Anatomy Of The CeFi Implosion

I have been and still am a big fan of DeFi (decentralized finance) and for that matter CeFi (centralized finance) but the recent implosion highlights the issues for all financial services. Celsius and Lehman went down for the same reason, too much risk. This sounds innocuous but you can rewrite this sentence: Celsius and Lehman went down for the same reason, too much greed.

In a boom the greedy win, the insanely greedy win biggest. And with the biggest winners it is insanity that sets them on their pedestal of fame and wealth. Then a boom turns to a bust and brings about a shattering fall. The insanely greedy are the first to go in a crash.

The fundament of banking is to borrow money offering low risk to the lender and some payment for their deposit as an incentive and then lend that money out at a higher risk to capture a profit. The higher the risk up to a point, the greater the profit, but there is a tipping point where greater risk equals diminished profit and then a point where more risk creates losses.

You can see this at work analogically in the Kelly Optimization, a way of maximizing returns from a winning game process – it could be backing horse, it could be funding unsecured credit cards.

There is an optimal point in a range of risk, where profit is maximized. Kelly expresses this outcome in terms of position sizes but it is true also for simple risk. As I say about buying certain high risk stocks, “There is no real risk, you are certain to lose all your money.” Normally above a certain level of elevated risk you simply cannot win.

So in a boom, which is not normality, the insanely greedy will do incredibly well because every gamble, however risky, wins. So they double up their bets, they leverage them, they leverage the profits from the leverage, some will turn to fraud to raise their expose to the maximum. A giant tower of risk is created. Then when the bubble stops, they begin to lose then start to lose heavily, then the tower comes crashing down, smashing into other palaces of the insanely greedy causing a cascade.

CeFi and DeFi was and is built on depositors’ funds, but not the ones you might think. Exchanges park their customer funds in these platforms (remember “not your keys, not your crypto?”) and use them to earn free money and balance their books on the huge short positions they often carry.

These shorts get settled over time either at a profit or from a stop drive. (Would you like a stop loss with that leverage? Oops somehow the market spiked and now your crypto is ours.) An exchange can deposit USDc from its depositors’ balances and borrow a coin it’s short of, to cover redemption or any other operation it fancies. Exchange depositors money has been flowing around DeFi, CeFi and on to operations like 3AC that went bust days ago, and it’s ended up in all sorts of nooks and crannies and as we now know with Celsius’ $1 billion-plus deficit, it’s not coming back.

The broker/bucket shop takes your crypto, puts it at risk for yield and the DeFi/CeFi system churns it on. It is how capitalism works. The thing to remember is capitalism is a boom and bust cycle and crypto is now in the bust cycle.

When the prices go up, many brokers get short, so they borrow tokens on DeFi/CeFi to cover the hole and by doing so push up annual percentage yields (APYs), and money flows in to capture that APY. The opposite is true, when prices fall exchanges get long and repay and deposit and APYs fall.

There is however, a critical difference between decentralized finance and centralized finance. While the inflexibility of DeFi protects it from the boom bubble cycle and constrains it in a bubble, CeFi is exposed by the flexibility of the human element in a crash but unrestrained in a boom. Humans expose CeFi to gambler’s ruin and that is what we have seen. (Gamblers ruin is when someone over-bets and loses it all and thereby is unable to continue to play the game even if long term it is a winning game.)

APYs collapsed on DeFi platforms like AaveAAVE
and Compound (COMP), because the APY is mainly driven by APY algos. To “fix” that collapsing APY and keep it unsustainably high, code would need to be forked and its false nature exposed in the code. That might take weeks of coding or risk some huge bug vulnerability and people would be exposing it in hours. So as the APY falls the management is left staring glumly as market forces take their toll. Volumes fall, money is pulled, TVL nosedives and everyone can see that. However, that is the way it is, that is reality. Code keeps management from temptation, a temptation that leads management so often in finance to catastrophic failure.

In CeFi, management can willingly suspend its disbelief and pretend its APYs are sustainable and hope the tide turns. It’s a strategy of doom but it’s common. I must disclose I pulled my funds from Celsius months ago because when BlockFi dropped its rates, Celsius didn’t. Meanwhile DeFi rates were plummeting, so I saw this as a huge red flag.

Then there is another bigger weakness in CeFi and it is again people-based.

CeFi management works to keep APYs up, it’s not the job of an algo on a take it or leave it basis, so the humans go looking for ways to get yield for its deposits and in the boom, methods however wild and weird are everywhere and lucrative. They can even hand out equity investors’ funds to grab market share. In a bust opportunities dry up, redemptions rise and you are left with illiquid assets and a legacy of busted investments. This is an old story in funds of all shapes and the demise of many a classic hedge fund.

So when the insanely greedy show up at the door of a yield-hungry CeFi enterprise still shimmering with the afterglow of superstardom, offering to borrow at high yields, the CeFi outfit bites the borrower’s arm off on covenant-light terms.

Meanwhile a DeFi contract still needs its inflexible robotic terms met and can’t be charmed, bullied or negotiated with. If business is done the protocol is well covered, unlike the CeFi company that has lent and is now praying.

The soon to be ex-crypto-superstar doesn’t repay. Boom the CeFi outfit is bust and those that lent them money go pop next and in turn those they owed money to go foop!

If the market crashes, CeFi has to call up the borrower and request margin they might not have and might not deliver, then CeFi has to do deals to get out of the mess, and if they can’t it’s all over.

DeFi simply liquidates over-collateralized positions.

DeFi can default but only at a code level, a DeFi has to fork its code to pull a fast one. People can breeze into disaster, smart contracts are inhumanely ridged and only extreme transparent actions can bend them. That is DeFi’s strength which make DeFi robust in crashes. This robustness can be seen in the low APYs of Aave and Compound which makes no one happy in the short term but in the long term is key to survival and prosperity.

The crypto crash is defining the strengths and weaknesses of decentralization and its polar opposite, centralization. Centralization is almost always safe, ingloriously opaque but subject to catastrophic failure; decentralization is always risky, gloriously transparent but resistant to catastrophic failure.

So in a boom you want to ride the comforts of centralization and in a bust you want to be a denizen of decentralization.

Neither is going away and like in risk, position size and most other spectrums, there is an optimal mix.

Another crypto leg down will certainly test both.