Crypto Contagion

Research Jun 16, 2022

Key take-aways

  • After a tumultuous May, June is shaping up to be just as unfriendly and not just for crypto.
  • All risk assets are suffering because as the hotter than expected US CPI print and 75bp Fed rate hike – the largest hike since 28 years – confirmed, the macro backdrop remains challenging.
  • Crypto price weakness is being exacerbated because of the emergence of liquidity problems for some firms such as Celsius Network, a crypto lender, which this week suspended client withdrawals.
  • As anyone familiar with bank runs knows liquidity crises are swift and dramatic affairs. Unlike fiat, there is no central bank to step in and intervene - the process just has to play out.
  • While the deleveraging process is painful, ultimately the lack of a centralized backstop is a good thing. Moral hazard is avoided and responsible crypto firms will survive  – it’s the financial equivalent of natural selection.

After an event like the Terra depeg, the natural instinct of any crypto investor is to ask who’s next? One early depeg candidate was Tether, the largest stablecoin by market cap, given continued scepticism about the reserves backing the stablecoin[1].  Although USDT’s market cap has shrunk by more than $10bn since the Terra crash, its peg with the USD has largely remained intact, albeit with a brief wobble at the time – see chart below.

Tether: USD Exchange Rate

Source: coinmarketcap.com

More recently, focus has shifted to another crypto currency stETH, which is the token issued under the Lido staking protocol and is pegged 1:1 with ETH staked on the Beacon Chain[2] – Ethereum’s Proof-of-Stake (PoS) blockchain that will replace the current Proof-of-Work (PoW) blockchain when the Merge[3] eventually happens.

For the past month, the exchange rate between stETH and ETH has been consistently below parity, with an average divergence of roughly 2%. However, in the last few trading sessions, the gap has widened to more than 5%, one of the largest divergences seen in the 18 months since stETH was launched – see chart.

StETH: ETH Exchange Rate

Source: coinmarketcap.com

stETH has a very different structure to both Terra (an algorithmic stablecoin) and Tether (a fiat-backed stablecoin). It is created by depositing ETH into a smart contract within the Lido liquid staking protocol, which is then staked on the Beacon Chain.

Lido has proved to be a very popular with crypto users because it provides a way to circumvent the 32 ETH limit required by Ethereum to become a validator in their PoS protocol. In addition, stETH also allows its owners the potential to earn yield while also earning staking rewards via the protocol. The final big advantage is liquidity. In order to minimize disruption in the run-up to the Merge, ETH staked on the Beacon Chain cannot be redeemed - it is locked[4]. Lido’s smart contracts essentially converts illiquid - at least until after the Merge - ETH staked on the Beacon Chain into a new liquid tokenized version.

As testimony to the success of Lido, in early April, the total value locked of Ethereum (TVL) in the protocol hit an all-time high of $20bn, accounting for nearly a third of all Ethereum staked on the Beacon Chain - a ratio that raised concerns about the centralizing effect such staking pools could have once the Merge takes place[5]. However, in light of the Terra debacle, and the general bearishness of investor sentiment towards crypto, there has been a sharp pull-back in Lido’s TVL to around $4.5bn or (3.8m ETH) – see chart.

Lido TVL (ETH)

Source: defillama.com

Behind The Curve

Obviously liquidity doesn’t just appear by magic. It is provided via Curve, an exchange liquidity pool focused on stablecoins. Unlike regular exchanges, liquidity pools represent a set of shared tokens which users deposit in order to earn rewards and a share of transaction fees on the platform, specifically CRV rewards and LDO[6] rewards. These rewards provide compensation for providing liquidity to ETH tokens staked and locked on the Beacon Chain and the additional risk premium due to the possibility of bugs in Lido’s smart contracts.

Ideally, the Curve pool for ETH/stETH would be balanced meaning equal quantities of both tokens in the liquidity pool as this would indicate users, on aggregate, are pretty indifferent between holding stETH and ETH. However, as can be seen in the graphic below, at the time of writing the Curve pool has become quite unbalanced, with ETH accounting for less than 19% of the overall reserve pool (ie. there is around $130 million of ETH liquidity supporting a $641mn combined liquidity pool[7]).

stETH/ETH Curve Pool Reserves

Source: curve.fi

As per the chart below, which plots the evolution of the pool size of ETH/ stETH on Curve over time, this is somewhat unusual. Since early May, stETH has had a much greater share of the pool relative to ETH, something that has been weighing on the conversion rate between the two tokens. Indeed, on Monday it fell to nearly ETH 0.93 – an almost unprecedented 6.5% discount.

Curve ETH/stETH Reserves

Source: dune.com

In response to recent events, and clearly intending to signal that it should not be tarred with the same brush as Terra/Luna, Lido issued a tweet stating…

“Staked ETH issued by Lido is backed 1:1 with ETH staking deposits. The exchange rate between stETH:ETH does not reflect the underlying backing of your staked ETH, but rather a fluctuating secondary market price.[8]

Merge Worries It’s Not

The timing of the drop in stETH’s price versus ETH is certainly odd in one sense. As mentioned, one of the key reasons why stETH is less attractive to hold over regular ETH (ie not staked on the Beacon Chain but on Mainnet) is that it is locked until several months after the Merge is successfully implemented. Therefore, any expectations that the Merge will be delayed, or more extremely would not occur/fail, would provide a major incentive to dump stETH in preference for ETH – something that would lead to the sort of unbalancing behaviour currently visible on the Curve pool.

However, only last week Ethereum successfully managed to transition their Ropsten testnet to PoS. This is the second such testnet merge to have taken place without a hiccup this year – the first being the Kiln testnet back in March - and it was widely considered by the Ethereum community as a final dress rehearsal before the actual Merge, which is pencilled in for sometime between August and October this year – see below.

Source: twitter

Clearly, the successful Ropsten testnet merge means it is unlikely that rising fears that the Merge will not take place later this year (or that it will fail) is the source of stETH’s price weakness as investors demand a higher risk premium. Something else is responsible for be driving the price of stETH lower versus ETH.

A Lehman Doppelgänger

Fourteen years ago, the US investment bank Lehman Brothers[9] went bust. It went bust for the  reason all banks go bust[10] – lack of liquidity: in common parlance, a bank run. Customers, once spooked into believing they may not get their money back, rush to the bank and seek to withdraw their deposits. However, commercial banks do not keep their clients’ money in liquid form, they lend out a large portion of those deposits to borrowers (illiquid) in return for a higher yield  - the difference being their revenue source. Only those customers who act quickly are able to withdraw their money. This skew in incentives is what makes liquidity crises so dramatic affairs as the collapse of Lehman Brothers and more recently Terra – the crypto equivalent - aptly demonstrates.

The often-deployed defence mechanism to stem liquidity crises in the world of fiat is either to seek emergency financing, from the central bank as a last resort, or to impose withdrawal limits on customers. Indeed, one crypto company has just done the latter.

Zero Celsius = Frozen

On Monday Celsius Network, a crypto lending platform, announced that it had halted client withdrawals because of “extreme market conditions”, a statement[11] made all the more surprising because in a blog post published the week prior, it stated it had “the reserves (and more than enough ETH) to meet obligations” and  “continues to process withdrawals without delay”[12].

If a week is a long time in politics, it is an eternity in crypto.

From the limited information available, it is clear that Celsius has a liquidity mismatch between its asset holdings and its liabilities – hence the decision to pause account withdrawals, an action no financial institution takes lightly given the damage to its credibility (often fatal).

According to reports on social media, a significant percentage of the ETH owned by Celsius is directly staked on the Beacon Chain, which is locked up and inaccessible until several months after a successful Ethereum Merge. In order to meet client redemptions Celsius either has to sell its substantial holdings of stETH[13] issued via Lido or use those assets as collateral to fund loans to meet client withdrawals.

However, with only 120,00 ETH available on Curve there is very limited scope for selling without putting even more downward pressure on the stETH/ETH conversion rate. Conversely, using it as collateral is problematic given that falling cryptocurrency prices increases the risk of being liquidated, which not only occurs when prices are low but also attracts a liquidation fee. Neither option is attractive from the perspective of company profitability.

As mentioned, given the success of the Ropsten testnet merge last week, all the indications are that the Merge will take place later this year (August-October being the most likely). Following this landmark crypto event, ETH staked on the Beacon Chain will be able to be redeemed. This should serve to bring the stETH/ETH back towards parity as liquidity risks are lowered. In that sense, it is a very different dynamic that what happened with Terra (that was a solvency issue that became a liquidity issue). However, this is still several months away, and liquidity crises operate at much shorter time frames.

Contagion Risks

What makes liquidity crises especially problematic is that because finance has highly interconnected dependencies, problems in one company can easily and quickly spread. This is what is playing out in crypto at the moment. According to media reports, Three Arrows Capital – a crypto venture capital firm - is now also facing liquidity issues after being on the wrong-end of the stETH trade (not to mention many others) and has been actively selling according to blockchain metrics. A cryptic tweet by co-founder Zhu Su only served to fuel the rumour mill – see below.

In the fiat world, in order to limit contagion generated by balance sheet deleveraging and increased counter-party risk, the central bank steps in and floods the system with liquidity – this is indeed what happened after Lehman Brothers failed (and LTCM before). Obviously, in crypto there is no central bank as it runs contrary to the very ethos of the sector. As a result, things will just have to play out, and it will continue to weigh on crypto asset prices, already suffering as a consequence of the macro backdrop, which I described as follows in an article published last month [14].

“Global financial markets have a distinct whiff of 2007/8 about them. Unfortunately, the macro backdrop is even more challenging than prior to the Great Recession.”

Crypto Consequences

Obviously, the slump in crypto prices has the naysayers jumping for joy, extolling how smart they were to avoid another “tulip mania” and predicting the demise of the entire sector[15]. This is ludicrously pessimistic[16]. What is happening instead is the crypto market equivalent of natural selection[17]. Absent a central bank, the onus is on firms operating in the space to be responsible and those that aren’t (ie, excessive leverage, poor risk management, poor security etc) will not succeed. This process is without doubt painful, but ultimately the lack of a centralized backstop is a good thing as it means moral hazard is avoided because there are no bailouts in crypto unlike in the fiat system.

Of course, governments’ tolerance for failure in the sector has already been tested by the recent Terra debacle so, if anything, expect to see an even greater push for regulation to be applied to crypto-assets and companies operating in the sector. Indeed, the UK government recently launched a consultation document setting out their proposed approach to managing the failure of a systemic digital settlement asset (including stablecoin) firms[18].

For crypto die-hards and privacy advocates the increasing entanglement of government in the crypto world via regulation is unambiguously bad. However, as I argued in a recent article[19], this is not necessarily so. Indeed, it is likely to be a necessary element in the crypto rebound, which will come when the deleveraging process has played out and when central banks are eventually forced to capitulate in the face of emerging recessionary headwinds generated by the combination of negative wealth effects (global equities have lost roughly $10tr since the start of the year, which is far more damaging to the economy than the decline in crypto) and rising living costs from the surge commodity prices.

Until next time.

Ryan Shea, Crypto Economist


[1]  In October 2021, Tether was fined $41 million by the CFTC in October 2021 for misrepresenting the fact that its reserves were fully backed by US dollars, but were instead held in other financial assets – see: https://www.cftc.gov/PressRoom/PressReleases/8450-21

[2]  This is not to be confused with ETH that is not staked on the Beacon Chain to which stETH has no formal peg.

[3]   I covered Ethereum’s merge in considerable detail in my previous article – see: https://blog.trakx.io/peering-into-the-ether/

[4]   Staked ETH on the Beacon chain does not fully unlock straight after the Merge to limit an exodus of users. Unlocking starts around six months after the Merge and even then only partially.

[5]   See: https://www.bloomberg.com/news/articles/2022-06-11/biggest-ether-staking-service-has-a-centralization-problem

[6]  CRV is the native utility token on Curve, which can also be locked in order to participate in governance voting. LDO is the equivalent token for the Lido DAO.

[7]   The overall size of the stETH/ETH pool has dropped by almost 50% during the course of the past week, although in part that is also a reflection of the move in ETH/USD exchange rate.

[8]   See: https://twitter.com/LidoFinance/status/1535184472546889735

[9]  Full disclosure I worked at Lehman Brothers between 1994-97. I left because I was unhappy with the direction the firm was taking under CEO Dick Fuller.

[10]  Liquidity issues can bust even solvent banks and insolvent banks can remain in business as long as they have sufficient liquidity.

[11]  See: https://blog.celsius.network/a-memo-to-the-celsius-community-59532a06ecc6

[12]  See: https://blog.celsius.network/damn-the-torpedoes-full-speed-ahead-4123847832af

[13]  Celsius holds an estimated 409,260 stETH tokens on deposit on Aave V2 – see: https://apeboard.finance/dashboard/0x8aceab8167c80cb8b3de7fa6228b889bb1130ee8

[14]  See: https://blog.trakx.io/crypto-carnage/

[15]  For fiat lovers I recommend taking a closer look at Japan’s economy and specifically the impact of BoJ policy on the JPY and then recall how extreme public sector indebtedness is in the other major economies.

[16]  I outlined the rationale as to why the longer-term outlook for certain crypto tokens was bullish, notwithstanding the negative short-term dynamics back in February – see: https://blog.trakx.io/fed-fears/

[17]  In all liquidity crises companies issue statements denying financial linkages to counterparties tagged as having issues, in order to ring-fence themselves. Tether, Nexo and BlockFi have already issued such statements and expect many more to follow suit in the days ahead – see: https://tether.to/en/tether-condemns-false-rumours-about-its-commercial-paper-holdings/, https://twitter.com/Nexo/status/1536957253634375680 and https://twitter.com/BlockFiZac/status/1536174316550770688.

[18]  See: https://www.gov.uk/government/consultations/managing-the-failure-of-systemic-digital-settlement-asset-including-stablecoin-firms[19]         See: Roadmap to Utopia















































Carole Laizet

Senior marketing manager with 15+ years of experience in the Financial Industry (traditional Banking as well as Crypto Assets). Responsible for market research @trakx.io