Recently I’ve started to see advertisements for Crypto lending products, where you basically ‘loan’ your BTC to some crypto broker and they pay you a yield for the privileges of borrowing your HODL, with enticing offerings of up to 4% or 5%, which is pretty attractive when you are zero bound.
Unfortunately what you are buying is not an interest rate yield but a product that is embedded with credit and systemic risk that is likely to result in those taking up the offer to lose everything they put into it.
First up in explaining this it is necessary to start with the term structure of the Crypto market. Term structure means the pricing structure of both the spot asset and future assets prices (prices today and in the future), as derived from various pricing tools – mainly futures.
The normal state for any futures market is one of backwardation**. Backwardation is a pricing structure that starts with spot price (i.e. current price today) as being the highest, and then future prices of the asset tend to be lower further into the future (this is not strictly correct as we are really talking about convergence of future prices vs expected future spot prices, but that is more esoteric than I have time to explain).
Broadly the reason for this is the term structure of money and the uncertain of the future – money in the hand today is worth more than money in the future. Likewise assets needed today are generally more valuable than assets needed in the future. Commodity producers and manufacturers however like future prices, because it locks in production certainty, so they are often prepared to accept a little less than the current price today for their future sales, in order to guarantee production/funding.
A more unusual state in the futures market is Contango. This state occurs when the pricing structure of the commodity is upward sloping, meaning that prices in the future are higher than prices in the present.
Normally Contango as a state most commonly occurs in commodity markets when there is some form of supply dislocation. The most famous recent example was the crash in the Oil price last year ahead of the COVID lockdowns. If you had easy access to storage then an oil trader could buy oil now (or even be paid to take delivery of it) hold on to it in a salt mines or a large derelict oil tanker parked in the Philippines, while selling a future at a higher price to lock in a profit now. The only cost to the trader is cost of storage during the interim between now and the future that was sold and the date the oil would have to be delivered, and cleaning up any oil that might leak from your rusty tanker.
The futures curve for Bitcoin has been permanently upward sloping in Contago pretty much since inception, back in 2017 meaning that the price of the future asset is higher than the spot price of the asset for pretty much 4 years:
So here a ‘risk free’ arbitrage trade would be to simultaneously buy a BTC in the spot market for $66.5k (i.e. going Long) and selling a Dec 22 Future for $72.6k (going short), immediately locking in a risk free return of $6.1k for a yield of 9.2% – so long as no one cracks your wallet passport, not a bad return huh?
Nope! – the issue with financial assets is that they should NEVER go into Contango.
Firstly there are no storage costs for electronic money (crypto or otherwise). Secondly the whole market would normally rush in and buy the asset today and sell a future at a higher price to unload it in the future, locking in an instant profit – arbitrage. But, this action would quickly start to hammer the future price and pump up the spot price, until the arbitrage opportunity disappeared.
The implication that this arbitrage opportunity persistently exists and is not hammered by investors until it closes, is that there is some form of market dislocation or systemic credit risk that cannot be properly quantified or hedged.
In finance we spend a lot of time trying to understand the risks and one of the biggest risks is embedded counterparty risk or credit risk. We ask ourselves “Who ends up holding the bag?” The reality is that Finance is a Zero sum game – for every winner there is a loser, this is the reality particularly at the shallow end of the finance pond. The trick in the game is to make losers feel like they are winners, and one of the means of getting them into the trade is by paying them a yield to take on risks they don’t understand.
That said, if I am an unscrupulous trader and I want to grab that tasty futures spread without risking my precious capital how do I go about it? Answer – I borrow the stock.
But there is NO WAY any financial institution would lend money to guys trading on an anomalous BTC futures pricing discrepancy, whose main collateral is more crypto.
So this is where Celcius comes in – they are an enabler. Effectively a conduit or intermediatory that borrows crypto from retail and lends crypto to “Investors”.
“Celsius network are a community of over 1 million users that earn up to 17% yield on their crypto. Get paid in new coins every week and borrow cash at 1%”…or so their marketing says. (17% in a zero bound interest rate environment screams credit risk to me)
The reality is that Celsius serve one purpose, to funnel money to traders wanting to capture arbitrage risk across different markets leaving them massively exposed to liquidity and credit risk. There is no other financial activity of note in crypto that can sustain this sort of activity and demand to borrow crypto.…. to be clear I’ll say that again, ‘There is no other financial activity of note in crypto that can sustain this sort of activity and demand to borrow crypto’.
If you want to spend some time combing through Celcius’s website you’ll see that their business model is a little more complicated than just that. They have their own coin ‘CEL’ (ironically named when you consider that many of those involved in this will end up in their own cell) which is engaged in the same sort of Tokenomics that many tokens issued in space are engage in, which is really just Ponzinomics built around the liquidity constrained systems that exist in crypto and that I have explained previously.
Celcius do a little bit of lending to retail and have some dinky credit cards called CelPay connected to their CEL coins, but really their main business is borrowing crypto from retail and lending it to “institutional” investors.
Not that you would realise this by reviewing their website – it is full of attestations by retail customers and reviewing it would lead you to think that this is their main business, as I said – it isn’t. Their founder stated as much:
“Our business is to lend out coins to institutions,” Mashinsky said in an email to CoinDesk. “Celsius lends mostly to large institutions and sometimes to exchanges, both provide us with collateral.”– Alex Mashinsky
To me the mismatch between the marketing, i.e. safe loans to consumers, versus the reality, lending to high risk traders, is misleading to the point of being deceptive.
Celsius claim to mitigate risks around their borrowing and lending by placing ‘conservative’ limits on leverage by applying prudential limits of 25%, 33% to a top LVT of 50%…. conservative you think until you remember that it is not uncommon for price decline by up to 95% to occur during crypto bear markets (Celsius was founded in 2017 – they haven’t endured or survived one of BTC’s famous bear markets). This is how they can make money on loans to you at 1%, you provide 4 times the collateral i.e. Borrow $60k USD place 4 BTC as collateral, which feeds into the next issue.
The other issue is that because these guys are completely unregulated from a Financial services perspective, they are also most likely involved in Rehypothecation (they actually admitted to it in this article).
For those who don’t know what rehypothecation means, briefly it occurs when a financial institution takes collateral that they have been provided on loans that have made, and then RELEND that collateral to other investors via new loans – essentially small scale credit creation increasing systemic leverage in the process. Some banks and regulated financial institutions engage in the practice, but it is essentially small scale for them and their capital reserves in other areas of their business generally cover these risks in aggregate.
This bring me to another Red flag over Celcius – their management. Celcius was founded by Alex Mashinsky, S Daniel Leon and Nuke Goldstein. Nuke is an IT nerd, Leon is a serial start up entrepreneur whose previously been involved in a range of small unimpressive start-ups (a chauffeur company and some low key IT companies mainly in pharma) while Alex Mashinsky who is also in IT achieved great financial success by pioneering VoIP (actually it turns out he wasn’t even a pioneer in this field although he did engineer a successful float of a VoIP company that later tanked to practically zero).
What is missing from this team is ANY financial markets experience. These guys are very clever, have had previous success, yet very little understanding of financial markets and the risks that they are engaging in… they are the perfect marks for someone like Jordan Belfort of the Wolf of Wallstreet fame.
So who are the “Wolves of Wallstreet” in this game? Well unsurprisingly one of Celcius’s main founding investors was ‘Tether’. Another ‘investor’ heavily involved in this space is FTX which is a Bahamian based crypto exchange owned by Sam Bankman-Fried…. who along with quantitative trading firms like Cumberland Trading and Alameda Research (which is also owned by Sam Bankman-Fried) would also be one of the main “Investors” borrowing these BTC.
Okay, time for another little diagram to show you how people investing in these crypto lending products are going to be the bag holders when this business model eventually blows up (which I guarantee it will eventually do).
To start, look back up to the previous chart and understand that this is the position of the trader: Long BTC from borrowed stock, Short BTC via futures, and consider the retail HODL’er who is simply long BTC:
Basically the HODL’er starts long, they are holding BTC. When they lend their BTC to the financial adviser/intermediatory they effectively become short BTC, while the financial adviser/intermediatory they are placing their BTC with become Long BTC. These guys then lend it to Celsius, becoming Short BTC and net square in the process, while Celsius are then long BTC. Celsius get square by lending it to the traders and hedge funds (probably with several times leverage) who are then obliged to stake some collateral. Celsius then rehypothecate these coins, making new loans further increasing the leverage in the system.
This situation is likely to continue for some time. It is quite possible that it will last for several more years, although I doubt it – Celsius was founded in 2017, the same year that CME BTC futures went live. This is no surprise (and I might talk about it more in the comments below) but as there was enormous lobbying to get BTC futures onto the CME, rather than just relying on dodgy exchange futures like those offered by Bitmex, and would leak cash from their main liquidity constrained system (BTC). Celsius haven’t even been battle tested through one of BTC’s famous sell offs yet.
So yeah, this situation is likely to continue for some time, indeed the attraction of people seeking yield is actually likely to support the spot price of BTC for a time as retail investors buy BTC simply to then lend into these crypto borrowing schemes in order to earn yield. The problem is that as the BTC price term structure gradually increases, it requires more BTC to stake as collateral against the futures and steepen the Contango futures curve even further – hence the desire/need to borrow even more funds. Which is where the retail mug punter comes in.
What will happen at some point, because it always inevitably does, is that the Contango positioning of the BTC Future price will eventually unwind – if something is unsustainable, then eventually it must end. There is no magic pudding in terms of making money.
My personal opinion is that this systemic risk, as represented by the permanent state of Contango, is a function of the systemic risk that exists with Tether and the fact that real institutional investors have no desire to take on the unknown credit risks that exist in the market due to the lack of genuine price discovery that Tether’s actions result in.
The leverage and positioning used in this way all but ensures that when this event eventually occurs it will be non-linear and asymmetric. Supposed hedging relationships will blow up, either because correlation breaks down, or the complicated financial plumbing that exists between Celcius, other financial providers and the “Investors” becomes clogged – the recent experience of Robinhood and the Game Stop debacle is a good example.
Then traders based in the Bahamas will simply disappear, Celcius’s rehypothication and collateral lending schemes will implode the moment the SHTF and BTC drops 80%, becoming insolvent in a flash. Losses will then flow back down the line until the eventual bag holder, the mug punter Hodler cops it in the nuts.
This BTC futures spread isn’t the magic pudding – people haven’t discovered a risk free way of making money. This spread is essentially a form a concentrated systemic credit risk and HODL’ers investing in this product are not buying a lending product, they are buying embedded credit risk disguised as yield.
I have no problem with people buying crypto and being exposed to price and volatility swings. This is what is to be expected and people buying crypto should be under no illusions that they are exposed to massive price swings. But at the end of the day they will still own their BTC – whatever its price may be.
What I have an issue with is people taking on risks that they don’t understand – they think they are getting a low risk yield, but the reality is they are taking on enormous and undefined financial risks at the far end of the above flow diagram and are likely to lose everything they put it, losing out not only on price, but their entire collection of BTC’s in the process.
If you are wondering if this sounds familiar it is because it is. This is near EXACTLY the same business model that existed in the GFC, where embedded credit risk was passed off to retail investors (and dumb institutional investors) in the form of CDO’s and other similar products.
When and if you see any institution advertising an attractive yield for borrowing your crypto then just think of Basis Capital – google it to find out how a pair of smart guys thought they had discovered a risk free way of making money, and bought equity tranches of CDO issuances that Goldman Sachs and the likes were unloading as fast as they could. Basis then farmed out the risks that they were taking on to a whole heap of unsuspecting retail investors via their financial advisers who thought they were buying an interest rate product. Those retail investors lost their entire investment.
These two doofuses from Basis Capital thought they were ahead of the pack, but the reality is, when you are the smartest guy in the room – chances are you are the only guy in the room.
**Edit: I received some valid criticism from financial market types on my stereotyping of Contango as being an abnormal market condition. This is fair enough, to avoid complicating the underlying issue for the everyday reader, I deliberately ignored carry and used spot as a proxy for future spot without wishing to complicate it further by bringing in forward curves and running through complete pricing attribution. Truth is some mild upward slope in future prices is actually a normal futures pricing curve for many commodities (and some financial products). This slightly positive slope reflects the embedded storage and finance cost charges, i.e. “Carry” e.g. hire of oil tanker. However I was trying to keep it simple in order to highlight what imho is a genuine super contango pricing structure built around ponzinomics and not simply a normal futures curve reflecting the supposed ‘new normal’ of market forces unique to crypto.