Down markets are a great time to look at things from a different perspective.
You can see what things worked and those that failed.
You can see the shifts in sentiment and look back at changes that contributed to the downturn.
Bad ideas are exposed and ruthlessly taken down.
And there is a lot of tuition paid in the form of losses.
Down markets also give us a chance to look through the rubble for important lessons. And given that crypto is still relatively young, this is a great time to look at what is and isn’t working.
This means digging into the whitepapers and then looking at the eventual results.
So today, we are going to do just that. And the focus will be on Celsius because we have a whitepaper, results, an intelligence report, and a court filing.
Using these, you can create a set of trading rules about whom you deal with in the future and what the criteria will be.
White papers as a window into a projects soul
A whitepaper is a technical document that shows you what something is going to do. It can highlight a particular aspect of a technology or product or can explain it in its entirety.
The Bitcoin whitepaper is an example of what a white paper can be. It’s elegant in its simplicity.
Whitepapers in the crypto space can be like a more traditional whitepaper. However, many have evolved to sound more like manifestos or even quasi-prospectuses. They aren’t regulated investing documents but have, over time, evolved to accommodate ICOs and other offerings.
The whitepapers often, but not always, will give you a lot of insight. But they must be read with a critical eye. And that goes not just for those participating in offerings but those considering the use of the platforms they represent.
As a crypto participant, you operate in a largely unregulated environment, which is both a plus and a minus.
On the plus side, you get more flexibility and have more potential for upside. There is more volatility and opportunity with no cap on what can be created. And because there is little or no regulation, there are no illusions about risks. You know, when you get involved in projects, you will ultimately be responsible for the outcomes. This is what it means to be your own bank.
And this responsibility is a powerful incentive to pay close attention to how something was constructed, how it makes money, and what your role will be in it.
This brings us to Celsius.
Whitepaper + Outcome + Report + Lawsuit
Celsius began with a whitepaper for its ICO in 2018. With withdrawals halted and a pending bankruptcy filing, we also have an outcome. Plus we also have the benefit of an independent report that came out on July 7th, 2022. Then there is a lawsuit filed against Celsius by a counterparty.
These documents give us a clearer picture of what Celsius said they were doing, and how they did it.
The whitepaper gives you insight into the thinking and background of the founders. It will tell you how they intended to make money. And if you read critically, you can see the holes in their argument that may become relevant at some point.
The report adds color to the activities evaluated by an intelligence firm.
Add to that a legal document, and now you can see how the claims in the white paper might be on point or false. And you can see what the results of the business model, risks, and assumptions were.
The legal document, while technically allegations, contains some additional information to help traders and enthusiasts going forward.
And if you aren’t watching these filings, you should be. You will learn a lot about crypto/DeFi business models and what works and what doesn’t by doing so.
Let’s dive in.
Celsius was briefly a success story
The Celsius whitepaper describes a business that involves a series of opportunities. Hodlers of crypto can deposit their tokens, altcoins, and cryptocurrency to earn yield. They can deposit coins and borrow against them in dollars.
Their CEL token was like a membership token. They used this to pay out interest and rewards.
Their initial raise was through an ICO, which totaled $50 million. They did some subsequent raises for another $60 + million. And in late 2021, they raised $750 million, of which $400 million came from The Caisse De Depot (Quebec’s Pension Fund) and Westcap.
At its peak, Celsius was “running” somewhere between $20 and $28 billion in assets for between 1 million and 1.7 million users. According to the Arkham Intelligence report, they had $12 billion AUM (Assets under management) as of May 2022.
And to put that in perspective, getting to $1 billion as a hedge fund manager is a big deal. And the bigger you get as a hedgie, the harder it is to deploy capital and generate returns.
So even with the volatility and inefficiencies of the crypto market, Celsius was looking for yields ranging from a few % to 15%, plus interest rates that were eye-watering. It’s no wonder they attracted so many users.
Overall, this was a complex operation operating in a dynamic, highly speculative market environment.
This business would be tough for anyone concerned with risk management.
Pawn shop + prime brokerage desk
One of the core ideas was for hodlers of digital coins to use them in a variety of ways. One is to use them as collateral for a USD loan. The idea here is that hodlers may be looking for cash but don’t want to sell an asset, incur a tax liability and miss potential upside. This process transforms their digital asset into capital.
Or the user could deposit coins that can be borrowed by institutions for short selling. And they can earn yield and interest (paid in CEL tokens) on their coins as a result of these various mechanisms.
So what we are initially looking at is a bit like a pawn shop and a crowdfunded bank with a prime brokerage desk.
What is interesting is the emphasis on the passive nature of the income. It sounds like easy money. All you have to do is join with CEL tokens and put your assets in the hands of Celsius.
Celsius then deploys your assets across DeFi to do all the hard work for you.
Celsius makes crypto look easy, which ended up being part of the problem.
The greedy non-profit
Greed. They talk a little about this on page 5 of their whitepaper. This is in relation to institutions like hedge funds and family offices that want to borrow coins to short them.
Now, I’m not saying hedgies are nice guys or perfect. However, the good ones are sharks.
We’ve talked about short selling and why it’s an incorrectly maligned aspect of the market. Short selling is nothing more than a liquidity provision. Yes, it can be abused, but the market and regulators are ruthless towards short sellers and short selling generally. Which means it is hard to do.
But it is interesting that Celsius will be running the equivalent of a prime desk where hedge funds and family offices will be their customers. And yet their attitude towards them seems negative.
And when you look at the lawsuit, you will see that Celsius eventually had to operate more or less like a hedge fund. And they also had to engage outside trading expertise.
Remember those fat yields, rewards, and interest rates? Those required returns from somewhere.
Consider that these guys had, give or take, $20 billion to somehow provide returns for. So the concept of greed on page 5 is both ironic and prophetic.
And it is also somewhat surprising that they tell you on page 10 that they are operating a non-profit model.
Celsius spends a little time on the risks related to the platform. The big print ones are on page 9.
What is interesting looking at the lawsuit is the revelation that coin depositors essentially no longer own their coins on the Celsius platform. Their agreement says that Celsius can do whatever they want with them.
Given the various ways to earn on the platform, that makes sense.
But do the depositors know this? Did they read the fine print on their agreement?
The ownership problem may come back to bite depositors in the bankruptcy filing. Technically, Celsius owns the coins after deposit.
Celsius gets the coins, then they are sent to an exchange or put in a wallet to be managed by a trading operation. So they are now twice removed from the original owner.
These coins are lent, exchanged, swapped, bought, and sold to generate returns.
Now let’s go back to the idea that people want loans without selling digital assets and incurring a tax liability. I’m unclear how this structure takes that into account.
There is no mention of hedging and how price changes in volatile assets are being managed when it’s time to return the coins to the hodlers. This was highlighted in the lawsuit.
It doesn’t look like they took hacks into account either. Several subsequent hacking episodes on other platforms ate up a bunch of customer funds.
The risks in the small print later in the document cover a lot of items, all of which anyone participating in the platform should be aware of.
Running a hedge fund with no financial experience
The founding team has lots of experience, but they are primarily tech-focused. One has a bunch of patents. This is an important point as well. While great entrepreneurs can cross various niches and verticles, you have to think about the background.
The Valley model for the last many years is to rapidly grow an audience at whatever cost, then convert that into cash flow. Many crypto projects are built around this mantra.
You would think that a lending, staking, and prime brokerage business would be sustainable and very profitable at a certain level if done right. It could be argued that Celsius was too attractive and eventually had too much money to succeed. Add to that a series of unexpected events, and they blew themselves up.
If AIG, one of the biggest insurance firms in the world, can blow themselves up in 2008, there is no reason Celsius can’t do the same in crypto.
Because what we have is a non-profit, lacking management with relevant market experience, lending dollars on speculative assets and rewarding speculative assets with yield by running the equivalent of a hedge fund. Then comes evolving market conditions and some big surprises.
What could possibly go wrong?
The KeyFi lawsuit
The KeyFi lawsuit alleges that Celsius realized they needed some outside help to generate the resources to cover the yields they were advertising.
They engaged an outside firm called KeyFi to help them make the difference between the loan interest and yield targets.
This relationship eventually soured, with KeyFi filing a lawsuit against Celsius.
Now, it’s important to recognize that the document should be considered a series of allegations. However, the story that the document paints is one of a firm that was ill-equipped for the markets they were involved in.
And there are some key elements that traders and enthusiasts should be aware of if they get involved in future lending, yield, and borrowing projects.
The court filing is here.
Of note is that the Arkham Intelligence Report says that KeyFi may have been involved in some of the losses Celsius experienced.
No paperwork and no hedging
One element that comes out in the filing is that Celsius was alleged to have considered the coin deposits for loans to be theirs. As in, they owned them, not the borrower. And it appears that these were articulated in the terms of service.
KeyFi alleges that an agreement with Celsius to trade customer assets was made in principle and that virtually no paperwork was available. That is an unusual arrangement given that at one point, KeyFi claims to be using and trading up to $2 billion in customer assets for Celsius.
KeyFi tells us that they were not responsible for hedging the price risk of the coins they were using. As in, they could use them to generate a profit, but they were not responsible for the price at which they were reacquired. If the price rose between the use of the coins for trading and their return to the original owner, Celsius might have to eat a loss. And there was no hedging strategy in place, so there would be a loss on the part of Celsius.
You can see how this would be a problem in a rising market.
And this is something you might want to know before getting involved in a project like this in the future.
Dynamic, volatile markets create additional challenges
As the balances of Celsius grew, attracted by high yields, they had an increasingly difficult time finding the returns to meet their advertised promises. They were spread across DeFi platforms and levered up.
In the Arkham Report, you can see on page 9 the extent to which they were involved in DeFi. It was whale-sized involvement.
The entire market Celsius was involved in was dynamic and volatile. Add leverage and the results in unexpected conditions are predictable.
KeyFi alleged that Celsius also had accounting problems in that everything was accounted for in dollars. This is in spite of assets being returned in various coins and not necessarily the original coins available for trading.
So no hedging, plus dollar accounting on speculative assets, and then some other possibly shady stuff like marking up CEL tokens. Again, all allegations.
The results outlined in the lawsuit show us the result of the business model, thinking, and experience of the founders.
The whitepaper gave adequate warnings about some of these potential problems.
Arkham gives us additional clarity about what this looked like in the end.
Watch the bankruptcy filings and be ready next time
Celsius is one of many companies in DeFi with problems which is understandable given the scale of their involvement. However, while market conditions are a factor in all of them, the business model and views are somewhat different.
Celsius telegraphed the potential risks throughout their whitepaper with statements about how they saw the world and what they believed. And the results of these beliefs are documented in the court filing and the eventual failure of the company.
The whitepaper shows us that these highly experienced founders were out of their depth operating in the financial markets. Certainly out of their depth at that scale.
You can see the deficiencies in their thinking. And some potential pitfalls in the assumptions they made about the business.
And there were numerous potential pitfalls.
Yes, they were successful. Successful enough to attract $750 million from sophisticated investors like the Quebec Pension Plan in late 2021.
Successful enough to attract a million-plus users and tens of billions in AUM.
But their success was the seed of their eventual failure.
Return of equity, not return on equity
I am reminded of 2007 when the asset-backed commercial paper market blew up in Canada. Various CFOs had raised money and were searching for an extra point of yield in a low-interest-rate environment. So they had commercial paper on their books.
Asset backed commercial paper is boring, safe, secure paper. One day it wasn’t.
But when disaster struck, the entire ABCP market froze up. It almost wiped out several firms because they could no longer access capital.
They chose return on equity instead of return of equity.
In traditional market lore, risk and reward exist on a pendulum.
The more risk, the higher the expected return and vice versa.
And when something seems too good to be true, it just might be.
So take a look at these very attractive numbers and returns and look more closely at how those will be obtained. How does the team get paid? What are the risks, and how are they managed?
Do they have a shark or two on their team, or does the team lack any real-world market experience?
Good markets forgive mistakes, but hard markets require much more skill in the management of risks.
And look carefully at the terms. Actually, read them.
Because in the case of Celsius, there were some potential surprises.
Looking at Celsius, given their presence across the space and their condition, crypto will likely be pinned down until the weight of their presence is lifted.
Remember, the idea of being your own bank is about responsibility. And that means being crystal clear on what you are getting involved in.
And in a market filled with uncertainty, it’s better to learn from the failures of others if you can.
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