Crypto Market "Mass Exodus": Liquidation, Sell-off, Run on the Bank

Author: Jasmine, Wen Dao,

The traceable panic began with the collapse of UST. Within a month, a sell-off and capital withdrawal unfolded simultaneously in the crypto market, triggering a series of chain reactions: the crypto lending platform Celsius faced a liquidity crisis and suspended customer withdrawals; the crypto hedge fund Three Arrows Capital encountered large-scale liquidations, nearly going bankrupt; the centralized crypto asset exchange AEx experienced a bank run, and soon after, a similar platform Hoo suspended user withdrawals… The collapse of a dollar stablecoin in the decentralized crypto finance market impacted several centralized crypto platforms, ultimately causing risk spillover that spread throughout the entire crypto market.

Although Bitcoin rebounded to $20,000 in the early hours of June 20, the crypto asset market it leads could not reverse from the downturn, with a total market capitalization of crypto assets shrinking by two-thirds compared to the peak in November last year, now at $900 billion.

Another panic occurred on June 18, when Bitcoin (BTC) fell below the $20,000 support level, hitting a low of $17,500, while Ethereum (ETH), the second-largest by market cap, dropped below $1,000, reaching a low of $880. Both major crypto assets hit annual lows. On that day, the total liquidation in the crypto asset market exceeded $560 million.

Unlike the previous bull-bear cycle, the new player in this cycle, DeFi (Decentralized Finance), also suffered heavy losses during the market crash. On June 18, the total value locked (TVL) in the DeFi market also fell to a yearly low of $72.9 billion, evaporating 71.2% from the peak of $254 billion in December last year.

The traceable panic began with the collapse of TerraUSD (UST). Within a month, a sell-off and capital withdrawal unfolded simultaneously in the crypto market, triggering a series of chain reactions: the crypto lending platform Celsius faced a liquidity crisis and suspended customer transfers and withdrawals; the crypto hedge fund Three Arrows Capital encountered large-scale liquidations, nearly going bankrupt; the centralized crypto asset exchange AEX experienced a bank run, and soon after, a similar platform Hoo suspended user withdrawals…

The collapse of a dollar stablecoin in the decentralized crypto finance (DeFi) market impacted several centralized crypto platforms, ultimately causing risk spillover that spread throughout the entire crypto market. In this "domino" market collapse, the whales speculating in DeFi failed, and DeFi strayed far from its goal of "financial democratization."

Debt Chase on "Three Arrows"

After the collapse of UST and the zeroing of LUNA, the storm center shifted to the hedge fund Three Arrows Capital.

Three Arrows Capital probably did not expect that the stETH, which initially profited from DeFi circular lending, would one day detach from its peg to ETH. These collateralized crypto assets were depreciating, and its positions were facing liquidation.

Panic began on June 14, when this crypto hedge fund exchanged over 50,000 stETH at a discount for ETH and converted 16,625 ETH into stablecoin DAI worth over $20 million. Crypto analysts speculated that Three Arrows Capital's goal was to prevent the liquidation of its $295 million position on the DeFi lending platform.

But liquidation still arrived mercilessly. On the afternoon of June 15, alarms from blockchain security firm PeckShield rang out on social media, indicating that addresses suspected to be related to Three Arrows Capital were liquidated for 14,538 ETH within an hour. Based on ETH's price of $1,027 at the time, the liquidation value exceeded $14.9 million.

After news of Three Arrows Capital's liquidation spread, ETH dropped from around $1,092, falling over 6% in a short time.

Prior to that, Three Arrows Capital had already sold 33,000 ETH to repay debts, worth over $33.89 million. On June 16, the fund's behavior of selling stETH did not stop, and the liquidation of its positions included not only decentralized DeFi lending platforms like Aave but also centralized trading platforms such as FTX, Deribit, and BitMEX, all of which provided financial derivative services for crypto assets, including futures and options.

On June 17, The Block cited sources saying that after Three Arrows Capital failed to meet margin call requirements, the three trading platforms had liquidated Three Arrows Capital's positions over the past week. Among them, BitMEX confirmed the liquidation news but did not respond to claims that Three Arrows Capital owed it $6 million; Deribit publicly stated that its shareholder, Three Arrows Capital, indeed had a few accounts with net debts on the platform, but the funds of platform users were safe.

Among those chasing debts were Three Arrows Capital's clients. Danny, the trading director of 8 Block Capital, directly defended his rights on social media, accusing Three Arrows Capital of misappropriating $1 million from their accounts, suspecting that the money was used for margin calls; another DeFi project founder claimed that funds stored in Three Arrows Capital's OTC trading company TPS Capital were unaccounted for.

A series of debt crises brought Three Arrows Capital to the brink of bankruptcy, and related DeFi platforms also faced crises. The staking yield platform Finblox stated that it had a partnership with Three Arrows Capital and, in order to "diversify risks as much as possible," it suspended all yield distributions, prohibited the creation of new crypto addresses, and limited user withdrawals—capping daily withdrawals at $500 and monthly withdrawals at $1,500.

On June 17, Three Arrows Capital's co-founder Kyle Davies finally broke his silence, admitting in an interview with The Wall Street Journal that the collapse of Terra was a significant reason for the company's losses, and the rapid decline of the crypto asset market further exacerbated the company's losses.

As an investor in the Luna Foundation Guard behind Terra, Three Arrows Capital had invested about $200 million in LUNA, which was meant to help UST maintain its peg to the dollar. However, after the collapse of UST in May, Three Arrows Capital's investment became worthless.

It is reported that Three Arrows Capital has hired legal and financial advisors to find solutions for its investors and lenders, attempting to resolve its debt issues through asset sales or rescue plans.

This once $10 billion crypto hedge fund resembles a beached whale, precariously positioned while also dragging smaller players onto the dry shore.

The assets of the whales were heavily liquidated, and panic and sell-offs surged together. On June 18, when BTC fell below $20,000, it dropped by 7.34%, while Ethereum, which fell below $1,000, showed an even larger decline of 8.47%, with ETH liquidations on that day reaching $190 million and BTC liquidations reaching $269 million.

Two Suspensions of Withdrawals

Liquidity risks were spreading to small and medium-sized platforms. On June 16, the same day Three Arrows Capital faced on-chain liquidation, the crypto asset trading platform AEX suspended withdrawals of mainstream assets like BTC and ETH for 36 hours. Although user withdrawals were later restored, AEX still imposed limits on withdrawals, with the current cap set at $600.

AEX, known in Chinese as AnYin, was founded in 2013, initially established in mainland China, and later went overseas due to tightening domestic regulations.

In its announcement, AEX stated that it was facing a bank run exceeding $1 billion.

The "LUNA collapse" was also seen by the trading platform as a trigger for liquidity shortages, stating, "Since the collapse of LUNA in mid-May, the total market value of various assets flowing out of AEX has reached 450 million USDT (including withdrawals by partner institutions), which has quickly consumed AEX's short-term liquidity assets and some medium-term assets."

AEX's liquidity crisis was not only related to the bank run.

Like Three Arrows Capital, this centralized trading platform also allocated assets in DeFi. In its 80% medium to long-term allocated assets, $110 million worth of crypto assets were staked on-chain for "mining." The USDT/USDC pool stored on the Curve platform for "mining" (providing liquidity for rewards) was exchanged after the UST collapse, resulting in short-term liquidity asset losses.

Meanwhile, AEX was also lending crypto assets, claiming that delays in repayment from clients of its staking loan business were also one of the reasons for its withdrawal difficulties, with external staking loans amounting to $230 million.

It is evident that while AEX operates a crypto asset trading business, it also acts as a "bank," sharing similar functions with the crypto lending platform Celsius, which suspended customer withdrawals on June 13. Celsius's liquidity risk was also related to its participation in DeFi, with Terra being one of the roots of its explosion. Currently, reports indicate that this lending platform is seeking external investment or acquisition, but Reuters reported that securities regulators in five regions have launched investigations into Celsius.

These platforms that extracted profits from DeFi and lent externally all share common issues: Do the funds deposited in DeFi and the loans issued externally belong to user assets? Did they obtain informed consent from users? AEX and Celsius have not publicly addressed these two questions.

Another crypto trading platform facing withdrawal difficulties is Hoo, which started from a crypto asset wallet and was founded in mainland China in 2018, later moving its office to Dubai in 2021.

Hoo attributed the suspension of withdrawals to "recent market volatility" and "some large structures in the industry being liquidated and running out of liquidity," stating that the liquidity of its hot wallet was thus affected, and the multi-signature wallet transfer processing required time, leading to delays in user withdrawals. The platform promised to gradually restore normal operations after 72 hours.

Without the detailed disclosures of AEX, Hoo's withdrawal restoration time was longer than others, and its suspension faced user skepticism. People suspected that the platform also faced losses due to putting assets into the DeFi market for profit, but the users' doubts went unanswered by Hoo.

DeFi Not "De"

Centralized crypto asset institutions have fallen into the predicament of liquidity exhaustion. If it weren't for the frequent explosion events, the outside world might not have delved deeply into their on-chain dynamics. "Crypto whales participating in DeFi" is at most a well-known phenomenon within the industry.

In June 2020, after the decentralized lending platform Compound on Ethereum ignited DeFi with "liquidity mining," users' crypto assets began to flow from centralized trading platforms into the decentralized DeFi market, providing liquidity for decentralized trading platforms, lending platforms, and stablecoin protocols in hopes of earning token rewards issued by these platforms. These rewards quickly generated trading prices due to the existence of liquidity exchange pools, turning tokens into "real money."

The wealth effect began to brew in the early stages of the crypto asset market's bull market and peaked at the height of the bull market, while the total value of crypto assets locked in various DeFi protocols surged from less than $100,000 to nearly $300 billion in just over a year.

In this process, users injecting crypto assets into DeFi platforms and contributing liquidity upgraded from ordinary retail investors to professional players (commonly referred to as scientists) who could operate bots. However, as APY decreased, some scientists were eliminated, and only those with substantial capital and knowledge of smart contract technology could profit in DeFi, especially by leveraging DeFi products that allowed circular lending.

Taking stETH as an example, this token, originally created to release ETH2.0 staking through the Lido protocol, was introduced as collateral for loans by some lending platforms. Staking ETH2.0 itself generates a 4% yield, while depositing stETH in lending platforms can earn interest; even more profitably, stETH can be used as collateral to borrow stablecoins, which are then exchanged for ETH and staked back into Lido for stETH… The cycle of lending is backed by continuous leverage.

However, when the collateral depreciates to a certain extent, liquidation begins to knock on the door of risk.

On June 14, the Bank for International Settlements (BIS) released an announcement regarding DeFi lending after Celsius suspended withdrawals. The BIS pointed out that DeFi overcomes the long-standing information asymmetry in financial markets through anonymity, but its heavy reliance on on-chain collateral (crypto assets) not only fails to shield the sector from the "boom-bust" cycle but also leads to a liquidation spiral.

Historically, financial intermediaries have always aimed to improve the information processing aspect, while current DeFi lending seeks to change this approach, attempting to replace information collection with collateral provided by borrowers to fulfill the functions of financial intermediaries.

The BIS explained that to ensure lenders are protected, DeFi platforms set liquidation ratios relative to the amount borrowed. For example, a 120% collateralization ratio may be accompanied by a 110% liquidation ratio; if the collateral falls below this threshold, it will depreciate. Smart contracts stipulate that at this point, anyone can act as a liquidator, seizing the collateral, repaying the lender, and pocketing a portion of the remaining collateral. Profit-driven incentives ensure a sufficient supply of liquidators, mitigating potential credit losses for lenders.

"Due to the anonymity of borrowers, over-collateralization is common in DeFi lending…" the BIS noted. To avoid forced liquidation, borrowers typically submit crypto assets exceeding the minimum requirements, resulting in higher effective collateralization rates. Considering the "boom-bust" cycle of the crypto market, in fact, "over-collateralization and liquidation ratios do not eliminate the risk of credit losses. In some cases, the value of collateral declines rapidly, and borrowers do not have time to unwind loans before they depreciate, leading to losses for lending institutions."

The BIS believes that the current DeFi primarily serves to "facilitate crypto asset speculation" rather than "real economy lending," which contradicts its goal of "financial democratization," as the collateral-based lending model only serves those with sufficient assets, excluding those with little wealth. This not only fails to achieve inclusive finance but also leads to centralization.

In this round of crypto asset bull-bear cycles, DeFi emerged, depicting a utopia that could replace traditional finance to the outside world, but it became a "toy" for whales during the bull market and turned against those playing with fire during the bear market. Meanwhile, the goal of "financial democratization" is becoming increasingly blurred in the shadows of the market.