The Fatal Lesson of Liquidity: The Rise and Fall of the Crypto Unicorn Celsius in the Run on Deposits

Author: Hu Tao, Chain Catcher

In the recent cryptocurrency market crash, the crypto lending platform Celsius is recognized as one of the most important triggers, now widely considered insolvent and on the brink of bankruptcy. How did a crypto company that raised over $700 million just 8 months ago and managed assets worth over $20 billion suddenly face such a disaster?

On the surface, the direct cause is the large-scale withdrawal of deposits by users amid market panic, which has put the company in trouble due to a lack of liquidity. The deeper reason lies in the long-standing serious issues with the company's operational mechanisms and risk control strategies, intertwined with the inherent high-risk problems of the DeFi market, leading to this explosion.

1. How does Celsius operate?

Founded in 2017, Celsius is a highly influential cryptocurrency lending platform. Unlike decentralized lending platforms like Aave, this project is centralized, with all user assets deposited into the platform's wallet address rather than controlled by user wallets. Currently, Celsius offers various types of services including lending, trading, payments, custody, and Bitcoin mining, with its core business being a service called Earn, where users can deposit any supported cryptocurrency into their platform account and earn interest weekly, with the principal available for withdrawal at any time.

However, the deposit interest rates for Celsius platform users are not determined by the lending market but are set by the platform itself. For example, the annual interest rate for ETH deposits on Celsius is 6% (for amounts less than 2 ETH), while the annual interest rate for ETH deposits on decentralized lending platforms like Aave has long been below 1%, and the annual interest rate for ETH on centralized exchange Binance is only 2.4%. Additionally, the annualized interest rate for SNX on Celsius is 18.6%, the highest among all its assets, while stablecoins like USDT have annualized rates around 9%.

Deposit interest rates for some cryptocurrencies on the Celsius platform

The high interest rates for demand deposits attracted a peak value of over $24 billion in cryptocurrency assets under management to Celsius last December, growing more than tenfold compared to a year ago, ranking among the top in similar platforms and significantly higher than decentralized lending platforms like Aave, with the number of users exceeding 1.7 million.

With such achievements, Celsius also gained favor from capital providers, securing a $400 million Series B funding round led by WestCap, founded by former Airbnb executive Laurence Tosi, and the Caisse de dépôt et placement du Québec (CDPQ), Canada’s second-largest pension fund, in October 2021. This funding round was later expanded to $750 million in November, ranking fifth among all crypto companies last year, with a valuation reaching $3.25 billion. Previously, Celsius had also received a $10 million investment from Tether.

The question is, where does the high deposit rate, which is Celsius's core competitive advantage, come from? According to the company's risk disclosure statement on its official website, Celsius deploys the digital assets lent to it by users in various revenue-generating activities, including lending these digital assets to third parties and transferring them to external platforms and systems. In other words, Celsius not only uses user assets for collateralized lending among platform users but also lends them to third-party platforms to maximize returns, using part of the profits to pay interest to users.

According to public information, the third-party platforms Celsius collaborates with include MakerDAO, Maple Finance, Lido, Core Scientific, Stakehound, etc., involving decentralized lending, Ethereum 2.0 staking, and mining financing. For example, earlier this year, it provided a liquidity pool to Maple Finance worth $30 million in WETH, which could be used for decentralized staking/providing liquidity or for collateral-based loans.

The specific returns these actions can bring to Celsius remain unknown, but several industry insiders have questioned whether the returns cover the high interest rates offered to users. Additionally, the security of third-party platform smart contracts is uncontrollable, which could lead to asset theft incidents, making it impossible for Celsius to withdraw deposits.

Celsius even engages in collateralized lending on decentralized lending platforms like MakerDAO. For instance, it recently collateralized WBTC to borrow nearly 280 million DAI, but due to the recent sharp drop in BTC prices, it had to continuously add over 5,500 WBTC as collateral to lower the liquidation price and ensure it wouldn't face a margin call. However, if BTC continues to plummet or if the collateral is not added in time, there remains a significant risk of liquidation.

In response to external doubts, Celsius founder Alex Mashinsky stated, "I don't understand why people are surprised that we participate in every DeFi protocol. We hold these assets on behalf of our community, and we collateralize or move them to maximize returns."

Celsius claims to conduct thorough due diligence on any such third parties or platforms, including security, financial, and credibility tests, but in reality, these measures have not provided Celsius with security for its funds, leading to multiple serious incidents of financial loss.

2. Continuous Security Issues

In December last year, the decentralized lending platform BadgerDAO was hacked, resulting in a loss of $120 million. The attacker added a script to the project's website front end, tricking users into allowing the attacker to withdraw assets from their wallets. On-chain data shows that addresses associated with Celsius lost over $51 million worth of 896.8 WBTC, after which the Celsius founder admitted that some assets were stolen.

In early June this year, Dirty Bubble Media revealed that Celsius had previously encountered a significant asset loss incident in June last year, when the Ethereum 2.0 staking solution Stakehound announced it had lost the private keys to a wallet representing 38,178 ETH staked on behalf of clients. Celsius had staked a large amount of ETH on that platform and currently holds about 42,000 stETH (valued at approximately $110 million based on prices from early June last year), accounting for over 60% of the total issuance of stETH. Currently, the Stakehound website and social media have not been updated for over a year, and the price of stETH has dropped to $34.

Of course, compared to the hundreds of billions in assets under management, Celsius's losses in the aforementioned incidents are not catastrophic and cannot lead to a liquidity crisis, as its financing amount is sufficient to cope. For Celsius, the more serious issue is that it has locked a large amount of user assets in illiquid areas like staking, while also offering users the ability to withdraw at any time without any restrictions on term deposits. Once a withdrawal rush occurs, the Celsius platform will inevitably face paralysis.

According to statistics from Dirty Bubble Media and several Twitter users, Celsius currently manages about 1.001 million ETH, but only 27% of that is in ETH spot. Additionally, 44% is staked in Ethereum 2.0 contracts through Lido and held in the form of stETH (which shares a name with the previous Stakehound ETH but is not the same token), while 29% is directly staked in Ethereum 2.0 contracts. This means that only 27% of the ETH held by Celsius is liquid, and although stETH can be traded for ETH through liquidity pools, there is insufficient liquidity to sell such a large amount of stETH without significant discounts.

On June 4, @yieldchad also tweeted that Celsius was functionally bankrupt on its ETH position. If it redeems 50,000 ETH weekly, Celsius will run out of liquid ETH in about 5 weeks. Due to the insufficient liquidity of stETH, Celsius cannot redeem under conditions of significant losses. Ultimately, they will be forced to suspend all redemptions.

The reality is that before even reaching 5 weeks, Celsius announced just one week later that it had suspended users' withdrawal and transfer functions, indicating that its liquidity crisis was more severe than anyone had anticipated. Even if Celsius is not insolvent and has sufficient capital reserves, the large amount of assets locked in Ethereum 2.0 smart contracts, which require at least a year to withdraw, forced Celsius to make such a decision.

Had it not been for the aforementioned revelations and dissemination, Celsius might not have faced a liquidity crisis. The 27% liquidity of ETH is already significantly higher than the deposit reserve ratio of traditional banks, and the whistleblowers have long been short-sellers of companies like Coinbase, Tesla, and Tether, which at the time were questioned by many industry insiders for deliberately creating panic. However, in the emotion-driven crypto market, Celsius seems unprepared for extreme situations.

As a lending platform, the core capabilities lie in risk control mechanisms and liquidity management to ensure its ability to meet redemptions, but unfortunately, Celsius made fatal mistakes in both areas. At the same time, Celsius has also been exposed to many unprofessional behaviors in its daily management and operations, which do not match its hundreds of billions in assets under management.

For example, in the BadgerDAO hack incident, the project formulated a compensation plan for affected users, repaying part of the Bitcoin from its multi-signature wallet and creating a "remBadger" token to be deposited into user vaults, allowing victims to receive Badger tokens over the next two years as compensation for remaining losses. However, if remBadger is withdrawn, all future compensation will be forfeited.

In March of this year, Celsius withdrew all remBadger tokens. After realizing the mistake, Celsius contacted the BadgerDAO project team and stated it was a human error by a team member. After receiving advice, Celsius initiated a vote on the project's governance site to re-deposit and regain compensation eligibility, but it was voted down by the BadgerDAO community, meaning Celsius's losses could no longer be compensated.

Additionally, Celsius's former CFO Yaron Shalem was arrested last November for allegedly being involved in a cryptocurrency fraud case at a previous employer, and its head of institutional lending, Jessica Khater, was recently revealed to have been a pornographic actress. Entrusting important positions to individuals with such complex backgrounds further highlights Celsius's lack of professionalism in management.

Now, the long-accumulated risks of Celsius have erupted, with the platform's billions of dollars in user assets effectively frozen, and even the entire crypto market is to some extent affected by its potential explosion news. In the announcement to suspend withdrawals, Celsius stated that it is taking necessary actions to stabilize liquidity and operations, but facing a short-term pressure of over a billion dollars in ETH withdrawals, the options before Celsius are likely acquisition or bankruptcy liquidation. Currently, the company's competitor Nexo has already made an acquisition offer.

3. Lessons from the "Wild West"

In summary, the main reason Celsius has fallen into its current predicament is the serious inadequacy of its risk management strategy. In pursuit of higher interest rates, Celsius has deposited most of its assets into higher-risk DeFi smart contracts, even locking most ETH into Ethereum 2.0 smart contracts with lock-up periods of 1-2 years.

At the same time, similar crypto lending platforms like BlockFi and Nexo also offer products with interest rates as high as 15-18%, but BlockFi CEO Zac Prince stated on Twitter that the risk of stETH on their platform is zero, while Nexo claims to hold only "a limited amount of stETH."

Moreover, Celsius users likely did not receive clear risk disclosures. On the main page of the Celsius website, most wording consists of enticing marketing phrases, such as "Earn free cryptocurrency," "Sign up now to get $50 in cryptocurrency," "Earn up to 18.63% annual interest, paid weekly," etc. Additionally, it lowers users' vigilance through promotions like "military-grade security" and "access your tokens anytime, always keep them safe," without any risk disclosures.

The only security warning is located in a discreet area at the bottom of the website, stating, "There are significant risks in holding, trading, or using crypto assets. Please read our risk disclosure page carefully." On the risk disclosure page, Celsius states that its obligation to return the digital assets available in users' Celsius accounts to them is not affected by losses suffered by Celsius, including losses due to any hacking attacks or asset deployment, but Celsius may not be able to repay its debts to creditors, in which case user funds may be lost in whole or in part.

External doubts about Celsius have long existed. Coindesk published an article at the end of 2020 titled "Why the Crypto Lending Institution Celsius Didn't Tell Its Depositors?" stating that the risks associated with the crypto lending services offered by the institution may be greater than its depositors realize, involving many risky behaviors such as re-pledging user collateral.

To some extent, Celsius's business model is similar to that of banks in the cryptocurrency market, absorbing depositor funds at certain interest rates and generating revenue through lending, but it lacks the legally required deposit reserve ratio and deposit insurance, and the level of risk disclosure and investor protection mechanisms is also very inadequate.

More accurately, Celsius may resemble the P2P platforms that grew wildly in China nearly a decade ago, where both platforms attracted depositor funds with high returns and then lent them to third parties with varying degrees of risk, even facing issues of insufficient collateral liquidity or lack of collateral altogether. At the same time, the platform's revenue is difficult to cover the interest paid to depositors and operational costs, and the sustainability of the development model has been repeatedly questioned, raising suspicions of a Ponzi scheme.

Many of Celsius's actions, if they occurred in traditional financial markets, would inevitably face fines and restrictions from financial regulatory agencies. However, due to the censorship-resistant nature of cryptocurrencies and other reasons, regulatory agencies in various countries have not kept pace with the rapid development of the crypto industry, showing a lag in policy formulation and regulation of violations.

In November last year, crypto lending institution BlockFi was reported to have been charged by the U.S. SEC for illegally offering a product that paid high interest rates to borrow digital tokens, which was deemed a security that needed to be registered with the SEC. The latter ultimately reached a settlement with BlockFi for $100 million this year. In January of this year, Bloomberg reported that the U.S. SEC was reviewing crypto lending platforms like Celsius Network, focusing on whether its high-yield deposit business should be registered as a security with regulatory agencies. The subsequent results have yet to be released, but it is too late regardless.

As U.S. SEC Chairman Gary Gensler described, the current crypto industry resembles the "Wild West." From the collapse of Terra to the liquidity crisis at Celsius, from DeFi to CeFi, in just about a month, the issues that had been masked by the industry's rapid growth over the past two years have erupted in the bear market, and the consequences of the industry's rough development and bubble expansion ultimately need to be borne by investors.