Celsius: Ponzi scheme in disguise

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Celsius Network LLC is (was?) a crypto brokerage that took crypto deposits from customers, paid 18% interest on those deposits and then invested the money in crypto loans and complex algorithmic trading strategies.

Okay let me stop there. Read that sentence again. What does it say? If you said “it says Celsius Network was a Ponzi scheme,” then, congratulations, you have been paying attention to crypto. Oh, I kid, I kid. Not every crypto banking platform is a Ponzi, and I don’t know if Celsius was. But the very least surprising piece of news in the whole world would be “this 18%-crypto-interest product was a Ponzi.”

“Ooooooooh we will take your cryptocurrency and give you 18% interest on it by investing it in secret things”! I’m sorry! What do you think that means? “Either the bank is lying or Celsius is lying,” Celsius Chief Executive Officer Alex Mashinsky once told Bloomberg Businessweek, and I am pretty sure that as a matter of formal logic that statement reduces to “lol I’m running a Ponzi.”

Anyway Celsius blew a hole in its balance sheet by making unsecured loans to crypto hedge funds, froze withdrawals a month ago and hasn’t reopened since. Also a guy who managed money for it sued Celsius on Thursday, claiming that (1) Celsius was a Ponzi and (2) he deserves a bigger cut of the loot:

Celsius Network, the crypto lender that froze assets last month, used customer funds to manipulate the price of its proprietary token and lost hundreds of millions of dollars by failing to hedge risk, a former money manager for the company said in a lawsuit. …

But Celsius was in fact struggling to cover the payouts and suffered “severe exchange rate losses” due to the fluctuating values of different coins, according to a complaint filed Thursday in New York state court by KeyFi Inc., the company founded by the former money manager, Jason Stone.

Stone, who called Celsius a Ponzi scheme in the complaint, said it cheated him out of potentially hundreds of millions of dollars in pay. 

The complaint is a wild ride. At the center of it is a kind of exchange-rate risk. Celsius took deposits of crypto assets from its customers, promising them something like 18% interest. It then invested them in various risky strategies to earn that 18% interest, including giving hundreds of millions of dollars of assets to Stone and KeyFi to invest. But its liabilities (to depositors) were denominated in crypto, and its investments were denominated in dollars, and crypto — during most of the relevant period, though not now! — mostly went up:

Celsius’ customers provide it with crypto-assets, and expect to receive those assets back in the same form. Celsius provided similar assets to Stone and KeyFi to invest, but provided for profits to be evaluated in USD. This created a risk for Celsius that KeyFi might earn it a USD profit, but that, if the crypto-asset appreciated in value, it might not be able to profitably repurchase the base crypto-asset.

For example, if Celsius provided KeyFi with 100 ether worth $100,000 in total (or $1,000 per token), and KeyFi’s investments returned a mixture of coins comprised of 50 ether and a mix of other coins worth $150,000 in total, it cannot be disputed that that would constitute a profitable investment in USD. If, however, over the same period, ether’s price rose to $1,250 per token, and Celsius needed to convert its USD investment into ether, it would have to use some of these USD profits to do so. If ether’s price rose even further, it might overtake the profits and require Celsius to use its own funds to purchase the ether. This potential risk, which is a product of Celsius’ relationships with its customers and need to return funds to them in the same kind as were deposited, is unaddressed in the parties’ agreement and thus remained with Celsius.

Great stuff. If Celsius gave KeyFi 100 Ether worth $100,000, and KeyFi did its magic and handed back 80 Ether worth $120,000, then KeyFi could say “look we made you a 20% profit.” And then Celsius’s depositors would say “we want our 100 Ether back” and Celsius would … uh … say “either the bank is lying or we are lying!” and grin and run away? I don’t know. Crypto is so funny man:

Celsius represented to Stone that it was tracking his DeFi activity, balancing his risk through various hedging strategies ….

Celsius’ owners and managers have even boasted publicly about being savvy about managing exchange rate risks. In DeFi investment “impermanent loss” refers to losses caused by exchange rate volatility. On May 20, 2021, Celsius CEO Alex Mashinsky wrote on Twitter that DeFi “looks easy until you get bitten or understand the impact of impermanent loss and volatility.” Mashinksy’s tweet then touted the sophistication of Celsius with the tagline “Unbank Yourself and let us manage these rough waters for you.” …

Critically, Celsius has failed to provide KeyFi or Stone with an accounting reflecting any of the hedging transactions it was supposed to make on Stone and Celsius KeyFi’s behalf. This is because, on information and belief, Celsius lied to Stone and never engaged in these transactions.

I love that, in crypto, when the price of your tokens move against you, that is called “impermanent loss.” If you sell 100 Ether at $1,000 to buy 10,000 RandomCoins at $10, and then a month later RandomCoin is worth $5 and Ether is worth $2,000 and you sell your RandomCoins for 25 Ether, you shrug and say “impermanent loss!” And you hope that someone — not you for some reason! — was hedging that risk by buying Ether futures and selling RandomCoin futures. The future of finance is so good.

The specific dispute between KeyFi and Celsius is over whether KeyFi made any profits for Celsius: KeyFi thinks it did (in dollars) and wants a cut, but Celsius apparently thinks it did not (in crypto). But the broader implications of that dispute are … well … I mean, the customers want their crypto back, and if Celsius has losses (in crypto) that’s not great. The p-word gets thrown around:

As mentioned above, Celsius paid a portion of interest on deposits in CEL tokens and a portion of interest in other crypto-assets such as bitcoin and ether. With respect to consumers who chose to be paid in the crypto-asset they deposited (rather than CEL tokens), Celsius logged those liabilities on its books in a U.S. dollar denominated basis from 2018 through 2020 despite the fact that it paid its customers out in the underlying token. It then failed to mark-to-market those assets in its internal ledger as those crypto-assets appreciated, creating a substantial hole in its accounting.

Throughout 2020 and 2021, crypto-assets such as bitcoin and ether substantially appreciated compared to the dollar. Yet Celsius failed to update its ledger in order reflect the increased dollar value of its liabilities at least at any time before 2021. The accounting error masked hundreds of millions of dollars in liabilities that Celsius was not prepared to pay out. When Jason Stone left Celsius, Celsius had a $100-$200 million hole on its balance sheet that it could not fully explain or resolve. Despite this balance sheet insolvency, Celsius continues to take on more customer assets, which means it continues to accrue considerable liabilities to the detriment of its current creditors.

In January 2021, the crypto-markets began a bull cycle which caused Celsius (who had recklessly and fraudulently failed to hedge its investments) to suffer severe exchange rate losses.

In January 2021, the price of ether increased over 50% in just a couple of days and continued to climb over the next few weeks, going from a low of 0.24 BTC per ether on January 1 to a high of 0.45 BTC per ether token on February 4.

Celsius had massive liabilities to depositors denominated in ether but had not maintained ETH holdings equal to those liabilities. Instead, Celsius had authorized DeFi strategies that resulted in the shifting of assets from ether to other cryptocurrencies and (inexplicably) had failed to hedge against this well-known risk. 

As customers sought to withdraw their ether deposits, Celsius was forced to buy ether in the open market at historically high prices, suffering heavy losses. Faced with a liquidity crisis, Celsius began to offer double-digit interest rates in order to lure new depositors, whose funds were used to repay earlier depositors and creditors. Thus, while Celsius continued to market itself as a transparent and well capitalized business, in reality, it had become a Ponzi scheme.

These are just allegations in a complaint, and I don’t know if they’re true. One thing that is going on here is, like, uncovered interest rate parity? Schematically, if you have one currency (Ether), and you don’t like the interest rate you can earn on that currency, and you notice that some other currency (some random cryptocurrency you find in your DeFi strategy) pays an 18% interest rate, and you think “aha, I will just exchange my Ether for that random cryptocurrency, earn 18% interest, and then swap that random currency back for Ether,” then you have made a pretty basic foreign-exchange mistake. If one currency (the random coin) pays a higher interest rate than another (Ether), then that implies that Ether is expected to appreciate against the random coin, because there are no free lunches in financial markets. For a long time, though, there were many many many free lunches in crypto markets, so you could do this sort of thing and think you were being smart.

By the way, if you believe this story — that Celsius was a Ponzi done in by the rising prices of cryptocurrencies — then you might think that it would have been rescued by the recent crash in crypto prices? Schematically, Celsius allegedly took deposits of 100 Ether worth $100,000, turned them into $120,000, and then owed the customers 118 Ether worth $236,000. If Ether crashed back down to $1,000 then everything should be fine! And yet it isn’t.