Behind Celsius' Insolvency: ETH's Liquid Token Becomes Less Liquid

Original Author: Conor Ryder, Kaiko Analyst

Original compilation: 黑米@白泽研究院

The crypto market is collapsing, and certain companies that took big risks are facing the consequences.

Celsius, one of the largest DeFi lending platforms with about $12 billion in assets under management, announced on Sunday that they would be suspending all withdrawals, sparking widespread investor panic about the company’s “insolvency.”

There have also been rumors in the past two days that Three Arrows Capital (3AC) is struggling to achieve solvency. How exactly did a large institution intertwined with the largest market players end up with a Lehman-like end?

Poor asset management, bearish market conditions, and derivatives on Ethereum combined to create a storm with disastrous consequences.

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What is stETH?

Later this year, the Ethereum mainnet will complete the process of the Merge, transitioning from Proof of Work (PoW) to Proof of Stake (PoS). Before the merger, investors can stake ETH to secure the new PoS chain, or earn yield for themselves. However, this gain has come at the cost of illiquidity, as stakers are unable to redeem their staked ETH until the network completes the transition, and skeptics worry that the merger may not even complete this year. In order to become a validator on the new chain, staking directly through Ethereum also requires a high threshold of 32 ETH.

So, some small investors started to enter Lido Finance: a decentralized staking platform that aims to provide liquidity solutions for ETH staking. Lido provides a 1:1 derivative token stETH with ETH (without the requirement of 32 ETH), and also provides a return similar to that directly pledged on the PoS chain (about 4% annual interest rate). After the Ethereum merger is completed, the ETH (stETH) pledged on Lido can be fully redeemed through Lido, providing pledgers with all the benefits of staking on the PoS chain, but without the disadvantages of insufficient liquidity and high barriers to entry. stETH can also provide other functions, such as lending, staking (yes, you can re-stake stETH), and trading.

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stETH Liquidity Pool

To support the growing demand for stETH, the decentralized exchange Curve has introduced a liquidity pool for the stETH-ETH pair, so that investors can easily convert their ETH to stETH at a reasonable price, or the liquidity pool provides liquidity , and earn income in the form of CRV tokens.

However, the rapid rise of Lido/stETH and the collapse of Terra caused some problems for the stETH-ETH exchange rate. In May, stETH began trading at a 5% discount to ETH, sparking initial concerns. This discounting was repeated last week, sparking the beginning of Celsius' liquidity problems.

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Behind the discount of stETH: a heavy blow to liquidity

Unlike TerraUSD (UST), stETH does not need to maintain its peg. stETH is simply a 1:1 token representation of the amount of ETH a user has staked in Lido. As a decentralized staking service, Lido had to honor merged stETH redemptions.

Therefore, the issue of discounting stETH focuses on liquidity. Under normal market conditions, the stETH-ETH liquidity pool enables efficient exchange between assets, allowing stakeholders to easily cash out ETH when they want to exit stETH.

Only the combination of discounts and poor market conditions has created serious problems for protocols like Celsius that manage funds on behalf of clients. Celsius users are increasingly looking to redeem ETH after the extremely bearish price action last month and news of their possible exposure to Terra became public. However, it is clear that Celsius will struggle to meet these redemption requests due to the illiquid holdings of stETH.

While it's not entirely clear how much of Celsius's ETH holdings were converted to stETH, it's estimated to be around $475 million, based on public wallet information provided by Dune Analytics. The platform has since halted all withdrawals, all but confirming investor concerns.

Despite being fully centralized, Celsius has its own token — CEL — that rewards platform users. The CEL perpetual contract market reacted almost immediately to the announcement, with open interest surging and funding rates plunging, suggesting investors were adding to short positions in anticipation of a full-blown Celsius collapse.

The price of CEL has been hammered since the beginning of the year due to a generally bearish market, but the price plummeted to just $0.17 after the announcement.

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1) Waiting for Ethereum to merge, convert stETH 1:1 to ETH

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2) Sell stETH on the open market and pay back the redemption

If you need liquidity, the first point is to check whether selling stETH on the open market is an appropriate option. First, let’s look at the decentralized exchange Curve, as it has by far the most liquid stETH market.

May 18, 2022:

June 15, 2022:

Today, there are only 116,000 available ETH (approximately $130 million) available for sale for stETH, and if Celisus were to dump here to get the liquidity it needs, this would absolutely cause the exchange rate between stETH and ETH to collapse. We can see in the graph above that a month ago, liquidity was more readily available, with 291 million ETH available in the Curve pool.

For example, selling 100,000 stETH for ETH on Curve would result in an exchange rate of only 0.84 (which is only 1/4 of the total held by Celisus).

Next we can see if selling stETH on a centralized exchange is an option.

We can check the Depth of Market on FTX, the only stETH spot market on a centralized exchange, to see if there is enough liquidity to support a large stETH sell order.

We can clearly see that without lowering the price of stETH, FTX's market depth is far from being able to handle the order of magnitude required by Celisus.

Using 2% market depth as a measure of available stETH liquidity on centralized exchanges, we observed only $300,000 worth of stETH liquidity on FTX prior to June 11. But after Celisus fear swept the market, that number dropped to less than $50,000, and stETH holders have now drained nearly all of the available stETH liquidity they could find on centralized exchanges.

To illustrate the losses that would be incurred by selling just $100,000 worth of stETH on FTX, I plotted the slippage of the stETH-USD pair on the exchange, and we can see that selling just $100,000 worth of stETH on FTX has becomes completely infeasible. Slippage on the pair has increased to 3.5%, which combined with the roughly 5% discount of stETH to the ETH price means that selling stETH on a centralized exchange results in an 8.5% loss on an order of $100,000.

Spot volumes we have observed on FTX over the past few days suggest that daily volume topped out at $10 million and has since fluctuated between $1 million and $5 million, likely due to lack of liquidity. Celsius may or may not have entrusted its ~$475 million worth of stETH to FTX.

Overall, stETH transaction activity is dominated by Curve, accounting for 98.5% of the total transaction volume in 2022. Although stETH is also listed on other decentralized exchanges such as Uniswap and Sushiswap, the transaction volume and liquidity are far from being as high.

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3) Use stETH or other reserves as collateral for the OTC protocol

Clearly, institutions facing solvency issues cannot wait for Ethereum to merge to redeem their stETH holdings, nor can they sell large amounts of stETH on centralized or decentralized exchanges. This really only leaves one option to avoid complete bankruptcy: use stETH as collateral, enter into some form of over-the-counter (OTC) contract with an exchange or market maker.

In the last week, not only have we seen Celsius and crypto trading platform Amber Group's "Desperate Survival", they were both found to be sending large amounts of stETH and other reserves to FTX. The figure below shows the coin minting and burning in the Curve stETH-ETH pool. We observed that both stETH and ETH had a large amount of burning last week, indicating that liquidity has been withdrawn from the Curve pool in large numbers.

Interestingly, a large amount of stETH was burned from the pool, which shows that users are willing to lock up stETH discounts, either for long-term holding or exchanging them for ETH. Through the data on the chain, we can find that in the past few days, wallets belonging to the Amber Group have destroyed more than $150 million worth of stETH from the Curve pool. Then Amber Group sends stETH to FTX.

FTX is now the largest holder of stETH outside of smart contracts after receiving large deposits from Celsius and Amber. As I pointed out before, these deposits never made it into FTX's spot market, since transactions of such magnitude are easy to spot.

To me, OTC is the only way to get stETH liquidity rewards. The problem with over-the-counter transactions is that they are essentially off-chain transactions, so they cannot be found. Therefore, we are temporarily unable to determine how these stETH will be handled.

But the Ethereum futures market on FTX does show some interesting trends that might provide some insight. We observed a sharp increase in open interest on FTX, while open interest on other exchanges fell as the price of Ethereum plummeted. When asset prices crash, we typically observe a drop in open interest due to increased liquidations, unwinding of futures contracts, and the impact of falling prices on the actual open interest data itself. Seeing open interest go up in the face of falling FTX prices is interesting in itself, but the trend is even more interesting when you consider the large amount of stETH and ETH deposits the exchange has received over the past few days.

guess:

• Celsius can trade OTC via FTX, use or swap their stETH, and take a short ETH position on the perpetual futures market, and if ETH falls, they can profit by liquidating the contract at a lower price. Suspension of withdrawals provides them with the only chance that they may be profiting from the position.

• Another guess might just be FTX or some market maker taking stETH from Celsius at a steep discount in order to profit when stETH is 1:1 convertible to ETH. They may have used a short position in ETH via FTX to hedge price risk, minimize losses, and ensure their profits are entirely from the price difference between stETH and ETH.

All in all, what happens after FTX receives a massive influx of stETH and ETH is anyone's guess. However, going through the data, it can be accurately said that Celsius would not be able to directly sell all of their stETH on centralized or decentralized exchanges, and thus may have to use stETH for OTC type transactions to remain solvent.

According to the "Notice on Further Preventing and Dealing with the Risk of Hype in Virtual Currency Transactions" issued by the central bank and other departments, the content of this article is only for information sharing, and does not promote or endorse any operation and investment behavior. Participate in any illegal financial practice.

risk warning:

According to the "Notice on Further Preventing and Dealing with the Risk of Hype in Virtual Currency Transactions" issued by the central bank and other departments, the content of this article is only for information sharing, and does not promote or endorse any operation and investment behavior. Participate in any illegal financial practice.