If you have a $1,000 balance at Celsius – the crypto bank that froze withdrawals last week, triggering the latest phase of the crisis in the sector – how much money do you have?
The answer seem clear: you have $1,000. You can withdraw that money and spend it as you see fit. Of course, it may be invested in some esoteric cryptocurrency with a fluctuating value, and you may have to pay a fee to turn your $1,000 of play money into cold, hard cash, but you can treat your balance as something like money in your pocket.
What about now, with Celsius having blocked users from withdrawing or transferring funds for seven days and counting? How much money do you have? One answer is nothing: you can’t access the money, so you don’t have it. You may, in the future, have $1,000 again, but right now you have lost it all. Another possible answer is that the money is just resting in your account and, though you can’t reach it, you definitely have it.
What’s at stake?
Neither of those answers are satisfying, because valuing illiquid holdings is genuinely hard. It’s easy to treat money you can’t access right now as the same as money you can while the times are good, but when things get tricky, the difference becomes stark, and you have entered a liquidity crisis.
This problem isn’t affecting only depositors, it is also the main problem for Celsius itself. The crypto bank has a lot of money locked up in a convoluted crypto derivative called stETH, and can’t get it out.
It seemed like a great idea. Ethereum (ETH), is one of the most popular cryptocurrencies, but investment opportunities for the currency are slim. At the same time, there is a parallel project, ETH2, which is run as a test network for a new type of blockchain called “proof of stake”. In proof of stake, people “stake” their cryptocurrency – locking it up for a period of time – in order to generate raffle tickets from verifying transactions. The result is similar to earning interest at a bank, if doing so also gave you a vote on how the bank is operated.
The big freeze
So Celsius used an intermediary, called Lido, to take ETH invested by customers, and stake it on the ETH2 network, earning interest in turn. But there’s a problem: you can’t turn ETH2 back into ETH until the two networks merge at some point in the future. (Like self-driving cars, augmented reality and Linux on the desktop, the date of this merge is months away, and has been months away for about three years.) So Lido gives users a new token, called stETH or staked ETH, to represent their ETH2 claims.
Owning stETH should be great: it reflects not only the ETH you have locked up, but also the gains that ETH will have made by the time the merge happens. And, unlike deposits in a bank, if you need to get some ETH back, you can just sell the stETH to someone else. Until you can’t find buyers for your stETH, at which point bad things happen.
That seems to be the situation Celsius found itself in in early June. The not-bank had already taken a hit on the collapse of the Terra/Luna stablecoin, and as the crypto market fell, depositors began withdrawing their ETH. Each withdrawal required Celsius to sell a little more stETH to a rapidly declining pool of people who were willing to buy it, until, in early June, it ran out of buyers on the main exchange: you could not sell stETH at any price. The stETH still has value; the money is still there; but Celsius cannot access it.
A few days later, it froze withdrawals. On Monday, the company said: “Our objective continues to be stabilizing our liquidity and operations.”
If you have the luxury to freeze withdrawals, a liquidity crisis can go away: eventually, the stETH turns into ETH, and Celsius can let its depositors withdraw their money. Of course, if they all withdraw their money at once, because you froze withdrawals and they lost faith in the bank, you might very quickly find yourself back at square one.
Pseudo banks and ‘psychic wealth’
But how much money do you have if you have a $1,000 bank balance, along with 99 other people, and the bank only has $50,000? Then you don’t have a liquidity crisis: you have an insolvency one.
In a typical bank, the bank’s insolvency is discovered fairly quickly, retail depositors are protected through deposit insurance, and everyone else takes a haircut. The government steps in to top up your deposit, you take home $1,000, and the bank stops trading.
In the crypto world, if your money is in the insolvent bank, you share a portion of the losses: you may have a $1,000 balance, but you’re only going to get $500 if the crypto bank declares bankruptcy. And you may not even get that: as a depositor, you’re an unsecured creditor, who only gets paid back after people with more “senior” debts have been reimbursed.
One last question: if you do find that your $1,000 is actually only worth $500, when did you lose that money? Is it the day your bank hands you cash and says: “There’s no more where that came from”? Is it the day you discovered that they were in trouble? Or is it the day that they lost half their reserves in the first place?
The idea of a gap between experiencing a loss and realising it isn’t new. The Canadian-American economist John Kenneth Galbraith wrote about a parallel but in that case nefarious concept, “the Bezzle”, in the 1950s. That’s the money that companies and individuals think they have safely in their accounts, but which has actually been embezzled by crooks. In that period of time, he wrote, “There is a net increase in psychic wealth.” But the increase is only ever temporary:
This inventory – it should perhaps be called the bezzle – amounts at any moment to many millions of dollars. It also varies in size with the business cycle … In good times, people are relaxed, trusting, and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances, the rate of embezzlement grows, the rate of discovery falls off, and the bezzle increases rapidly. In depression, all this is reversed. Money is watched with a narrow, suspicious eye. The man who handles it is assumed to be dishonest until he proves himself otherwise. Audits are penetrating and meticulous. Commercial morality is enormously improved. The bezzle shrinks.
Or, as a friend put it: nobody gets naked in the denouement of the Emperor’s New Clothes; they’ve been naked all along.
In the cryptocurrency sector, though, there’s no easy villain: Satoshi Nakamoto isn’t sitting in bitcoin headquarters creaming off money into his personal bank account. But the psychic gap in wealth exists nonetheless: people who thought they were millionaires with their money safely in bank accounts have discovered they weren’t millionaires, didn’t have money and weren’t even storing it in real bank accounts.
There’s a hole in the middle of the sector, and we’re still finding out how deep it goes.
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