- The primary telltale sign of vulnerable platforms is unusually high yields.
- Speculators should treat incentive schemes that reward holders for not selling with suspicion.
- The sector is also defined by the regular use of leverage, something which amplifies risk and exposes platforms to some very big comedowns.
- One other issue affecting crypto as a whole is that of contagion, with many platforms lending to and/or depositing with each other.
- The crypto industry needs to significantly improve its risk management practices, making them stricter and more systematic.
It’s every crypto investor’s worst nightmare, depositing money with a platform that later goes bust, making it all but impossible to recover funds. It’s also bad enough investing in the native token of any such platform, the collapse of which will send that token plummeting to Earth like a lead balloon.
This nightmare has already been realized on more than one occasion during the current bear market, with the collapses of Terra and Celsius leaving more than a few investors out of pocket. Yet while we can all point retroactively to how dangerous such platforms and their business models were, spotting the ‘next Celsius’ before it collapses is certainly a big ask.
However, a number of crypto industry players affirm that, at least in the worst cases, there are a few telltale signs that reveal some platforms are exposing themselves to more risk than others. At the same time, a diversification strategy always remains a sound policy, since predicting the next collapse in a highly interconnected market isn’t always possible.
Telltale signs of the next Celsius
Pretty much every commentator is in agreement as to the primary telltale sign of vulnerable platforms: unusually high yields. Yes, Celsius and Terra (via the associated Anchor Protocol) offered yields that seemed too good to be true, or rather, too risky to be true for long.
“At the very least, Celcius displayed a woeful lack of due diligence in lending vast amounts of depositors’ money to highly speculative ventures. But the way it made such lofty promises of high returns to sign up and lock away their money had many hallmarks of a giant Ponzi scheme,” said Susannah Streeter, the senior investment and markets analyst at Hargreaves Lansdown.
Streeter advises that speculators should treat incentive schemes that reward holders for not selling (and that charge does who do) with suspicion. Likewise, GlobalBlock analyst Marcus Sotiriou also flags high yields as the major warning sign of a potentially risky platform.
“Celsius, for example, were offering yields of up to 17% – to offer this yield, it meant they had to take on significant risk with client funds. One of the biggest factors that led to their demise was using client funds to gain exposure to DeFi [decentralized finance],” he told Cryptonews.com.
This touches on another big risk factor: using investors’ and depositors’ funds to speculate and trade on other platforms, many of which carry their own risks. In fact, this almost always tends to occur with the offering of high yields, since it’s really the only possible way of providing such yields (unless a platform is an outright Ponzi scheme).
“These platforms were characterizing themselves as ‘deposit takers’ and alternatives to banks, but were investing client funds in various, sometimes aggressive trading strategies to fund the high yields offered to attract those deposits,” said Charlie Beach, the chief risk officer at Nasdaq-listed crypto-exchange EQONEX.
One of the big issues with investing with user funds is that, if investors withdraw liquidity faster than investors deposit, then a platform would be at risk of not having enough liquidity to fulfill its withdrawal obligations. Of course, it’s not always transparent as to what exactly a DeFi platform is doing with its users’ funds, yet users should endeavor to find out, and if they can’t they should probably steer clear.
And aside from the inherent volatility of the crypto market, platforms also have to be wary of hacks and other technical mishaps. These are also not uncommon in crypto, something which Celsius discovered, much to its chagrin.
“It started in June 2021,” said Marcus Sotiriou, “when Celsius lost at least ETH 35,000 [USD 58.8m today] according to on-chain data provided by Nansen, in the Ethereum staking service Stakehound […] In addition, according to [an] analysis by DirtyBubbleMedia, Celsius lost USD 22m from the Badger DAO hack after it mistakenly forfeited restitution payments.”
Crypto and contagion
Unfortunately, more than a few analysts and industry figures affirm that risk is almost unavoidably amplified in crypto, given its immaturity. This will make picking out the next Celsius more than a little difficult.
“Much of the innovation and programs we see around digital assets are still experimental, and with only 5% global penetration, the liquidity base is not strong enough to withstand extreme market stress, and with over 20,000 cryptocurrencies in the market, liquidity is even more stretched out leaving the market more vulnerable than it needs to be,” said Ben Caselin, the head of research and strategy at Hong Kong-based crypto exchange AAX.
While it’s not exclusive to crypto, the sector is also defined by the regular use of leverage, something which amplifies risk and exposes platforms to some very big comedowns. This reliance on leverage may subside to an extent as the market matures and becomes more liquid, but for now, it’s another factor that makes crypto riskier than many other areas of investment.
“Cryptoassets are intrinsically risky and require careful risk management, but the industry is only starting to learn that lesson in a painful way. When asset prices were increasing, hedge funds and lending platforms were lending/borrowing with insufficient collateral and often using those funds to trade inherently risky trading strategies with leverage,” said Charlie Beach.
One other issue affecting crypto as a whole is that of contagion, with many platforms lending to and/or depositing with each other. This is another magnifier of risk, and makes spotting a future bankruptcy particularly difficult.
“Contagion has impacted many collapses and bankruptcies, with lenders being impacted the most due to a liquidity crisis. The contagion has meant that lenders have been forced to withdraw credit from the system to reduce risk, which has a knock-on effect and resulted in many lenders struggling to meet withdrawal obligations,” said Marcus Sotiriou.
The future needs to be transparent
On the other hand, contagion isn’t unique to crypto, with the legacy financial system also exhibiting strong interconnectedness. However, in the main, traditional financial firms have done a better job of avoiding bankruptcies in recent years due to more advanced and rigorous risk management.
“Interconnection is not unique to the crypto ecosystem, but a characteristic of any financial system […] The recent collapse of Archegos Capital Management caused billions of dollars of losses for several leading wall street firms and exposed some poor risk management practices, but put into perspective, the risk management in those firms is far superior to practices in many crypto firms, and for most of them the losses were contained,” said Charlie Beach.
As such, the crypto industry needs to significantly improve its risk management practices, making them stricter and more systematic. This is the only way to minimize the threat of contagion and avoid dangerous market behavior.
“As an example, Voyager Digital had lent out a total of USD 2bn to market participants, and around USD 660m of which was lent to Three Arrows Capital. The fact that around a third of funds lent out was allocated to one institution is extremely risky and resulted in Voyager Digital collapsing. If they reduced the total exposure to Three Arrows Capital to 5% of lent funds, their collapse could have been avoided,” said Marcus Sotiriou.
On top of better risk management, some would like to see regulators getting involved, if only to protect retail investors.
“[Recent collapses] will intensify the urgency for regulators to start imposing more rules on the crypto world to ensure that more retail investors are prevented from getting caught up in the hype and gambling with money they can ill afford to lose,” said Susannah Streeter.
As for retail investors, there are a few things the average trader can do to reduce their exposure to the next Celsius.
“In my opinion, the typical investor should always implement diversification amongst various products/services to reduce the impact of collapses. Also, investors should always question where a ‘DeFi’ or ‘CeFi’ [centralized finance] platform is obtaining its yield from, particularly if the yield is over 5%-10%,” said Sotiriou.
In addition, investors should also carry out their own due diligence to find out what the platform they are investing with is doing with their funds, especially if the platform does not make this clear and transparent on its website. And again, if a platform doesn’t provide transparency, then perhaps it would be better to avoid it.
– Terra’s Collapse Is a Hard Lesson for Sloppy Crypto VCs and Gullible Retail Investors
– Anger, Worry, and Doubt – Celsius Customers ‘Pray’ for the Return of Their Crypto
– US Government Bodies Blast Voyager’s ‘False and Misleading Statements’ On Deposit Insurance
– 3 Reasons Why 3 Arrows Capital Failed, Per Its Founders
– Give Us Our Money Back: The Issue With Custodial Wallets and the Implications of Halting Withdrawals on Crypto’s Reputation
– Crypto Industry’s Custody, Ownership Rights Are ‘Fundamental Problems’ That Need Solving – US Official