Celsius Halts Bitcoin Withdrawals: What Went Wrong?

Celsius Halts Bitcoin Withdrawals: What Went Wrong?
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The purpose of this issue will be twofold:

The first will be an in-depth look at the Celsius platform, and breakdown the design of the business/ecosystem to understand what went wrong.

The second is to detail the events that have transpired over the recent weeks with Celsius “yield generation” strategies, and update subscribers on the state of the market, with potentially big ramifications on the horizon.

The following is written by Bitcoin Magazine‘s Namcios, detailing Celsius’s core business operations.

Celsius: Design And Assumptions

This section takes a deep look at the inner workings of the project itself, as per its white paper, including some red flags in its design and backboning assumptions that could’ve served as a warning to investors – and can hopefully be applied to other projects to prevent similar losses in the future.

“As more people join the Celsius ecosystem, the more everyone benefits,” per the white paper.

Image source: Celsius network white paper.

Image source: Celsius network white paper.

Throughout its white paper, Celsius conflates terms and assumptions, pushing forward design decisions that don’t necessarily play along. Celsius’s white paper is an example of this. It names itself Celsius “network” but has an entire section dedicated for showing an “executive committee”. Although networks don’t have executive teams, Celsius does have a few founders, a CEO and a COO, along with marketing and development departments. It refers to a “community”, which it seeks to build with its network. However, the user can be sure that the executive team will almost always protect its own interests instead of the community’s. This is exactly what happened on Sunday when withdrawals were stopped in the platform. (We will discuss the withdrawal issue in detail in a later section. )

Image source: Celsius network white paper.

Image source: Celsius network white paper.

Celsius fails to provide a proper explanation for why its project needs a token, as seen in the image above. The white paper simply states that its “lending and borrowing model requires a blockchain and an open ledger technology,” citing that such needs come “in order [for the project] to really gain traction.”

Both can hardly be seen as factual responses to that question. The white paper is actually more like a marketing deck or pitch to investors than what it should be: a technical document explaining engineering decisions that led to the project’s design.

Moreover, complex trading platforms exist in the world that handle very complex structures and settlement orders, meaning that a smart contract is also not a strong enough reason for a blockchain.

Indeed, the real reason as to why Celsius needs a blockchain and an open ledger technology is to issue its CEL tokens – for which it built an ecosystem around to generate enough “traction.” Moreover, the CEL tokens also allowed the team to raise money from investors to build out the platform and wallet. Still, the issuance of credit could’ve been done without a blockchain, but in that case the team would’ve lacked an important motto for generating hype nowadays – “crypto,” “decentralized” and “blockchain.”

The white paper demonstrates that Celsius performed a presale of CEL tokens (amounting to 40% of the total number of CEL tokens) at $0. 20 per token and later did a crowdsale (amounting to 10% of the total number of CEL tokens) at $0. 30 per token. While the presale occurred in Q4 2017, the crowdsale began in March 2018.

Image source: Celsius network white paper.

Image source: Celsius network white paper.

Celsius details in its white paper how big of a role CEL plays in the project. All of the platform’s functionality, including borrowing and lending, would be available only after tokens were issued.

CEL is an ERC-20 token, meaning that it is a fungible token deployed with a smart contract on Ethereum, that seeks to “create a value-driven lending and borrowing platform for all our members,” as per the white paper.

Ownership of the token allowed users to join the Celsius platform, deposit cryptocurrency into the Celsius wallet, apply for dollar loans and pay interest on those loans at a discounted rate at launch. The document also stated that the token would allow users to lend cryptocurrency to gain interest and receive rewards for cryptocurrency lent out. Seniority was a reward system that rewards those who choose to use CEL at higher rates. This is a self-enforcing feedback loop that provides incentives to increase demand for CEL.

This feedback loop extends beyond this dynamic to play a key role in the user acquisition and retention strategies for Celsius. This feedback loop plays a key role in Celsius’ user acquisition and retention strategies.

Celsius’ white paper details the feedback loop based on the CEL token. Image source: Celsius network white paper.

Celsius’ white paper details the feedback loop based on the CEL token. Image source: Celsius network whitepaper.

“The system also creates a supply and demand cycle of the Celsius token (CEL),” the white paper states, referring to the platform composed of borrowers, lenders and the orchestrating Celsius service.

All in all, Celsius’ design involves a mix of traditional and burgeoning technologies to market yields much higher than those available in traditional financial systems. The complex web of moving parts was tentatively joined together by confluent incentives derived form the CEL token. This token was based on a reinforcing economy for issuance and distribution to acquire and retain users.

Play-by-Play Of Celsius Missteps

Late Sunday evening, crypto exchange Celsius announced they were halting all withdrawals, transfers, and asset swaps on the platform. In recent weeks/months, the platform, which provides yield on crypto assets as well as the ability of users to borrow against them, has been under intense scrutiny for their apparent yield-generation strategies.

Throughout 2021, there were multiple arbitrage strategies that offered traders “risk-free return.” These strategies were the GBTC arbitrage, and the futures market contango. These strategies, which took advantage of pricing dynamics between spot market bitcoin and select derivatives (in this case the Grayscale Bitcoin Trust and bitcoin futures contracts) allowed for market neutral arbitrage, and for many individuals, funds and companies to capitalize on the massive “yield.”

Many companies capitalized on this dynamic by offering native yield products, where they put on these trades with customer funds, and profited on the difference that was harvested against what was paid to customers. This strategy was possible when the music was playing. However, as the demand for yield products grew, so did the arbitrage with GBTC and in the futures market.

This dynamic caused Celsius to turn to increasingly exotic and risky instruments to generate “yield” for depositors. On-chain analysts discovered that Celsius had transferred funds to the anchor protocol on May 3, just before the LUNA/UST crash.

Following the LUNA/UST collapse, rumors began to fly as to which companies/counterparties had been hit, and whether insolvencies were a worry, with Celsius being a key focus.

Given the opaque nature of the company’s operations, there wasn’t any way to know for certain whether the company was insolvent from an asset/liability standpoint, but merely the potential for such a situation made the risk/reward of using the platform’s yield products a bad trade-off.

Aside from depositing user funds on the Anchor protocol for yield, it was uncovered that Celsius also had a large stake in stETH. stETH, a liquid derivative allows users to stake their ETH in anticipation for the merge to proof of stake. However, they still have liquid access to their capital in stETH. Similar to the GBTC redemption system, once ETH has been staked for stETH it cannot be untaken until “the merger” is completed.

While this issue won’t delve deep into the weeds of Ethereum’s proof-of-stake system and the exotic derivatives complex that has been built around it, the purpose of mentioning stETH is to highlight another yield-generation strategy that went wrong for Celsius, as the stETH<>ETH exchange rate began to break from 1.0.

With Celsius holding a large amount of stETH that was falling from its alleged peg, illiquidity worries increased further, with the market to buy ETH for stETH not nearly liquid enough for Celsius’ massive position to exit without sustaining massive losses. Celsius announced that they would stop all withdrawals, swaps and asset transfers from the platform due to an increase in users pulling their funds.

We are taking this necessary action for the benefit of our entire community in order to stabilize liquidity and operations while we take steps to preserve and protect assets. Customers will continue to receive rewards during the pause, in keeping with our commitment to customers.

We understand that this news is difficult, but we believe that our decision to pause withdrawals, Swap, and transfers between accounts is the most responsible action we can take to protect our community. We have one goal: to protect and preserve assets in order to fulfill our obligations to customers. Our ultimate goal is to stabilize liquidity and restore withdrawals, swap, and transfers between accounts as fast as possible. This process is complex and will take time as we consider all options. There may also be delays.

Published statement on Celsius blog post.

The biggest problem with Celsius’ operations was that it was increasingly obvious that the firm was taking extreme risk with user funds that were often not able to be properly quantified. The biggest problem with Celsius’ operations was that it was taking too much risk with user funds, especially bitcoin, which is extremely scarce.

Now, with the price of bitcoin trading at $23,100 at the time of writing, Celsius is on the verge of a margin call on 17,900 wBTC (wrapped bitcoin on Ethereum).

The liquidation price level was at $20,272 before Celsius topped off the vault with additional collateral, pushing the liquidation price to $18,300. This liquidation price level is transparent and speculators are selling indiscriminately to force Celsius to sell (either by forced liquidation or willingly covering).

You can check the status of the vault here with live updates to liquidation levels.

Market Implications

Either way, the market is in a precarious position over the short term, with a likely partially-insolvent exchange doubling down on a margin position. If bitcoin’s history (and the financial markets) has taught us anything, it is that doubling down in a leverage position will not end well. The worst part is that user funds are being put at risk.

With this in mind, the probability of a volatile wick to the downside looks likely. Short-term traders and speculators should closely monitor the status of Celsius loan vault, as a liquidation could bring a few hundred million dollars of selling pressure.

Lessons Learned

As of late, novel narratives have been employed to drive retail customers to believe in the power of “blockchain technology” and “cryptocurrency” as drivers for a revamped financial system. As we have argued, blockchain serves a specific purpose: to solve the double spending problem and port cash (peer–to–peer money) into digital realm. This was achieved by Satoshi Nakamoto, who, after decades of research by many scientists and mathematicians, arrived at the design of Bitcoin – published in a proper white paper in 2008.

From the point of view of users, three lessons can be learned.

First, beware of self-reinforcing ecosystems. This was true for Terra’s UST project and is also true for Celsius. Terra and the Luna Guard Foundation have repeatedly said things along the lines of “generate enough demand” for the survival of UST, while Celsius’ white paper repeatedly makes the case that the more people join, the better it is for everyone. It is not easy to argue that a lending or borrowing platform needs its own token in the case Celsius. For example, Hodl Hodl allows peer-to-peer loans that are backed by bitcoin. It does not require a token and leverages an escrow. )

Second, if something seems too good to be true, it probably is. Celsius was marketed as a secure, care-giving system that is impossible to fail. It also offers the lowest rates and yields on the cryptocurrency lending market. Celsius CEO Alex Mashinsky made the case that users could always withdraw funds from his platform, though on Sunday announced nobody was able to withdraw funds. Although the platform claimed that this decision was in users’ best interest, it is not true.

Lastly, and this one is getting old – hold your own keys. You don’t have complete control over your bitcoin. This means you can’t transact with anyone you want, whenever and wherever you want. It seemed like a good idea to deposit bitcoin into Celsius for some “risk free” yields, but it wasn’t. If in doubt, always custody your own coins. Withdraw your bitcoin from exchanges and walk yourself through a self-custody solution that only you know the key to. You should also be careful when you keep a large amount of your net worth in credit to a newly-founded company like Celsius (CEL token). They can go under, just like Terra. Do your own research.

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