The death of easy money: Why 20% annual returns are over in crypto lending

PARIS — Celsius and Voyager Digital were once two of the biggest names in the crypto lending space, because they offered retail investors outrageous annual returns, sometimes approaching 20%. Now, both are bankrupt, as a crash in token prices — coupled with an erosion of liquidity following a series of rate hikes by the Federal Reserve — exposed these and other projects promising unsustainable yields.

“$3 trillion of liquidity will likely be taken out of markets globally by central banks over the next 18 months,” said Alkesh Shah, a global crypto and digital asset strategist at Bank of America.

But the washout of easy money is being welcomed by some of the world’s top blockchain developers who say that leverage is a drug attracting people looking to make a quick buck — and it takes a system failure of this magnitude to clear out the bad actors.

“If there’s something to learn from this implosion, it is that you should be very wary of people who are very arrogant,” Eylon Aviv told CNBC from the sidelines of EthCC, an annual conference that draws developers and cryptographers to Paris for a week.

“This is one of the common denominators between all of them. It is sort of like a God complex — ‘I’m going to build the best thing, I’m going to be amazing, and I just became a billionaire,'” continued Aviv, who is a principal at Collider Ventures, an early-stage venture capital blockchain and crypto fund based in Tel Aviv.

Much of the turmoil we’ve seen grip crypto markets since May can be traced back to these multibillion-dollar crypto companies with centralized figureheads who call the shots.

“The liquidity crunch affected DeFi yields, but it was a few irresponsible central actors that exacerbated this,” said Walter Teng, a Digital Asset Strategy Associate at Fundstrat Global Advisors.

Back when the Fed’s benchmark rate was virtually zero and government bonds and savings accounts were paying out nominal returns, a lot of people turned to crypto lending platforms instead.

During the boom in digital asset prices, retail investors were able to earn outlandish returns by parking their tokens on now defunct platforms like Celsius and Voyager Digital, as well as Anchor, which was the flagship lending product of a since failed U.S. dollar-pegged stablecoin project called TerraUSD that offered up to 20% annual percentage yields.

The system worked when crypto prices were at record highs, and it was virtually free to borrow cash.

But as research firm Bernstein noted in a recent report, the crypto market, like other risk-on assets, is tightly correlated to Fed policy. And indeed in the last few months, bitcoin along with other major cap tokens have been falling in tandem with these Fed rate hikes.

In an effort to contain spiraling inflation, the Fed hiked its benchmark rate by another 0.75% on Wednesday, taking the funds rate to its highest level in nearly four years.

Technologists gathered in Paris tell CNBC that sucking out the liquidity that’s been sloshing around the system for years means an end to the days of cheap money in crypto.

“We expect greater regulatory protections and required disclosures supporting yields over the next six to twelve months, likely reducing the current high DeFi yields,” said Shah.

Some platforms put client funds into other platforms that similarly offered unrealistic returns, in a sort of dangerous arrangement wherein one break would upend the entire chain. One report drawing on blockchain analytics found that Celsius had at least half a billion dollars invested in the Anchor protocol which offered up to 20% APY to customers.

“The domino effect is just like interbank risk,” explained Nik Bhatia, professor of finance and business economics at the University of Southern California. “If credit has been extended that isn’t properly collateralized or reserved against, failure will beget failure.”

Celsius, which had $25 billion in assets under management less than a year ago, is also being accused of operating a Ponzi scheme by paying early depositors with the money it got from new users.

So far, the fallout in the crypto market has been contained to a very specific corner of the ecosystem known as centralized finance, or CeFi, which is different to decentralized finance, or DeFi.

Though decentralization exists along a spectrum and there is no binary designation separating CeFi from DeFi platforms, there are a few hallmark features which help to place platforms into one of the two camps. CeFi lenders typically adopt a top-down approach wherein a few powerful voices dictate financial flows and how various parts of a platform work, and often operate in a sort of “black box” where borrowers don’t really know how the platform functions. In contrast, DeFi platforms cut out middlemen like lawyers and banks and rely upon code for enforcement. 

A big part of the problem with CeFi crypto lenders was a lack of collateral to backstop loans. In Celsius’ bankruptcy filing, for example, it shows that the company had more than 100,000 creditors, some of whom lent the platform cash without receiving the rights to any collateral to back up the arrangement.

Without real cash behind these loans, the entire arrangement depended upon trust — and the continued flow of easy money to keep it all afloat.

In DeFi, however, borrowers put in more than 100% collateral to backstop the loan. Platforms require this because DeFi is anonymous: Lenders don’t know the borrower’s name or credit score, nor do they have any other real-world metadata about their cash flow or capital upon which to base their decision to extend a loan. Instead, the only thing that matters is the collateral a customer is able to post.

With DeFi, instead of centralized players calling the shots, the exchanges of money are managed by a programmable piece of code called a smart contract. This contract is written on a public blockchain, like ethereum or solana, and it executes when certain conditions are met, negating the need for a central intermediary. 

Consequently, the annual returns advertised by DeFi platforms like Aave and Compound are much lower than what Celsius and Voyager once offered customers, and their rates vary based upon market forces, rather than staying fixed at unsustainable double-digit percentages.

The tokens associated with these lending protocols are both massively up in the last month, which is a reflection of the enthusiasm for this corner of the crypto ecosystem.

“Gross yields (APR/APY) in DeFi are derived from token prices of relevant altcoins that are attributed to different liquidity pools, the prices of which we have seen tumble more than 70% since November,” explained Fundstrat’s Teng.

In practice, DeFi loans function more like sophisticated trading products, rather than a standard loan.

“That’s not a retail or mom-and-pop product. You have to be quite advanced and have a take on the market,” said Otto Jacobsson, who worked in debt capital markets at a bank in London for three years, before transitioning into crypto.

Teng believes lenders who did not aggressively extend uncollateralized loans, or have since liquidated their counterparties, will remain solvent. Genesis’ Michael Moro, for example, has come out to say they have cut significant counter-party risk.

“Rates offered to creditors will, and have, compressed. However, lending remains a hugely profitable business (second only to exchange trading), and prudent risk managers will survive the crypto winter,” said Teng.

In fact Celsius, though itself a CeFi lender, also diversified its holdings in the DeFi ecosystem by parking some of its crypto cash in these decentralized finance platforms as a way to earn yield. Days before declaring bankruptcy, Celsius began to pay back many of its liens with DeFi lenders like Maker and Aave, in order to unlock its collateral.

“This is actually the biggest advertisement to date of how smart contracts work,” explained Andrew Keys, co-founder of Darma Capital, which invests in applications, developer tools, and protocols around ethereum.

“The fact that Celsius is paying back Aave, Compound, and Maker before humans should explain smart contracts to humanity,” continued Keys. “These are persistent software objects that are non-negotiable.”