Contagion or Arbitrage? Celsius & 3AC

June 28, 2022 - 24 min
Contagion or Arbitrage? Celsius & 3AC

An extended read into the Celsius & 3AC defaults, the role of derivatives in crypto's 2008-like subprime crises, upcoming defaults, and potential arbitrage opportunities.

Two weekends ago, Bitcoin breached $18,000 to fall below a prior cycle’s all-time high for the first time, while Ethereum traded below $1,000. Despite both having since recovered, the price action in response to the Fed’s 75bps rate hike and expectations of future hikes of the same magnitude suggests that the market is struggling to find a direction. Current macro headwinds make it impossible to sustain any risk-on attitude, especially with crypto facing a major deleveraging cycle.

The insolvency of major crypto institutions such as Celsius and Three Arrows Capital (3AC) in the wake of the Terra Luna debacle has created a cascade of unknowns, with the only guarantee being that someone else will default. On-chain data, especially the knowledge of liquidation prices, seems to have led to stop-hunting and, in turn, forced selling of various leveraged positions. If Luna’s collapse was crypto’s Bear Sterns moment, then Celsius and 3AC may be the equivalent of Lehman Brothers and Citi.

Read on to find out:

  • What happened to Celsius and 3AC
  • How Lido’s liquid-staked Ethereum product (stETH) played such a significant role in the collapse
  • Who's next in line to default ($USDT?)
  • What to do if you are a Celsius client
  • Why there may be a potential silver lining for savvy investors

As always, any terms or definitions you find confusing can be found in the glossary here.

A Background on Celsius & 3AC


On June 13, Celsius, a platform that lends out user-deposited cryptocurrencies in return for interest, announced that it would pause withdrawals, swaps, and transfers. As of May 2022, Celsius had $12 billion in assets under management, of which more than $8 billion had been lent out. Celsius operates like a bank - it borrows funds from one set of clients that it uses to offer partially secured loans to another group of clients and pockets the difference in interest. However, unlike a bank, Celsius does not have any deposit insurance from the government and, as it turns out, very little risk management.

Celsius’s business model is reminiscent of the subprime mortgage crisis in that Celsius lends out portions of the collateral borrowers hand over, a practice referred to as rehypothecation. This practice is eerily reminiscent of how subprime loans were repackaged and sold as mortgage-backed securities and then resold as collateralized debt obligations in the years leading up to the 2008 financial crisis.

Celsius also has an illustrious history of bad treasury management. In 2018, Celsius raised $50 million from the Initial Coin Offering (ICO) of its $CEL token. However, the firm did not convert these holdings to fiat or stablecoins, and in 2019, financial statements filed with the U.K. registrar showed proceeds of only $25 million. Unfortunately, this absence of risk management is endemic to many startups operating in the crypto and Web3 space. Many of these startups raise funding via ICOs in which people exchange ETH, BTC, or other L1 cryptocurrencies (depending on which L1 chain the project is launching on) for the startup’s native token. Unfortunately, despite the existence of Web3 treasury management services, a surprising number of these startups fail to convert the proceeds into fiat and stablecoins, a practice that has been exposed by the recent market-wide decline in crypto prices.

Moreover, Celsius also has a history of losing funds through various exploits and operational oversights. For example, in February 2021, Celsius sent 35,000 Ether to Stakehound, an ETH 2.0 staking service provider, in a single transaction. Their net exposure was closer to 42,306 Stakehound staked ETH tokens, which are redeemable 1:1 after withdrawals are enabled on the Beacon chain (6-12 months after Ethereum completes its transition to the PoS). Subsequently, in June 2021, Stakehound lost the keys to its wallet, resulting in a loss of over 38,000 ETH. Nansen estimated that at least 35,00 of these belonged to Celsius, a loss of over $71 million. Stakehound’s stETH tokens, not to be confused with Lido’s stETH tokens (more on that later), are now nearly worthless.

Later that year, in December 2021, a decentralized autonomous organization (DAO), BadgerDAO, was exploited by a phishing attack, losing 2100 BTC and 151 ETH. The most prominent victim of the attack was Celsius, which lost 896 BTC. As part of a restitution plan, Badger disbursed about 10% of the loss to victims, or 90 BTC to Celsius, and created a $remBadger token, which guaranteed payout in Badger tokens that would cover the remainder of the loss over a 2-year period. The only caveat was that the remBadger tokens would have to remain in the Badger vault to be eligible for restitution payments, and users were prompted on screen if they attempted to withdraw. In March 2022, however, Celsius withdrew all 901 of its allotted $remBadger (worth $2.1 million) against their effective loss of almost $25 million. Once they realized that error, they authored a resolution on BadgerDAO to allow them to redeposit, but it was voted down by 89% of the vote.

In more recent news (that remains surprisingly shocking despite their other shenanigans), Celsius had also deposited over $500 million of user assets in the Anchor Protocol on the Terra Blockchain, which offered 20% APYs for holding their algorithmic stablecoin TerraUSD ($UST). As many may know, $UST now trades for less than $0.1. As $UST fell, Celsius pulled more than $535 million in crypto assets from Anchor, according to public blockchain data. However, despite Mashinsky claiming that “Celsius Network did not have any meaningful exposure to the depeg,” it seems unlikely that Celsius was able to liquidate its sizable holdings without taking a significant haircut.


Meanwhile, Three Arrows Capital is a Dubai-based prop trading crypto fund whose founders Su Zhu and Kyle Davies have been amongst the most vocal proponents of crypto markets in the last few years. In mid-June, rumors of 3AC’s insolvency began to circulate amidst reports that it was hurtling towards liquidation.

Zhu, who made his name championing a crypto “supercycle,” claimed that BTC would hit $2.5M and become a new form of gold. He also believed that digital assets were best placed to navigate a macroeconomic downturn thanks to blockchain innovation. On May 27, however, reeling from the Terra UST collapse, Zhu walked back the statement, admitting that the “supercycle price thesis [was] regrettably wrong.” The firm saw early success with investments in Avalanche, Solana, Near, and Deribit and also launched a $100M NFT fund last August. However, 3AC’s troubles began earlier this year with the collapse of their $600 million investment in LUNA, a stake worth less than $700 due to the implosion of the Terra ecosystem. In a move known as “Revenge Trading,” the size of 3AC’s Terra loss led them to take on excess leverage in an effort to earn it back. According to The Block, $400 million of Three Arrows’ positions have been liquidated, including by prominent exchanges and lenders such as BitMEX, Deribit, and BlockFi, while another $300 million is at risk of liquidation on Aave and Compound if the market continues to crater. The damage of 3AC’s liquidation outside the price effects on its holdings is also unknown. 3AC offered treasury management services and 8% APY to startups it had invested in. It’s an open question whether 3AC used those funds to collateralize their leveraged positions, and if so, how users of those startups will be affected. For example, a staking platform called Finblox, which raised $3.9 million from 3AC in March, has now reduced its customer withdrawal limits.

Despite these examples of mismanagement, the current scenario may never have come to pass had it not been for a crucial miscalculation. That miscalculation assumed that Lido’s staked Ethereum of stETH would remain pegged 1:1 to the price of ETH in the secondary market since they would be able to redeem stETH at that ratio 6–12 months after Ethereum’s move to PoS, currently scheduled for September. However, before getting into the semantics of how this impacted their balance sheet and subsequent liquidation prices and LTV (Loan-to-Value), it is first essential to understand how derivative assets such as stETH work.

Lido’s Staked Ethereum: stETH

Proof-of-Stake Networks (PoS), such as the one that Ethereum intends to migrate to, require users to lock up their tokens (ETH) to secure the system. The system allows staked users to validate transactions on the network in return for rewards, with bad actors liable to lose their stake for incorrectly validating transactions. Last year, with Ethereum’s move to PoS, users would be allowed to deposit a minimum of 32 ETH to become active validators on the network’s upcoming PoS Beacon Chain. Since many users did not have 32 ETH (worth almost $100k at last year’s prices), exchanges and other crypto firms allowed users with smaller holdings to deposit ETH with them in return for a share of the rewards.

This staking system required all user holdings (including those with the minimum 32 ETH) to be subject to a lockup of 6-12 months after Ethereum’s migration, creating a significant opportunity cost for token holders. One of DeFi’s core ideas has always been liquid-staking. Liquid-staking offers stakers a tokenized IOU representing a claim on the staked token. The alternative token can usually be redeemed 1:1 for the underlying (staked) token subject to certain conditions and, in the interim, be sold or used as collateral to take out loans (for example).

Lido is the largest non-custodial and decentralized liquid staking platform for Ethereum, with over 90% of the liquid staked Ethereum market share. Lido also accounts for almost 30% of all staked Ethereum. Lido’s liquid-staking mechanism works as follows: Users deposit a certain amount of ETH with Lido, which it then deposits with node operators on Ethereum 2.0, thereby circumventing the minimum 32 ETH requirement for smaller holders. In return, Lido gives depositors stETH, a minted representative ERC-20 coin redeemable 1:1 for ETH after Ethereum transitions to PoS. Rewards from ETH2 staking are then redistributed to depositors based on their share of the pool, with Lido taking a 10% cut.

Source: @Leo_Glisic, Messari

One of the key benefits of liquid-staked assets, in this case, stETH, is that holders can exit their position at any time. However, since stETH cannot be redeemed for ETH until after Ethereum’s PoS transition, and there is no burn mechanism on Lido’s protocol, the exit price of stETH is determined secondary market.

The largest secondary market for stETH is the stETH:ETH Curve AMM pool, which the Lido DAO incentivizes by offering LDO and CRV tokens to liquidity providers. Similarly, Uniswap and Balancer pools and CEXs such as FTX allow stETH holders to exit their staked positions. The only mechanism to prevent the stETH:ETH peg from deteriorating is the arbitrage opportunity, where a depeg offers arbitrageurs a chance to acquire post-merge ETH at a discount. Existing ETH holders can also exchange their tokens for stETH in a delta-neutral arbitrage unaffected by ETH’s price. Similarly, fiat and stable coin holders manufacture a delta-natural positing by going long on stETH and then shorting ETH either in the spot or futures market to collect the discount irrespective of Ethereum’s post-merge price.

However, the situation becomes much more complicated when borrowers use stETH as collateral for loans on lending platforms such as Aave. The risk of depeg coupled with the already falling price of ETH significantly increases the risk of liquidation and forced selling in the secondary market, thereby creating a depeg spiral.

The most popular DeFi strategy this year has been to recursively borrow stETH on Aave, which allows users to borrow up to 70% of collateral value to leverage up staking returns. Depositors use stETH to borrow Wrapped Ethereum (WETH), swapping for more stETH, which can then be deposited back into Aave as additional collateral to continue the borrowing cycle. Structured products, like Index Coop’s icETH, similarly offer leveraged stETH strategies through Aave, with the key distinction that they programmatically manage collateralized debt positions and LTVs. Unfortunately, this type of risk management was not baked into the yields Celsius and like were offering their depositors, who were unaware of the potential depeg risks.

Source: @Leo_Glisic, Messari

Like stETH, various other long-duration derivatives are trading a discount to their underlying asset. One such example is Grayscale’s Bitcoin Trust, which played a significant role in 3AC’s collapse, and since February 2021, has been trading at a growing discount to the value of the BTC it holds. The discount to market value is a function of regulatory uncertainty regarding its conversion to a spot ETF and the fund’s 6-month lockup rule.

Liquidation Cascades

When derivative assets are pledged as collateral, events such as a hack, governance attack, node slashing, and a market-wide liquidity crunch can cause cascading liquidations and a massive deterioration in stETH:ETH pair.

The size of the derivative discounts creates a massive asset-liability mismatch on balance sheets (3AC and Celsius). Crypto firms, in general, tend to be much more susceptible to this phenomenon due to issues around duration matching and risk management.

Unlike traditional loans, loans in crypto don’t tend to have a fixed term and require borrowers to deposit collateral above the amount they want to borrow (over-collateralization).

In the case of stETH and GBTC, the price deterioration of the underlying assets due to inflation and the subsequent depegging turned a lot of long-term debt into short-term debt and, in some cases, got liquidated. The forced selling pressure further degrades the asset peg, instantly turning millions in long-term debt into short-term debt, drastically changing the liabilities’ duration. As the market craters and assets compress, liquid crypto-related assets and balance sheet inventories reduce the current asset base. Simultaneously, the deterioration in the peg for derivatives reduces a firm’s ability to liquidate long-tail risk assets.

In the case of stETH, the asset was priced pari passu (on equal footing) to ETH on the balance sheet and was held as a current asset that could be liquidated at par. With the depeg, however, stETH transformed from a short-term investment into a long-term asset priced at a discount. This migration of short-term investments to long-term assets compounded by the erosion of current assets (from market-wide price declines) creates a mismatch due to the inability to pay down debt.

To balance accounts, firms such as Celsius and 3AC began to sell any and all assets into cash to cover debt costs and margin calls. This led to a recursive pattern where spot sales caused a downward price shift, which led to margin calls and further spot selling. Let’s dive into how this cycle played out for Celsius and 3AC 👇


Celsius’ problem began with a shift in its yield strategy. In a 2020 video, Celsius Founder Mahinsky said that their primary business model was “to generate profits by lending assets, similar to banks, on a short-term basis” for arbitrage, market making, and shorting certain stocks or digital assets. He claimed that Celsius was the “equivalent to securities lending in the digital world.” Since early 2021 however, as DeFi yields became more attractive, Celsius started to turn to these more volatile opportunities to generate higher yields. One prominent example was converting user stablecoin deposits in $USDC and $USDT to $UST and depositing that on Anchor for 20% APYs.

In the wake of the Terra and $UST collapse, a discount between stETH and ETH first opened up in May. The discount was a confluence of depositors looking to generally deleverage as the price impact of Terra’s collapse spread across the system, compounded by the need to maintain liquidity which was achieved by selling assets such as stETH. Subsequently, in June, Huobi Research published a note reporting that Celsius had incurred a $71 million loss on the Ethereum staked with Stakehound, which led to a frenzy of Celsius depositors attempting to redeem their position. The rapid withdrawal rate, around 50,000 ETH/week, forced Celsius to sell other assets like stETH for ETH on secondary markets like Curve to acquire more liquidity and take out loans against stETH to repay its ETH depositors. As of June 11, Celsius’ breakdown of ETH holdings was as follows, with their 445,000 ETH far exceeding the Curve pool liquidity of 132,000 ETH:

Having been aware of this upcoming depeg, other investment firms began to reduce their stETH exposure by selling it on the secondary market while further exacerbating the discount and market illiquidity. For example, Alameda Research, one of the largest crypto investment firms, sold around 50,000 stETH on June 8. Subsequently, in an attempt to remain solvent, Celsius’ tried to exchange its stETH for ETH in an already illiquid market, which pushed the stETH:ETH peg discount as high as 8% in mid-June.

In addition to stETH, Celsius also held leveraged positions using other assets as collateral, the biggest of which is wBTC, a derivative product that allows Bitcoin holders access to the Ethereum DeFi ecosystem. wBTC is a derivative token fully backed by Bitcoin and can be exchanged with Bitcoin at a 1:1 price ratio. While wBTC does not suffer from a depeg scenario, the underlying decline in BTC prices becomes problematic when wBTC is used as collateral for stablecoin loans. Celsius holds around 17,900 wBTC in a Maker DAO vault, which it used to borrow DAI, a stablecoin pegged 1:1 with USD. While the original liquidation price for the vault was around $20,000, in a rare silver lining, Celsius has added collateral to the vault, pushing the liquidation price to $13,607.40 at the time of writing.


Three Arrow Capital’s troubles also seemingly began with the collapse of the Terra Luna ecosystem, which saw their $600 million stake fall to less than $700 in a matter of days. However, recent reports indicate that 3AC’s demise began as early as December 2020, when they disclosed a 6.1% stake in GBTC. At the time, their GBTC stake was worth over $1 billion, and GBTC was trading at a 20% premium. In the first half of 2021, 3AC mentioned on several podcasts that they were borrowing BTC from miners and lending to institutions against their GBTC and, in some cases, without collateral to lever up the GBTC arbitrage. However, in February 2021, the GBTC premium turned negative and currently sits at a 30% discount to Net Asset Value (NAV). This would imply a drawdown of over 50% and a loss of $500 million without even factoring in the cost of carry from 3AC’s borrowing activities.

On June 17, Frank Chaparro reported that in the days leading up to 3AC’s liquidation, the firm was pitching investors on an arbitrage opportunity pertaining to GBTC. The pitch was a structured trade that was predicated on the discount between the GBTC market price and NAV collapsing as the deadline for the SEC decision on GBTC’s conversion to spot ETF neared. In truth, this was simply an effort by 3AC to regain liquidity by converting their GBTC to BTC in the private market rather than risking an even wider discount by transacting in the secondary market.

In addition to 3ACs illiquid GBTC trade, it turns out that 3AC was also the largest seller of stETH during the crash from June 7 – June 14, with the firm dumping the asset from all of their accounts and seed round addresses.

On June 14, a wallet tagged as 3AC also dumped 30,000 stETH (~$33.7 million) to ETH and subsequently used that to unwind positions on Aave where they had borrowed stablecoins. Although later dismissed, rumors also circulated that a wallet originally tagged as 3AC on Nansen was paying back Aave debt against a 223,000 ETH ($264 million) position that had been used to borrow $198 million worth of stablecoins such as USDC and USDT, and had an LTV of 77%, which would face liquidation if ETH’s price deteriorated another 11% to $1,042.

Meanwhile, 3AC has also been an early investor in the blockchain ecosystem and currently owns illiquid tokens which are subject to lockup periods. However, when these lockups expire, there is a material risk that these will be liquidated to repay debtors in case of bankruptcy proceedings. The assets that 3AC owns are shown in the graphic below:

3AC’s insolvency also poses major issues from crypto outside of the price impact of the liquidation. 3AC borrows from almost all major lenders, such as FTX, Celsius, BlockFi, Voyager, and BitMex, to name a few. In fact, on June 17, The Block reported that FTX, BitMex, and Deribit had all liquidated 3AC positions over the preceding week and that 3AC owed $6 million to BitMex.

As discussed further below, the impact of 3AC’s activities and the ensuing risk became clearer as funds such as Voyager and BlockFi began to seek additional liquidity to cover user withdrawals in the wake of 3AC’s collapse. Unfortunately, the meme below seems representative of 3AC's thought process.

Who’s Next?

More than $1B worth of digital assets were liquidated on June 14, according to data from Coin Glass. Around $480 million was wiped out on centralized exchanges, with ETH representing 42% ($202 million) of margin calls, while $154.4 worth of BTC positions were wiped out. Similarly, on-chain liquidations also surged, with 370 margin calls wiping out more than 53 million DAI on MakerDAO alone. By contrast, only 401 liquidations worth $55.8 million had occurred in the preceding month.

Although markets have stabilized, large amounts of debt remain in the system, mainly due to the recursive stETH borrowing strategy on Aave. Huobi’s note, published earlier this month, shows the amount that will be liquidated at the following stETH:ETH levels:

In addition to outstanding leveraged debt, there is additional contagion risk for companies and CeFi lenders that loaned out money to now underwater firms such as 3AC. For example, Voyager Digital, another CeFi lender, announced last week that it had issued a “notice of default” to 3AC. This announcement sent Voyager’s shares tumbling over 60%. Voyager’s exposure to 3AC comprised 15,250 BTC (~$300 million) and $350 million USDC. As a result of this blowback, Voyager needed to secure a revolving line of credit from Alameda Research, including a cash/USDC-based credit facility with an aggregate principal amount of US$200 million and a revolving credit facility for 15,000 BTC.

Meanwhile, it was rumored that BlockFi also had exposure to 3AC, with the firm’s CEO Zac Prince tweeting last Thursday that a “large client… failed to meet its obligations on an overcollateralized margin loan.” Prince, however, claims that BlockFi “fully accelerated the loan and fully liquidated or hedged all the associated collateral” and that “no client funds are impacted” as a result. Twitter sleuths have since questioned BlockFi’s management after it was leaked that BlockFi lost more than $285 million throughout 2020 and 2021, despite being in a bull market that saw BTC go from $6,000 to $69,000. Additionally, it is reported that at the end of 2021, BlockFi held only $467 million worth of liquid assets in its wallet, while its yield assets sat at $13.5 billion. This would imply that these long (and likely unprofitable positions) would need to be unwound before users could fully withdraw their assets from the firm.

Assuming that each BlockFi user deposited the same amount, only 3.4% percent of users would be able to withdraw their funds.

On June 24, it emerged that FTX was in talks to acquire a stake in BlockFi after it had given the lender a $250 million revolving credit line. As it stands, the credit offer (if inked) would entirely wipe out all shareholder equity in the company, although user funds would remain safe. Morgan Creek, an early backer of BlockFi, is also in conversations with various funds to provide a competing offer.

Outside lenders, the general macroeconomic outlook also continues to paint a worrisome picture for the crypto markets, especially Tether. Tether, a subsidiary of the exchange Bitfinex owns the stablecoin $USDT - the largest stablecoin by market capitalization. Tether is also used as the primary settlement currency across DeFi and various exchanges, and most futures contracts are denominated in $USDT.

In October 2021, it was announced that Tether would pay $41 million to the Commodity Futures Trading Commissions (CFTC) to settle allegations that it lied in claiming its digital tokens were fully backed by fiat currencies. Despite telling customers that it had $1 in reserve to back every token, the CFTC found that through various periods in its history, such as June to September 2017, there was never more than $61.5 million backing its more than 442 million coins in circulation. In its enforcement action, the CFTC said Tether failed to disclose that it held unsecured receivables and non-fiat assets as part of its reserves and falsely told investors it would undergo routine, professional audits to demonstrate that it maintained “100% reserves at all times.” Previously in 2018, Tether had announced the dissolution of its relationship with the auditing firm Friedman LLP, “given the excruciatingly detailed procedures Friedman was undertaking for the relatively simple balance sheet.”

In addition to short-term treasuries and fiat, Tether’s assets include commercial paper and crypto tokens. What is concerning is that the country of origin of the short-term treasuries and commercial paper (as well as the quality) is unknown. Furthermore, the commercial paper holdings are at significant risk of default in the current economic climate, while any crypto token positions (for example, BTC) may suggest that Tether is already underwater.

Blockworks Research published a tweet in which they argued that Tether’s balance sheet is “almost identical to money market funds that de-pegged from $1, froze redemptions, and were bailed out by the Fed in 2008.” The example below compares the balance sheet of Reserve Primary, which had $1 units backed by an asset pool considered safer than Tether’s but experienced a bank run due to a minuscule 1.2% exposure to Lehman.

Moreover, since the implosion of $UST, there has been mounting selling pressure against $USDT (Tether). Leon Marshall, head of institutional sales at Genesis Global Trading, noted that “there has been a real spike in the interest from traditional hedge funds who are taking a look at tether and looking to short it.” In fact, from June 13 – June 15, Tether saw $1.6 billion in redemptions, although the pace has since stabilized.

In fairness to Tether, it has repeatedly denied that 85% of its commercial paper portfolio comprises Chinese or Asian commercial paper (currently traded at a 30% discount), arguing that 47% of its total USDT reserves are now in U.S. Treasuries. Over the last two quarters, Tether has reduced the amount of commercial paper it holds to $11 billion and expects to reduce it to $8.4 billion by the end of June 2022. It also claims that the reports of its exposure to Celsius are overblown and that its Celsius position was liquidated without any loss to the company. On June 15, 2022, Tether CTO Paolo Ardoino announced that a top-12 accounting firm would undertake a full audit of the company to provide further transparency. While the potential for Tether defaulting on redemptions may be overblown, it is crucial to understand the risks that a cycle of defaults and ensuing liquidation cascades pose for the market.

What you should do if you borrowed from Celsius

Earlier, we discussed that one of Celsius’ main issues may be the rehypothecation of collateral. However, whether the entire amount of collateral was rehypothecated or only the interest is unclear.

Following Georgetown Law Professor Adam Levitin’s chain of thought, let’s assume that the collateral is still there. The loan agreement, in this case, would be an “executory contract,” under which both parties would still owe performance. In this scenario, “Celsius gets the option of whether to (1) accept repayment and return the collateral or (2) let borrowers keep the proceeds and Celsius keep the collateral. If Celsius chooses option (2), the borrower has an unsecured claim for the delta between collateral value and loan amount.”

However, when determining the “collateral value,” there is still the question of a valuation date, which could either be the bankruptcy date or the date that the borrower learns of Celsius’ choice to exercise option 2. Unfortunately for depositors, Celsius can take its time in making the decision, allowing it to track market conditions to determine whether to accept repayment or keep the collateral and pay out an unsecured claim. Under option 1, Celsius may also decide that it wants to perform on the loan contract and sell it to someone else, which would then become the new counterpart in the contract.

However, suppose Celsius has indeed rehypothecated the collateral and cannot return it to borrowers upon repayment. In that case, Celsius has no choice but to choose option 2, which would likely involve litigation regarding the valuation date.

Adam Levitin argues that if he were a borrower (from Celsius), he” would be VERY hesitant to repay Celsius because there’s a risk that Celsius takes the money and doesn’t return the collateral.” In this scenario, the buyer is then stuck with an unsecured claim for the entire value of the collateral, rather than just the amount of overcollateralization (the excess collateral put up to secure the loan). However, “failing to repay also risks a default that lets Celsius keep the collateral, which would mean that in a subsequent bankruptcy, the borrower would have a claim for the amount of overcollateralization, but the valuation date there should be the date of the default.” As a borrower, the best recourse would be to walk away with the loan amount based on whether or not you think the collateral will keep falling in value and if you believe it will end up below 100% LTV.

Arbitrage Opportunities?

Despite the turmoil in crypto markets and the looming threat of recession, there are silver linings for savvy investors that did not use leverage or get liquidated in the recent cycle. The most prominent of these opportunities involve taking advantage of the discounts offered on long-term assets as over-leveraged investors rush to find liquidity. In particular, the widening gap between derivatives such as stETH and GBTC and their underlying assets presents an opportunity for long-term ETH and BTC holders and delta-neutral traders to profit.

Significantly, holders of ETH and BTC who are optimistic about the future of these tokens can now increase their holding of the tokens at a discount. For example, an investor with liquid ETH (and no intention of selling anytime soon) can exchange 1 ETH for 1.036 ETH for a 3.6% upside with no price risk, as long as they are willing to wait until the completion of the move to PoS. Recall, however, that the peg went as low as 0.926 on June 18, which represents an upside of 8%, so it may be in the investor’s best interest to wait. Many speculators believe that the actual value of stETH is closer to that of GBTC and ETHE, both of which are trading at a 30% discount to NAV. Unlike the two, however, stETH can be used in the DeFi ecosystem and has no underlying regulatory risk. This means that a similar discount is unlikely to materialize. An ETH to stETH trade is also completely delta-neutral since stETH conversions to ETH are guaranteed 1:1 after the Merge. Moreover, any slashing risk will also be covered by Lido.

Similarly, GBTC, a close-ended fund trading 30% under its NAV, is waiting for SEC’s approval to convert it into a spot ETF. It’s essential to remember that a decision on Grayscale’s ETF application is due on or before July 6, and the heavy betting is that the SEC will deny the proposal. Nevertheless, CEO Michael Sonnenshein reiterated his company’s “unequivocal” commitment to converting GBTC from a trust to a spot ETF. The company has also lined up market-making heavyweights Jane Street and Virtu Financial as authorized participants should the ETF application be granted. Moreover, the recently approved ProShares Short Bitcoin Strategy exchange-traded fund ($BITI), which offers a return inversely related to the daily performance of the S&P CME Bitcoin Futures Index, was approved by the SEC on June 22. In addition to the already operating long futures BTC ETF, $BITI's approval makes it more likely that Grayscale’s conversion request will also eventually be approved.

For traders holding fiat or stablecoins, these discounts also provide an opportunity to put capital into action, using low-risk strategies that involve buying the derivative such as stETH or GBTC and then opening a corresponding short-position on ETH or BTC, thereby netting the discount without any risk from price changes in the underlying assets.

For example, traders can buy stETH and then open a corresponding short position in ETH on the futures market. Users can either open a short position using a perpetual futures contract while paying/earning the variable funding rates or purchase June 30, 2023 contract while making the 1.75% basis on Deribit. A positive funding or basis rate means that traders who are long on the contract have to pay short-position holders. The funding rates and basis for various exchanges and contracts can be seen below.

However, opening a futures short position also exposes traders to potential liquidation risks depending on the price movement of Ethereum, which requires active position management. Futheremore, with a perpetual contract, the trader needs to estimate the impact of oscillating funding rates on their position, as the loss from potentially negative funding rates may not be enough to offset the  stETH discount, which is currently around 4%. Similarly, shorting via a dated futures contract can also result in a loss if the contract expires before withdrawals becoming active on Ethereum’s Beacon Chain (when stETH is redeemable 1:1 for ETH). To avoid these scenarios, traders can also use the -1x ETH short token $ETHHEDGE on FTX, which is less likely to liquidate since it automatically rebalances the underlying holdings at various percentage changes and the end of the day. However, the $ETHHEDGE token is still subject to funding rates and the impact those may have on net returns. As such, for delta-natural traders with fiat holdings, it may make sense to wait until a more significant discount opens up before creating an arbitrage trade.

Such a strategy is also feasible for GBTC, where the discount is far more significant. Traders interested in making such a trade can purchase GBTC on FTX and determine which exchange to open a short position using Laevitas. However, unlike stETH, where the redemption is guaranteed to close any existing discount, there remains the issue of regulatory risk since there is no guarantee or fixed timeline for if/when the SEC will approve the Trust’s conversion to a spot ETF.

Other strategies (which I will cover in subsequent posts) for various derivatives, such as $cDOT, which is crowd-loaned $DOT (redeemable 1:1) at a future date, have also recently drawn interest, especially with Parallel Finance introducing liquidation-free recursive borrowing for the asset.

It is often said that fortunes are made in a bear market, especially for investors who can cut through the noise and accumulate positions while others sell into the panic. However, it is essential to remain prudent and manage risk as the threat of contagion and an uncertain macroeconomic and regulatory environment remain on the horizon. Time-tested strategies such as DCA’ing or smaller limit orders at various support bands may prevent investors from catching the entirety of the potential upside but also prevent massive losses that are hard to recover from, both financially and psychologically. Spreading out investments over time also allows investors to research and discover new information about their investments which could have a long-term impact on their viability. Bear markets provide a unique opportunity to accumulate while building conviction in one’s investment through research without chasing a market that’s frothing in the teeth. As always, feel free to reach out to me on Twitter (@pirouneB) or email ([email protected]) if you’d like to discuss any ideas or thoughts regarding potential trades or investments. Good luck!