Liquidation levels might not tell the full story of a borrower’s capital position
As markets fall, miners accelerate their sale of bitcoins
A Proxy for Market Stress in DeFi Worsens
Headlines about distressed financial institutions in the crypto industry have been topical the past week. One of the instruments that we follow as a proxy for financial stress in the ecosystem, particularly DeFi, is the price of Lido Staked ETH (stETH). Lido is a DeFi platform that allows users to deposit ETH (and other proof of stake digital assets), participate in the consensus process, earn the block rewards paid to validators (thought of as yield), and withdraw a synthetic asset, stETH, on a one-for-one basis with ETH. This is in lieu of directly staking their ETH on Ethereum’s proof of stake network, the Beacon Chain.
Why would users want to delegate their ETH and receive a synthetic asset as opposed to simply staking on their own? First, staking can be difficult for the average user. Stakers need at least 32 ETH (worth $35,011 as of yesterday at 4PM) to stake on the Beacon Chain as well as a reasonable degree of technical know-how to run a staking node. Improper staking behavior can result in financial penalties, called slashing, furthering the case for delegation. Second, and more important, stETH is liquid and can be sold or used in Ethereum-based activities like posting collateral, providing liquidity on automated market makers or lending in DeFi. Troubled lender Celsius likely has approximately $410M of stETH being lent out on the Aave platform, for example.
But there is one issue. ETH deposited in the Beacon Chain, is presently irretrievable, locked until a technological update called the Shanghai hard fork is implemented following the long-awaited Merge, neither of which has a set date. Since stETH is just a passthrough instrument for staked ETH, this means that users cannot redeem their stETH for the locked-up ETH and that there is no arbitrage mechanism for keeping the price of stETH pegged to ETH. Given this lack of arbitrage mechanism and the liquidity mismatch between stETH and ETH, stETH is being sold to reduce risk or make capital calls. A discount that emerged with the LUNA/UST fiasco that has now reached as low as 7.8%. Given this dynamic and the importance of stETH throughout the ecosystem ($4B market cap), we continue to watch this discount as a sign of crypto market stress.
The Ephemerality of Liquidation Levels
With speculation about leverage in the crypto ecosystem running rampant, one aspect that market watchers have paid close attention to is liquidation price levels. Because much of the information about loans in DeFi is publicly available, blockchain analysis can reveal the loan terms, the value of the collateral, and determine the price at which a loan will break its covenants and be liquidated, the liquidation price level. This is interesting for two reasons. First, with counterparty risk becoming an increasing concern, this analysis can help participants determine levels at which certain entities might find themselves in financial difficulties. Second, liquidations create negative price pressure. Much of the pledged collateral is assets like wrapped bitcoin (WBTC) or ether (ETH) on the Ethereum blockchain. When loans are liquidated, large amounts of these assets can be sold on the market and drive price levels lower.
However, casual observers need to be careful about how to interpret liquidation levels. Borrowers are mindful of the prices at which they will be liquidated; and they have no interest in being liquidated. As prices approach liquidation levels, borrowers can contribute capital held elsewhere or repay some of the loan outstanding, both of which reduce the price at which their loan will be liquidated. An example is one particularly large position, likely held by Celsius, on the MakerDAO platform. MakerDAO allows users to pledge collateral to take out a stablecoin, Dai (DAI), which users can lend out, stake, or use for other purposes. In this case, as of last week, the borrower had pledged 17,758 WBTC worth $533M (as of June 9, 4PM) to borrow 278M DAI worth $278M. With a minimum collateralization ratio of 145% on the loan, this meant that liquidation would occur at a price of $22,737.71. Given the size of this position, observers were extremely concerned about this position as markets crashed. However, as price approached the liquidation level, the account quickly topped up their collateral across several transactions and returned DAI, bringing the total collateral up to 23,963 WBTC and total DAI down to $231M. This reduced the liquidation price to $14,004.11. The original liquidation price, clearly, was not in play as long as the borrower had capital elsewhere to deploy. This demonstrates the fact that liquidation levels, while interesting, may not tell the entire story of a borrower’s capital position.
Public Miners' Bitcoin Sales Accelerate
The new issuance of bitcoins, called the block subsidy, is rewarded to miners who create new blocks. At network launch, the block subsidy was 50 bitcoins per block, but that amount halves roughly every four years and currently stands at 6.25 bitcoin/block. Given that a block is found every ten minutes on average, this means that, on average, 900 new bitcoins are issued to the market every day. Miners also receive transaction fees for mining blocks, but these fees are generally much smaller and do not represent new bitcoins. When they receive a block subsidy, miners face the decision of whether to keep the bitcoins or sell them on the market to raise cash, thus circulating the new issuance. When times are good, and miners have more than enough cash to cover their energy costs and administrative costs, they often choose to keep the bitcoins.
However, fortunes have turned in the markets, and it appears that miners are starting to sell their accumulated balances. Looking at miner financial filings, public miners sold a net 4,411 bitcoins in May 2022, considerably more than the previous average of 1,115 bitcoins per month earlier in 2022. If prices continue to stay low, we may continue to see more bitcoin issuance circulated into the market. As of the end of May, those same miners held about 46,594 bitcoins according to public filings, or about $1.5B at prevailing prices at the time.
Market Update
Risk assets had an extremely difficult week following the higher-than-expected inflation print last Friday. The price of bitcoin fell precipitously, decreasing by 30.5% on the week. Equities fell alongside bitcoin, as the S&P 500 decreased 8.7%, and the Nasdaq Composite declined 9.4%. Bonds also fell: Investment Grade Corporate Bonds were down 2.1%, High Yield Corporate Bonds fell 4.1%, and Long-Term Treasuries declined by 2.1%. Gold declined by 1.0% on the week, real yields increased and inflation expectations declined, likely factoring in further and more aggressive tightening from the Fed.
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