CoinSnacks - Special Edition: The Liquidity Crisis


June 22, 2022 | Issue #225

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Coin Snacks

Editor's Note: It's hard to make sense of crypto right now, with so much happening so fast. That's why in this week's issue, were skipping the Regulatory Front section we typically feature so we have more room to talk about what matters most – the ongoing liquidity crisis.

Thanks again for subscribing and for sticking with us through these rough patches. It may not look like it today, but there's a whole lot more to look forward to.


A Week For The History Books

The headline says it all. The cascade of events that have recently unfolded in the world of crypto will be talked about for years to come. Take it or leave it: It's truly been a historic week.

But unlike many of the "milestones" or breakthrough announcements we've covered over the years, this week's news, unfortunately falls on the wrong side of history – one that's filled with pain, regret, and in many cases, utter disappointment.

Is there any good news? Of course. But we're not here to sugercoat anything, but rather to only outline the facts. So gear up.

The Bubble Goes "Pop!"
Terra... followed by Celsius... followed by Three Arrows Capital (3AC)... to Babel Finance... BlockFi... the list goes on and on and could very well grow from here.

For those who haven't been paying attention, respectfully so, each one of the companies listed above has been the latest victim of today's evidently systemic liquidity crisis. By that we mean that each one, despite having billion-dollar valuations only months ago, have lost so much money to the point where they are (or were) at risk of insolvency... or even worse, on the brink of losing all of their users' capital.

On the heels a falling market, rising inflation, and a horrendous economic backdrop, the near collapse of these companies has caused a massive ripple effect, where one sinking ship caused another to capsize and so forth.

The selling cascade has impacted retail investors like us, venture capital funds, governments, and even stocks trading on traditional markets (take a look at this chart)...

The Latest Development
Sparking both controversy and praise all across Wall Street, has been the collaborative effort to bail out ailing crypto companies in this time of crises.

Unlike the 2008 financial crisis, however, the government isn't the one stepping in... this time, it's none other than FTX's Sam Bankman-Fried, or "SBF" for short.

Yesterday, FTX, SBF’s crypto exchange, agreed to provide crypto lender BlockFi with a $250 million revolving credit facility. Then today, Alameda, SBF’s quantitative trading firm, also committed $500 million in financing to Voyager Digital, a crypto brokerage that had a ton of expsoure to 3AC.

As a result, SBF has emerged as something of a savior for the crypto market as it battles a deepening liquidity crunch.

Now, did SBF actually save these companies? Probably...

Did he help prevent further catastrophe? Absolutely...

Lastly, did he save the entire crypto market? Time will tell...

In the meantime, we have some other stuff we'd like to get off our chests...


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Our Thoughts:
There's no beating around the bush... as covered above, there's a lot of bad news in the markets right now.

And yes, FTX/SBF/Alameda are stepping in to "save the day" with some individuals cheering about how private companies bailing out private companies "is how capitalism is supposed to work." And yes, we agree that the private option is significantly better than the government using taxpayers dollars to bail out companies.

But we still can't help but point out that the point of crypto is decentralization. SBF being the "lender of last resort" for multiple companies may be good for them, but we need to ask, how is it good for the users?

But let's back it up a bit...

As of now, you might be thinking... how the heck did all this happen anyway?

We'll save you the company-specific details, but to sum it up, this crisis was simply ignited (and fueled) by the misuse of leverage.

Legendary investor Charlie Munger once said “there are only three ways for a smart person to go broke: liquor, ladies, and leverage”. Although we haven’t heard of any big names in crypto going broke due to liquor or ladies (yet), the past couple of weeks have made it clear that Mr. Munger was spot on about leverage.

For those unaware, leverage is using borrowed money to invest, which allows one to invest more than they actually have. This is an extremely powerful tool that on the upside has the potential to exponentially multiply gains, but also carries the downside of exponentially multiplied losses.

Using leverage in this way works really well in a bull market because the value of the collateral is going up, which means there is no risk of liquidation. However, in a bear market where the value of the collateral is going down, liquidation suddenly becomes a very real possibility.

This is precisely what started taking place when prices started to go south last month and it's why we are where we're at today. There was way too much leverage.

Moving on, one thing that is glaringly obvious is that this whole cascade is giving crypto bad PR.

But we want to be the first one's to tell you that this isn't the fundamental crypto projects, specifically Bitcoin, that's doing the damage.

So it is necessary that we all take a step back and take note of how we got here:

  1. Certain companies – commonly known as CeDeFi firms, as we discussed last week – luring retail investors to trust them with their hard earned cash by promising overly high yields (APYs) through taking hidden, ridiculous risks.
  2. VC's with perverse incentive structures that only fund short-vesting projects with a goal to quickly flip and extract value from a bull market.
  3. Founders cashing out, while their customers lose their life savings

And of course, we have to point a finger at the group of octogenarians and academics, that fill the halls of government and central banks, printing money and forcing people to search for any hope of returns.

But ultimately, many of the glaring problems that we have been pointing to in CoinSnacks are the same ones that led to the market's recent woes.

To quote our newsletter from May 19th: 

"The rabbit holes into DeFi, algo stablecoins, and the thousands of altcoins involved come with a double edged sword. Yes, many of these things are groundbreaking and innovative and do serve a purpose to some extent in the world of decentralized finance and banking. But many folks fail to realize just how speculative these projects are. Since its inception, the DeFi space has again and again reminded us of the ICO boom in 2017; copied over whitepapers, endless shilling, deceptive marketing, exchanges listing everything under the sun to drive more fees… the list goes on and on.

But most importantly, we saw the retail crowd rush into these assets without any foundational understanding of how DeFi actually operates.

As the saying goes, the important thing is to know what you know and know what you don’t know. In other words, stop putting your capital in things you don’t understand."

We aren't in this game to move numbers around on a ledger. And promises of changing the future aren't the same as actually doing it.

There's a saying that goes, "to figure out how something works, figure out how to break it". We've obviously done the breaking... let's hope we've better figured out how this whole crypto thing should work.

In the end though, bitcoin, ethereum, and other real-world use cases – although down on a price basis – are still bringing financial freedom to hundreds of millions of people around the world. THIS is why we crypto.


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It's Not ALL Bad News...

While the overall crypto market is in a bit of a slow motion crash (see above), one area of the market seems to be bucking the trend.

Over the past week, several NFT exchanges have either been acquired or funded at huge valuations. Let's take a look:

First, we have Uniswap Labs, the developer of the Uniswap decentralized exchange (DEX), acquiring the NFT marketplace aggregator, Genie. Genie is not to be confused with Genies, the metaverse focused startup which we covered previously.

Next up jumping into the NFT marketplace game is eBay in their acquisition of KnownOrigin. Although most likely not a huge acquisition, as KnownOrigin has only raised £3.5 million to date, its still telling that a company like eBay is making the foray into the space.

Lastly, Magic Eden, a marketplace for NFTs on the Solana blockchain, saw its valuation 10x after raising $130 million at a $1.6 billion valuation. This comes after having raised as recently as March. Avichal Garg, a managing partner at Electric Capital and an investor in both rounds when asked about valuation stated that he was “not too worried about overpaying." Now, some might call these his "famous last words," but there is no denying the fact that Magic Eden is hauling in a significant amount of cash.

Now, the takeaway here isn't to say that the NFT craze hasn't been effected by today's market. They have been, as NFT prices, on average, have significantly fallen as well. The point we are trying to make is that NFTs are still relevant with meaningful demand... the same goes for DEX's, considering that Uniswap handled $1 trillion in crypto trades just last month.

While there's not a whole lot to lean on in times like these, it is worth noting that no bear cycle will be like the last. Last time prices capitulated in 2017/2018, we didn't have NFTs... we didn't have DEXs, nor the metaverse... and we didn't have the millions of users that were recently, in one way or another, onboarded into the crypto ecosystem.

Perhaps these are just glimmers of hope, or frothy words of positivity... but there's seemingly a lot more room for innovation in comparison to the last down cycle.

Related: FalconX more than doubles its valuation to $8 billion in $150 million round

The Lengths We Go: Saving Solana

Solend, the most popular and valuable lending protocol on Solana, has had to navigate out of a tricky situation over the last couple days.

Faced with the threat of a dangerously overleveraged whale wallet approaching a potentially catastrophic liquidation, Solend was forced to grapple with the question of how far a decentralized project can go to protect itself and its users.

The Importance of Solend
Solend is what is known as a lending protocol. Lending protocols are simply tools that allow users to borrow and lend assets. Typically, lending protocols are an important part of a blockchain’s ecosystem, as they regularly attract healthy amounts of users and capital.

Solend is no exception, as it is not only the largest lending protocol on Solana, but it is also the most valuable protocol on Solana, with a sizable total value locked of $420 million.

Because of this, Solend is extremely important to the health of Solana as a whole. And Solana, as the 5th largest chain in crypto, is very important to the health of crypto as a whole.

A failure on Solend would not just impact Solend or even Solana, but the entire crypto market. This is the last thing a market that’s already been battered the last few weeks needs.

The Solend Crisis
The crisis began with a June 18th tweet thread from Solend founder Rooter. In the thread, Rooter describes how a whale that has what can only be described as a massive position is at risk of liquidation. This position truly is incredible in its size, with $170m in SOL deposited and $108m in stables borrowed.

As Rooter explains, if SOL dropped to $22.30, then 20% (~$21 million) of the position will be liquidated. Liquidations on Solend are handled by bots, and these bots are programmed to sell the collateral on Decentralized Exchanges (DEX’s). The problem with this is that because there is not enough DEX liquidity on Solana to absorb $21 million of SOL, a sale of this magnitude would cause a crash in the price of SOL. A crashing SOL would cause more liquidations, which would cause more sales, which would crash the price further, and on and on it would go.

After attempts by Solend to contact the whale proved unsuccessful, and faced with a truly dangerous situation, Solend proposed SLND1. What SLND1 proposed was something never before seen in DeFi: a decentralized project taking control of a user's assets in order to liquidate the whale’s position in a more orderly manner. The argument was that in a desperate situation, desperate action was warranted. After a 6 hour voting period, SLND1 passed.

As expected, the public backlash to SLND1 was intense, with critics harping on everything from the short voting period, to the fact that 90% of the vote was from one person, to the ethics of a decentralized protocol taking control of a user’s assets.

Eventually the backlash got so intense that SLND2 was proposed and passed, which invalidated SLND1. Although SLND2 pleased proponents of decentralization, it left Solend in pretty much the same difficult spot as before… the potential for cascading liquidations.

And although a third proposal, SLND3, would mitigate future risks by gradually reducing the account borrow limit, it did not provide the immediate relief needed to potentially save Solend and Solana.

As soon as it looked like Solend would just have to hope that the position doesn’t get liquidated, a miracle happened. The whale finally got in contact with the Solend team and began to deleverage, allowing everyone to take a big sigh of relief.

Crisis Averted… For Now
Even though this story has a happy ending, the Solend crisis still shone light on some ominous signs that should give us all reason for concern... the same overleverage problem we covered above. Although the crypto market dodged a bullet with Solend, we are likely not yet done hearing about leverage and liquidations. 

Solend also opened up a debate on the spectrum between decentralization and acting in the project’s best interest. How far does the ethos of decentralization go? Does a decentralized project have the right to step in and address an existential threat? These are questions fundamental to the future of decentralized finance, as their answers will shape the future of the space.

CoinSnacks has in the past called out the rise of projects that are “decentralized in name only.” This seems to be another one of those cases… 


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