Failure to Understand
Over the past week, we keep uncovering the repercussions of mismanaged leverage — most notably the liquidation of 3 Arrows Capital (3AC).
We could spend time arguing about market action and the impact of “whales” manipulating market prices to force it. The fact remains, if risk management were properly done, the risk of forced liquidations would have been much reduced. I do not profess to know the inner workings of the risk management departments of the affected companies, but from what I can gather, there was a fundamental lack of understanding of how derivative products, and lock-ups, work. Among the issues at play, which applies to Celsius as much as to 3AC, is that the theory behind liquid staking buckled under real-world conditions.
For those new to the concept, $ETH staking was introduced in order to incentivize the migration from proof-of-work to proof-of-stake (POS). Network users who staked their $ETH earned a return for establishing the staking base to facilitate the migration. The catch, a user needed to stake 32 $ETH and they could not unstake until after the merge, the migration to POS, finished. Enter liquid staking, a derivative product where each $stETH represents an equal amount of $ETH and can be redeemed 1:1. The protocols that offered this enabled retail user with less than the required $32 ETH to participate in staking, in order to earn rewards, by pooling small amounts of $ETH to arrive at the minimum threshold. In exchange for this service, the protocol kept part of the yield. Sounds great, right?
Well, in a rising market with low interest rates, when everyone is greedy and hungry for yield, there is more demand to deposit $ETH into $stETH than there is redemption demand. When the market rolls over, however, and interest rates start to rise, redemption began as investors sought to reduce their exposure and found “safer” alternatives offering more competitive yields. Now, in theory, this should not pose a problem, but since the merge has been pushed back multiple times, unstaking is not yet possible. So what happened when investors try to unstake their $stETH? Initially, I imagine that the protocols satisfied some redemptions from their balance sheet and reserves, but when they could no longer do so, they were forced to gate withdrawals. This breakdown led to another, in theory impossible, dynamic — the 1:1 relationship between $ETH and $stETH broke down. Coupled with the overall decline in market prices, this decoupling added additional stress to collateralization ratios.
I suspect that the fundamental misunderstanding at the risk management offices was that in practice, until $ETH successfully migrated to POS, $etETH is inherently inaccessible and an imperfect derivative. If this would have been better understood, I contend that the risk management team would have applied a higher discount, or a higher risk weighting, to any assets or loans associated with $stETH, even as collateral.
In the case of 3AC, I suspect that there was another problem. The company was known for, and indeed lauded for, its prowess and ability to invest early in successful projects. These investments most certainly included a lock-up period where the tokens that they received in exchange for their early monetary support, were inaccessible fur to a time-lock or vesting period. Based on what information I’ve read, I believe that the company pledged these inaccessible assets as collateral. The problem here is that you should not be able to pledge assets over which you do not have full control, as collateral. Why? Because you cannot liquidate them, if needed, in order to satisfy your commitments. As such, this would appear to be break-down of the loan overcollateralization for which crypto is known and helps explain why a “successful” company such as 3AC would enter liquidation despite its ostensibly large asset base.
In both cases, the question remains: was this due to greed, a lack of understanding of the products you used, or a failure of imagination to explore a contrary situation? My answer, it was probably a mix of all three.
TL;DR: DYOR and fully understand the limitations, and risks, of the products you use
Disclaimers: The above does not constitute a recommendation or solicitation to purchase or sell any securities or cryptocurrencies referenced herein. As of the time of this writing, the author may or may not have positions in some of the abovementioned securities or cryptocurrencies.
