Episode 83 – Contagion and Cascading Liquidations in Cryptocurrency

Contagions and Cascading Liquidations in Cryptocurrency Crypto Critics' Corner

Bennett and Cas discuss the risk of contagion in the cryptocurrency ecosystem and how the leverage between lenders and trading firms contribute. This episode was recorded on June 16th, 2022 and produced by Asher Hirsch.

In this episode Bennett Tomlin and Cas Piancey talk about how the recent issues with Three Arrows Capital and various lenders in the space represent broad risk to the cryptocurrency ecosystem.

This episode was recorded on June 16th, 2022.

Other episodes mentioned in this episode:

This episode was edited and produced by Asher Hirsch.

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English Transcript:

00:00:05:05 - 00:00:19:20
Cas Piancey
Welcome back, everyone. I am Cas Piancey, and I'm joined, as usual, by my partner in crime Bennett Tomlin. I know how he's doing. He's doing good. I know how I'm doing. I'm doing bad. Today we are talking about contagion, which is a bad movie.

00:00:19:20 - 00:00:21:19
Bennett Tomlin
And and a pretty mediocre book.

00:00:21:19 - 00:00:49:22
Cas Piancey
And a pretty mediocre book. But it also is what seems to be happening in the cryptocurrency industry right now as we speak, as we record this on June 16th. Bennett I think contagion is one of the things that we have long feared. This is this gets back to the heart of the problem that we see in cryptocurrency, whether it comes to tether or centralized exchanges like, let's say, finance, the most liquid cryptocurrency exchange in the world.

00:00:50:00 - 00:01:13:16
Cas Piancey
I see contagion risks everywhere right now. I'm wondering how you're feeling if you think that like the cold that has been caught in the ecosystem, the flu whatever you want to call it, we won't go with the C-word, I guess, either. C-word. Actually, there's three key words. We won't go with anyway. How come there's so many bad C words now?

00:01:13:16 - 00:01:31:11
Cas Piancey
What's up with that anyway? Do you think we're like part of the way through this disease? Do you think we're like halfway through three quarters of the way through? The contagion has already worked itself out of the system. Or do you think it's just been caught Do you think we're just getting the first bits of fever?

00:01:31:15 - 00:01:57:11
Bennett Tomlin
Let's talk a little bit about where we're at to answer that question. So Celsius network shut off withdrawals and has brought in Citigroup to help them restructure. Block. They had to liquidate assets. They held for Three Arrows Capital tether had to liquidate assets they were holding for Celsius, they're a bit had to liquidate loans. They had out for three arrows.

00:01:57:11 - 00:02:29:14
Bennett Tomlin
Capital Three Arrows Capital is a crypto market making venture capital and hedge fund that had at one point about 10 billion in assets under management, whatever that means in crypto where liquidity can be fleeting and has apparently now ended up insolvent and unable to pay some of their debtors. So where are we at in the contagion? Well, I think that depends on who's exposed to who and who's holding on to something that's going to need to be liquidated still.

00:02:29:20 - 00:02:55:26
Bennett Tomlin
Right. So Celsius network, we really don't know what position they're in or who might still be holding debts that Celsius owes, hoping they'll still be able to pay. There might still be liquidations or people holding on to toxic debts. Three Arrows Capital is an even more fascinating example because it seems they were offering to some of the companies they invested in to services.

00:02:56:05 - 00:03:37:02
Bennett Tomlin
One they would take some of the USDC or USDT that you raised as part of your venture capital rounds, and they would manage it for you, promising you an 8% return. The other service, Three Arrows Capital was apparently offering was market making for many of these coins. So depending on how bad the situation is with Three Arrows Capital and what ends up needing to happen it could potentially affect a whole bunch of DeFi protocols and affect the liquidity for a bunch of protocols across the entire system.

00:03:37:11 - 00:04:13:17
Bennett Tomlin
Now, the final part that we've just kind of hinted at here is, of course, tether tether, who is fully reserved by assets of unknown quality that every single day maintain basically the exact same assets over liabilities, no matter what happens to the bond market or the Bitcoin market or any of the other assets they're exposed to. So tethers are miraculous case where we never need to worry about their systemic risk because they're managed by a team of consummate professionals who have never made any mistakes and who follow every rule so carefully that, you know, they're not overexposed to any of these things.

00:04:13:25 - 00:04:40:06
Bennett Tomlin
So I think the contagion stops at Three Arrows Capital and goes no further More practically, we don't know exactly how far the contagion can go because despite cryptos claims of transparency, there's a lot that still happens in over-the-counter deals, telegram groups, dark pools and other things. We can't see the full extent of what debts can't be paid in what might be liquidated is unknown.

00:04:40:13 - 00:04:44:27
Bennett Tomlin
And what assets 3 hours capital may end up committing or needing to sell is still unknown.

00:04:45:05 - 00:05:13:17
Cas Piancey
Yeah. And so as funny as that was to hear there is some level of truth to that statement, like any good joke. And the reason I say that is because we've experienced this before. We've seen insolvent cryptocurrency companies, some of them very large, get bailed out by other companies in the cryptocurrency industry. The one I'm obviously thinking about is Bitfinex and Tether after they had a bunch of their accounts frozen.

00:05:13:17 - 00:05:30:26
Cas Piancey
We saw Arthur Hayes and the lads at BitMEX and we saw Zhao Dong and the company of Renrenbit, which I would assume is now defunct and gone and Bank2TheFuture, which also had funds with I believe, Celsius or equity with Celsius.

00:05:31:02 - 00:05:39:03
Bennett Tomlin
And we should also remind people that Tether was the lead equity investor in Celsius' early venture capital rounds.

00:05:39:10 - 00:05:54:22
Cas Piancey
Correct. And they have a deep history with them in which Mashinsky said that he gets, you know, billion dollar loans from them denominated in tether. But that is troubling, too. And that would again point to contagion risks. I would.

00:05:54:22 - 00:06:27:25
Bennett Tomlin
Suggest well, that's quite possibly what accelerated the Bitcoin selloff that ended up pressuring Celsius wrapped Bitcoin maker vote. Right. Was that tether said they liquidated the position And so if they're talking about the Bitcoin secured loan that Celsius had and they sold the Bitcoin that were in it, they might have been largely responsible for then ending up putting Celsius Network's other position their de position in danger which would be funny because tether also owns equity in Celsius.

00:06:27:26 - 00:06:30:08
Cas Piancey
Yeah. Yeah, funny, crazy.

00:06:30:14 - 00:06:32:14
Bennett Tomlin
I keep forgetting to laugh at the funny things.

00:06:33:11 - 00:07:06:25
Cas Piancey
Well, it's actually fascinating to me because now we're ending up in what was already a largely centralized ecosystem. I don't know what else to call it. And now we're seeing players plummet and fall off one after another really fast. I mean, I think the succession of Do Kwon, Terra Luna, followed by this Celsius thing, followed by this Three Arrows Capital thing, I mean, this is three incredibly large I wouldn't say trusted by most, but trusted by plenty.

00:07:07:02 - 00:07:28:09
Cas Piancey
And it's troubling. And to me, I think Three Arrows is probably the scariest to most people in this space. In our Tether Papers episode with David Canellis. I think we talked about them, but maybe you can talk a little bit more about them. They've been in the space for a very long time. It's Zu Su and Kyle Davis they they're the partners who run this hedge fund.

00:07:28:15 - 00:07:41:25
Cas Piancey
It's a hedge fund. It was originally based in Singapore, is now based in Dubai. They have billions of dollars under management and they were one of the top receivers of tether. But yeah.

00:07:41:25 - 00:08:06:03
Bennett Tomlin
Yeah, my understanding is that they were basically a garage fund initially funded by their own initial appreciation in crypto. Well, from earlier smaller investments that they ended up then rolling over and over until they ended up with, like I mentioned before, numbers say about 10 billion in assets under management. It's a little bit tricky to get an exact number for that kind of thing, but that's what you see commonly cited.

00:08:06:14 - 00:08:40:08
Bennett Tomlin
And so yeah, they were a $10 billion asset under management fund. They were early venture capital investors in a variety of different protocols they were a major investor in Terra, especially in some of the more recent sales which might be contributing to some of their liquidity problems. Right now. There was some analysis I saw that suggested they might have compounded their problem by doing the same thing that Celsius did, perhaps moving too much ether to staked eth and then being trapped in an unfortunate position, which seems to be a common mistake.

00:08:40:14 - 00:09:02:09
Bennett Tomlin
But yeah, so they're a market making fund. They do a lot of market making in that crypto dot com, which was something we observed commemorating the Tether papers. And they would often market make for the very tokens that they had just invested in. And so yeah, they were a large market making hedge fund and venture capital fund because they have to do it all in crypto.

00:09:02:20 - 00:09:06:18
Bennett Tomlin
And now it seems they can't pay back people they're supposed to be paying back.

00:09:06:21 - 00:09:26:25
Cas Piancey
And it's more than that though, because these guys, they had a stake in a derivatives exchange called Deribit they had a stake in I think of a I'm not looking at their website right now, but they had large stakes in very if not important protocols, at least protocols and platforms that.

00:09:26:26 - 00:09:27:18
Bennett Tomlin
BlockFi.

00:09:27:24 - 00:09:46:24
Cas Piancey
BlockFi that are important to the community. Now, what we've been seeing recently who knows by the time this comes out, but we've been seeing a lot of these companies and platforms that they have stakes in come out and say, like, this has not harmed us, this is not disruptive. US we're going to be OK. I think Celsius was saying that before Celsius collapsed.

00:09:47:06 - 00:10:19:13
Cas Piancey
I think we saw what is it, deploying more capital steady leads from from Do Kwon. So so it is common parlance to say everything is fine, don't worry. And the best way to avoid a bank run is to tell people, please don't come to the bank. So I, I think I get it. And I'm not suggesting they're doing anything wrong, but I am saying that the waters are very choppy and it does feel like there are still contagion risks going around right now.

00:10:19:14 - 00:10:25:17
Cas Piancey
To me, it seems like we're just getting sick and like we're just starting to puke for the first time. You know.

00:10:27:03 - 00:10:47:04
Bennett Tomlin
There's a chance that BlockFi did liquidate their position early enough and weren't overly harmed by three those capital going silent on everyone. Right. But that's only a partial explanation, right? Because they were previously raising at a $5 billion valuation and were last reported raising at a $1 billion valuation, an 80% down round. That's going to basically ruin their cap table.

00:10:47:12 - 00:11:10:20
Bennett Tomlin
Like it is unclear that without investors like three arrows capital in the liquidity provided they're that BlockFi going to be able to close that billion dollar round. And so there are long term risks to BlockFi business besides just them being so exposed to 3 arrows capital, they would end up insolvent. Right? Liquidity's kind of like a tide when there's a whole bunch of liquidity.

00:11:10:20 - 00:11:22:20
Bennett Tomlin
Things are hidden, things can keep functioning, you can pull from the future. But when the liquidity goes out, things get exposed. And you realize where people had overextended and were over levered.

00:11:22:25 - 00:11:48:10
Cas Piancey
Yeah, it's the classic Warren Buffett. When the tide goes out, you know who's swimming naked. Another aspect of contagion that I really want to touch on here is stable coins in general, which we've seen a lot of the algorithmic. If they didn't completely peg, we saw their market caps just completely plummet over the past 30 days. Magic Internet money is down 83% in its market cap.

00:11:48:20 - 00:12:22:14
Cas Piancey
Fay is down 25% in its market cap, FRAX is down from all time highs of 2.5 billion to now 1.5 billion so that is a really large decline in all of the algorithmic stable coins. And then we have other stable coins as well that seem to be struggling with liquidity issues. And maintaining their peg outside of algorithmic stable coins. And we saw the head of trading at Cumberland stated, now this is a thought experiment.

00:12:22:20 - 00:12:49:04
Cas Piancey
I don't want to assign any real value to this thread and thing they wrote and said, but they did mention that the next shoe to drop that would really mess things up and drop prices and screw around with volumes and trading would be a top to stable coin. I guess failing something along those lines, there's a lot of hedging in the statement they used, if would, and top two stable coin.

00:12:49:04 - 00:12:56:11
Cas Piancey
So they didn't name any names and they said top two which. Yeah, sure, OK.

00:12:57:10 - 00:13:06:00
Bennett Tomlin
Could be the one that just got an audit. Could be the one that once partnered with the money launderers for the Colombian cartels. Either one is in. Who knows?

00:13:06:15 - 00:13:24:29
Cas Piancey
Yeah, yeah, yeah, yeah, yeah. Who knows. But yeah, yeah. I think that's the contagion risk that you and I have been talking about for a very long time that a lot of people have suggested as simply black swan nonsense doesn't feel that way right now. I guess this happens every bear market though.

00:13:25:08 - 00:13:44:17
Bennett Tomlin
It does. And like, well, again, we say that, but like Last Bear Market Tether was doing a lot of shady shit, right? And that was 2018. That's when all the worst of the self-dealing was happening and all of the stuff they were hiding about their insolvency not being backed. And so we say that like we just do this every bear market.

00:13:44:17 - 00:14:10:11
Bennett Tomlin
But like last bear market tether did some pretty bad things. And so like its tethers changed, tether's a new company, they're focused on transparency now, but their asset composition that we know of now is like substantially worse than what we imagined years ago. And there's still the risk based on the fact that Bloomberg reports they've gotten target letters for bank fraud.

00:14:10:21 - 00:14:38:12
Bennett Tomlin
And like we know, there's other ongoing federal investigations that tether could end up doing. The Black Swan things which aren't Black Swan, if you can predict them, might end up doing the Black Swan thing where it gets shut down and where that pool of what still $70 billion worth of liquidity right. They've done like 12 billion in redemptions or something but yeah, still like $70 billion isn't a lot of dollars that's like reserve primary fund size from 2008.

00:14:38:22 - 00:15:10:24
Bennett Tomlin
It's a really substantial thing that would fundamentally change the liquidity and the faith in the system as a whole. Like that's the ultimate contagion risk. Great. That's why the Cumberland people are mentioning it is because that is the thing that fundamentally destabilizes mass of portions of the ecosystem, which is not to say that no cryptocurrency would ever survivor, that no cryptocurrency company would survive it, just that many, many people are exposed in myriad ways to stable coins.

00:15:11:02 - 00:15:27:08
Bennett Tomlin
And that's what makes them such a broad, systemic and contagion risk for the ecosystem. And that's why it's so important that if you're going to have an ecosystem based on stable coins, that they are well behaved and trustworthy because they are so fundamentally important.

00:15:27:14 - 00:15:47:25
Cas Piancey
I was thinking today about, you know, the broader markets, and I think this is an old cliche, but at the idea that, like, everyone is a good trader in an up market, right? So I think there's some truth to that. And I think part of this contagion risk that I'm talking about and that we've been talking about, it relies on this idea that, well, everyone's a good trader in an up market.

00:15:48:00 - 00:16:22:25
Cas Piancey
But in this industry in particular, everyone's trading with each other and getting equity with each other and getting tokens for loans and this and that. Right. Like it is so inside baseball that the contagion risk is super amplified because they've created a really Jenga like ecosystem that is easy to break. And now we see this and I think one of the best questions that people have asked for a long time about tether, for instance, is how are they making money?

00:16:23:12 - 00:16:41:22
Cas Piancey
How are they making money? It's like a very simple question. How do they make money? They get their 20 bips or whatever it is on each transaction back to redeem or mint. It's that's nothing how do they make their money? And nobody can answer it. Nobody can say where, how, how they're going to do it.

00:16:41:25 - 00:16:43:00
Bennett Tomlin
I mean, Zeke Faux.

00:16:43:00 - 00:16:43:29
Cas Piancey
Did what did he say.

00:16:44:03 - 00:17:18:15
Bennett Tomlin
In his reporting when he was chasing down the story for Bloomberg Businessweek? He said that Jon Betts said that when Giancarlo Devasini seen he was desperately interested in finding ways to earn more yield and to others reserves and that's why they've fundamentally restructured themselves in their promises. And that's why like when you say something like tethers reserves fairly valued or probably less than their circulating market cap, a lot of people in cryptocurrency won't disagree with you because there's this like implicit understanding that for tether to make money, they're juicing it.

00:17:18:25 - 00:17:23:29
Bennett Tomlin
They're finding places to do things which aren't fully legitimate so that they can get that kind of yield.

00:17:24:10 - 00:17:42:29
Cas Piancey
And so but I think what's important to note there is that when you say they're looking to places to juice it, well, there's a lot of places you could look to juice those numbers. There's a lot of industries you could look to juice those numbers they're not looking without. They're looking with it. And again, these are inherently huge issues.

00:17:43:16 - 00:18:16:11
Cas Piancey
If tether were to hypothetically fail for some random, who knows what reason? I mean, I guess I don't know anymore. I keep my feelings change on on the odds for others as time passes. I just never know. I just never, ever know. Sometimes it's a coin flip and sometimes it I think what seemed like their only risk being regulatory has transformed to serious market and liquidity issue risks that are now being posed yes.

00:18:16:11 - 00:18:39:25
Bennett Tomlin
Yeah. I have upgraded those risks in my head more recently. And I think what you're kind of getting at is way back in our first episode and terror before it crashed, one of like kind of my fundamental arguments against algorithmic stable coins is that the entire value proposition is self-referential. Right? It's valuable because it's valuable. And like if you lean into that, you can get it to a large enough size, right?

00:18:40:03 - 00:19:16:24
Bennett Tomlin
It's an entirely a faith based episode. And in many ways, so much of crypto value is so self-referential, like where we know tether is partially backed by Bitcoin and partially backed by equity and crypto companies and that the loans for tether, the secured loans they're extending to a whole bunch of different places are collateralized by cryptocurrencies. So much of the value proposition ends up being self-referential in that same kind of way where it's valuable for as long as it's believed to be valuable, and that when things get bad, when liquidity draws out, that faith is harder to maintain.

00:19:17:00 - 00:19:49:17
Cas Piancey
Which brings me to the final contagion risk, which I think is the bleeding into actual markets. That this knock on effect could present if enough liquidity and volume dries up from cryptocurrency markets. I know Michael Saylor has said that MicroStrategy seems to have very little risk for liquidation on all of their stuff, and that's fine. I'm not I'm I'm not going to try to suggest he's wrong I know that Coinbase is now trading at around, I think, $55.

00:19:50:04 - 00:20:17:07
Cas Piancey
And I know that there definitely companies, larger companies and banks listed publicly that could definitely suffer consequences for cryptocurrency issues like liquidity drying up. And so I wonder if that's the last contagion that we are. We would see if this all does actually run through the system and hit as hard as some people expect it to.

00:20:17:12 - 00:20:20:11
Bennett Tomlin
A Fed says it's not systemic and the Fed never.

00:20:20:11 - 00:20:22:17
Cas Piancey
Gets it wrong. It's transitory.

00:20:22:26 - 00:20:47:00
Bennett Tomlin
I don't think it's broadly systemic. I think that there are certain companies that could get hurt in certain scenarios, right? Like you named MicroStrategy, we can talk about Coinbase we can talk about a lot of companies which are currently, you know, dedicating resources to these things. I don't think it's broadly systemic to the financial system. I think it's still relatively isolated.

00:20:47:13 - 00:21:16:17
Bennett Tomlin
And so I think that we're not yet at the point where crypto is broadly systemic to the financial system. But like part of the reason the Federal Reserve has written papers pushing for state Bitcoin regulations and part of the argument behind many of the stable credit regulations is that at a certain scale they become systemic, right? They become like the reserve primary fund breaking the buck in 2008, they become a real risk to the financial system because that liquidity matters so much more.

00:21:17:03 - 00:21:53:25
Cas Piancey
There's two ways this episode goes, I guess, which is unfortunate for us. Either we look silly because in a week and a half or whatever, when this comes out, people are like, Well, obviously it was a massive contagion event. Everything's failing already, or they go, Everything is fine and there's no more problems, idiots. So we're walking a thin line with this episode, but I think it's worth talking about because I do think that this is the risk of these bear markets, especially with speculative assets like, you know, worthless tokens and companies that don't do anything and Ponzi schemes.

00:21:53:25 - 00:22:19:17
Cas Piancey
So some of these projects are just straight up obvious Ponzi schemes or broken protocols. I am still blown away that that dumb ass just insane coin exists at all besides Tron as like 25 fucking really dumb coins. So I, I think there's room for more risk and contagion. I think we haven't seen the end of it. Who knows?

00:22:19:17 - 00:22:36:09
Cas Piancey
I could be wrong. We've seen these people bail each other out and succeed before, so they could very well do that again. And it could totally just be fine. But I don't know. Who knows? I guess we'll see I would tell people to be extra careful on any lending platforms.

00:22:36:18 - 00:22:40:15
Bennett Tomlin
Be very aware of your counterparty risk is just generally good advice.

00:22:40:24 - 00:22:53:09
Cas Piancey
Yeah. Be cautious on your centralized exchanges. Now that that's a contagion risk we haven't even really addressed at all. If the feds are somehow able to shut one of these exchanges down, that would be bad news. Bears big time.

00:22:53:09 - 00:22:57:08
Bennett Tomlin
And yeah, it's more liquidity being drained out.

00:22:57:15 - 00:23:18:23
Cas Piancey
Exactly. And unexpected and not something anyone thinks is going to happen. So that's a real black swan in my in my humble opinion would be one of these big, big exchanges getting shut down. But who knows, man, I don't it's not like I foresee it happening. So I just I just want I think we're talking about contagion because we want people to be aware.

00:23:18:25 - 00:23:32:07
Cas Piancey
It's like if there's a bad cold going around, you just tell people like, yeah, there's a bad cold going around here. Full heads up. So it's yeah, it's worth it's worth talking about. I don't know if it will lead to anything and maybe it stops here, but maybe.

00:23:32:07 - 00:23:32:21
Bennett Tomlin
It does.

00:23:38:28 - 00:24:07:22
Cas Piancey
Hey, guys, I'm recording this outro for our Contagion episode. On May the first. And I just wanted to say that if you've been donating to us, if you've been watching on YouTube, we just got monetized. So all of our funds, everything are giving to us and in fact, all of my personal income and money, everything I have is now in Celsius Network Three Arrows, Capital and I have a ton of Luna and Terra.

00:24:07:28 - 00:24:27:15
Cas Piancey
So, you know, we are going all in on crypto. And so give us those like give us those, give us those subscribes. We're going totally in on this and, and fingers crossed like and subscribe and I don't know.

5 responses to “Episode 83 – Contagion and Cascading Liquidations in Cryptocurrency”

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