20% return over in CeFi, DeFi lives on

PARIS — Celsius and Voyager Digital were once two of the biggest names in crypto lending, because they offered retail investors outrageous annual returns, sometimes approaching 20%. Now both are bankrupt, as a crash in token prices—combined with an erosion of liquidity following a series of rate hikes by the Federal Reserve—exposed these and other projects promising unsustainable returns.

“$3 trillion of liquidity is likely to be taken out of markets globally by central banks over the next 18 months,” said Alkesh Shah, a global crypto and digital asset strategist at Bank of America.

But the laundering of easy money is welcomed by some of the world’s top blockchain developers who say influence is a drug that attracts people who want to make money – and it takes a systemic failure of this magnitude to flush out the bad actors.

“If there’s anything to learn from this implosion, it’s that you should be very wary of people who are very arrogant,” Eylon Aviv told CNBC from the sidelines of EthCC, an annual conference that draws developers and cryptographers to Paris in a week.

“This is one of the common denominators between all of them. It’s kind of like a god complex — ‘I’m going to build the best, I’m going to be amazing, and I just became a billionaire,'” continued Aviv, who is a principal at Collider Ventures , an early stage venture capital blockchain and crypto fund based in Tel Aviv.

Much of the turmoil we’ve seen grip the crypto markets since May can be traced back to these multi-billion dollar crypto companies with centralized figureheads taking action.

“Liquidity crunch affected DeFi returns, but it was a few irresponsible central players that exacerbated this,” said Walter Teng, a Digital Asset Strategy Associate at Fundstrat Global Advisors.

When the Fed’s benchmark interest rate was practically zero and government bonds and savings accounts paid nominal returns, many people turned to crypto lending platforms instead.

During the boom in digital asset prices, retail investors were able to earn outlandish returns by parking their tokens on now-defunct platforms such as Celsius and Voyager Digital, as well as Anchor, which was the flagship lending product since failed US dollar pegged stablecoin project called TerraUSD which gave up to 20% annual percentage return.

The system worked when crypto prices were at record highs, and it was virtually free to borrow cash.

However, as research firm Bernstein noted in a recent report, the crypto market, like other risk assets, is closely correlated to Fed policy. And indeed in recent months, bitcoin along with other large cap tokens have fallen in line with these Fed rate hikes.

In an effort to contain spiraling inflation, the Fed raised its benchmark interest rate by another 0.75% on Wednesday, taking the funds rate to its highest level in nearly four years.

Technologists gathered in Paris tell CNBC that siphoning off the liquidity that has rampaged around the system for years means an end to the days of cheap money in crypto.

“We expect greater regulatory protections and required disclosures supporting returns over the next six to twelve months, likely dampening today’s high DeFi returns,” Shah said.

Some platforms put client funds into other platforms that similarly gave unrealistic returns, in a kind of dangerous arrangement where one breach would turn the whole chain upside down. A report based on blockchain analysis found that Celsius had at least half a billion dollars invested in the Anchor protocol that offered up to 20% APY to customers.

“The domino effect is just like interbank risk,” explained Nik Bhatia, professor of finance and business administration at the University of Southern California. “If credit has been extended that is not properly secured or reserved against, failure will lead to failure.”

Celsius, which had $25 billion in assets under management less than a year ago, is also accused of running a Ponzi scheme by paying early depositors with the money it received from new users.

So far, the fallout in the crypto market has been limited to a very specific corner of the ecosystem known as centralized finance, or CeFi, which is distinct from decentralized finance, or DeFi.

Although decentralization exists along a spectrum and there is no binary designation that separates CeFi from DeFi platforms, there are a few characteristics that help place platforms in one of the two camps. CeFi lenders typically use a top-down approach where a few powerful voices dictate financial flows and how different parts of a platform work, often operating in a sort of “black box” where borrowers don’t really know how the platform works. In contrast, DeFi platforms cut out middlemen such as lawyers and banks and rely on code for enforcement.

A big part of the problem with CeFi crypto lenders was the lack of collateral to stop loans. Celsius’ bankruptcy filing, for example, shows that the company had more than 100,000 creditors, some of whom lent cash to the platform without receiving the rights to any collateral to back up the scheme.

With no real money behind these loans, the whole scheme depended on trust – and the continued flow of easy money to keep it all afloat.

However, in DeFi, borrowers put more than 100% collateral to stop the loan. Platforms require this because DeFi is anonymous: Lenders don’t know the borrower’s name or credit score, nor do they have other real-world metadata about their cash flow or capital on which to base their decision to extend a loan. Instead, the only thing that matters is the security a customer can provide.

With DeFi, instead of centralized actors calling the shots, the money exchange is managed by a programmable piece of code called a smart contract. This contract is written on a public blockchain, which ethereum or solana, and it is executed when certain conditions are met, negating the need for a central intermediary.

“Gross returns (APR/APY) in DeFi are derived from token prices of relevant altcoins attributed to various liquidity pools, the prices of which we have seen fall more than 70% since November,” explained Fundstrat’s Teng.

In practice, DeFi loans work more like sophisticated trading products, rather than a standard loan.

“This is not a retail or mom-and-pop product. You have to be quite advanced and have a feel for the market,” said Otto Jacobsson, who worked in debt capital markets at a London bank for three years before moving to crypto.

Teng believes that lenders who did not aggressively make unsecured loans, or who have since liquidated their counterparties, will remain solvent. Genesis’ Michael Moro, for example, has come out to say they have significantly cut counterparty risk.

“Rates offered to creditors will, and have, been compressed. However, lending remains a hugely profitable business (second only to stock trading), and prudent risk managers will survive the crypto winter,” Teng said.

In fact, even though Celsius was a CeFi lender himself, he also diversified his holdings in the DeFi ecosystem by parking some of his crypto-cash in these decentralized finance platforms as a way to make money. Days before declaring bankruptcy, Celsius began repaying many of its liens with DeFi lenders such as Maker and Aave, to unlock the collateral.

“This is actually the biggest advertisement to date of how smart contracts work,” explained Andrew Keys, co-founder of Darma Capital, which invests in applications, developer tools and protocols around ethereum.

“The fact that Celsius is paying back Aave, Compound and Maker before humans should explain smart contracts to humanity,” Keys continued. “These are persistent software objects that are not tradable.”