First, you need to understand CeFi vs. DeFi. CeFi stands for centralized finance, e.g. when you hold money with a traditional bank or CeFi players like Coinbase, they actually hold your money, you just trust they will give it back. DeFi stands for decentralized finance, e.g. when you use a non-custodial wallet, you actually hold the funds, only you who hold the private keys can access them. Celsius is CeFi (but uses DeFi to get returns).
In 2017, the original idea for Celsius included 2 products: 1) a user deposits crypto and can borrows USD against it, and 2) a user deposits crypto, Celsius lends it out or otherwise generates yield with that crypto using DeFi, and then Celsius gives most of the yield back to you and keeps the rest as revenue. By 2022, the “Loan” and “Earn” product had become very popular with $12B in management and nearly 1.7M users (source).
Have you ever noticed some DeFi yields seem absurdly high? An economically sound reason for why that may be is because who they are lending it to - e.g. hedge funds, crypto traders, etc. are willing to borrow at a high interest rate. An economically unsound reason is that the decision-makers at these companies decide to boost APY as marketing. A so-so reason is that they take on risky strategies to get those yields.
What was the case with Celsius? I don’t know, it’s not fully transparent how they made their yield, but given that rates were past 18%, the sustainability and risk taken on should be in question.
Like many times before it, a loss of confidence in the market isn’t caused by one event, more so a series of events that tip public opinion into a mass sell-off, but here’s a non-comprehensive step-by-step explanation:
Crypto and non-crypto markets were already in bad shape precipitated by the Terra/Luna crash, fed interest rate hikes, general sell-off, etc.
Why does that matter? 1) people were trying to withdraw money from Celsius and 2) anybody with leverage (took on debt) is getting closer to liquidation (forced selling) if prices fall below a certain point so they’re selling assets to avoid that (this’ll come into play in one second)
Terminology moment: what Celsius needs to pay to users is a liability (e.g. people wanting to withdraw ETH), and the crypto it holds is an asset (e.g. ETH it holds). However, people noticed that Celsius holds a lot of their ETH as stETH (staked ETH has a higher APY but is also illiquid meaning its hard to sell).
As mentioned above, leveraged firms were selling assets including stETH such that stETH traded at a discount to ETH (stETH price < ETH price). Thus, Celsius’s liabilities in ETH grew relative to its assets which were largely held as stETH.
People got concerned so they were withdrawing 50k ETH from Celsius a day. Celsius got concerned so they stopped allowing users to move money off the Celsius platform. General public loses confidence, sell-off.
Taking a step back, a takeaway is that one of the interesting aspects of crypto has been the new financial mechanisms that can be created, but as with every new mechanism before it, there are complicated and unexpected consequences.
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