Foreword

The ancient Greek philosopher Heraclitus said that One Cannot Step Twice in the Same River. But it is clear that Babel Finance, which just completed its funding at a $2 billion valuation, has stepped into that river again. During 2020/3/12, Babel Finance was on the verge of bankruptcy because of its high-risk operations, and Tether’s forbearance and market recovery saved it.

On June 17, 2022, Babel told its partners that the company was insolvent and that it would suspend product redemption and withdrawal features on its website. Babel Finance may become the third crypto finance management company on the verge of collapse after Celsius and 3AC. Unlike last time, there is no longer a savior, as Tether says it is no longer working with it. And the market downturn could continue through the end of the year. Similar to 3AC, Babel Finance started selling off equity in an attempt to increase liquidity half a month ago. But that didn’t work out against the backdrop of the downturn. How exactly did the problem happen this time? It remains to be investigated in the future.

After 2020 312, it was widely believed that Babel strengthened its risk control and even became extra low profile in its behavior. In 2021, they completed A $40 million Series A financing, with the participation of top institutions such as Animism Capital (an early stage fund of Boyu Capital), Sequoia Capital China, BAI Capital, Tiger Global Fund, Dragonfly Capital and so on. Previously, Babel has completed two rounds of financing with investors including True Fund, Lightspeed China, Keyin Capital, NGC, etc. On May 26, 2022, Babel announced the completion of its Series B funding round with $80 million, promoting it to a unicorn with a valuation of $2 billion. Major investors include Jeneration Capital, private equity firm 10T Holdings, and existing shareholders Dragonfly Capital and BAI Capital. The financing press release said the outstanding loan balance reached more than $3 billion at the end of last year, derivatives trading volume averaged $800 million per month, and options structured products issuance reached more than $20 billion.

With so many famous VCs, how do they do their due diligence? Did they not read our article and simply didn’t understand the huge risks involved in this model, or did they also think that One Cannot Step Twice in the Same River？

This is an article in Chinese written in September 2020，read more:

Babel Finance’s Business Model

Babel’s main business lending model is as follows.

A miner stakes 100 BTC to Babel, and Babel lends the miner 50%-65% (LTV) of the equivalent 100 BTC in USDT according to the staking lending terms, with an annualized interest rate of 8.88%-15%. Babel stakes the 100 BTC to institutions such as Genesis, Tether, BlockFi, and OSL, and borrows USDT, which it then lends to miners. Babel is in a back-to-back business, with risk control at both ends.

The general staking rate LTV for overseas inter-institutional lending is 71%-100%, and the annualized interest rate is 6.6%-8% (market interest rates change from time to time, and the more common rate in the past year is 8% or less than 9%). It is thus clear that if only the spread is earned, the profit will be very slim, so this is not Babel’s real business model.

Babel adds leverage to its own funds, the collateral of its users, and funds obtained from other financial products. Babel can use between 10%-50% of the user’s collateral. For example, if you stake 1 BTC to Babel, then 0.1–0.5 BTC of that will be taken by Babel in exchange for USDT.

If BTC goes up, Babel earns a profit of the increase multiplied by the leverage multiple. Babel tells overseas institutions that the lending customers are miners, so the risk is low, in turn in exchange for low interest rates and high staking rates (LTV).

Essentially, Babel’s business model does not rely on lending spreads, but rather on increasing capital leverage at low cost to earn profits from rising BTC. Babel later began to buy a small number of put options to hedge, and the business model became more diversified, such as the capital management business.

Although most lending companies use their clients’ collateral, Babel has the highest leverage. The risk of operating this way is that if the price of BTC fall sharply, Babel will be unable to resist the risk because of its high leverage and low reserves, eventually leading to liquidation.

Fright night on 3.12

Then, “312” came.

The price of BTC fell rapidly that day, and Babel needed to increase BTC to raise the margin. But Babel’s money was trapped in a highly leveraged serial operation, and there was no BTC to cover the position, so a default was formed for Tether, BlockFi, OSL and other institutions. At the time, Babel couldn’t even get 200 BTC out, but tether’s position alone needed to be increased by more than 2,000 BTC to get back to maintenance margin, or more than 5,000 BTC to get back to initial margin.

Babel co-founder Wang Li told everyone that night that the industry was extinct.

If Tether had chosen to close its position at that time, then all of Babel’s BTC, as well as its users’ collateral, would have been lost. OSL did choose to close its position, but in a relatively small amount. At this point in time, Tether gave Babel a chance to survive by not choosing to close its position, allowing it to go through a month to raise funds (typically, there is only 48 hours to cover the position).

Babel then quickly released an option finance product with a yield of up to 50%, raising over 2,000 BTC. Meanwhile Babel liquidated some users and obtained their collateral of about 3,000–4,000 BTC, giving Tether a small amount each day to cover their positions.

The good news is that as prices rose rapidly afterwards, Babel was freed from the vortex of leverage and even made a lot of profit again, sponsoring a lot of subsequent events and launching new businesses such as mining pools.

Looking back at 3.12, if Tether hadn’t given him a month, if bitmex hadn’t had machine downtime (which prevented bitcoin from continuing to fall), and if the market hadn’t picked up immediately, Babel would currently be broke.

After 3.12, Babel was questioned overseas. blockFi, OSL and Tether broke off their partnership with Babel and the partner that continues to support Babel is Genesis. Previously BlockFi gave almost 1:1 LTV with a high level of trust.

One explanation in Babel’s favor is that Babel preferred to default on its own during 3.12 in order to protect its customers from liquidation. But there is evidence that more than 3/4,000 bitcoins were liquidated by Babel customers during 3.12.

Essentially, Babel is still betting its fate on Tether, believing that the crypto world’s central bank will surely give it time and fill the deficit by printing unlimited money for the sake of the industry. In response, Tether has not yet responded to WuBlockchain, and is suspected to be concerned about whether this action poses legal risks and whether other borrowers will also request an extension.

Adjustment and Reflection

Babel claims to be a commercial bank, but does what funds and asset managers do. Babel is indeed transforming and starting to focus on asset management business.

Highly leveraged investments are not uncommon in the crypto world, and Babel’s 3–5x leverage doesn’t seem to be high compared to contract users who are often 10x and 100x. But one problem with the Babel model is whether users and funders are aware that Babel is operating with high leverage? So far, the vast majority of them do not know, only a few people vaguely guessed the insider. Babel officials also admit that users’ funds and their own funds are mixed together and almost impossible to distinguish.

Babel once promised: “Babel Finance strives for safety and transparency from its initial creation, manages its collateral through multi-signature wallets, never unilaterally uses users’ collateral for transactions, and completely eliminates collateral losses due to market reasons”. The word “unilateral” is intriguing. In the contract between Babel and the customer, there is only one short sentence for the collateral: “The lender shall properly keep the collateral and its related documents.” There are claims within Babel that customers can promise not to use the collateral if they are willing to accept a higher interest rate. Recently Babel is still offering lending services to customers at rates as low as 6%, so what is the purpose of such money-losing lending? Babel has chosen a model that is high risk and high profit, and currently Babel also provides unsecured credit loans to many quantitative teams and others, which may further increase the risk.

However, this expression is not really an anomaly; for lending companies, there is hardly anyone who does not completely misappropriate the collateral of their users. It has become almost a consensus that it is just a matter of leverage and exposure (degree of risk) to make money on collateral. Amber, for example, also uses users’ collateral for quantitative trading. Matrixport, for another example, which previously did not use clients’ collateral, but was under pressure to perform.

3.12 taught Babel a deep lesson and they started to buy some options in the market to hedge, while granting each other credit with a large number of institutions, as well as increasing their own funds and reserves.

If you look at Babel through the lens of traditional finance, it does have a ton of problems. But if you look at it from the perspective of the crypto industry, some may consider the “Babel model” to be very successful because it managed to survive the crisis and make a profit, and even want to imitate it. In an unregulated industry, some think Babel is perhaps the smartest because it has the best utilization of capital.

Others, however, believe that Babel is doing something like robbing peter to pay paul. It is a bit like a P2P model, it has to be very delicate to maintain the balance, if one link of the chain breaks, maybe the whole company will go bankrupt.

Rationally, compared with Cobo, Poolin, Matrixport, renrenbit, etc., Babel does not have a strong backer. The founder of Babel started from nothing and had no choice but to make it this far. One crypto entrepreneur told us that if it were him, he would probably choose a similar model. The result of the catfish effect may be that the industry will have to imitate the high-risk Babel model.

Babel’s investors include Dragonfly, Parallel Ventures, NGC and others. Babel’s core customers or partners include SparkPool, NGC, Nervos, Dforce, Hash Age, BigOne, Matrixport, Kucoin, etc. Babel’s beginnings were closely linked to Poolin’s mining pool, but the two parties subsequently discontinued their cooperation and Poolin started its own financial services business.

Declaration of interest: There is no interest relationship between the author and the relevant parties in the article.

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