By Benjamin Dean
A deleveraging process is underway in the digital asset industry. The events of the past few months are a helpful demonstration of how digital (or “crypto”) assets are merging with traditional finance, for better or for worse. The liquidation of Capital of the Three Arrows (3AC),1 alongside the increasingly apparent exposures of its lending counterparties, shed light on the relatively new crypto lending industry.
At the same time, these events demonstrated the strengths of decentralized finance (DeFi) applications, which still work well, and offer transparency and auditability, as all transactions on “defi” platforms are carried out via open source software code and stored on distributed databases. which can be checked 24/7.
DeFi versus CeFi
To begin with, it is important to establish what DeFi is. Here is a succinct definition: “Decentralized finance (DeFi) offers financial instruments without the use of financial intermediaries such as brokerages, exchanges or banks by using smart contracts on a blockchain.”2
According to the WisdomTree digital asset taxonomy,3 the DeFi segment of the digital asset ecosystem represents less than 1% of the ecosystem’s overall market cap.4 The segment includes a set of decentralized applications (dApps) that run on networks of smart contracts (eg, Ethereum (ETH-USD), Polygon (MATIC-USD)). These dApps provide financial instruments or services such as trading, lending or derivatives. Examples include Aave (AAVE-USD), Compound (COMP-USD), and SushiSwap (SUSHI-USD).
The key element of the DeFi definition is at the end. Using smart contracts on a blockchain means that one can audit holdings at any time, due to the transparent nature of distributed ledgers (blockchains) and open source smart contract code. The rules of the contract are very clear. Those who use DeFi applications do so with their public/private key pair5which means that they themselves keep their assets and decide when and how these assets are used.
DeFi contrasts with what some call centralized finance (CeFi). Historically, these two areas were separate in the sense that digital asset networks, like the Bitcoin network, were created outside of the traditional financial system (indeed – Bitcoin (BTC-USD) was created at least in part in response to an accommodating monetary policy over previous decades). In recent years, however, the lines have blurred.
An example of this is the emergence of the centralized crypto lending industry. The industry can be broadly divided into crypto lending companies (e.g. BlockFi, Celsius (CEL-USD), Babel Finance), intermediaries connecting lenders to borrowers (e.g. Genesis), and the borrowers themselves. These borrowers were often hedge funds, which in some cases took leveraged positions in various digital assets. 3AC is one such hedge fund. If not taking leveraged long positions in digital assets, borrowers could also invest their holdings in DeFi applications to take advantage of the sometimes high returns offered.6 Much of this lending activity involved US dollar-pegged tokens (stablecoins), which is another example of the scrambling of the crypto and traditional financial rails.
With these concepts in mind, it is possible to better understand what is happening now.
Let the deleveraging begin
To understand current events, it helps to start with the collapse of Terraform Lab’s TerraUST (UST-USD) and related cryptocurrency LUNA (LUNA-USD). At the start of April 2022, the LUNA cryptocurrency was valued at the equivalent of approximately $41 billion. As of mid-May, he was worth less than $300 million.seven The maximum amount of USTs in circulation was over $18 billion on May 7, 2022. As of July 1, 2022, one UST was trading at 4¢ to the dollar.8
Think of the UST/LUNA collapse as a depth charge. Now those who were exposed to the explosion are floating on the surface of the water.
The first to show public signs of tremor was crypto lender Celsius, when it suspended withdrawals citing “extreme market conditions.”9 Next was crypto lender BlockFi, which began to downsizeten before revealing that he was one of several companies involved in liquidating positions belonging to the 3AC hedge fund.11 It is at this point that the interdependence of different crypto lenders with 3AC (and each other) becomes apparent.
So far, 3AC is believed to have had over $200 million in LUNA exposure12 – and this is the beginning. Crypto broker Voyager Digital (OTCPK:VYGVF) revealed in public filings that 3AC was unable to meet payments on a 15,250 BTC loan, worth approximately $305 million , and $350 million in USD Coin (USDC-USD).13 Market maker and lender Genesis are believed to have hundreds of millions of dollars of exposure to 3AC.14
Currently, a number of buyout and rescue efforts have been initiated but not completed. The FTX crypto exchange is one of the main parties.15 Crypto investment firm Morgan Creek Digital is another.16 Time will tell how this will unfold.
If this story sounds familiar, it’s because you’re thinking about long-term capital management (LTCM) — minus Nobel-winning economists (or government bailouts). The result of taking large, leveraged and long positions in markets as volatile as digital assets is hardly surprising. It should be noted that the lack of transparency around the leveraged positions of hedge funds, such as 3AC, and the level of collateralisation of the positions of lenders such as BlockFi or Celsius, contrasts with the transparency and auditability which, as we noted above, are features of DeFi.
In the coming months, expect digital asset prices to remain subdued. Forced liquidation of digital asset positions adds additional supply to markets that have been characterized by risk sentiment since January 2022. Even networks or dApps that have nothing to do with liquidated positions and insolvencies, and continue to function properly, are likely to end up with collateral damage. Also expect more insolvent parties to emerge, especially as trading volume dries up on smaller crypto exchanges.
The path to responsible DeFi
The good news is that the liquidation and bankruptcy of these entities have not yet had any significant contagion impacts on the traditional financial system.17 However, as the lines between crypto and traditional financial systems continue to blur, it’s hard to imagine regulators not taking a closer look at activities in and around the digital asset ecosystem. What is likely to emerge will be a “more responsible DeFi,” spurred by a stricter set of regulatory and oversight requirements in industrialized economies. This trend was already apparent with the executive decree on ensuring the responsible development of digital assets18 in the United States and with the Markets in Crypto Assets (MiCA) which will soon be adopted19 in the EU. It will continue to accelerate in the near future.20
3 For a copy of “A New Asset Class: Investing in the Digital Asset Ecosystem”, please contact [email protected]
5 Public key cryptography underlies digital signatures. There is a public key, which is revealed to everyone. Then there is a private key, which must be kept secret. It is the technological means by which one can ‘self-guard’ one’s digital assets, i.e. keep the private key secret, and sign transactions using the public/private key pair when adding new entries on a distributed database (i.e. ‘blockchain’).
Important risks related to this article
Benjamin Dean is an employee of WisdomTree UK Limited, a European subsidiary of WisdomTree Asset Management Inc.’s parent company, WisdomTree Investments, Inc.
Information provided by WisdomTree regarding digital assets, crypto assets or blockchain networks should not be considered or relied upon as investment or other advice, such as a recommendation by WisdomTree, including regarding the use or suitability of any particular digital asset, cryptographic asset, blockchain network, or any particular strategy. WisdomTree does not act and has not agreed to act in the capacity of investment adviser, fiduciary or quasi-fiduciary to any advisor, end client or investor, and has no liability with respect thereto, in regarding digital assets, crypto assets or blockchain networks. .
Benjamin Dean, Director of Digital Assets at WisdomTree in Europe
Editor’s note: The summary bullet points for this article were chosen by the Seeking Alpha editors.