The crypto market has been in a tailspin since the collapse of UST and LUNA. Whilst the dominoes continue to fall, the performance of decentralised finance protocols—and the smart contracts that underpin them—offer an interesting case study and a potential glimpse into the future of other real-world use cases of blockchain, where efficiency and transparency are greatly needed.
1. UST was Terra’s algorithmic stablecoin. Its value was pegged to the US Dollar and maintained by a 1:1 relation with Terra’s native token, LUNA. UST suffered a de-peg event in early May that led to the collapse of the stablecoin, the token LUNA and the blockchain Terra. Terra and LUNA were later revamped, while UST was discontinued. The collapse of Terra led to the loss of $40 billion in assets by retail and institutional investors.
2. Celsius is a leading centralized lending service. Customers provide funds to the platform, and Celsius manages the capital with the promise of up to 18% APY and almost immediate redemptions.
3. Three Arrows Capital or 3AC as they are widely referred to, was a crypto hedge fund manager that claimed to manage assets worth $18 billion, although it is now clear that most of their assets were sourced by uncollateralized borrowing from various lending platforms.
Both 3AC and Celsius filed for bankruptcy protection this month. Court filings show Celsius' liabilities of $5.5B, of which $4.7B is owed to Celsius users. 3AC owes at least $3.5 billion to 27 or more companies. Its second largest creditor is TSX-listed Voyager Digital, with a loan of ~$685M, which also filed for bankruptcy in July.
3AC and Celsius are what the industry refers to as centralised finance institutions or Cefi, where risk management remains centralised and in the hands of humans. Centralised institutions typically reserve the right to freeze their customers’ funds, as banks have done in the past. This is in contrast to decentralised finance protocols that automate redemptions and risk management like Compound, Aave and Maker. Decentralised finance protocols are, by definition, unable to override their users’ will in such a way. Smart contracts are hard-coded and transparent, and their operations are public.
May 2022: UST and sister coin LUNA implode in a $40 billion collapse, disrupting the cryptocurrency market and spurring $300 billion in losses across the cryptocurrency economy.
June 12, 2022: Celsius freezes withdrawals, swaps and transfers in response to “extreme market conditions,” fuelling rumours that the platform has become insolvent.
Leading up to July 13, 2022: Celsius repays over $648 million in Defi loans.
July 13, 2022: Celsius Network files for Chapter 11 bankruptcy protection in the U.S. Bankruptcy Court for the Southern District of New York.
Despite teetering on the edge of bankruptcy both Celsius and Three Arrows Capital repaid their Defi loans, in full. Both were clearly aware that you can seek protection from the courts, but not in the smart contract world of Defi. There is no ability to restructure or renegotiate smart contracts. Now lawyers and courts (not smart contracts) will decide whether investors get repaid.
Crypto commentator David Hoffman calls this “The New Supreme Court” :
“The legal courts overseeing the Celsius and 3AC cases are subordinate to the court of the EVM; the code that enforces the smart contracts that power the DeFi lending applications. The EVM is the most superior court in the world. The legal contract system of nation-state courts is junior to Ethereum and the EVM.
When markets break down, they revert back to a system of lawyers and courts, and we are currently witnessing that in the cases of 3AC and Celcius. Long-drawn-out court proceedings are beginning; meanwhile, DeFi is still chugging away and onto the next thing. And no DeFi lenders lost a dime.”
In contrast, the world's largest investment banks lost over $10b in the collapse of Archegos Capital despite predominantly lending against liquid-listed equities.
Compound, Aave, and Maker continue to be fully functioning decentralized protocols. Once the dust settles hopefully the performance and fairness of Defi will not go unnoticed in the eyes of regulators.
Whilst we don’t entirely agree with David Hoffman, what cannot be argued is the greater transparency and efficiency of smart contracts and the benefit of the continuity of crypto markets that trade 24/7. Smart contracts can provide security of ownership that is superior to traditional contract law and reduce other transaction costs associated with contracting or enforcement.
What will be interesting is the usage of smart contracts in more complicated scenarios like insurance or governance of DAOs, but that’s a discussion for another day.
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