The Implications Of The CeDeFi Collapse And What It Means For Investors | by Vincent Tabora | The Capital | Jun, 2022

The cryptocurrency market has collapsed in the second quarter of 2022, and it could have been foreseen. Warning signs were there, but not everyone was aware of them. When you have an over-leveraged market that is going long on crypto prices, when the unexpected strikes, there is no way around it. The Russia/Ukraine conflict, supply chain shortage issues, inflation, and rising interest rates have played a part in the collapse. What happened was the result of macroeconomic events that have led to economic downturns around the world.

While the traditional financial markets have been affected severely, this has unfortunately also affected crypto. Bitcoin has fallen significantly, touching below $20K, and has been down for 9 consecutive weeks, which was unprecedented. The second top crypto, Ethereum, has also fallen and reached below the $1K support level. The altcoin market was much worse during the crash, as sell offs plunged coins like ADA, XRP, BNB, and emerging crypto like SOL, AVAX, and DOT. This has brought the overall cryptocurrency market cap below $1 Trillion (source CMC).

The dominoes began to fall in crypto after Bitcoin could not hold its support, as it continued falling from $30K between March and May. The chaos has caused FUD in the market as sell offs began. It was also a result of negative news from the Feds increasing interest rates by 25 bps (Starting in March 2022). This was further aggravated by rising inflation, reaching 8.6% by May 2022. This has significantly affected a sector of the crypto industry called CeDeFi. Before we get to that, let us look at the difference between decentralization and centralization.

The main purpose of cryptocurrency is to introduce a decentralized monetary system that is not controlled by the government. Bitcoin is the best example at the moment, as it remains, for the most part decentralized because there is no majority entity or individual who controls the network. This is in contrast to banks and other financial institutions, which are highly centralized.

Centralization means control by an authority that regulates and manages the distribution of currency. The government run Central Bank is an example of this (e.g. US Federal Reserves). Each country has the equivalent of a central bank that issues the national currency, which is legal tender for payments and exchanges. The central bank controls the supply of money through quantitative measures. This type of control is the opposite of decentralization. In a decentralized system, the supply of money is fixed and its value is determined by the free market.

Decentralized has no central authority, while centralized is fully under the authority of a single entity or group.

The rise of DeFi (Decentralized Finance) aimed to bring more financial inclusion and independence to users. This led to protocols, which are software developed to provide DeFi services to users. The early DeFi protocols were truly decentralized, meaning they had no organized entity and were open to all users. They were cumbersome and rather difficult to use, requiring users to have some degree of technical knowledge. This was where CeDeFi enters the scene.

The rise of CeDeFi begins with digital exchanges like Coinbase and Binance. These companies offer users a gateway to crypto as an onramp to onboard new users. They also simplify the process of owning crypto through a professional service that handles the complexities involved in crypto (e.g. wallet address, private keys, etc.). Users sign up with these exchanges by undergoing a KYC process similar to other traditional finance services. Personal information is collected to comply with anti-money laundering laws and anti-terrorist financing. Users can choose not to undergo KYC, but they will be limited to the exchange’s offerings. A user is provided a custodial digital wallet, which holds information about their cryptocurrency assets.

They sell and trade various types of cryptocurrency to users, but they must comply with the rules and regulations of the financial system. This makes them regulated entities, and they are also centralized. They are centralized because they control a user’s wallet by having custody of the private key. That means that the exchange can freeze an account if deemed non-compliant or in violation of policy. This prevents users from buying or selling crypto and withdrawing or transferring their funds. This is very much how banks operate as well.

Fintech companies began developing their own protocols to offer DeFi services that would open the market to earning, staking and liquidity pools. This allowed users to earn on interest from yields that were sometimes too good to be true. These protocols offered returns that are much higher than any bank can offer. These were offered by companies like Block-Fi, Celsius, Nexo and Abra. They allowed users to earn interest from their cryptocurrency like Bitcoin and Ethereum, by depositing it into their system. These companies take the asset as unsecured collateral, which they can then lend out. Users earn on derivatives from interest on loan payments. This is very much how banks work, but in a crypto setting.

These companies were not DeFi, but CeDeFi or Centralized DeFi. Although they offer instruments to DeFi, they are not themselves decentralized. These companies are centralized because they control everything on their platform. They have custody of their customer’s account private key, which gives them full control of their digital wallet. They can freeze all withdrawals and transactions, especially during meltdowns.

The collapse began with the fall of Bitcoin. Since it is the dominant crypto, the rest of the market tends to follow its lead. In this case it was a downturn as a result of the correlation with the stock market. Investors, mostly newbies, were treating crypto like Bitcoin as risk assets and were thus selling them off due to economic uncertainty. The market reached a critical level, and this triggered a series of events that would collapse CeDeFi.

The next collapse was that of Terra’s stablecoin UST (Terra USD). The stablecoin was pegged to the US Dollar at a 1-to-1 ratio. The pegging was not actually backed by any commodity or asset, but it was algorithmic in nature. That means the stablecoin backing is determined by purchase of the Terra native token called LUNA. In order to mint UST, LUNA must be burned to back the value in USD. During the more bullish period of 2021 and 2022, many investors bought LUNA and burned it to get UST. The burning removed LUNA from circulation, which also raises its price. The catch here is that users can then earn from UST by depositing it into the Anchor earn protocol. At one point, it was offering returns of up to 20% APY. That might be a red flag right there for financial analysts.

The meltdown in the crypto markets have brought anxiety to investors (Photo Credit: Andrea Piacquadio)

During extreme volatility in the market, UST lost its peg to USD. This was because of a bank run caused by panic selling in the market. More UST was being withdrawn than LUNA being burned. This affected the price of both UST and LUNA. As the prices began to plummet, investors began to worry, and things got worse. Terra was not able to keep the peg, so LUNA crashed below $0 in value. UST also crashed, and this affected big holders, that includes CeDeFi companies.

Following the fall of Terra, the focus was on the investment funds that held UST or LUNA. There were plenty of liquidations across the market, as investors hurried to pull their money out of UST. Even though Terra had reserves from their LFG (Luna Foundation Guard), it was not enough to restore the peg to UST. This would hyper-inflate LUNA as more UST was being burned back to LUNA tokens. 58% of traders placed futures bets on higher LUNA prices despite the drop, leading to $106 million in liquidations when UST dropped to $0.35. The burning of UST to prop up its peg did not work as expected and instead led to more LUNA being minted (which drops its price). The reaction from exchanges like Binance was to halt LUNA and UST trading.

The focus turned to CeDeFi companies after the Terra meltdown. This was because some of these companies had invested heavily into Terra’s UST or LUNA, and these could lead to more worries for investors. The first to collapse from the UST depeg was the Anchor protocol. The total value locked had fallen from $14 Billion to $8.7 Billion as UST price declined. The protocol has fallen to $600M+ in UST (as of posting).

There was now a liquidity crisis in the crypto market. Liquidations across the board drained the market. There were less payments on loans, while more users were making withdrawals from the system. The warning signs began to appear with Celsius as more withdrawals were being made than capital inflows. They also held plenty of staked ETH (stETH), which was losing its peg to ETH as holders began dumping. This led Celsius to halt withdrawals around June 12–13, 2022. Users would not be able to withdraw their assets or exchange any crypto.

Messages like this do not give customers much confidence in CeDeFi protocols.

3AC (Three Arrows Capital) was the next to be scrutinized for insolvency. 3AC has $3 Billion worth of assets under management which includes projects in the crypto space. Due to the crypto crash, 3AC was not able to meet the margin calls of undercollateralized loans. They had also taken leveraged positions, in danger of being liquidated. 3AC had lost a lot of money from the Terra LUNA crash. $1 million had also gone missing from one of 3ACs trading accounts, and this needs to be addressed.

Other CeDeFi companies feeling the heat included Block-Fi, but they have not halted withdrawals. They actually found a lifeline from an FTX bailout. Other CeDeFi companies are holding their ground so far, but as long the sell offs continue, they are on unstable ground. There is still so much uncertainty in the market, investor anxiety is reaching extreme fear and bearish sentiments.

So, is it the developer’s fault for creating these protocols that collapse during unexpected events?

It is not. Instead it is the people behind these CeDeFi protocols who are more to blame. The algorithms in their products were designed for a purpose. It is fair to say it was meant to get customers the most yield in interest, from their digital assets. The fact is that users who deposit to these protocol’s expecting huge returns are also surrendering their assets to the company. The company then decides what to do with those assets. It just so happens that these companies may not always make the best decisions in risk management. This is how it works with CeDeFi lending protocols.

There are people behind CeDeFi protocols who make decisions with what to do with customer asset deposits. (Photo Credit: fauxels)

These assets have no security in case the company experiences problems like insolvency. When the money stops flowing, there are risks to liquidation of assets. The fintechs do not talk too much about this, and instead focus on the ridiculous returns their protocol makes for customers. What is not known to users is that their assets are being used as collateral to get those returns from other protocols. These can be decentralized yield farming protocols like Yearn or Aave, or invested into earning protocols like Anchor on the Terra network.

The use of customer’s digital assets opens them up for risks that cannot be mitigated in the event of a bank run or economic downturns. CeDeFi companies have faced scrutiny for not following financial rules that regulators like the SEC have put forth. These deposits are not fully secured, and therefore there is no full obligation by the fintechs to guarantee their safety to customers. Instead, they offer assurances of security through brilliant marketing that aims to get the customer’s trust in return for their assets. Some of the fintechs are now following these rules to secure customer’s assets, but there have been no enforcements in the past.

Perhaps it is time to say the quiet part out loud or the details that no one wants to discuss about CeDeFi. Let’s enumerate them:

– CeDeFi is not decentralized, these are centralized companies that can control user assets. They censor your transactions, freeze your account, halt withdrawals and even liquidate your crypto.

– CeDeFi are like banks and lending institutions in general. They take your deposited crypto assets and lend it to other institutions. You make a yield on interest from loan payments, at higher than normal rates because there are less intermediaries to deal with in crypto. That means less middle-men get a cut, granting more to the users.

– When depositing your crypto to CeDeFi protocols to earn, you are giving the company your assets as an unsecured loan. You are lending to the company to lend out your assets as collateral for funding. Since it is unsecured, there is no guarantee the asset can be recovered in the event of a bankruptcy or other unfortunate event. It is not FDIC covered like in traditional financial systems, so this is a risk the user must understand.

In order for CeDeFi to regain confidence in the market, some things need to change. These protocols compared to real DeFi have collapsed. Maker DAO, which is a decentralized lending protocol, has held up through this meltdown. This is because they don’t follow the same practice as CeDeFi companies. Maker DAO issues its stablecoin DAI, which is backed by a commodity that is overcollateralized to cover any situations of non-payment of loans. DeFi protocols follow a market driven approach that cannot be controlled by any group or individual.

The meltdown has led to calls for new regulations on the crypto market, targeting the fintechs who are CeDeFi companies. While this is meant to provide more consumer protection, it can also be to restore faith in this market. Right now, there is a total loss of confidence after withdrawals were halted, and many users are fearing the worst. This has led to users on other CeDeFi platforms to quickly withdraw their assets.

What happened here is a cautionary tale once again. You have these financial geniuses entering a totally new financial system that aims to deliver higher yields than traditional financial systems. They quickly poured capital to invest in these DeFi projects, but operated by a centralized company. You can get higher returns because that was what the system was programmed to do, but when it comes to extremes in market conditions, they could not adjust to prevent a collapse. Some of these fintechs engaged in over leveraged activities, not foreseeing the downturn in market conditions. They can give high returns on interest rates, but never manage to explain how they were going to sustain those payments on returns.

It is better to have some form of regulation for CeDeFi to at least mitigate some (if not all) of the disaster that happens when markets crash. True DeFi protocols at this point appear less risky, since they do not prevent withdrawals and actually work according to the free market. CeDeFi can be controlled by a few decision-makers, who can shut down the network whenever they like, preventing users from accessing their assets. Regulation should also include requiring more transparency on where users’ assets are being used to discourage bad faith practices from these fintechs.

These events have given a bad name to DeFi, although it was the CeDeFi fintechs that caused the problem. Users are learning that it is better to have custody of their own assets (e.g. Your Keys, Your Coins) rather than granting custody to a third party. Even if it doesn’t earn interest, at least it remains in their possession and cannot be liquidated. This should also signal to fintechs to review their strategy in DeFi to provide more protection to customers and offer realistic returns that are sustainable. Right now, CeDeFi needs to build more trust and confidence with their customers, or else time to pack it up.

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