Zipmex Bankruptcy Filing Highlights the Domino Effect on the Crypto Sector

From Celsius to Three Arrows Capital, major industry players lost to the crypto crash of 2022. Although the market appears to be stabilizing now, the cascading effect of the LUNA/UST crash is still being felt on businesses today. today.

Zipmex, the Singapore-based crypto exchange, was the latest victim after being forced to halt withdrawals earlier this month.

Zipmex announced on July 20 that customers would not be able to withdraw their crypto holdings until further notice. The company cited reasons “outside its control” such as volatile market conditions and resulting difficulties for major trading partners.

While it is true that Zipmex could not have predicted market volatility, it certainly could have been better prepared for it. In reality, it would seem that the platform’s difficulties are the result of mismanagement of funds – a decision that Zipmex has always been in control of.

To understand this, let’s connect the dots between Zipmex and the LUNA/UST crash.

Key issue: overleveraged positions

At the start of the LUNA/UST crash, crypto lending firm Celsius was heavily exposed to a token called Lido Staked ETH (stETH), whose value was pegged to Ether (ETH).

The company accepted ETH deposits from its client and staked them in exchange for stETH. These deposits offered an interest rate of about four percent. Then, Celsius used stETH as collateral to borrow more ETH. Finally, ETH was staked in exchange for stETH, and the cycle would repeat itself.

To illustrate, let’s say you have 100 ETH, which you stake in exchange for 100 stETH. At this point, you can expect a return of 4 ETH per year.

Then you use the 100 stETH as collateral to borrow 70 ETH, and stake those as well. Now your return rises to 6.8 ETH per year. You also receive 70 stETH which you can use to repeat the process.

By doing it over and over again, you are taking a more and more leveraged position. This is how Celsius was able to offer high returns to its customers for their ETH deposits.

As you might expect, as leverage increases, so does risk.

Image credit: Bloomberg

Going back to the example, you currently have a loan of 70 ETH secured by 100 stETH. The loan originator argues that at any given time your loan cannot be worth more than 80% of your collateral.

So, if the value of 100 stETH were to fall below the value of 80 ETH, you would either have to complete your collateral or your position would be liquidated. If you were more in debt, it would become even more difficult to maintain your position, because you would be forced to reload a larger amount in the event of volatility.

Celsius’ position depended on the stability of the peg between ETH and stETH. The company has not hedged against a scenario where this peg is broken.

Turns out that’s exactly what happened. The panic resulting from the LUNA/UST crash caused the value of stETH to fall below that of ETH. If Celsius did not provide enough collateral, its entire position would be liquidated, meaning the company would lose a significant portion of its clients’ funds.

celsius chirp
Screenshot of a Celsius tweet from 2019

This forced Celsius to stop withdrawals. Since the platform was using its funds to maintain an over-leveraged position, it no longer had the cash to meet withdrawal requests from its customers.

On July 13, Celsius announced that it had filed for bankruptcy.

This example of over-leveraged trading is not a unique case, nor is it limited to ETH/stETH. This is the main reason for the cascading fall of crypto businesses, which we are witnessing today.

How does this relate to Zipmex?

Zipmex offered its users annual rewards of up to 10% on crypto deposits. The company generated these rewards by lending the crypto to other platforms.

At the time of LUNA/UST’s collapse, Zipmex had loaned $48 million to Babel Finance and $5 million to Celsius. Both companies were exposed to over-leveraged positions, which forced them to freeze withdrawals when the market crashed.

zipmex win
Zipmex screenshot

Zipmex, now unable to collect those loans, was also forced to freeze withdrawals. As it stands, the company has canceled its loan to Celsius, but is working with Babel Finance to recover customer losses.

The stock market crash has shed light on the interdependence between different companies in the crypto space. The collapse began with large corporations managing billions in funds, and now the consequences are rippling through the smaller companies that had invested with them.

How can retail investors avoid such risks?

By asking the right questions.

If a crypto exchange offers a 15% interest rate on a coin, where do those returns come from? It is important to realize that even though crypto box offer interesting investment opportunities, they do not generate money out of thin air.

With centralized exchanges – such as Zipmex – it’s not always clear how your holdings are used for other investments. As seen over the past month, this creates a risk of inaccessibility if the company faces liquidity problems.

Zipmex website risk warning / Zipmex screenshot

To ensure that your funds are protected, it is best to use an exchange regulated by the Monetary Authority of Singapore (MAS). While many crypto exchanges are based in Singapore, many have not yet obtained a license and only operate under exemption.

Buying crypto through a licensed exchange ensures that you can seek legal redress if the company is mismanaging your funds.

Using decentralized wallets and personally managing your holdings is another option.

From a long-term industry perspective, most DeFi builders, advocates, and commentators actually believe that the breakdown of centralized platforms is a bull case for DeFi, where users want self-custody actives. As they say, ‘not your keys, not your assets’.

– Imran Mohamad, Marketing Manager, Kyber Network

Lending crypto and earning interest through DeFi protocols allows you to be fully aware of the risks you are taking and avoid losses resulting from mismanagement by third parties.

kyber exchange
KyberSwap is a DEX that offers a range of liquidity pools for users to deposit their crypto holdings / KyberSwap screenshot

Decentralized exchanges (DEX) allow users to earn returns by providing liquidity. For example, let’s say you deposit your ETH and USD Coin (USDC) holdings into a liquidity pool. Every time someone converts between the two cryptocurrencies using the DEX, you will earn a portion of the transaction fees charged to them. In this case, the source of your returns is very clear.

“They are organic, sustainable and not guaranteed,” says Mohamad. “You would see some of these pools with less than 1% APR and some with more than 100% APR, and these are happening due to market supply and demand, not backed by external funding.”

Featured image credit: Zipmex / Outlook India

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