Preamble

My wife and I recently packed our bags and relocated to New Jersey! Texas was good for us but now we are on to our next adventure in Greater New York City. Would love to meet up if you are in the area.

It’s been fascinating observing people’s reactions when I say I work in crypto. Some acquaintances immediately start walking me through their crypto portfolio while others clutch their pearls and flee for dear life. Jokes aside, I am often the first person they have met who works in the space. Sometimes, I get the sense they don’t quite know what to make of me. Crypto’s unsettling reputation has not been helped by the recent market downturn, hacks, and bankruptcies. My singular refrain has been that “the underlying technology could solve real-world problems, focus on that”.

But you can’t bury your head in the sand and ignore the world around you. If you fail to study history, then you are bound to repeat the same mistakes. We are living through the early days of Crypto’s history. Let’s learn from this moment lest we fall prey to the same dragons.

Heartache 💔

Celsius - a prominent centralized crypto lending company - filed for bankruptcy on July 13, 2022. Customers had been unable to withdraw their funds since June 12, 2022. It now looks unlikely that they will ever reclaim all their funds. Some devastated customers have written letters to the judge presiding over the bankruptcy proceedings. These letters are gut-wrenching. Here are excerpts from two of them:

But how did we get here?

Celsius: Background🔎

Celsius was founded in 2017 by Alex Mashinsky (CEO), Daniel Leon (former COO, now Chief Strategy Officer), and Nuke Goldstein (CTO) in Hoboken NJ. Celsius provides customers with high interest-bearing accounts for cryptocurrencies and crypto-collateral-backed loans.

High interest-bearing crypto accounts

Example 1: Johnny cashed out some of his cash savings and stock investments to buy 1 bitcoin on Coinbase. He then sees an ad from Celsius offering 17% interest rates for customers who deposit bitcoin with the company. He looks at his regular bank account and is reminded that Bank of America is only offering 0.1% interest. It’s a no-brainer! Johnny moves his 1 bitcoin from Coinbase to Celsius to earn high interest.

Crypto-collateral-backed loans

Example 2: The price of bitcoin has more than doubled. Johnny is feeling good about his investment. Time to finally buy that engagement ring he has been eyeing. The price of bitcoin is $50k but he only needs $10k. However, Johnny doesn’t want to sell his bitcoin because he believes the price will be much higher in the future.

Step 1: He transfers 0.3BTC valued at $15k as collateral for a $10k cash loan.

Note: (a) There are no interest payments on the loan but he has 1-year to pay it back. (b) There are no credit checks because the loan is overcollateralized with a loan to value (LTV) ratio of 67% => $10k loan / $15k crypto collateral.

Step 2: Celsius will monitor the LTV ratio as the price of bitcoin continues to fluctuate. If the price of bitcoin drops deeply, Johnny will have 24 hours to add more collateral or pay down the loan if the LTV hits the predetermined threshold ex 90%. If Johnny fails to bring the LTV back to an acceptable range say ~67% within the prescribed time then Celsius has the right to sell his collateral for cash.

Besides lending, Celsius generated revenue from token sales, bitcoin mining, and discretionary trading of cryptocurrencies. As of June 2022, Celsius had lent out $8 billion to customers and had $12 billion in assets under management. The company had 450 employees and reportedly 1.7 million account holders.

How did it go wrong?⚡

TLDR: Celsius CEO said the company went bankrupt due to “..certain poor asset deployment decisions”. Basically, weak risk management. Unfortunately, this does not appear to be an isolated incident, rather, tales of poor decision-making and under-resourcing are emerging from different parts of the organization.

On the surface, the main thrust of Celsius business model was sound. It’s the same model that banks have used for centuries: pay interest to depositors then loan those funds out to another entity at a higher interest rate. Then you simply profit off the difference in interest rates.

Celsius grew rapidly by offering up to a 17% interest rate on crypto deposits. At its peak, it had $24B of assets under management. This helped it raise $750M in Nov 2021 at $3.3B valuation. That fundraising round was led by the second largest pension fund in Canada. But it all came crashing down when Celsius filed for bankruptcy due to the $1.2B hole in its balance sheet.

Celsius reported its total assets were $4.3B but total liabilities were $5.5B. Of the $5.5B liabilities, Celsius owes its customers $4.7B but does not have the assets to pay them. The company only has $125M cash on hand. Much of the $4.3B of assets are said to be Celsius’ holdings of its own crypto token which has dropped in value from a peak of $7.7 in June 2021 to $0.9 in July 2022. There are questions about the current market value of the $4.3B listed assets and fears the actual is lower than what has been reported.

Where did risk management fail?

We are still learning about the failures that led to Celsius bankruptcy. Here’s what I have gathered thus far:

1. Failure of leadership

Celsius executives reportedly told the Chief Human Resource Officer NOT to run background checks on the incoming CFO, Yaron Shalem. This is a major red flag 🚩 In Nov 2021, Shalem was arrested in Israel and charged with money laundering at his previous company.

Perhaps stronger controls could have identified a CFO who might have steered Celsius away from taking on increasing levels of risk. But ultimately the CEO is responsible.

2. Under resourcing

Disruptors don’t color within the lines. They dream up new industries and take risks executing their visions. This is the nature of technological disruption. Uber and Airbnb are great examples of disruptors who launched products ahead of supporting laws, rules and regulations. The Silicon Valley swagger to move quickly and break things has produced results….but one wonders if it is a fit for financial services.

Celsius reportedly only had 3 compliance professionals serving 1.7 million account holders. Some banks serving fewer customers might have 10 to 30x compliance professionals. A former Celsius compliance employee shared how the department was seen as a cost center and not a strategic partner for the business. One could extrapolate and imagine that the same attitude of under-resourcing likely applied to risk management too.

3. Poor fund management

Celsius CEO said in retrospect, they made poor fund deployment decisions. These decisions primarily fall into two camps: (a) over-leveraged positions and (b) over-exposure to stETH.

(a) Over—leveraged positions:

Celsius loaned out depositors’ funds on MakerDAO, a decentralized lending platform. One loan is ~$550M. This loan is overcollateralized like the loans Celsius itself issues. One challenge is that the price of Bitcoin has tumbled more than 60% since the 2021 highs. As a result, Celsius has had to pay down the loan or provide more collateral to bring the LTV back in range, otherwise, the entire $550M collateral would be liquidated. Celsius likely used new customer deposits to secure the collateral consisting of old customer deposits. Celsius came close to losing $550M a couple of times. It has reportedly lost smaller amounts due to insufficient liquidity to shore up the LTV ratio.

A sound risk management approach would have considered that crypto prices could fall significantly and perhaps limit Celsius exposure to this high-risk strategy.

(b) Over-exposure to stETH

Celsius used customer deposits to acquire over $400M of stETH, an irresponsible amount given that no counterparties hold a comparable amount to trade with. stETH is an illiquid receipt stoke for staked ether. stETH is a derivative of ether with each stETH representing one staked ether on the new Ethereum blockchain. However, the price of stETH and the price of ether decoupled in recent months, stETH now has a 3% discount at the time of writing.

A sound risk management approach would have considered whether Celsius should have used user’s deposits to acquire stETH, and if decided to, there could have been controls to limit the amount of exposure to this illiquid asset in Celsius portfolio.

What next for Celsius customers? ⏭

Celsius presented itself like a bank but operated more like a hedge fund. Many customers did not read the fine print in Celsius terms and conditions. Reading through now would yield several realizations.

Uninsured deposits

Depositors at US banks are protected by the Federal Deposit Insurance Corporation (FDIC). If a US bank goes bankrupt, all depositors’ funds are insured for up to $250k. Unfortunately, Celsius is NOT a bank and did not hold any insurance for depositor’s funds.

Section 13 of the Celsius user agreement explicitly states that if the company goes bankrupt, customers may not be able to recover ANY funds.

Bankruptcy claims

Celsius customers are filing bankruptcy claims. Some have also written letters petitioning the judge to release funds to them.

Interestingly, although Celsi...