It's all connected … and that's the problem
Welcome to the Block & Mortar newsletter! Every week, we bring you the top stories and our analysis on where business meets web3: blockchain, cryptocurrencies, NFTs, and metaverse. Brought to you by Scott Robbin and Q McCallum.
It's been one hell of a week for crypto, right?
Sort of. Depends on how you define "crypto."
The term is often used as a catch-all, which can muddy things. As your Block & Mortar editors explore business use cases for this domain, we find it easier to navigate if we split "crypto" into three layers: the underlying blockchain technology; the financialized tokens of crypto**currencies** and DeFi; and other token applications such as NFTs and DAOs. Disturbances in one layer don't necessarily invalidate the business potential for the other two. Something to keep in mind as you follow the news.
That doesn't mean we can ignore what's happening in DeFi right now. It's been just a few weeks since TerraUSD/Luna fell apart. Bitcoin's price continues its free-fall. And now Celsius and Three Arrows Capital (3AC) are hurting.
For that last point, it helps to look at the big picture:
- Success in trading is ultimately about developing a healthy respect for risk. Risk is your exposure to – that is, how much you're standing in the path of – oncoming events.
- Success in risk management is ultimately about understanding complexity. Complexity is a special kind of widespread interconnectedness. An incident at Point A spreads to Points G and H, leading to a cascading failure from N through Z.
- Connectivity limits visibility. In a complex system, there are too many connections for a person to understand the entire system. There are plenty of dark corners for problems to hide.
- A catastrophe is greater than the sum of its parts. There is rarely a single cause to a catastrophic incident. You need several smaller problems, through a mix of unfortunate timing and unexpected pathways, to collide.
All of this is to say: if you want to understand the recent DeFi hell that is centered on Celsius and 3AC, it helps to see it all through the lenses of "risk" and "interconnectedness."
A special report from our friend Shane Glynn explains:
(This section was written by Shane Glynn. Some of you may know him as the guy who reviews our newsletter drafts. He's also an experienced attorney who has spent the past few years focused on crypto.)
One way to view the last thirteen years of cryptocurrency is that the industry is speedrunning the 400 year history of modern trading firms. Along the way, the field is creating new innovations and replaying some of the same pitfalls that modern finance discovered in the past.
The choice to ignore financial history represents both the good and the bad of "first principles thinking." The Good? You get extremely interesting innovation, because you try some stuff that current market participants think won’t work (but they've never bothered to test). The Bad? You fall into some very obvious traps, because you try stuff that current market participants think won’t work (because they've already done it and it failed).
The most recent pitfall discovered by the crypto industry is global systemic risk. This concept is well known to anyone who traded securities, or owned a house, or had a bank account in 2008. Yet here it is somehow unfamiliar.
The last five weeks in crypto have felt like a year:
- 09 May: The Terraform Labs ecosystem, primarily composed of the Luna token and the UST stablecoin, collapsed and wiped out $50B of notional value.
- 11 June: The exchange rate between Ether (ETH) and Lido staked Ether (stETH) dropped from its historical 1:1 ratio to 1:0.95, while trading liquidity on the pair decreased.
- 13 June: The Celsius Network halted customer withdrawals and reportedly routed funds to collateralize large illiquid loans. As of June 16, they've bought themselves some time and hired restructuring advisers.
- 16 June: Three Arrows Capital (3AC), a multibillion-dollar prop trading firm that also made VC investments, reportedly missed margin calls and had several hundreds of millions of dollars in positions liquidated.
These are interesting events in isolation, yes. What is even more interesting, from the perspective of financial systems, is how they are interrelated:
- Celsius and 3AC had substantial exposure to the Terraform Labs ecosystem. Celsius has a reported 9-figure position in UST, while 3AC had reported significant positions in both UST and Luna.
- Celsius and 3AC had substantial exposure to stETH and both reportedly liquidated significant stETH positions at a loss.
- **Celsius is a significant source of capital across decentralized finance platforms. **Their reallocation of assets contributed to a drop in liquidity across the industry.
- 3AC is a major investor in cryptocurrency companies and is also reported to be a major borrower of crypto assets from exchanges and other trading entities.
All of these interrelationships, combined with a lack of transparency for off-chain debt obligations, have resulted in circumstances where many parties are unsure about the solvency of their financial counterparties.
In one sense, the problem could be described as many trading companies having undefined financial exposure to each other. This same set of circumstances led to the collapse of Bear Stearns and Lehman Brothers in 2008.
In another sense, part of 3AC's problems allegedly involved them borrowing from many other firms … without those firms understanding the cross-party risk. This is similar to the issues that Archegos had with Credit Suisse, Goldman Sachs, and Morgan Stanley.
That's all well and good; but looking backward works best when it helps us plan our moves forward. What can we learn from this?
I’d offer two positive conclusions and one area for improvement.
- On the positive side, credit and swap mechanisms that are entirely on-chain and driven by smart contracts have weathered the financial crunch surprisingly well. Products like Curve, Uniswap, and DYDX continued to function under significant performance stress.
- Similarly, centralized exchanges like FTX that use a fairly strict programmatic liquidation engine were able to provide an orderly market during the last month.
- The notable failures involved centralized firms that relied on personal relationships and margin calls made via phone. Around here we like to say that "everything old is new again." It seems crypto managed to import the old-boys network – complete with all of the ugly failure modes that allow insiders to take on oversized risk, with occasionally disastrous consequences.
These bullet points could indicate that, when it comes to mitigating financial risk, people are the problem and computers can be a solution.
For example, FTX’s liquidation engine doesn’t care about the size of your position, or if you have a personal relationship with an executive, or whether you answer your phone. The liquidation engine will slowly unwind everyone’s risky positions in the same manner. This is far better than a traditional liquidation system, which all too often results in one well-connected trader's losses being absorbed by all of a firm’s counterparties.
It should go without saying, and with a nod to Terraform Labs, that automated systems are not infallible. An improperly designed computer system can exhibit all of the problems and failures of the people who programmed it.
But based on what we've seen these past few weeks, automated systems provide a cold, calculated consistency that has been conspicuously absent in certain parts of the crypto ecosystem.
Trouble was brewing in the cryptocurrency space even before Celsius and 3AC blew up. General issues in the sector, complicated by fears of a wider economic downturn, have led some crypto companies to lay off a portion of their staff.
Some of the affected employees may find their next job in the regulatory space. FINRA CEO Robert Cook opened that door when he discussed the group's plans to become more deeply involved in crypto affairs: "We're going to need to be engaged and prepared to have the resources to do that, so anybody who is getting laid off from a crypto platform and wants to work for FINRA, give me a call."
This strikes us as a smart move. FINRA would do well to have experienced, crypto-knowledgeable people on its team. (Though, given recent events, will there be any crypto left to regulate?)
Maybe Cook can sweeten the deal for the recently downsized recruits by offering them fancy titles. As a gift to the fine folks at FINRA, we offer "Karma Specialist," "VP of Revenge," and "Chief Payback Officer."
Elon Musk was apparently late to join a meeting with Twitter staff this week. Perhaps he was busy dealing with a lawsuit? Along with his companies Tesla and SpaceX, he's accused of engaging in a cryptocurrency pyramid scheme.
This is when we could get into the description of the charges (racketeering). Or the amount in damages (total $258 billion). Or that it involves cryptocurrency (DogeCoin). Or even that Musk is very clear on his stance ("I will keep supporting Dogecoin").
We could do that. But we won't.
We actually don't have anything to add to this story. We just wanted an excuse to use the joke you see in our headline.
Carry on. Nothing to see here.
We'd like to extend a special thanks to our subscribers. Not only did you sign up to read our weekly musings on web3, but you did so in spite of our old, barebones website. Consider yourselves our early fans. From our indie-rock days. When we were still recording songs in our basement.
We have now entered The Big Time™. Please check out our new, fancy website… which also lists our new, fancy services:
This is just the beginning. Over time, we plan to roll out even more content. Tutorials. Workshops. Consulting. Who knows? Maybe there'll be some stray NFTs. Stay tuned!
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Note: We’d like to thank Shane Glynn for reviewing early newsletter drafts. Any mistakes that remain are ours.