We’re still firmly in Hard Times. Sure, my article last week about price and macro risk was published just before an eight-hour flurry when bitcoin gained 6.35%, but both hazards remain salient.
This article is the second in a three-part series about the risks facing cryptocurrency markets right now. Next week we'll look at public company risk.
This week we'll explore platform and protocol risk, which is one of my favorite topics in crypto because it’s the main area people try to get a “gotcha!” on me by conflating the latest failing in decentralized finance (DeFi) as a failing of Bitcoin. But this conflation, coupled with all the countless crypto hacks and failed blockchain projects, is exactly why we should pay attention to this risk vector.
Anyway, here goes two of three …
– George Kaloudis
What exactly platform and protocol risk means is straightforward. Protocol risk includes the risk associated with failures of the various crypto projects (i.e. protocols), like Bitcoin, Ethereum and Terra. Platform risk includes the risk associated with the failures of the institutions that have cropped up around crypto (i.e. platforms), like Coinbase (COIN), Three Arrows Capital (3AC) and Celsius Network (Celsius).
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But what has really made these two risks worth discussing in tandem is the fact that these protocols and platforms are intertwined.
Protocol risk is really technology risk
The collapse of Terra was just a month ago. Last week, Celsius Network, a company that offers high-yield products on crypto, paused withdrawals from its platform as it faces liquidity issues. Also last week, it was confirmed that prominent crypto hedge fund Three Arrows Capital is facing insolvency following poorly timed bets on Luna, GBTC and stETH.
When Terra collapsed, it dragged down the market meaningfully. Why it did was obvious (without hindsight) for two main reasons:
- Terra was interoperable with other protocols, meaning it aimed to work in tandem with other crypto projects (such as the Cosmos IBC), and so when Terra went down, all the protocols it touched suffered collateral damage.
- Terra held 80,000 bitcoins (BTC), which it liquidated in a failed attempt to protect the protocol, and a well-known entity selling 80,000 bitcoins in a short time frame put an immense amount of selling pressure on bitcoin’s price.
And that was just Terra. There has been a glut of DeFi scams, hacks and exploits plaguing crypto protocols with at least $5 billion of funds lost according to DEFIYIELD’s REKT database. Examples include Ronin for $625 million, Poly for $600 million and Wormhole for $326 million. Day by day, as the dizzying number of crypto protocols coming to life becomes more dizzying, the potential for one exploit to take down multiple protocols increases.
One piece of bad technology can take down entire swathes of capital. That, in and of itself, is a systemic risk.
Platform risk is really transparency risk
As of this writing, Celsius and 3AC still exist, but there’s no denying they are adding to the stress on the system.
For its part, Celsius offers retail customers yield in exchange for holding their coins. Its founder, Alex Mashinsky, has described Celsius as a platform that generates a certain amount of profit by lending assets, similar to banks.
Celsius has moved from providing short-term loans to market makers and arbitrage traders to deploying capital in DeFi’s lending protocols, which allow for higher-yielding strategies. Higher yield comes with higher risk. Higher risk than (and with fewer assurances than) any responsible bank would be comfortable with. There’s nothing wrong with offering yield, but there is something troubling about offering yield by way of putting customer assets at risk. And that increased risk profile has come to bear.
Following Celsius’ announcement that it was freezing withdrawals from the platform, my colleague Oliver Knight wrote a great article for CoinDesk about Celsius in which he quipped:
Meanwhile, 3AC, an actual leveraged crypto hedge fund, looks likely to fail after making some bad bets. This seems less bad than a Celsius insolvency, given 3AC’s customers and counterparties aren’t regular people. But it might get close to as bad for two reasons:
- It shows that the mighty can fall, given most people in crypto considered 3AC to be an impressive firm run by “smart people.”
- Hedge funds place many different bets with many different counterparties using many different techniques to use an undetermined amount of effective leverage to make More Money Than God.
The former wouldn’t be so bad if the latter didn’t mean that this failure by smart people meant that a lot of different entities (and eventually regular people) were affected. There is worry that 3AC’s failure will lead to a “contagion event” across all of crypto.
3AC placed enough margin bets so that its insolvency could set off cascading liquidations across trading desks, DeFi lending protocols and exchanges. In effect: Counterparty A will be forced to sell assets to avoid complete loss, pushing asset prices down, which leads to Counterparty B doing the same. And so on as asset values cascade down toward zero.
I submit that if Terra is Bear Stearns and Celsius is Lehman Brothers, maybe 3AC is Long-Term Capital Management.
In fairness, this isn’t necessarily a failure of the DeFi protocols because the leverage 3AC employed was generally between entities and on protocols. But therein lies the point. Platform risk is platform risk because of a lack of transparency.
Putting protocol and platform risk together
So if we put together the fact that crypto protocols are becoming more interdependent and that platforms are still operating opaquely, it is clear that we could be in for more pain if we protect the status quo. It is easy to imagine a world where we face another massive DeFi hack during a 3AC-like price-induced insolvency. It could be much worse.
In all, that’s a lot of doom and gloom for one newsletter, but I (as a bitcoiner) want to make something abundantly clear. The Bitcoin protocol is still working as designed. Bitcoin supporters like to say “tick tock, next block” in times of market stress; a dedication to the Bitcoin blockchain that continually operates, adding blocks to the chain no matter how many (or few) dollars you have to sell to buy 1 BTC (as long as someone is running mining equipment).
In a world where shoddy technology development and the lack of transparency by surrounding platforms can spell disaster, perhaps there is something to be said about keeping it simple.
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