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TechScape: What the Great Crypto Freeze Means for Your Money

If you have a $1,000 balance at Celsius — the crypto bank that froze withdrawals last week, triggering the latest phase of the industry crisis — how much money do you have?

The answer seems clear: you have $1,000. You can withdraw this money and spend it as you see fit. Sure, it can be invested in some esoteric cryptocurrency with fluctuating value, and you might have to pay a fee to turn your $1,000 of play money into cash, but you can treat your balance as something like money in your pocket. .

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What about now, with Celsius preventing users from withdrawing or transferring funds for seven days plus? How much money do you have? One answer is nothing: you can’t access the money, so you don’t have it. You might, in the future, have $1,000 again, but for now, you’ve lost everything. Another possible answer is that the money is just sitting in your account, and while you can’t reach it, you definitely have it.

What’s at stake?

None of these answers are satisfactory, because it is really difficult to value illiquid assets. It’s easy to treat money you don’t have access to right now as money you can access while times are good, but when the going gets tough the difference becomes stark and you’ve entered into a liquidity crisis.

This problem does not only affect depositors, it is also the main problem of 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 side project, ETH2, which functions as a testnet for a new type of blockchain called “proof of stake”. As proof of stake, people “bet” their cryptocurrency – locking it up for a period of time – in order to generate raffle tickets from transaction verification. The result is similar to earning interest in a bank, if it also gives you a vote on how the bank works.

The big frost

So Celsius used an intermediary, called Lido, to take the ETH invested by customers and stake it on the ETH2 network, earning interest in turn. But there’s a catch: you can’t turn ETH2 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 for this merger is months away, and has been months away for about three years.) So Lido is giving users a new token, called stETH or staked ETH , to represent their ETH2 claims.

Own stETH should be awesome: it reflects not only the ETH you have locked, but also the gains that the ETH will have made at the time of the merger. And, unlike deposits at a bank, if you need to get ETH back, you can simply sell the stETH to someone else. Until you find no buyers for your stETH, at which point bad things happen.

A physical representation of the Bitcoin cryptocurrency.
A physical representation of the Bitcoin cryptocurrency. Photograph: Jose Cabezas/Reuters

This appears to be the situation Celsius found itself in at the start of June. The non-bank had already taken a hit during the collapse of stablecoin Terra/Luna, and as the crypto market fell, depositors began withdrawing their ETH. Each withdrawal forced Celsius to sell a little more stETH to a rapidly declining group of people who were willing to buy it, until in early June the main exchange ran out of buyers: you couldn’t sell stETH at any price. stETH still has value; the money is still there; but Celsius can’t access it.

A few days later, he froze withdrawals. On Monday, the company said, “Our goal continues to stabilize our liquidity and operations.”

If you have the luxury of freezing withdrawals, a liquidity crunch can go away: Eventually, 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’ve frozen withdrawals and they’ve lost faith in the bank, you could very quickly find yourself back at square one.

Pseudo-banks and “psychic wealth”

But how much money do you have if you have a bank balance of $1,000, along with 99 other people, and the bank only has $50,000? So you don’t have a liquidity crisis: you have an insolvency crisis.

In a typical bank, bank insolvency is discovered fairly quickly, retail depositors are protected by deposit insurance, and everyone else gets 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 some of the losses: you may have a balance of $1,000, but you’ll only get $500 if the crypto bank goes bankrupt. And you might not even have that: as a depositor, you are an unsecured creditor, who is only repaid after people with more “senior” debts have been repaid.

One last question: if you find that your $1,000 is really only worth $500, when did you lose that money? Is it the day your bank hands you money saying, “There’s no more where it came from”? Is it the day you found out they were in trouble? Or is it the day they lost half of their reserves in the first place?

The idea of ​​a gap between experiencing a loss and realizing it is not new. Canadian-American economist John Kenneth Galbraith wrote about a parallel but in this case nefarious concept, “the Bezzle”, in the 1950s. It is the money that businesses and individuals think they have safe in their accounts. , but which has actually been hijacked by scammers. During this period he wrote: “There is a marked increase in psychic wealth. But the increase is only ever temporary:

This inventory – perhaps it should be called the bezzle – amounts to several million dollars at any given time. It also varies in size with the economic cycle… In good times, people are relaxed, confident and money is plentiful. But even though money is plentiful, there are always many people who need more. Under these circumstances, the embezzlement rate increases, the discovery rate decreases, and the bezzle increases rapidly. In depression, all of this is reversed. Money is watched with a narrow and suspicious eye. The man handling it is supposed to be dishonest until he proves otherwise. The audits are thorough and meticulous. Business morality has improved tremendously. The bezzle shrinks.

Or, as a friend put it: no one goes naked in the outcome of The Emperor’s New Clothes; they have always been naked.

In the cryptocurrency industry, however, there are no easy villains: Satoshi Nakamoto isn’t sitting in Bitcoin headquarters pouring money into his personal bank account. But the psychic wealth gap exists nonetheless: People who thought they were millionaires with their money safe in bank accounts found out they weren’t millionaires, had no money, and didn’t even store it in real bank accounts.

There is a hole in the middle of the sector, and we are still trying to find out how far it goes.

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