Respond ?2 questions in 300-400 words: ? Why is Anchor in trouble? What was Anchor’s business model? What are Tether (USDT) and TerraUSD (UST)? How do

1

UV8663 Feb. 14, 2023

Crypto Winter Buries Celsius Network and Batters DeFi

Celsius is going after all the money in the world.

—Alex Mashinsky, Celsius Network Ltd. Founder and CEO1

In June 2022, major cryptocurrency (crypto) lender Celsius Network Ltd. (Celsius) froze the accounts of its 1.7 million clients, sending shockwaves across the burgeoning and largely unregulated decentralized finance (DeFi) industry. Cryptos were in a free fall, and Celsius’s clients had made withdrawals at a rate that mirrored a bank run. The consequences were disastrous; on July 14, Celsius filed for Chapter 11 bankruptcy protection. Assets under management (AUM) were under $200 million, an unimaginable drop from October 2021 when the firm’s AUM were $25 billion.2 At the time of the bankruptcy filing, Celsius owed its clients nearly $5 billion.3

Decentralized Finance

DeFi was a new and disruptive vision of banking and financial products and services—such as payments, lending, borrowing, trading and investments, capital raising, and insurance—conducted without a trusted central authority (e.g., bank, brokers, and stock exchanges).4 Instead, DeFi relied primarily on Ethereum blockchain technology (ledgers connected by a network of computers) to record and share data. It used smart contracts—self-executing software—to record transactions and transfer funds. Smart contracts were used to create decentralized applications (dApps) that provided financial products and services. Smart contracts were “if-then” statements between two parties and were not without their risks. “Smart contracts introduce an additional risk that does not exist in most text-based contractual relationships—the possibility that the contract will be hacked or that the code or protocol simply contains an unintended programming error,” wrote lawyers. “Given the relative security of blockchains, these concepts are closely aligned; namely, most ‘hacks’ associated with blockchain technology are really exploitations of an unintended coding error.”5

Alex Moskov, “Crypto Interest Account Pioneer Alex Mashinsky and Takes on Big Finance,” Coin Central, May 25, 2020, https://coincentral.com/crypto-interest-account-pioneer-alex-mashinsky-and-takes-on-big-finance/ (accessed Sept. 14, 2022).

2 MacKenzie Sigalos, “ From $25 Billion to $167 Million: How a Major Crypto Lender Collapsed and Dragged Many Investors Down with It,” CNBC, July 18, 2022, https://www.cnbc.com/2022/07/17/how-the-fall-of-celsius-dragged-down-crypto-investors.html (accessed Sept. 13, 2022).

3 https://www.cnbc.com/2022/07/17/how-the-fall-of-celsius-dragged-down-crypto-investors.html. 4 Francesca Carapella et al., “Decentralized Finance (DeFi): Transformative Potential and Associated Risks,” Finance and Economics Discussion

Series 2022-057 (Washington, DC: Board of Governors of the Federal Reserve System, 2022). 5 Stuart D. Levi and Alex P. Lipton, “An Introduction to Smart Contracts and Their Potential and Inherent Limitations,” Harvard Law School Forum

on Corporate Governance, May 26, 2018, https://corpgov.law.harvard.edu/2018/05/26/an-introduction-to-smart-contracts-and-their-potential-and- inherent-limitations/ (accessed Nov. 1, 2022).

This public-sourced case was prepared by George (Yiorgos) Allayannis, Robert F. Bruner Distinguished Professor of Business Administration, and Aldo Sesia, Senior Case Researcher. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright  2023 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an email to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Our goal is to publish materials of the highest quality, so please submit any errata to [email protected].

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

Page 2 UV8663

Governance tokens were used to establish decentralized governance on a blockchain project. They gave holders a vote in how the project was run. Projects used various calculation methods to award their governance tokens to their stakeholders (e.g., founders, investors, and users). Generally, smart contracts tabulated the votes of token holders.

Advocates of DeFi believed it would solve problems with traditional centralized finance including inefficiency, limited access, and opacity, among others. Scholars wrote,

A centralized financial system has many inefficiencies. Perhaps the most egregious example is the credit card interchange rate that causes consumers and small businesses to lose up to 3% of a transaction’s value with every swipe due to the payment network oligopoly’s pricing power…Today, 1.7 billion people are unbanked making it very challenging for them to obtain loans and to operate in the world of internet commerce. Further, many consumers must resort to pay-day lending operations to cover liquidity shortfalls. Being banked, however, does not guarantee access…The current financial system is not transparent. Bank customers have very little information on the financial health of their bank and must place their faith in the limited government protection of FDIC [Federal Deposit Insurance Corporation] insurance on their deposits…Centralization has many layers. Most consumers and businesses deal with a single, localized bank. The bank controls rates and fees. Switching is possible, but it can be costly. Further, the US banking system is highly concentrated…Our financial system is siloed and designed to sustain high switching costs. Moving money from one institution to another can be unduly lengthy and complicated.6

Still, they cautioned, “Blockchains can remove traditional financial risks, such as counterparty risk, with their unique properties, but DeFi is built on code. This software foundation gives attackers a larger attack surface than the threat vectors of traditional financial institutions.”7

DeFi projects was the term used to describe offerings. Common DeFi projects included decentralized exchanges (DEXs), lending and borrowing, derivatives, payments, insurance, savings, wallets, and stablecoins. (See Exhibit 1 for total value locked for DeFi from November 2018 to June 2022 for multiple blockchains.)

Stablecoins

Crypto (or digital money) was the lifeblood of DeFi, particularly a type called stablecoins. Cryptos were bought and sold either on centralized exchanges (CEXs)—such as Binance, Coinbase, Gemini, and Kraken— or on DEXs—such as Curve, Thorchain, and UniSwap. DEXs were not subject to the same oversight as traditional exchanges, such as the New York Stock Exchange. CEXs typically required users to place assets in their custody before trading.8 Bitcoin (BTC), the world’s first crypto and not a stablecoin, was introduced in 2009 and available to buy, sell, and trade on online crypto exchanges in 2010. BTC was created to be a peer-to- peer cash system. Unlike traditional currency, BTC was not backed by a government or a central bank; while government backing did not eliminate volatility risk, especially in emerging markets, arguably it provided investors with some measure of safety compared to BTC, which had no intrinsic value and was backed by nothing.

6 Campbell R. Harvey, Ashwin Ramachandran, and Joseph Santoro, DeFi and the Future of Finance (Hoboken, NJ: John Wiley & Sons, Inc., 2021). 7 Harvey, Ramachandran, and Santoro, DeFi and the Future of Finance. 8 Benedict George, “Centralized Exchange (CEX) vs. Decentralized Exchange (DEX): What’s the Difference?,” CoinDesk, August 5, 2022,

https://www.coindesk.com/learn/centralized-exchange-cex-vs-decentralized-exchange-dex-whats-the-difference/ (accessed Nov. 1, 2022).

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

Page 3 UV8663

Consequently, the value of cryptos that were not stablecoins had been subject to wild swings rendering them unreliable means of payment.9 In 2018, the value of a BTC, for example, fell from around $20,000 to $3,000.10 Volatility led to more innovation with the introduction of the first stablecoins in 2014. Stablecoins were created to offer the features of cryptos (i.e., instant transfers and low fees) without the volatility. In theory, this meant investors avoided wild swings in the value of their portfolios. By early 2022, there were roughly 200 stablecoins worldwide, a mere fraction of the more than 10,000 total cryptos in existence.11 (See Exhibit 2 for the top 12 cryptos by market value in September 2022).

Stablecoins were considered the bedrock of DeFi trading and lending.12 More than 90% of trading volume in cryptos occurred in stablecoins.13 Stablecoins were widely used to move funds between different cryptos or into regular cash. Members of the Monetary and Economic Department of the Bank for International Settlements (BIS) wrote,

Initially, stablecoins evolved in order to address the failure of Bitcoin and other cryptocurrencies to provide an effective monetary and payment instrument. This reflected the preference of main market participants to base transactions and payments on sovereign fiat currencies [i.e., government issued and backed], in particular the US dollar. It also reflected weaknesses in Bitcoin and other cryptocurrencies inter alia as means of payment, store of value or unit of account. However, as no digital form of the dollar or other sovereign fiat currencies was available, market participants developed the stablecoin structure as a means to address this issue, as well as to provide an instrument to support hedging between crypto-assets and fiat currencies. The need was for a bridge between DLT (digital ledger technology) and fiat currencies, with stablecoins seeking to fill this need. This was particularly relevant in the context of high volatility in the price of Bitcoin, making it less useful as a payment instrument and more of an investment—speculative or otherwise—or hedge.14

Stablecoins were either asset-linked (centralized) or algorithm-based (decentralized). The business models and revenue streams of stablecoin companies varied depending on whether they were a centralized or decentralized stablecoin.

Asset-linked

Most stablecoins were asset-linked (centralized), meaning they were backed by a reserve pool of collateral— a fiat currency (e.g., US dollar), assets (e.g., bonds or commercial paper), or even other cryptos. In this model, which was the closer of the two to traditional structures in the financial services industry, stablecoins were collateralized off-chain, meaning the “backing” asset was held on the balance sheet or through third-party firms (e.g., banks).15 Created in 2014, Tether (USDT), was considered the first and largest stablecoin and was asset- linked backed by the US dollar, meaning an exchange rate of 1:1.16 In other words, for each USDT issued, Tether Holdings Limited Inc. (Tether), a blockchain company and issuer of USDT, should have $1 in reserves. Tether and many other of the biggest cryptos maintained a reserve of cash or cash-equivalent assets whose

9 Eswar Prasad, “Five Myths about Cryptocurrency,” Brookings, May 24, 2021, https://www.brookings.edu/opinions/five-myths-about- cryptocurrency/ (accessed Oct. 13, 2022).

10 Cale Guthrie Weissman, “What the Hell Happened to Crypto This Year?” Fast Company, December 21, 2018, https://www.fastcompany.com/90285052/beyond-the-bubble-what-happened-to-bitcoin-in-2018 (accessed Oct. 13, 2022).

11 Khristopher J. Brooks, “What Are Stablecoins, and How Do They Differ from Other Cryptocurrencies?,” CBS News, May 13, 2022, https://www.cbsnews.com/news/stablecoins-definition-cryptocurrency-cbs-news-explains/ (accessed Oct. 13, 2022).

12 Jack Denton, “How a Digital Token Designed to Be Stable Fueled a Crypto Crash,” Barron’s, May 16, 2022. 13 Denton, “How a Digital Token Designed to Be Stable Fueled a Crypto Crash.” 14 Douglas Arner, Raphael Auer, and Jon Frost, “Stablecoins: Risks, Potential and Regulation,” BIS working paper no. 905, November 2020,

https://www.bis.org/publ/work905.pdf (accessed Sept. 29, 2022). 15 “How Do Stablecoin Issuers Make Money?” PYMNTS, June 5, 2022, https://www.pymnts.com/cryptocurrency/2022/how-do-stablecoin-issuers-

make-money/ (accessed Oct. 2, 2022). 16 Tether issued several other fiat stablecoins (e.g., one pegged to gold).

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

Page 4 UV8663

value in theory matched the total value of the stablecoin in circulation. That is, when a buyer paid Tether $1 for a USDT, that money was supposed to be held in Tether’s bank accounts. (Tether revealed in 2019 that it held billions of its reserve not in cash but in US commercial paper, which were riskier and less liquid than cash, especially during financial turmoil as was shown during the global financial crisis.)17 Because of its wide use to transfer digital assets into fiat currency and vice versa and transact between different platforms, USDT was described as “the reserve currency of the crypto world.”18 It facilitated billions of dollars’ worth of trades every day. In times of high volatility in cryptos, investors often put their cash into USDT. On May 7, 2022, the market cap of USDT was $83.2 billion.19

Asset-linked stablecoin companies made money through short-term lending and investing. Companies used their reserve assets and lent them out to others earning interest, counting on the unlikelihood that a large number of stablecoin holders would redeem their collateral at once.20 Tether, for example, loaned $1 billion to Celsius in October 2021, at an annual interest rate of 5% to 6%.21 Asset-linked stablecoin companies also generated revenue by charging issuance and redemption fees, although fees were relatively small (Tether charged a 0.1% redemption fee and had a minimum withdrawal fee of $1,000 to discourage low-volume redemptions.)22

Algorithm-based

Algorithm-based (decentralized) stablecoins used algorithms to increase or decrease the stablecoin supply in reaction to demand.23 “The decentralized model uses smart contracts, the cryptos themselves or algorithms to keep that ‘peg’ in place, where a 1:1 relationship relies not on the traditional custodians, but on constant rebalancing of supply and demand.”24 TerraUSD (UST) was a leading algorithmic stablecoin (with nearly a $19 billion market cap at its peak on May 5, 2022) on the Terra blockchain.25 In theory, its peg was maintained by an automated arbitrage mechanism linked to a sister token, LUNA, a free-floating Terra coin. A UST could be exchanged for $1 worth of LUNA by burning the stablecoin and minting LUNA.26 Whenever either of them was exchanged, they were taken out of the circulation by the smart contracts programmed to maintain the system.27

It was “a complex mechanism involving swapping UST coins with LUNA, a free-floating crypto control supply.” (See Exhibit 3.) UST and LUNA were both on the Terra blockchain. “To entice traders to burn LUNA to create [UST], creators offered an insane 19.5% yield on staking—which is essentially crypto terminology for earning 19.5% interest on a loan—through what they called the Anchor Protocol,” wrote an observer.28 Terraform Labs had created DeFi project Anchor, a savings platform, in 2020. DeFi projects were software protocols running on top of a blockchain network. Investors remained in full control of their cryptos, but they did devolve or cede all their power of executing transactions to smart contracts.

17 Gillian Tett, “Stablecoin Investors May Be Due a Wake-Up Call,” Financial Times, October 14, 2021. 18 Tett, “Stablecoin Investors May Be Due a Wake-Up Call.” 19 “Tether,” Coin Market Cap, 2022, https://coinmarketcap.com/currencies/tether/ (accessed Oct. 22, 2022). 20 Sungyu Kwon, “How Do Stablecoins Make Money?,” Benzinga, June 2, 2022, https://www.benzinga.com/money/how-do-stablecoins-make-

money (accessed Sept. 30, 2022). 21 https://www.benzinga.com/money/how-do-stablecoins-make-money. 22 https://www.benzinga.com/money/how-do-stablecoins-make-money. 23 https://www.bis.org/publ/work905.pdf. 24 https://www.pymnts.com/cryptocurrency/2022/how-do-stablecoin-issuers-make-money/. 25 Created by South Korea’s Terra Labs, which was founded in 2018. 26 https://www.pymnts.com/cryptocurrency/2022/how-do-stablecoin-issuers-make-money/. 27 Muyao Shen, “How $60 Billion in Terra Coins Went up in Algorithmic Smoke,” Bloomberg, May 21, 2022,

https://www.bloomberg.com/graphics/2022-crypto-luna-terra-stablecoin-explainer/ (accessed Oct. 14, 2022). 28 Daniel Van Boom, “Luna Crypto Crash: How UST Broke and What’s Next for Terra,” CNET, May 25, 2022, https://www.cnet.com/personal-

finance/crypto/luna-crypto-crash-how-ust-broke-and-whats-next-for-terra/ (accessed Oct. 1, 2022).

For the exclusive use of C. Jimenez, 2024.

This document is authorized for use only by Carolina Jimenez in Fall 2024 – Financial Innovations taught by Florent Rouxelin, Florida International University from Aug 2024 to Dec 2024.

Page 5 UV8663

Risk to the financial system

Regulators in the United States and abroad had grown increasingly concerned that stablecoins could pose a systemic risk to financial systems. US Treasury Secretary Janet Yellen said as much. “They present the same kind of risks that we have known for centuries in connection with bank runs,” Yellen told congressional leaders, urging Congress to approve federal regulation of stablecoins by the end of 2022.29 European Central Bank executive board member Fabio Panetta echoed Yellen’s concerns. The European Union was planning new rules known as the Markets in Crypto-Assets Regulation (MiCA) to regulate stablecoins.30 The chair of the Financial Times US editorial board wrote,

Should the mainstream financial world care? Some seasoned performers might argue not. After all, stablecoins currently act somewhat like the poker chips of a cyber casino. While the tokens are used to make trades within the confines of crypto-land, they can only be used there. As a result it should not matter if they turn out, say, to be part of a pyramid scheme, as long as that casino is self contained— or so the optimistic argument goes. Yet that idea seems more and more naive. For one thing, mainstream investors and institutions are increasingly being pulled into the crypto world, for investment purposes, if nothing else. For another, the market now has tentacles into other parts of finance, as Tether’s holdings of US commercial paper shows. This might create contagion risk, as Fitch ratings noted…particularly if these products are combined with the type of leverage that might spark margin calls in a crunch (which they increasingly are).31

Lending Platforms

Unlike traditional banks, crypto lending companies were not overseen by financial regulators. For example, rules on capital requirements or transparency of reserves were nonexistent, meaning depositors faced risks of losing their funds in addition to risks associated with volatility in crypto markets that affected the value of cryptos they had loaned out. Crypto lending platforms were either decentralized (DeFi) or centralized (CeFi).

Decentralized

DeFi lending platforms matched savers and borrowers, peer-to-peer, entirely on an algorithm and used smart contracts to execute the transaction. Anyone who had access to the platform could provide cryptos to lend out or borrow without either party required to identify themselves. Depositors made money by lending their cryptos, typically receiving between a 5% and 10% interest rate, to investors or crypto companies for speculation, hedging, or as working capital. “DeFi lending platforms allowed [borrowers] to deposit collateral in the form of crypto assets and receive assets, typically dollar-denominated stablecoins, in return…Borrowers often take out DeFi loans to retain exposure to price movements in the collateral they post, while using the loan to purchase other assets or to finance consumption (similar to taking out a margin loan against a stock portfolio).”32 In addition, “Rates on DeFi platforms typically exceed those offered by banks on retail deposits because the lender was taking more risk, and the borrower expected to make higher rates of return on speculative crypto asset investments.”33 Normally, borrowers had to secure loans with collateral in cryptos and were limited to borrowing an amount typically less than the full value of the collateral. 34 Despite this

29 Ryan Browne, “Regulators Are Getting Nervous about Stablecoins after Terra’s Stunning Collapse,” CNBC, May 13, 2022, https://www.cnbc.com/2022/05/13/regulators-anxious-about-stablecoins-like-tether-after-ust-collapse.html (accessed Oct. 2, 2022).

30 Ryan Browne, “Investors Withdraw over $7 Billion from Tether, Raising Fresh Fears about Stablecoin’s Backing,” CNBC, May 17, 2022, https://www.cnbc.com/2022/05/17/tether-usdt-redemptions-fuel-fears-about-stablecoins-backing.html (accessed Oct. 1, 2022).

31 Tett, “Stablecoin Investors May Be Due a Wake-Up Call.” 32 Carapella et al., “Decentralized Finance (DeFi): Transformative Potential & Associated Risks.” 33 Carapella et al., “Decentralized Finance (DeFi): Transformative Potential & Associated Risks.” 34 Carapella et al., “D