How Celsius, 3AC misjudged risk and is DeFi’s future in interest rate swaps?

At the most macro level, interest rate swaps enable us to create products that have stability built into them. So far, DeFi has been an amazing environment for those that want high-risk volatile products. However, suppose we really want DeFi to become the financial system for the whole of the world. In that case, we need to be able to serve the financial needs of the whole world – so having stability in some products is extremely important.

Interest Rate Swaps enable this by allowing you to transition from a variable-rate to a fixed-rate (or vice versa). This unlocks a wide range of new products and trading opportunities that can be built, with the ability to move from “risk-on” to “risk-off” very easily.

The key with capital efficiency and synthetic nature of the pools is that the markets on Voltz Protocol are proper derivatives; you can trade with leverage, and you don’t need to own the underlying asset to trade. These are important attributes when trading basis points and looking to use them as a mechanism to construct new and interesting products.

Systemic risk was particularly misjudged by the lenders who provided 3AC with capital. This lending was often made against some form of collateral. However, like 2008, that collateral was overvalued, suggesting the positions were collateralized when actually they were undercollateralized.

Alongside this, liquidation of the collateral occurred near simultaneously. This meant all that capital flooded onto the market and caused the prices to drive down even sharper – creating a downward death spiral on asset prices and further contributing to the undercollateralized nature of the lenders. This downward death spiral was a systemic risk that hadn’t been properly considered by the lenders, leaving a number insolvent.

The 2008 crisis had a number of similar characteristics – particularly the system’s dependence on assets that were either overvalued or at massive risk of large price corrections. This led to systemic risk that caused a complete meltdown when the assets dropped in value.

However, unlike in 2008, there are a few differences. Most notably, the existence of DeFi, a system that is built so it cannot fail, rather than having a legal infrastructure in place to tell us what to do when the system does fail. This has meant a large portion of the “crypto-financial sector” has continued to function as normal, reducing some of the impacts from the poorly managed CeFi players.

It’s worth reiterating – CeFi is not DeFi. Many DeFi founders, like myself, have entered the space to build a financial system that is more equitable, transparent, and antifragile. Seeing many repeats of 2008 happen with the CeFi players further reinforces my view that permissionless antifragile financial protocols are the future.

Celsius appear to have entered highly levered positions with retail deposits to try to offer incremental yield as a form of “competitive advantage” vs. other CeFi players. This may have worked during a bull market, but it was always a massive risk of leaving them insolvent should assets ever drop significantly in value and investors try to pull their money out, as has recently happened.

Not only is this poor risk management, but it also stinks of the shady opaque world of TradFi, which is exactly what we’re trying to change.

Compare this with DeFi, a world where transparency and system integrity are core to the functioning of the system and one where the rules of the system are deliberately made known to everyone, and it’s a stark contrast to the way some of these CeFi players have acted.

FTX has effectively acted the way the Fed did during the 2008 crisis – bailing out insolvent lenders. However, unlike in 2008, it’s nice to see the industry saving itself rather than taxpayer money being used to save poorly run businesses.

Many people lost money with the Terra/Anchor collapse, and that will sadly leave some lasting scars. However, the fundamentals of DeFi haven’t changed – so there are many reasons to be bullish for the future. Now’s also the best possible time to be building; so I’m excited to see what we can create as a sector, and I’m even more excited about what we’ll do for society by providing everyone in the world with equal access to a global, antifragile and transparent financial system.

The Nansen report is consistent with the fact many of the CeFi players hadn’t properly considered a systemic risk. Whether that be the Terra collapse or, more generally, the risk of a large drop in asset prices across the sector, they all had assets on their balance sheet that weren’t actually equivalent to the “liquid value” they could achieve when everyone tried to move out of those assets at the same time. Alternatively – they hadn’t properly considered a systemic risk, meaning many of them were at risk of insolvency should a crash occur.

The contrast with DeFi is quite striking – where protocols are built with worst-case scenarios in mind to ensure they cannot fail. The fact this has happened to CeFi players only reinforces the fact that decentralized, permissionless protocols are the future of finance.