The collapse of Terra/ Luna and the failure of Celsius and other centralized finance (CeFi) lending platforms have raised concerns, questions, and more about the integrity of decentralized finance (DeFi) and ultimately, the future of crypto.
Such concerns are warranted given recent events but may be misplaced.
Define your Terms
In practice, both the Terra/Luna governance structure, and the Celsius platforms were unregulated, card-carrying, CeFi entities, not decentralized entities. Such CeFi firms are characterized by a traditional Command and Control structure, with power concentrated amongst a small number of people. This is very different from DeFi’s governance structure that is enshrined in code, across a sprawling network of nodes. While not all platforms and protocols fit neatly in these two specific buckets, the last few months of volatility across digital assets underscore the need to understand these differences. Adding to the complexity of the exercise is the reality that many protocols and platforms are a hybrid, possessing qualities of both CeFi and DeFi.
Therefore, we shift from the focus of last week’s bulletin – the potential opportunity that recent price declines in BTC and ETH may present to investors – to the task of defining terms to help drive greater understanding of the players and protocols.
Preparing for Change
We are not the only ones that believe language matters. The recently proposed U.S. bill to regulate Digital Assets, the Responsible Financial Innovation Act (RFIA), defines terms before laying out the proposed regulations. The proposals govern the rights and responsibilities of Decentralized Autonomous Organizations (DAO), as well as centralized businesses including exchanges, investors and protocols including stablecoins.
Representatives Gillibrand (D-NY) and Lummis (R-WY), present a united front that appears to be in support of the request made by President Biden in his March 9th Executive Order. In this order, Biden requested a comprehensive plan to regulate the space for review by September 2022. In the 69-page proposed bill, entities such as stablecoins are defined, including the assets required to satisfy regulation. Unsurprisingly, the regulation mandates that such assets are exclusively U.S. Treasuries. It suggests the U.S. treasury is cultivating a new source of demand for their growing supply.
Given the swiftness and detail of the proposed regulation, we tease out major differences between CeFi and DeFi below, given they have been conflated too often, and for too long.
For those wanting to develop their own opinions, we share the questions core to our assessment, including:
- Do people or code drive business decisions?
- Do custodians or smart contracts ensure performance?
- Is there transparency? e.g., on chain vs. off chain ledgers.
- Does the entity offer over-or-under collateralized lending?
- How are yields for clients/users generated?
The Venn diagram shown below provides a more detailed and structured approach.
Definitions
Operated by a business – CeFi platforms are operated by traditional businesses in a Command-and-Control manner. These businesses can be registered around the globe and have multiple subsidiaries. Some are private companies; some are publicly traded.
Know Your Client (KYC) – Clients are required to be onboarded and verified using government ID, banking statements, and by other credit-check methods. KYC is a basic component of an Anti-Money Laundering (AML) check, which supports the customer due diligence process during onboarding.
Fiat-to-Crypto – Offers funding methods to purchase cryptocurrency directly, typically via. a wire or money transfer.
Custodial – A process that involves an intermediary allowing the customer to electronically access their assets that are stored in a wallet/address not entirely controlled by the customer. They do not manage or own the private keys to a custodial wallet.
Off-Chain Activity – Revenue generating activities beyond the blockchain, not limited to: uncollateralized lending, traditional finance (tradfi) assets including the “Grayscale trade” (long or short GBTC vs. BTC spot or the BITO future), fees for services, etc.
On-Chain Activity – Activities that are conducted on the blockchain and visualized by using blockchain explorers such as Etherscan.io. and/or other software services such as Parsec.finance or Dune Analytics.
Operated by a DAO – A DAO is a community-led entity without a central authority. It is fully autonomous and transparent. Smart contracts underpin the foundational rules, execute the agreed upon decisions, and at any point, proposals, voting, and even the very code itself can be publicly audited. Holders of the “governance tokens” often have the right to vote on certain changes to the services or smart contract(s) involved. Source: ConsenSys, October 2021.
Depositor and Borrower is the Same Person – When you deposit funds as collateral for a loan, you are the recipient of the loan. Some CeFi businesses have been recently shown to loan money, uncollateralized, to certain counterparties.
Non-KYC, Addresses can be Blacklisted – DeFi protocols generally do not employ KYC policies, however they can have code in their smart contracts which allows them to blacklist bad actors or wallets associated with other blacklists and restrict them from using the protocol.
Crypto-to-Crypto – Otherwise known as “swapping” via. a liquidity pool (on-chain trading pair). For example, the ETH/USDC liquidity pool on Uniswap V3. These pools generate fees for participants providing the liquidity and generate fees to the protocol itself (Uniswap). Users are charged fees for swapping assets via these liquidity pools. These are some of the most common contract interactions on Ethereum.
Non-Custodial – The private keys to the wallet/address remain in the client’s possession. They are ultimately in control of any activity conducted with that wallet/address.
Lending – The act of providing a loan to a client in exchange for their cryptocurrency deposit collateral plus interest over time. In DeFi, generally all loans are over-collateralized; however, in CeFi they are not always over-collateralized.
Staking/Yield – The act of depositing cryptocurrency to generate interest, which often varies, on that cryptocurrency. Generally, both CeFi and DeFi platforms label this as annual percentage yield (APY).
Spot Trading/Swapping – See “Crypto-to-Crypto” above. Both CeFi and DeFi platforms may offer the ability to convert client assets into different assets, usually by trading with other users (Liquidity pools within DeFi) or through the business directly (CeFi).
Asset Management – Other creative tools and strategies offered by CeFi or DeFi platforms to generate returns for the user.
Voyager Digital, and other CeFi lending platforms accept BTC and ETH deposits from clients, along with other stablecoins and tokens. These platforms aim to provide a yield on these deposits in return. The way in which some CeFi firms generate this yield may come from a myriad of sources and are not always visible on-chain. These opaque practices can pose unforeseen risks to investors. For example, the apparent action by one CeFi platform that offered approximately $700mm in uncollateralized loans to a client. This is a non-standard practice within the Prime Brokerage businesses that leverages traditional assets, as it is deemed an unnecessary and poor risk/reward ratio.
As another example, a known off-chain yield strategy from CeFi platforms last year came from subscribing to GBTC on the primary market, then selling on the secondary market at a premium. This strategy has since gone south, with GBTC trading at ~30% discount to NAV with no redemption mechanism. This is an example of an asset liability mismatch on the books.
Amongst these recent collapses, we have seen large exchanges such as FTX step-in and bail out these CeFi businesses, similar to how central banks did back in 2008.
However, there has been some good in all of this. DeFi protocols, so far, appear to be working as designed. Bad debts are automatically filtered and liquidated when they go bad, and having been overcollateralized, there have been no asset/liability mismatches. These forcible liquidations can negatively impact the price of digital assets, but from an operational standpoint, it’s business as usual.
Looking at DeFi
Transactions in DeFi are on-chain, meaning every participant can see every deposit, withdrawal, and loan obtained. Participants can see “under the hood” by looking at the smart contracts directly. DeFi platforms differentiate by having their codes open source. It’s also why we think that regulation here could be challenging, granted the smart contract code can be forked and re-deployed with modifications, under a new name, at any time.
In DeFi, the depositor and borrower are the same person. If the borrower can’t repay, their deposit collateral gets automatically liquidated on-chain.
For example, in DeFi, participants “play with their cards open”. Everything about these loans can be visualized on-chain. The three largest DeFi lending protocols on Ethereum by total value locked (TVL) are Maker, Aave, and Compound.
Source: App.parsec.finance as of June 24, 2022.
As noted in the graph above, these DeFi protocols allow users to obtain loans based on their deposit collateral (over collateralized). These loans have certain liquidation thresholds. This means that if the price of ETH in USD (white vertical line on X-Axis) declines (shifts left), users are automatically liquidated on-chain and their collateral is lost. Continuing with the above example, if the price of ETH in USD declines to roughly $840, approximately $140 million USD worth of collateral on Aave would be automatically liquidated. It’s important to note that these clients can deposit more collateral at any time, lowering this liquidation threshold.
Lending is necessary for both traditional finance and digital asset finance. There is nothing inherently wrong-footed with using DeFi – in fact, it can provide unique advantages for some market participants. However, the recent failures in the CeFi sector raise several questions, specifically, was it the CeFi structure or individuals that drove the failures? In our opinion, we conclude that it may be the combination of both, as poor risk management practices are generally more likely to fester without letting users or regulators look under the hood of the business. If you’re centralized, you need to have both transparency AND regulation. If you’re decentralized, you need to have transparency AND unexploitable code.
Even more eye-popping is the custodial risk for these digital assets on CeFi platforms. In DeFi, even if the website front-end to the platform was compromised, users could still interact with the appropriate smart-contract and manage positions directly. However, CeFi platforms can “turn off” and there would be no recourse for users, as there is no direct smart contract to interact with. As we have seen over the last several weeks, these CeFi platforms may go as far as restricting deposits and withdrawals for their users, putting funds at risk while they scramble to align their assets and liabilities.
In DeFi, this is generally not the case; however, some experimental platforms on emerging blockchains, such as Solana, have faced dilemmas with governance. This can take the form of large actors dominating this (generally) democratic process of governance token voting. In many instances this may stem from Venture Capitalists who have large, vested interests in the DAO governance token, tilting votes in their favour.
Final Thoughts
By teasing out the differences between CeFi and DeFi, our take is that generally, DeFi plays within the realm of crypto ethos:
- Defi uses open-source smart contracts…CeFi uses people in a Command-and-Control structure.
- DeFi processes are publicly auditable by participants at code level…CeFi operations are often opaque.
- DeFi never uses CeFi platforms…CeFi platforms often use DeFi protocols, but also rely on off-chain activities.
The unaudited use of off-chain lending practices/yield harvesting by certain CeFi lending platforms may be perceived to be a core contributor to the recent failures.
With DeFi, we can see every transfer, deposit, and exploit in real-time. This is not the case with CeFi as critical metrics are often concealed from the general investing public, or they can be changed, arbitrarily, on the front-end and back-end with no blockchain involved. DeFi protocols execute clearly defined logics from their applicable smart contracts, whereas CeFi platforms do not.
However, DeFi may not be explicitly “safer” than CeFi for these reasons alone. DeFi has inherently greater reliance on technology as smart contracts are publicly accessible, with the potential to be exploited. As of today, there have been 102 DeFi-related exploits resulting in approximately $3.4 billion USD worth of lost funds at the time of exploitation. For a full list of DeFi-related exploits, please see here: http://info.3iq.ca/e/888123/defi-hacks-/8qh3r/177921694?h=CyeryDTLHmTzq5RIoeiiS_-uIpb4lpOIt6QvCDgMADw.
The Flip Side of DeFi ‘Hacks”
However, we see some exploits in the smart contract / DeFi world have often resulted in greater good. Who wants the burden of holding stolen digital asset collateral which is visible on-chain? These actors often turn into “white hats” – analyzing code, finding exploits, then offering solutions to the DAO or community at large. Stolen or exploited digital assets are a liability for hackers in our view, given that recent advancements in chain analysis tools allow exchanges to monitor these events closely, and not offer a cash-out, via fiat conversions for these types of compromised assets.
Digital Asset Universe
The total crypto market capitalization has dipped below $1 trillion USD, with BTC dominance unchanged from our previous bulletin.
Source: 3iQ Research. Data sourced from Coin.Dance, Etherscan.io as of June 27, 2022.
Source: 3iQ Research. Data sourced from Messari as of June 27, 2022. Figures expressed in USD unless otherwise stated. Past performance is not indicative of future results.
Bitcoin’s price has stabilized after dropping over 50% in the past three months, on the back of forced selling starting with the Luna Foundation Guard (LFG) in May 2022 and followed by forced unwinds by lending platforms as discussed in last week’s bulletin.
Source: 3iQ Research. Data sourced from Bloomberg as of June 27, 2022. Past performance is not indicative of future results.
With Technical Analysis (TA) playing a large part in the recent price action, we suggest investors revisit last week’s, Baby’s out with the Bathwater, publication as it places today’s price in historical context.
Source: 3iQ Research. Data sourced from Bloomberg as of June 27, 2022. You cannot invest directly in an index. Past performance is not indicative of future results.
