Zipmex’s bankruptcy filing highlights the domino effect on the crypto sector

From Celsius to Three Arrows Capital, major industry players have lost out on the 2022 crypto crash. Although the market seems to be stabilizing now, the cascading effects of the LUNA/UST crash are still being felt by companies today.

Singapore-based crypto exchange Zipmex 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 “beyond its control” such as unstable market conditions and the resulting difficulties of major business partners.

While it is true that Zipmex could not have predicted market volatility, it certainly could have been better prepared for it. In fact, it seems that the platform’s difficulties are the result of mismanaged funds – a decision over which Zipmex was always in control.

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

Main problem: Over leveraged positions

At the start of the LUNA/UST crash, crypto lending firm Celsius was exposed to a token called Lido Stacked ETH (STETH), which was pegged to Ether (ETH) in value.

The company accepted ETH deposits from its customers and staked them in exchange for stETH. Interest rates of around four per cent were offered on these deposits. Subsequently, Celsius used stETH as collateral to borrow more ETH. Finally, ETH was staked on the stETH exchange, and the cycle would repeat.

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

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

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By doing this over and over again, you quickly get into a position of leverage. In this way Celsius was able to offer its clients high returns for their ETH deposits.

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

image credit: bloomberg

Going back to the example, you currently have a loan of 70 ETH collateralized by 100 stETH. At any point in time, your loan cannot exceed 80 percent of your collateral, says the loan issuer.

Therefore, if the value of 100 stETH were to drop below the value of 80 ETH, you would either have to top up your collateral, or your position would be liquidated. If you are given more leverage, it will become even more difficult to maintain your position, as you will have to top-up a larger amount in case of volatility.

The Celsius position was dependent on the stability of the PEG between ETH and STETH. The company did not hedge against a scenario where this peg would break.

As it turned out, that’s exactly what happened. The panic generated by the LUNA/UST crash caused stETH to drop below ETH. If Celsius does not provide enough collateral, its entire position will be liquidated, meaning the company will lose a significant portion of its clients’ funds.

Screenshot of Celsius Tweet of 2019

This forced Celsius to stop the evacuation. Since the platform was using its funds to hold over-leveraged positions, it no longer had the liquidity to meet withdrawal requests from its clients.

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

This example of overleveraged trading is not a one-off affair, nor is it limited to ETH/stETH. This is the major reason behind the widespread collapse of crypto firms that we are witnessing today.

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How does it connect with Zipmx?

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

At the time of the collapse of LUNA/UST, Zipmex lent US$48 million to Babel Finance and US$5 million to Celsius. Both companies faced over-leveraged positions, forcing them to halt withdrawals when the market crashed.

screenshot of zipmex

Zipmex, which is now unable to collect these loans, was also forced to halt withdrawals. As it stands, the company has written off its debt to Celsius, but is working with Babel Finance to recover the loss for customers.

The market crash has brought to light the interdependence between different firms in the crypto space. The collapse began with large companies managing billions of funds, and now the results are extending to the smaller firms that invested with them.

How can retail investors avoid such risk?

By asking the right questions.

If a crypto exchange is offering a 15 percent interest rate on a coin, where are these returns coming from? It is important to realize that while crypto can provide attractive investment opportunities, it does not generate money out of thin air.

With centralized exchanges – such as Zipmex – it is not always clear how your holdings are going to be used for further investments. As has been evident from last month, it poses a risk of inaccessibility if the company faces liquidity issues.

Risk warning on Zipmex website / Screenshot of Zipmex

To ensure that your funds are safe, it is best to use an exchange that is regulated by the Monetary Authority of Singapore (MAS). While a lot of crypto exchanges are based in Singapore, many are not licensed yet and are operating only under exemptions.

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Buying crypto through a licensed exchange ensures that you can take legal recourse if the company mismanages your funds.

Another option is to use decentralized wallets and manage your holdings individually.

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

– Imran Mohammed, Head of Marketing, Kyber Network

Lending crypto through the DeFi protocol and earning interest allows you to be fully aware of the risks you are taking and prevent losses from third party mismanagement.

KyberSwap is a DEX that provides multiple liquidity pools for users to deposit their crypto holdings / Screenshot of KyberSwap

Decentralized Exchange (DEX) allows users to earn returns providing liquidity. For example, let’s say you deposit your ETH and USD coin (USDC) holdings into a liquidity pool. Whenever someone makes a conversion between the two cryptocurrencies using a DEX, you will earn a portion of the transaction fee, which is charged to them. In this case, it’s pretty clear where your returns are coming from.

“These are organic, sustainable, and not guaranteed,” Mohamed explains. “You’ll see some of these pools with less than one percent APR and some with more than 100 percent APR, and these are driven by market supply and demand, not backed by external funding.”

Featured Image Credit: Zipmex / Outlook India

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