Explainer | Turmoil in global market for blockchain-based DeFi products leaves investors holding the bag

Decentralised finance platforms, which run on blockchain technology, remain unregulated in Hong Kong
The case of beleaguered cryptocurrency lender Celsius Network highlights the risks involved in high-yield DeFi products

Banking & finance

Georgina Lee

Published: 12:30am, 22 Jun 2022

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Hong Kong investors caught in the decentralised finance (DeFi) industry’s US$247 billion global rout can expect little to no chance of getting any remedy, as a growing number of cryptocurrency lending platforms, hedge funds and stablecoin issuers are now mired in financial distress.

Cryptocurrency lender Celsius Network has become the latest major DeFi player hit by the crash in prices of digital tokens like bitcoin. The New Jersey-based company has suspended all withdrawals and transfers by clients since June 13 because of “extreme market conditions”.

The current troubles of Celsius reflect how the DeFi industry operates. It “shuns centralised authorities, is largely unregulated and operates across borders”, according to a Fitch Ratings primer on this sector.

Being inclusive and unregulated means that DeFi products can be accessed by any person with an internet connection and a compatible electronic wallet.

Celsius founder, chairman and chief executive Alex Mashinsky has said the platform, which has more than two million users, returns as much as 80 per cent of its earnings from lending cryptocurrency funds pooled from retail lenders to institutional borrowers, such as hedge funds.

Users can earn as much as 18 per cent annual percentage yield. Celsius claims to have processed US$8.2 billion in loans and US$11.8 billion in assets.

On Monday, Celsius said it “will take time”, before the platform’s liquidity stabilises, dashing hopes for aggrieved investors.

Investors have flocked to the DeFi sector because of its high yields, which have outstripped previous hefty gains in some cryptocurrencies. Photo: Shutterstock

What is DeFi?

DeFi represents a global ecosystem of web applications and e-wallets that enable so-called smart contracts between parties on public blockchain networks, without the need for a centralised trusted intermediary, such as a bank, or a traditional exchange. That is analogous to an over-the-counter swap transaction without a broker or dealer.

This sector’s decentralised apps or platforms, known as dapps, do not generally require “know-your-customer” identification reviews or anti-money-laundering checks, which can aid financial inclusion in countries with many unbanked consumers. These platforms allow users to lend or borrow funds from others and trade cryptocurrencies.

Digital assets, such as stablecoins and floating value cryptocurrencies, are used within dapps rather than fiat currencies. The digital records from DeFi transactions are transparent, with settlement recorded on public blockchains that are visible to all parties.

Money leaving DeFi might not be about cryptocurrency downturn

DeFi gained plenty of traction over the past two years, as investors gained double-digit returns per annum, surpassing even the previous hefty gains of some digital tokens. The number of new DeFi users, however, could decline amid recent developments.

The US Federal Reserve’s move to raise interests by three-quarters of a percentage point – the biggest increase since 1994 – prompted other central banks to follow in efforts to tamp down on inflationary pressure, while providing a signal to consumers to be more risk-averse in this environment.

External view of the Hong Kong Monetary Authority at the International Financial Centre in Central. Photo: Sam Tsang

Can DeFi investors get regulatory protection?

That is unlikely. The challenge for regulators globally is that DeFi runs on blockchain networks, which makes it difficult to pinpoint the particular entity in charge of running such an ecosystem, according to analysts.

DeFi platforms also use currently unregulated stablecoins, which are pegged to gold or the US dollar.

While the Hong Kong Monetary Authority has launched a consultation on regulating stablecoins, efforts by the city’s de facto central bank to bring this digital asset under its jurisdiction do not address some of the practical challenges of monitoring the DeFi space, according to Kristi Swartz, a partner in law firm DLA Piper’s intellectual property and technology practice.

The difficulty of holding a centralised, identifiable organisation or operator accountable still remains, Swartz said. That is especially true for a stablecoin issued by a decentralised autonomous organisation, or a member-led entity governed through blockchain smart contracts.

Stablecoins, such as tether, are backed by fiat currencies like the US dollar. Photo: Shutterstock

Why did Celsius Network pause withdrawals and transfers?

Celsius, which advertises high yields for investors, was forced to freeze its client accounts from June 13 because of the difficulties caused by its decision to lend customers’ funds to Lido, a platform for staking the cryptocurrency ethereum.

Ethereum staking is the process of locking up an amount of the eth token in the ethereum blockchain for a specified period of time to contribute to the security of the blockchain and earn interest on their staked coins, according to news site CoinDesk.

Celsius had invested nearly US$500 million worth of clients’ funds on Lido to get high returns for its staked ethereum. It was unable to convert the digital depositary receipts, representing the locked-up assets issued by Lido, back into ether because of the cryptocurrency market sell-off, according to media reports.

Rumours of Celsius’ insolvency, according to a report by CoinDesk, spread quickly across social media, sparking panic and sell-offs in the markets. The value of ether, the second-largest cryptocurrency after bitcoin, has plunged 71 per cent over the past six months.

Cryptocurrency lender Celsius Network has been hit by rumours of insolvency after the company froze customer accounts on June 13, 2022. Photo: Shutterstock

Can Hong Kong investors still access Celsius?

Some firms, such as cryptocurrency-wallet services provider CoinUnited, still offer an “earn” service on Celsius’ native token, cel. That features a 28 per cent annual percentage yield.

A user, however, needs to lock up part of their cryptocurrency holdings for 15 months in a gaming non-fungible token, called genopets.

Other platforms, such as New York-based cryptocurrency exchange Gemini, also offers an “earn” lending programme available to Hong Kong residents.

It does not carry Celsius’ token, but DeFi projects such as Aave and Curve are available. Curve, for example, offers an annual percentage yield of 8.05 per cent.

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