Bankruptcy, Risk, and Yield.

Bankruptcy, Risk, and Yield.

Over the past few months, Celsius, Voyager, Vauld, and BlockFi have faced issues ranging from declared bankruptcy to $80 million in losses [1].  These yield providers owe over $6.4 billion to creditors, primarily retail investors [2].  If you are one of the 100,000+ people owed money, I hope you are doing okay and realize that this is only a bump in the road.  There isn't much that can be done, because at this point, it's a waiting line for distributions.  What can be done is to look back at what happened, why it happened, the risks, and how this can be prevented in the future.

What Happened

Yield providers were generating yield any place they could, and some were using a system called Terra.  Terra had a stablecoin called UST, which was supposed to be worth $1 USD.  The mechanism to maintain this peg used an arbitrage between the native token in the Terra system and UST.  The native token collapsed, forcing the arbitrage mechanisms into high gear, creating more of the native token to maintain the peg as the value of the native token was well on its way to zero.  When the demand for the native token disappeared, the arbitrage didn't work anymore.  $45 billion in value was lost.

Similar to Terra, the same yield seekers used a system called Lido.  Lido took Ethereum (ETH) that was "staked" in the network.  This staked ETH was locked and set to be unlocked when the network upgrades to Ethereum 2.0 at a date TBD.  Lido created a system that allows you access to staked ETH through a token that could be traded similarly to real ETH, called Staked ETH or stETH.  This stETH was used to make yield in places, and when Terra collapsed, investors ran for liquidity and dumped their stETH at a loss.  This drove it to trade at an 8% discount to ETH.  Many yield providers had exposure to stETH.  The hedge fund Three Arrows also sold a rather large (400,000 stETH) position, further driving prices down.[3]

Terra had a treasury that held 80,000 bitcoin, worth about $2.9 billion.  This treasury was liquidated over 48 hours.  This selling pressure drove bitcoin to new yearly lows.

Bitcoin below $30,000 and then below $20,000 was seen as so unlikely that it appears some people wrote it off and built businesses around a volatile market, never making a down year.

Why this happened

Many yield providers used the Terra stablecoin, UST, because it paid a very high yield.  Sometimes over 20% APY.  This yield earned on UST could easily be converted to genuine United States Dollars.  After moving some assets around, they effectively got 16% to 20% on US Dollars.

Finance 101:
If it sounds too good to be true, it likely is.

If this yield was strictly paid to depositors of Terra/UST, no problem.  The depositor is already accepting that risk.  That isn't what happened.

To put some (rough) numbers around it.  A good trader or desk with solid risk management, proper hedging, and enough volume will do 4% on Bitcoin loaned to them.  They will then pay back 3% to the lender, taking 1%.  If we assume this is the median yield, 4%, how can a yield provider pay 5%, 6%, or 7% on Bitcoin?

They subsidize the difference with other yields.  Your bitcoin alone was never making 8%.  Not to say that isn't possible.  It is possible, but it requires additional borrowing, rehypothecation, and perfect terms, and it comes with more risk.  Not to mention that at the size of hundreds of millions, that return is squeezed rather significantly.

Depositors are now unknowingly exposed to the most speculative assets with varying degrees of risk.  These assets are also difficult or impossible to hedge.  The only way to reap any reward is to be directionally exposed, meaning the yield provider will likely have to own the asset.

Takeaways

Firstly, "if it sounds too good to be true, it likely is."

Second, given the risk, how valuable is the yield on a multi-year view?  This partly has to do with your outlook for your investment.  For example, if you expect to make 8% over the next year and close that position, maybe an additional 3% yield makes sense.  Suppose you have a 10-year outlook on an investment and are highly confident in an 8x return.  In that case, the risk associated with the yield might not be as appealing to you, especially when you have an asset like Bitcoin that you can custody for next to nothing.

Whether the yield is suitable for you also depends on where you earn that yield.  I'll give away a piece from our secret sauce, our risk model; Total Yield Assets.  If someone is paying yield on 50 crypto assets ranging from 1% to 25%, you might conclude that means more risk.  You could make this conclusion because the more markets, complexities of each asset, software stacks, and correlation that yield providers have to contend with become too much.  In conjunction with other factors, you might conclude that an organization that only works with a handful of assets is more capable.  This is just one piece of a much larger puzzle and should not be viewed as a single variable for making decisions.  This is also not an endorsement for or against any company.  It is absolutely possible for a large entity to offer yield on 500 assets and still satisfy risk tolerance.

Industry Changes and Final Thoughts

Borrowing and lending are not going away.  There will always be a need for borrowing digital assets, and thus there will also be someone willing to lend them.  Credit markets are essential to a functioning economy.  A credit market will exist even if that economy is built on a decentralized, verifiably scarce digital money.  I hope moving forward; we see new yield options for retail investors with greater transparency and not just attestations from Cayman Island accountants.  This transparency should include a thoroughly explained risk management framework with crystal clear boundaries.  This would allow investors to adjust allocations to fit their specific risk tolerance quickly.  Those providing yield could implement transparency and public risk management frameworks tomorrow.  I think BlockFi's blog post on their Risk Management is a great example.[4]

Stay safe out there, and don't risk more than you are willing to lose.


[1] BlockFi raised money through a line of credit to "add capital to our balance sheet to bolster liquidity..."  Not at all the same as bankruptcy.  (source)
[2] As of August 2, 2022.  Sources: Celsius $4.7B owed, Voyager $1.3 in assets inaccessible to creditors,  VAULD $400M owed.
[3] https://www.coindesk.com/markets/2022/06/17/biggest-steth-pool-almost-empty-complicating-exit-for-would-be-sellers/
[4] There are posts about risk management from BlockFi going back to 2020.  I included their most recent one as it's relevant to the current situation and has the most information.


Disclaimers and Disclosures
I, personally, have no affiliation with any of the companies mentioned above, nor do I have any financial interest in any companies mentioned.
We, the firm and myself, have no financial interest in the abovementioned companies.  We are not encouraging anyone to use or not use any such yield-providing accounts.  If you got the impression that any of this is financial advice, you are wildly mistaken, blatantly wrong, and need some milk.