From Celsius to Three Arrows Capital, major industry players lost to the crypto crash of 2022. Although the market appears to be stabilizing now, the cascading effect of the LUNA/UST crash is still being felt on businesses today.
Singapore-based crypto exchange Zipmex was the latest to fall victim after being forced to halt withdrawals earlier this month.
Zipmex announced on July 20 that customers will not be able to withdraw their crypto holdings until further notice. The company cited volatile market conditions “outside its control” and the resulting difficulties for important business partners as reasons.
While it is true that Zipmex could not have predicted market volatility, it certainly could have been better prepared for it. In reality, the platform’s difficulties appear to stem from mismanaged funds – a decision that Zipmex has always had under control.
To understand this, let’s connect the dots between Zipmex and the LUNA/UST crash.
Main problem: overly leveraged positions
At the start of the LUNA/UST crash, crypto lending firm Celsius was heavily exposed to a token called Lido Staked ETH (stETH), whose value was pegged to Ether (ETH).
The company accepted ETH deposits from its client and used them in exchange for stETH. These deposits earned interest of around four percent. Next, Celsius used the stETH as collateral to borrow more ETH. Eventually ETH was deployed to the stETH exchange and the cycle would repeat itself.
To illustrate, let’s assume you have 100 ETH that you are staking in exchange for 100 stETH. At this point, you can expect a return of 4 ETH per year.
Next, use the 100 stETH as collateral to borrow 70 ETH and wager that as well. Now your return increases to 6.8 ETH per year. You will also receive 70 stETH which you can use to repeat the process.
By doing this over and over again, you take on an increasingly leveraged position. In this way, Celsius was able to offer its customers high returns on their ETH deposits.
However, as one might expect, as leverage increases, so does risk.
Photo credit: Bloomberg
Going back to the example, you currently have a loan of 70 ETH collateralized with 100 stETH. The lender claims that at no time can your loan be worth more than 80 percent of your collateral.
So if the value of 100 stETH fell below the value of 80 ETH, you would either have to top up your collateral or your position would be liquidated. If you were further leveraged it would be even harder to hold your position as you would need to add a larger amount when there was volatility.
The position of Celsius depended on the stability of the connection between ETH and stETH. The company has not hedged against a scenario in which this bond would be broken.
As it turns out, that’s exactly what happened. The panic following the LUNA/UST crash caused the value of stETH to fall below that of ETH. If Celsius did not post enough collateral, its entire position would be liquidated, meaning the company would lose a significant portion of its customers’ funds.
Screenshot of a Celsius tweet from 2019
This forced Celsius to stop paying out. As the platform used its funds to hold on to an over-leveraged position, it no longer had the liquidity to meet its clients’ withdrawal requests.
On July 13, Celsius announced it had filed for bankruptcy.
This example of over-leveraged trading is not an isolated case, nor is it limited to ETH/stETH. This is the main reason for the cascading decline of crypto companies that we are witnessing today.
How does this fit with Zipmex?
Zipmex offered its users annual rewards of up to 10 percent on crypto deposits. The company generated these rewards by lending the cryptos to other platforms.
At the time of the LUNA/UST collapse, Zipmex had loaned $48 million to Babel Finance and $5 million to Celsius. Both companies were exposed to overly leveraged positions, forcing them to freeze payouts when the market crashed.
Screenshot of Zipmex
Zipmex, now unable to collect these loans, was forced to freeze withdrawals as well. It appears the company has written off its loan to Celsius but is working with Babel Finance to recoup losses from customers.
The market crash has brought to light the interdependence between different firms in the crypto space. The collapse started with large companies managing billions of funds, and now the fallout is affecting smaller companies that had invested in them.
How can retail investors avoid such risks?
By asking the right questions.
If a crypto exchange is offering 15 percent interest on a coin, where are those returns coming from? It’s important to realize that while crypto can offer attractive investment opportunities, it doesn’t generate money out of thin air.
With centralized exchanges – like Zipmex – it’s not always clear how your holdings will be used for further investment. As has become apparent over the last month, this creates a risk of unavailability when the company faces liquidity problems.
Risk warning on Zipmex’s website / Screenshot of Zipmex
To ensure your funds are protected, it is best to use an exchange that is regulated by the Monetary Authority of Singapore (MAS). While many crypto exchanges are based in Singapore, many are not yet licensed and operate under exemption.
Buying crypto through a licensed exchange ensures that you can take legal action if the company mismanages your funds.
Using decentralized wallets and managing your holdings personally is another option.
Indeed, from a long-term perspective of the industry, most DeFi builders, advocates and commentators believe that the collapse of centralized platforms is a bull case for DeFi, where users want asset self-custody. As the saying goes, “Not your keys, not your fortune”.
– Imran Mohamad, Head of Marketing, Kyber Network
Lending crypto and earning interest through DeFi protocols allows you to be fully aware of the risks you are taking and prevents losses caused by mismanagement by third parties.
KyberSwap is a DEX that offers a range of liquidity pools for users to deposit their crypto holdings / Screenshot of KyberSwap
Decentralized exchanges (DEX) allow users to earn returns for providing liquidity. Suppose you deposit your ETH and USD coins (USDC) holdings in a liquidity pool. Whenever someone converts between the two cryptocurrencies using the DEX, you earn a portion of the transaction fees they are charged. In this case, it is very clear where your returns are coming from.
“These are organic, sustainable and come with no guarantees,” explains Mohamad. “You would see some of these pools with less than 1% APR and some with more than 100% APR, and these are created because of market supply and demand and are not backed by external funding.”
Credit for selected images: Zipmex / Outlook India
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