Lido, Aave, Curve, Celsius & 3AC | What might they have done better?

Cipholio Ventures
13 min readJun 27, 2022

Author: Kevin Hao (Investment Analyst) from Cipholio Ventures

Just a month after the collapse of Luna and UST, the cryptocurrency market has ushered in greater turbulence. This market storm is influenced by a number of factors stacked on top of each other. From the external environment, high inflation has forced the central banks of many countries, such as the Federal Reserve, to raise interest rates sharply, and the probability of a recession is increasing; Within the industry, the bull market in the past two years has led many institutions and retail investors to be blindly optimistic and increase leverage regardless of market risks. At present, a number of large institutions in the industry have become insolvent and are facing bankruptcy. The successive news of horrendous liquidations has triggered a run on the market and a stampede, causing greater panic, and the ripple effect of the multiple incidents has exceeded many people’s expectations. In this process, projects and institutions such as Lido, Aave, Curve, Celsius, and Three Arrow Capital (3AC) played an important role. Could they have responded better if they were given a chance to review the series of events from God’s perspective?

I - Lido, Aave and Curve : We are just tools.

Lido, Aave, and Curve are dApps that are open and transparent about their design mechanisms, operational logic, and participation risks. Frankly, these projects act more as tools that any user can participate in and use. As long as there are no security issues of their own, then these projects should not be held too responsible for this incident. But there are a few points that I think are worth discussing.

(i) Essential of stETH in the Lido ecology

Lido offers users a non-custodial way to participate in ETH 2.0 Staking. stETH is acquired after a user’s ETH is staked and it’s a pledge certificate that represents the user’s claim to the pledged assets and proceeds. Before the official launch of ETH 2.0, users cannot redeem ETH with stETH; after the launch of ETH 2.0, they can exchange ETH back with stETH at 1:1. Therefore, as long as users hold stETH long enough, they can always redeem ETH at some time in the future without any loss from the ETH principal calculation.

Looking at the aforementioned business logic, Lido’s fundamental objective as a staking node service provider is to allow users to engage in Staking and Earn, and the pledged certificates created in the process do not necessarily need to have liquidity. However, during the expansion phase of Lido, the liquidity of stETH plays an important role.

The fact that pledged assets will lose liquidity is a discouragement to user engagement in Staking. To distinguish itself from previous projects, Lido provides liquidity to pledged certificates such as stETH, which is akin to compensating pledged assets with liquidity. The ability to sell stETH on the secondary market or use it as collateral to participate in other DeFi Lending Protocols significantly decreases the opportunity cost for users during the pledge period. If stETH lacked liquidity, Lido would not have become the dominant initiative in the Staking service track.

Therefore, although stETH is a means to attract users and is supplementary to the overall concept, it is crucial for Lido’s growth and development. In order to equip stETH with better liquidity, Lido increases the market acceptance and usage scenarios of stETH through various incentives.

Before the launch of ETH 2.0, stETH was a one-way flow financial product similar to GBTC. Users could not use stETH to redeem ETH from Lido, but could only sell it in the secondary market, and the arbitrage mechanism was not perfect. However, for ETH, which is already online on all exchanges and has a daily trading volume of over tens of billions of dollars, the liquidity of stETH is far from being comparable. The price of 1 stETH is capped at 1 ETH, and the closer to the launch of ETH 2.0, the smaller the difference between the two.

However, Lido made the stETH and ETH equivalent transactions work by providing subsidies, which made the market participants have the illusion that stETH is pegged to ETH. When the market fluctuates violently, a 1:1 pricing between these two uneven assets cannot be maintained. Finally, stETH will not vary too far from ETH because long-term ETH holders will continue to buy and wait for ETH 2.0 to come online to complete their arbitrage.

(ii) Composability of DeFi projects such as AAVE

The composability between projects has always been regarded as an important innovation of DeFi, which can continuously provide users with new financial products. Since the beginning of the DeFi summer, the cryptocurrency market has been in an upward cycle for a long time. Both the project parties and users are more concerned about how to improve the capital utilization and maximize the leverage as much as possible. It is very common to do multiple borrowing in a single project or nested among multiple projects. When a large number of participants operate in this way, the whole system accumulates huge risks.

Although lending protocols such as Aave have collateral ratio requirements, the actual collateral ratio of users may be much lower than this value. Holders of stETH can borrow new ETH through pledge on Aave, and then exchange ETH for stETH in other DeFi projects, and then conduct revolving lending. This kind of operation virtually enlarges the capital leverage, allowing users to obtain higher income in the rising market, but putting users at greater risk in the declining market.

When the price fluctuates dramatically downwards, Aave’s highly leveraged users are at risk of being liquidated. Once there is a massive liquidation, more stETH will be sold in the market, causing the price of stETH to fall further, and then a cascading liquidation will occur into a negative feedback loop.

“Multiple overlapping is a fire” can vividly describe the composability of the DeFi project. While improving the utilization rate of funds and bringing innovation, the risk is also approaching quietly. At present, this fire will burn to highly leveraged institutions and retail investors.

(iii) Applicability of the Curve algorithmic model

Curve’s algorithmic model is well suited for trading between equivalent assets. When creating liquidity pools for equivalent assets, Curve is often preferred by project parties. Within the core range, assets in the liquidity pool can be traded without slippage; however, outside of the core range, Curve’s algorithmic model causes prices to deviate more at a faster rate.

To increase the liquidity of stETH, Lido subsidizes Curve’s stETH/ETH liquidity pool to incentivize it. When the market is illiquid, ETH with better liquidity is preferred. A large number of institutions and users choose to exchange stETH for ETH. At this point, the ratio of assets in Curve’s liquidity pool is imbalanced, and a large number of stETH sell-offs in the short term cause the price curve to deviate from the core range, and the price of stETH falls further relative to ETH. The applicability of Curve’s algorithmic model to two assets with vastly different liquidity is questionable.

II - Celsius : The Butterfly Effect

The news that Celsius lost 40,000 ETH in the Stakehound Private Key Loss incident was the “Butterfly Wing” that caused the market storm. When I first read the news, I didn’t think it would have much of an impact on Celsius. According to public information, Celsius has about $30 billion in assets under management in 2021, and 40,000 ETH (about $200 million at the highest price of $4,900) do not account for a high proportion of the assets of the entire platform, which Celsius is fully capable of resolving properly.

However, more bad news followed, and Celsius has already suffered several bad debt losses from the Luna crash, the loss of Stakehound Private Keys last year, and the Badgerdao Hack. If it was just bad debt losses, then Celsius would still have a way to cope. But this news caused market panic and a run on the market, Celsius ushered in its biggest crisis: illiquidity.

Celsius’ business model has similarities to that of a bank: Celsius promises its users high returns in order to obtain funds, and then earns a spread by lending or investing for higher returns. To maximize the efficiency and yield of the funds, in addition to lending, Celsius also participates in other projects with higher yields, such as Staking through Lido, where a large amount of ETH on the Celsius platform is in pledged status.

When a large number of users choose to redeem assets in a short period of time, Celsius’ liquid assets cannot meet the redemption demand of users and is forced to sell stETH at a discount in the secondary market, which can cause even greater losses.

Celsius is a centralized financial management platform with no internal financial transparency and there is no way for outsiders to evaluate it directly from the disclosure data. However, Celsius suspended withdrawals, transactions and transfers on the platform, limiting users’ withdrawals with so-called security features. Such extreme measures would have greatly damaged users’ trust in Celsius, and Celsius would not have resorted to such measures if not absolutely necessary, meaning that the size of Celsius’ bad debts and liquidity gap is much larger than the disclosed figures.

Looking back on the whole incident, Celsius should not have concealed its loss in the Stakehound Private Key Loss. The reason for this incident is not directly related to Celsius, Celsius’ funding and platform revenue can fully cover this loss, and Celsius’ choice to hide it only shows that they have failed to trust each other and their users.

Meanwhile, Celsius didn’t pay enough attention to the problem of maturity mismatch of deposits and loans. Short-term source of funds and long-term use of capital is a common use case of financial platforms. When the market is good, new users are constantly participating and old users are willing to stay within and gain income, so the whole model can work without problems. However, when the market is bad, there are not as many new users and fresh funds entering, and some of the early participants will also realize their profits and leave the market. At this time, this “short-term deposit and long-term loan”, i.e. the mismatch of asset and liability maturity, will easily lead to liquidity risk.

III - Three Arrow Capital : Failure of proper risk management

Three Arrow Capital is an early stage investor for numerous high quality projects and is rather influential within the cryptocurrency industry. 3AC operates on a similar model to Celsius in that they will borrow funds from some of the larger CeFi institutions in the market and then trade or participate in other projects. This over-the-counter plus capital leverage model will magnify 3AC’s gains when done properly, but will also magnify 3AC’s losses when there is misconduct.

Unfortunately, 3AC has suffered a Waterloo from a series of recent operations. In the Luna collapse, 3AC lost several hundred million dollars and lost a significant amount of liquidity. This was followed by news of serious losses in 3AC’s leveraged trades and the receipt of margin calls. At the same time, 3AC’s on-chain address was made public (authenticity of this not verified) and many people were participating in or surrounding 3AC’s Liquidation operation.

There is currently no complete information on the actual losses incurred by 3AC in the market. But faced with rumors of misappropriation of client funds, which have never been responded to positively by its team members, 3AC could be facing very serious problems.

There is an old Chinese saying that goes “a son of a thousand pieces of gold does not sit under the obsolete roof”, meaning that a wealthy man foresees and mitigates risks. But 3AC, as a financial giant in the cryptocurrency industry, apparently did not stay away from the obsolete roof, but instead took the initiative to stand beside a dangerous wall. This has left many feeling that the risk control capabilities of these head institutions were largely overestimated. The founder of 3AC — Zhu Su once expressed the importance of risk control on his social media, but unfortunately, he himself did not follow suit.

Figure 1: Zhu Su’s view on risk control (Source: Twitter)

3AC lost a lot of money in the Luna crash, and could lead to a series of subsequent deformations in their operations. Once a project with simple operations and stable returns (e.g. Anchor) is available and a large number of users are found to be participating in the project, then it is assumed that the project will not be problematic. At this point, risk control measures are left behind and too much is invested in a single project.

IV - Horrendous Circumstances | Who’s next?

If large financial platforms and funds in the industry like Celsius and 3AC become insolvent, it could trigger a chain reaction. Their inability to repay loans from other institutions leads to a contraction in credit across the industry, which in turn leads to active or passive deleveraging by other participants.

First of all, the most affected are definitely other centralized financial institutions. Due to the complexity of cash flow between institutions, it’s hardly not to be jeopardized by others; users will rush into redemption by the influence of panic market sentiment. Babel Finance has recently issued an announcement suspending product redemptions and coin withdrawals, and is likely to be the next platform to go under. BlockFi has also been in bad news recently, losing huge amounts of money in the wake of Celsius, 3AC and SEC fines, and has reportedly liquidated one of 3AC’s collateral assets.

Secondly, many project parties, especially those that have been invested in by 3AC, are also at significant risk. These project parties may choose 3AC to manage their own financing funds. If 3AC misappropriated these funds, then the project owner will run short of funds and will not be able to sustain itself. There have already been reports from project parties that 3AC has diverted funds from long-term partners to fund margin calls.

CEX deserves more attention as they have the potential to embezzle funds from users to participate in wealth management. AEX, Hoo and several other exchanges have been experiencing withdrawal problems. In response to some questions from the community, Tame Huang, the founder of AEX, said that very few exchanges have 100% capital reserves. This may indirectly imply that most exchanges are facing problems of one kind or another. Certainly, every exchange is different, and Deribit, which is both a 3AC invested project and a derivatives exchange, has issued a statement that its finances remain healthy, customer funds are safe, and any potential losses will be covered by the platform.

For the above-mentioned institutions, if any problems occur, the remedies should always stick to the three principles: Stall for time, Look for a financial backer and Pray for the market. With the current global economic situation, it is impossible that the market would make a U-turn to a bull market; nor are there many institutions capable of helping others, and the odds of having a financial backer is seemingly low. The only viable way is to stall for time. Controlling withdrawals is a common way used by the institutions to stall for time and delay payments.

Lastly, retail investors are probably the most innocent, but the biggest victims from the losses. In the cryptocurrency industry, it is not a greedy act for users to invest in financial products with an annualized return of around 10%, but they can lose their capital due to mismanagement by centralized platforms and institutions. For ordinary users, there is no particularly good way to completely eliminate this risk, other than to engage in some non-custodial financial projects. As we know — Not your key, Not your coin.

V. Key Takeaways

The importance of Economic Cycles. In the past two years, the world was in the midst of quantitative easing and various assets, including cryptocurrencies, rose sharply. But now macroeconomic policies have changed dramatically, with interest rate hikes and tapering being the main themes for some time to come. The U.S. CPI in May exceeded expectations across the board, with high inflation causing the Fed to increase interest rate hikes, with this 75bps hike being the largest since 1994. Fed officials expect interest rates to rise to 4% by the end of the year (150bps higher than the March estimate) and 3.8% by the end of 2023 (100bps higher than the March estimate). Thus, the Fed will need to raise by another 175 basis points to reach 3.4% by the end of the year, a rate well above the neutral level — 2.5% (neither stimulating nor limiting economic growth), and fighting inflation could lead to a recession. Against this backdrop, it is almost impossible for cryptocurrencies to buck the trend and come out as an independent market.

The importance of Risk Control. Also in the face of this series of events, some platforms are running all right, while others are facing closure, the institution’s risk control ability plays an important role in it. In this industry, if not all industries, people generally have blind faith in institutions. Just as many people initially thought that Terra was too big to fail and that industry giants like Celsius and 3AC could solve the problems they were experiencing. But it turns out that too big to fail doesn’t exist in the crypto industry, and if it does, then this ‘Big’ does not mean the size of capital, but risk awareness and capability. As long as the risk is not properly controlled, all the previous achievements will also be taken away by a wave of extreme market. The same is true for the ordinary user. Financial derivatives like Lido and others are often created with ideals and good intentions aimed at providing convenience to the user. But when it comes to the actual operation, the user’s enlarged leverage can lead to all kinds of uncontrollable problems.

The importance of Regulation. There has been a serious division in the cryptocurrency industry over regulation. Some believe that regulation should be embraced towards the mainstream, while others believe that the spirit of cryptocurrencies is to resist censorship and there is no need to introduce regulation. However, the recent Luna crash and liquidity crises of centralized platforms have caused a lot of people to suffer losses and caused a great impact, and the possibility of regulators stepping in has become greater. In the future, the cryptocurrency industry will introduce appropriate regulatory frameworks and policies to avoid similar incidents as much as possible.

Friedrich August von Hayek once said, “The road to hell is paved with good intentions”. It is not certain that the path is paved by good intentions, but it sure is human greed that chose this path. The founder of Fcoin once quoted this when the platform was shut down and said that he would remain accountable for it till the end and with his lifetime. Now that another round of bull market has passed, the market has not heard from the founder again. Will he still be responsible? No, only you will be responsible for your own assets.

Disclaimer: This research article is opinion/insights only, it should not be viewed as financial or investment advices in any form. Readers are advised to do their own research and analyse the market on their own.