryptocurrencies on these decentralized finance platforms to generate revenue. A few days before declaring bankruptcy, Celsius began recoup many of their collateral rights with DeFi lenders like Maker and Aave to unlock his collateral.

“This is the biggest publicity to date for how smart contracts work,” said Andrew Keyes, co-founder of Darma Capital, which invests in apps, developer tools, and protocols for Ethereum.

“The fact that Celsius pays off Aave, Compound and Maker before people do should explain smart contracts to humanity,” Keys continued. “These are permanent program items that are non-negotiable.”