CeFi Casualties
CeFi Casualties
Rookie mistakes in risk management: an explanation of CeFi collapses and lessons learned.
Voyager, Celsius, BlockFi, Babel, Vauld, Coinflex, Finblox…like dominoes they all fall. I had not heard of some of these just a month ago. As contagion gripped the crypto markets, they all became topical; for all the wrong reasons. I posited in WTF LFG?...crypto crash explained that contagion would spread. It has.
Centralized Finance (“CeFi”) platforms are the casualties. CeFi platforms provide crypto lending, borrowing, investing and trading services. They’re like a traditional bank or prime broker for crypto.
Three themes are consistent in the story lines of CeFi Casualties:
Search for “yield” - Depositors put their money into CeFi products lured by high-teens annual returns (aka yield). Unbeknownst to depositors, CeFi platforms took huge risk and mismanaged assets and liabilities to generate yield. When crypto prices started to fall, CeFi collapsed.
Halting withdrawals - Preventing depositors from withdrawing their money is a signal that something is drastically wrong.
Exposure to 3AC - Three Arrows Capital (“3AC”) was a high flying crypto hedge fund with estimated $10-18 billion of assets. It used too much leverage. When crypto prices collapsed, it could no longer make margin calls. By the end of June, 3AC was being liquidated. On July 2, 3AC filed for bankruptcy.
In this piece I outline:
The CeFi Casualty List (what happened?)
Lessons from CeFi Casualties
CeFi Casualty List
1. Voyager
Voyager provides crypto lending, borrowing, trading and custody services. At the end of 2021, it had a public equity market cap of $2 billion. On July 6, 2022 it filed for voluntary bankruptcy.
As of March 31, 2022 Voyager had $5.9 billion of assets; $3.4 billion was investment in crypto assets and $2.0 billion were loans issued. Voyager disclosed it had $685 million in crypto assets as of June 30; an 80% decline from its $3.4 billion March 31 balance.
On June 30, 2021, Voyager’s loan book was $393 million. It ballooned to $2 billion by March 31, 2022 and declined to $1.1 billion by June 30. Voyager first issued a $514 million loan to 3AC in the quarter ended September 31, 2021. By June 30, 2022 it had a $654 million loan exposure to 3AC, consisting of $350 million USDC and 15,250 btc, paying 3-10% interest. 60% of Voyager’s loan book exposure was to one entity; 3AC. That’s insane portfolio concentration.
It gets worse. The loans Voyager issued were mostly unsecured loans. As of March 31, 2022 borrowers from Voyager had posted $227 million of collateral on a $2 billion loan book; that’s 11% collateralization ratio.
As crypto prices collapsed, Voyager asked 3AC to repay its loan. 3AC did not. Voyager became insolvent. Its assets were worth less than its liabilities. It issued a notice of default to 3AC. Voyager received an emergency $200 million cash and USDC and 15,000 btc credit facility on June 22 from Alameda “to safeguard customer assets.” It wasn’t enough. On July 1, Voyager suspended all trading, deposits, withdrawals and loyalty rewards. Five days later, Voyager filed for bankruptcy.
The swift collapse was caused by Voyager’s incomprehensible and reckless loan book management. Concentrating 60% of its loan book in one unsecured loan to a high risk levered crypto hedge fund is insane. A regulated bank would never be allowed to do that. I suspect 3AC got a favorable loan because 3AC funneled more of its trades through Voyager. Voyager was wooed by 3AC’s “investing pedigree.” 3AC took advantage of Voyager's ineptitude.
2. Celsius
The short story on Celsius, which I outlined in detail in Freezing Celsius, is that it took customer deposits, levered them and invested them in long term illiquid crypto assets and returned part of the proceeds to depositors as yield. I explained that cratering crypto prices and a mismanagement of its assets and liabilities likely made Celsius insolvent and that it would file for bankruptcy. On June 12, it paused all withdrawals sending markets into a panic. On July 13, Celsius voluntarily filed for bankruptcy. At its peak it had $25 billion of assets.
3. BlockFi
BlockFi is essentially a crypto bank. Depositors deposit crypto and BlockFi lends the deposits to mostly institutional borrowers who pay interest. Income from loan interest is partially passed on to depositors as “yield.” As of March 2022, it had $8.9 billion in deposits (down from $15 billion in March 2021) from over half a million depositors. In March of 2021, BlockFi raised a $350 million Series D valuing the 5 year old company at $3 billion.
On June 16, BlockFi announced it liquidated a large client “that failed to meet its obligation on an overcollateralized margin loan.” It was leaked that BlockFi had a $1 billion loan outstanding to 3AC that was 30% overcollateralized. BlockFi realized an $80 million loss on its 3AC loan and stated it has no additional exposure.
Seems like a crisis averted. But on June 30, BlockFi struck a deal with FTX for an emergency $400 revolving credit facility including an option to buy BlockFi for up to $240 million based on performance triggers. Selling for $240 million, down 92% from BlockFi’s prior round, is a clear indication something went horribly wrong.
The reason BlockFi did the FTX deal, which on June 21 was announced as a $250 million credit facility and 9 days later upped to $400 million, is because BlockFi was experiencing daily depositor withdrawals of over 10% of balances. That’s enormous. It’s more than TradFi banks are equipped to handle. Depositors were spooked by collapsing crypto markets and gating of withdrawals. They rushed to get their money out wherever they could.
BlockFi aims to hold 50% of deposits in assets that can be called in 7 days. Within a week of over 10% daily deposit withdrawals, BlockFi would be unable to fulfill depositor withdrawals. It was in a pinch from a bank run and needed cash asap to shore up its dwindling deposits. Alternatively, BlockFi would have had to halt customer withdrawals, which to its credit it has not.
The reason BlockFi was willing to sell itself for $240 million is twofold:
It probably doesn’t have a choice. To get the emergency cash it needed FTX took a pound of flesh. I’ve been a distressed investor, when you’re the only money available, the investment could go to zero, and the borrower is desperate, you take everything you can.
BlockFi’s equity was already likely wiped out. As of March 31, 2022 BlockFi had a $5.6 billion dollar loan portfolio with a net exposure of $1.6 billion. Net exposure represents the value of the loan portfolio that has no collateral backing it; BlockFi wears that risk. Given the market implosion, I suspect BlockFi will incur a $1.6 billion (or a number close to that) loss, which wipes out whatever equity there was at BlockFi’s $1 billion June 2022 valuation.
4. Babel Finance
Babel Finance provides crypto lending and trading to institutional clients. At the end of 2021, it had a $3 billion loan book and traded $800 million worth of crypto derivatives a month. In May 2022 Babel raised $80 million at a $2 billion valuation. On June 17, it halted redemptions and withdrawals citing “major [market] fluctuations” and “facing unusual liquidity pressures.”
It’s unclear but Babel likely has loans outstanding to 3AC and/or other levered entities that are unable to repay their debts. More pain will likely be felt because of Babel.
5. Genesis
Genesis Trading is one of the largest digital asset prime brokers. It provides trading, lending, borrowing and custodying for institutional clients. As of March 31, it had a $14.6 billion loan book. In Q1’22, it originated $44.3 billion of loans. Genesis announced it had loaned an undisclosed amount to 3AC with 80% collateralization. It liquidated the collateral when 3AC could not make its margin call. The loss incurred on the 3AC loan by Genesis, rumored to be in the “hundreds of millions” will be absorbed by its parent Digital Currency Group. Genesis seems to have escaped unscathed.
6. Vauld
Vauld is a centralized lending and investing platform. The funds deposited are used by Vauld to issue 150% collateralized loans and generate trading profits. The lending and trading functions generate a yield that is partially paid to depositors. On July 4, it halted all withdrawals stating that since June 12, $197 million was requested in withdrawals; 60% of its estimated $330 million asset base. It has filed for voluntary bankruptcy to restructure itself. Asian rival Nexo is entertaining acquiring Vauld.
7. Coinflex
Coinflex is a crypto exchange that halted withdrawals on June 23 due to “uncertainty involving a counterparty.” Coinflex later elaborated that it extended a loan to a special client on preferential terms that, unlike typical loans, cannot be liquidated. Instead this special client pledged personal guarantees, which Coinflex can’t enforce. Coinflex tweeted that bitcoin bull Roger Ver is the client responsible for the $47 million shortfall. Roger denies its him.
8. Finblox
Finblox, a startup launched in 2021 that provides crypto yield to customers, reduced customer withdrawals to $1,500 per month on June 16 citing 3AC insolvency. It appears that Finblox lent customer deposits to 3AC to generate its yield.
Lesson from CeFi Casualties
1. Poor loan underwriting
Voyager, Babel, Genesis Vauld, Coinflex and Finblox all made bad loans. Loan defaults are an expected part of managing a loan book. Banks deal with it all the time. Regulation exists to ensure banks don’t take on too much loan risk, have enough liquidity and equity cushion to withstand loan defaults without compromising deposits. However, in crypto there is no regulation or oversight on loan underwriting. CeFi platforms made large unsecured and undercollateralized loans to counterparties they did not understand. CeFi replicated TradFi loan underwriting without the checks and balances.
2. Mismanagement of assets and liabilities
CeFi platforms grew their asset base from retail depositors who could withdraw their money anytime. They borrowed short term capital; in the form of deposits. They invested that capital in long term risky assets. Mismatching the duration of assets and liabilities put CeFi platform in a bind. When depositors wanted their money back, it wasn’t available.
3. Elementary mistakes
The basic mistakes made by CeFi, particularly laxed underwriting standards and asset and liability mismatch, should not happen. These are basic loan 101 things to understand. It suggests CeFi was operated by ineptitude, carelessness and greed.
4. Pausing withdrawals seals your fate
Halting withdrawals is done as a last resort because there is not enough money on hand to fulfill customer demands. The person who panics first and withdraws gets their money out. The next withdrawer gets nothing. Pausing all withdrawals and going through a restructuring allows the loss to be spread amongst all depositors and creditors based on their seniority. It’s an equitable process. Pausing withdrawals seals your bankruptcy fate. You can’t open up withdrawals again because every depositor will demand their money back immediately. It will end your business. The only option is the restructure through a bankruptcy proceeding; like the CeFi Casualties are.
5. Bankruptcy is not always game over
In the wake of the Global Financial Crisis General Motors and Chrysler filed for bankruptcy. Through a restructuring process and a capital injection from the US government, they re-emerged. The equity of CeFi Casualties will be totally wiped out. They will continue to operate through their restructuring processes as lawyers, depositors and creditors fight over the asset scraps. It will be long and painful, but some form of consolidated entities will emerge on the other side.
6. Bank runs impact everyone
Once Celsius blocked withdrawals, many followed suit. BlockFi did not. BlockFi became the only ATM in town people could withdraw their crypto assets from. It had a flood of withdrawals. Notwithstanding that BlockFi had manageable exposure to 3AC, it became a victim of a system wide bank run. It didn’t matter that it was a decently well run business, depositors wanted their crypto back and BlockFi was the only place to give it back to them.
7. Unlike prior crypto winters
The 2017-19 crypto winter was caused by the bursting of a hype bubble. The Initial Coin Offering craze allowed businesses to raise money in pseudo security offerings. When the businesses later proved to be shams and the means in which they raised money questionable, the bubble burst. This crypto winter is caused by a deleveraging. The ballooning prices in crypto were generated by financial engineering facilitating huge amounts of leverage provided to crypto funds by retail depositors in search of “yield.” Crypto prices sold off as rising rates gave investors pause for concern. Prices capitulated once margin calls were triggered causing indiscriminate selling. Financial innovation will not thaw this winter like it did the last. Technological innovation and blockchain use cases are the only remedy.
Stay curious.
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PS - thanks to @milkroad for the cartoon cover image.