The collapse of Celsius (along with Voyager, Babel and Vauld ) has arguably been the biggest shock to the crypto-backed lending industry, making waves globally and shaking faith in crypto lenders which has caused many investors pull their money from these players which created a bank-run type situation. The incredible losses faced by customers of Celsius, Voyager, and others will force policymakers to initiate burdensome regulations for ‘centralized crypto lending’ that will forever alter their shaky business models.
The Celsius Saga
Celsius was one of the largest crypto lenders with over $20 billion in assets at its peak. It was a centralized lending-borrowing marketplace where crypto investors could borrow USDT/USD securitized with their crypto holdings. Meanwhile, depositors could lend their USDT/USD and earn yields as high as 12%. The issue was when borrowing demand waned, Celsius resorted to lending its customer’s crypto (USDT, BTC, ETH etc.) to higher yielding investments such as 3AC Capital which further invested in ‘Terra-LUNA-UST’. The collapse of Terra Luna had catastrophic ripple effects which not only brought down 3AC, but also many lenders like Celsius who lent to 3AC (Read Full story here ). Thus, Celsius became a textbook case for ‘rehypothecation risk.’
The Hidden dangers of centralized crypto lending
In Centralized custodian lending, as the amount of securitized funds increases, so does the hacking risk from both external and internal entities. Unfortunately, this phenomenon has no simple resolution, especially for centralized, crypto-backed lending. In the case of simple crypto custody, the industry has slowly evolved to deploy 2-of-2 multi-sig, where the platform and user each hold a key which is jointly required to unlock access to the securities which mitigates any single bad actor risk. Unfortunately for crypto-backed lending, full custody is the only mode that is deployed today, creating ever larger 'honey pots' to crypto assets—-an asset class with the highest flight risk in human history.
The risk of a counterparty going bankrupt or freezing withdrawals is all too common in the world of crypto. Centralized lenders, such as Celsius, have full custody of customer funds and assume many associated risks like hacking, seizure, and re-hypothecation where the customer is forced to take up all hidden risks and real loss.
Rehypothecation involves passing the collateral to a different counterparty which offers ‘yield’ to the centralized lender, like Celsius. When collateral is rehypothecated, the counterparty risk is magnified. Borrowers are not only assuming the risk of the lender defaulting on their collateral, but also the default of the lender’s counterparty.
Short selling - Price suppression risk
When centralized crypto lenders offer yield for storing ‘collateralized’ Bitcoin, they usually earn this additional yield by offering their customer’s Bitcoin to short sellers, who pay interest for this privilege. What’s even worse is that short selling suppresses price and increases volatility which acts as a de-accelerant to the long-term adoption of Bitcoin.
Owing to the incredible losses faced by investors in crypto lending platforms, regulators are focused on rolling out some of the most onerous regulations on the lending industry. Insiders predict these upcoming regulations will disrupt the current business models of crypto-backed lenders by increasing the cost of operations and regulatory compliance significantly.
Inadequate insurance coverage
Even though many centralized lending marketplaces claim to have insurance, coverage limits are wholly inadequate. Even the most trusted centralized crypto service providers such as Bitgo and Coinbase lack complete insurance coverage for their customer funds. Their insurance only covers the first $100 -200M of hacked funds, while these businesses have assets worth more than $10 Billion. In the case of a significant hack, most depositors will receive a large haircut on their assets, potentially eliminating a significant amount of their funds.
Here’s a WSJ video explaining the investor protection blackhole with even the best crypto companies
CeDeFi: Multi-sig-powered lending to the rescue?
2-of-3 multi-sig wallets are multi-party custodial wallets where 3 regular public keys/users share joint custody of this multi-sig wallet with at least 2 users needing to sign a transaction to access the custodial funds. This wallet configuration enhances security and transparency.
Using a 2-of-3 multi-sig wallet, a lender, borrower and a 3rd party mediator, like valuete.io, each holds a unique public/private key pair that will be used to create this 2-of-3 multi-sig wallet in which the borrower will transfer their collateral.
Security risk mitigated
In a 2-of-3 multi-sig wallet, while the mediator key is common, the 2nd and 3rd keys for every loan vary depending on the lender and borrower. 2-of-3 multi-sig is inherently a decentralized protocol requiring the 2nd key from a different source to access funds. This wallet confirmation mitigates the ‘external hacking’ risk. Moreover, the impact of insider hacking is minimal too, as alarms would be raised just after the compromise of a single loan (compared to a centralized custodian where insiders have access to complete collateral of all loans) which destroys the credibility of the platform, leading to lenders and borrowers closing all outstanding loans and terminating any and all future business prospects for the custodian institution.
Counterparty & Rehypothecation Risk mitigated
Collateral locked in 2-of-3 multi-sig wallets need 2 authorizations to access the funds, ensuring the funds are not moved ‘physically’ for the full loan term, which avoids rehypothecation and counterparty risks. Removing all rehypothecation risk means averting a repeat of a ‘Celsius’ type event.
“In a multi-sig wallet set-up, the lenders cannot unilaterally divert collateralized funds from a shared wallet’ without explicit authorization from the borrowers; and hence, this offers peace of mind to borrowers.”
Transparency and privacy
Unlike the collateralized assets of the centralized lender, the funds residing in the multi-sig wallet can be audited by all parties involved 24x7, ensuring total transparency This unprecedented transparency forces the involved parties to act in their collective best interests. Even though multi-sig wallets offer unprecedented transparency, the privacy of securitized funds is not compromised, meaning only those possessing all three public keys can reliably arrive at the multi-sig public key thus avoiding the prying eyes of bad actors.
In a 2-of-3 multi-sig configuration, lenders, borrowers, and the mediator only own a single key, and, as such, no single party can be labelled as a crypto custodian, as each lacks the typical custodial powers such as freezing or absconding the collateral. Crypto regulations, that are expected to address legal custodians, will not apply to those businesses involved with multi-sig lending, thus eliminating the additional overhead costs which can instead be passed to the end customers.
The path forward for crypto lenders
Even though multi-sig wallets offer incredible benefits, most borrowers would prefer to use a centralized lender for the sake of convenience, owing to the complexity of operating multi-sig wallets. Existing crypto exchanges/lenders can use multi-sig wallets in the background on behalf of their clients and become institutional borrowers who can borrow from large institutional funds that are always looking to earn yield in a safe and risk-minimized fashion.
Crypto-backed Lending at a Click
Bitcoin is expected to cross $1 Million by 2030 creating enormous wealth for the holders, but selling Bitcoin brings huge capital gains tax, the smarter alternative is to leverage Bitcoin for a loan. By Leveraging Bitcoin-backed loans customers can either invest in a business or go on a guilt-free holiday. Bitcoin for the first time ever enables everyone to enjoy the wealth strategy of the rich as it is designed to be the world's best store-of-value asset with long-term price appreciation as fiat currency gets printed forever.
“what's good for the borrower is good for the lender too”
Using multi-sig wallets for collateral regains the lost lender trust. Borrower collateral safely sits at one address for the entire duration of the loan and is immune from rehypothecation, providing the borrower assurance that it can be repaid at the conclusion of the loan. For this reason, institutional players with billions of USD can finally enter this space without concern of security and legal risks, opening disruptive and industry transformative possibilities for the crypto-backed loans industry.