Below 0° Celsius: When Your Deposit Gets Frozen

This column explores cryptocurrency markets from the perspective of a somewhat-grizzled trading veteran with a quantitative background and perhaps too much experience doing derivatives janitorial work. Finance is an old industry with a long history of everything from productive innovation to cartoonish fraud. Here we take a grand skeptical tour of a new corner of that world, with two tools that have consistently helped traders for millennia in our steamer trunk: math and knowledge of the past.

Celsius has paused withdrawals now. They’ve hired a restructuring advisor which isn’t very DeFi, but it does feel like an admission there is a serious problem.

And prices are generally falling. This is a classic run on shadow banks, made worse by a few particular features of crypto.

Shadow banking

Shadow banking is just banking without a license. Not in any negative sense necessarily – banking is really a term of art in a way that, say, driving is not. Traditional banking is taking deposits, getting supervised by a regulator, making loans of types approved by said regulator, having deposit insurance and so on.

“Banking” is taking in money that you probably can’t quite call deposits, making loans of whatever sort your shareholders allow and operating under generic “business law” type rules. There is nothing wrong with this per se – but it is clearly a riskier, if perhaps also more profitable, business than traditional regulated banking.

And Celsius was a pretty classic shadow bank. One of the business lines looked bog-standard. In round terms it took in crypto deposits and paid a few percent on them. Let’s say 4% for illustration. Then it made loans denominated in stablecoins like USDC or USDT at, say 9% in half the amount (50% LTV). So it collected more interest than it paid out. And as long as prices remained under control Celsius was fine.

In fact Celsius could probably have hedged their risks here with perps on an exchange. But that’s for another day. It is unlikely this business did them in.

Yield

But the other business line wasn’t lending – it was just “yield.” This is where you take in a deposit and, somehow, need to find investments to cover your promised interest payments to your customers. Your yield needs to come from somewhere. Earning a return, at least in the traditional finance world, requires taking some risk. Probably that’s true in crypto too.

And Celsius took risk. There is widely documented evidence they were involved in a number of hacks and were participants in the Terra-LUNA-UST fiasco. Whether they lost money in any of those incidents doesn’t really matter. The point is they were taking risk.

Staked ETH

One of their biggest risk positions was in staked Ether. This is Ether that is locked into the “Eth2” beacon chain. It is now generally accepted Celsius took client Ether deposits and fed them into Ethereum staking. These deposits accrue fees daily but cannot be redeemed back into regular old Ether until the migration to proof-of-stake is complete. Actually a bit longer than that, and they are subject to potential slashing. But those things don’t really matter.

What matters is they sent free-to-trade Ether into a box to earn some yield and cannot get it back out for “a while.” Likely a year +/- and maybe more. Here Celsius didn’t take price risk as the tokens are eventually redeemable for Ether. Rather they took liquidity risk. If they need Ether before the staking deposits are unlocked they’ll need to find them on the open market.

And it looks as though Celsius’s clients are asking for the Ether back. The staked Ether vs. Ether price is dropping on curve. And staked Ether are a great barometer of overall demand for liquidity. After all, if you believe Ethereum will be around for a long time there is nothing wrong with locking up some tokens in staking. But if you need Ether tokens right now to settle a debt – yeah, your beliefs no longer really matter. Only your token balance does.

And there is an awful lot of Ether staked.

Liquidity crisis

The market looks to want liquidity. Why else would hundreds of millions of dollars worth of staked Ether get sold for well under 1 regular Ether on curve over the weekend?

Is this what did Celsius in? Maybe. It certainly did not help. But it is indicative of a more serious problem crypto has yet to face. In traditional banking the regulator works hard to preserve insured deposits by arranging mergers. And, in the limit, the government will finance whatever fiat currency is required to make insured depositors whole. That is the deal with regulated (non-shadow!) banking.

But nobody can credibly promise to backstop Ether (or Bitcoin or Solana, etc.) deposits. There is no central issuer by design and on purpose. Years ago when the space was smaller if an operation blew up it was possible somebody had the required few million dollars lying around to buy up tokens and fix it. Things are more difficult now.

There is an old saying “when you owe the bank $100 and cannot pay you have a problem. But when you owe the bank $100 million, the bank has a problem.” Crypto’s problem now is that the quantities are too big. Long ago a million Ether for a bailout might be possible to source. Someone paid 10,000 Bitcoin for a pizza. But those quantities are out of reach now.

There are over 10 million Ether staked on the beacon chain worth, even now, over US$10 billion. It is exceedingly unlikely anybody has that kind of liquidity lying around and is willing to use it to backstop part of the crypto ecosystem. It’s also not clear that would even help as they cannot print the required tokens – they’d need to buy them in the market and try to avoid breaking things further in the process.

No bailouts

In crypto there are no bailouts. Nobody can print Bitcoin or Ether to fix these sorts of problems. So we are about the see the first uncontrolled liquidity crisis in generations. Even in the former USSR in the 1990s or the many 20th century defaults in Latin America we didn’t see large banks just vanishing with no government liquidity assistance at all. Temporary closures happened. Haircuts were imposed. Inflation ran down the value of deposits. But going back for generations the state made at least a basic attempt to keep some slice of the system up and running. Nobody can do that here.

It’s important to note part of why this is happening now. Taking fiat currency deposits in a similar way, from retail investors and without licenses, is almost surely illegal almost everywhere in the world. It is because this is “crypto” that we got here. Whether that turns out to be legal or not remains unclear – but this is precisely the sort of “regulatory clarity” question that keeps coming up.

How did so many retail investors get entangled with a shadow bank? Simply put: because it wasn’t so obviously illegal that nobody would try…so someone tried and got big. And maybe it was legal. We will find out. But these losses are not about the rules – they are about the token balances.

Further, we have not seen an incident where an institution with large numbers of developed country retail depositors vanished with no backstop in an extremely long time. The US deposit insurance scheme was set up in 1933. When Baring’s Bank failed in 1995 UK depositors were covered by insurance. German banks set up an insurance scheme following the failure of Herstatt Bank in 1974. The Japan deposit insurance scheme dates to 1971. I had a Northern Rock account that was covered by insurance in 2008. Many crypto market participant’s parents will not recall a bank failure with small retail depositor losses.

Nothing like Twitter and Reddit existed to transmit the information back then. Truly we are finally entering the era where crypto shows us new things.

And let’s hope the weekly AMA still goes ahead. That could be amazing.