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Cryptocurrency Deleveraging is Bitter Medicine

  • Nansen report suggests that one-way bullish bets and numerous levels of hypothecation of cryptocurrencies used in decentralized finance led to the contagion from the fallout of TerraUSD and Luna. 
  • Complete unwinding of leverage and counterparty failure will take weeks if not months to trickle through the entire cryptocurrency ecosystem.

A recent report published by blockchain analytics company Nansen.ai has started to shed light onto possible reasons that led to the fall of some of the biggest crypto firms such as lender Celsius Network and hedge fund Three Arrows Capital.

According to Nansen research analyst and report author Niklas Polk, “a lot of the selling pressure stemmed from the TerraUSD collapse” which created a domino effect on crypto lenders, firms and institutions which had treated TerraUSD as the equivalent of a dollar.

The Nansen report suggests that many whales (large holders) may have exacerbated the contagion through the crypto markets by leveraging high-yielding derivatives of Ethereum which would have come into contact with TerraUSD.

Under most circumstances, Ether doesn’t generate a lot of yield from staking, but by hypothecating Ether to other derivatives, whales with large amounts of Ether can leverage up bets and generate higher returns through a variety of delta-neutral strategies.

With the collapse of Terra-Luna large holders of Luna were badly affected, including Three Arrows Capital, which is believed to have had up to US$500 million worth of Luna at its peak, only to be worth US$604 after the collapse.

Because of Luna’s collapse, Three Arrows Capital and Celsius Network were forced to dump some US$800 million worth of Lido Finance’s staked Ether or stETH, a derivative of Ether that is “locked” until Ethereum completes its software upgrade, to an already illiquid market.

According to Nansen, Between May 12th and June 18th, investors liquidated US$4 billion worth of stETH holdings which sent Ether plunging by around 29%, but saw stETH, which till then had been assumed to be worth 1:1 to Ether, falling by 31%.

Making matters worse, as Celsius Network depositors called on their Ether deposits, the crypto lender was forced to withdraw 50,000 stETH tokens as collateral between June 8th to 9th as it utilized other crypto assets to “either add collateral or repay debt”, as stated by the report.

But as the equivalent of a run on the bank occurred for Celsius Network, its liabilities exceeded its assets and the lender was unsurprisingly forced to freeze withdrawals, and a crisis of confidence spread throughout the crypto lending industry.

Lenders like BlockFi and Babel Finance were dragged into the fray, and both had to freeze withdrawals, as well as smaller outfits like Finblocks.

While the deleveraging of the crypto industry as a whole is welcome, it will take some time for markets to regain normalcy, as litigation inevitably ensues, opportunistic buyers pick up assets at cents on the dollar and the market resets itself.

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