From Celsius to Three Arrows: The Domino Effect of Crypto Giants and the Epic Drain of Liquidity

Author: 0x137, BlockBeats

Since May of this year, the crypto market has been in turmoil. In just one month, we witnessed the overnight collapse of Luna's $40 billion financial empire, the decoupling of ETH 2.0's largest decentralized node Lido's derivatives, the suspension of withdrawals by the largest crypto bank in the U.S., Celsius, and then the liquidation of Three Arrows Capital, which reportedly held $18 billion in crypto assets at one point. When we connect these events—from Luna to stETH, from Celsius to Three Arrows—we can discover the subtle relationships between them and the development clues interspersed throughout.

Two Martyrs: Celsius and Three Arrows Capital

After the collapse of Luna, individuals and institutions in the crypto space were on edge, and on-chain operations became more frequent. Following the recent decoupling of stETH, Celsius was the first to encounter problems. This CeFi lending platform, well-known in Europe and the U.S., with 1.7 million users and over $30 billion in assets under management, was ultimately forced to suspend all withdrawals due to a liquidity crisis, becoming another "martyr" in the crypto space after LFG.

Prior to this, Celsius had already lost a significant amount of user assets due to various unexpected events: first, it lost about 35,000 ETH (worth over $70 million) in the incident involving the Eth2.0 staking company Stakehound losing its private key, and then it lost about 2,100 BTC and 151 ETH (worth over $50 million) in the BadgerDAO hack. More seriously, Celsius consistently concealed the truth and even failed to admit it after the news broke, directly undermining user confidence in the platform.

As one of the largest holders of stETH, Celsius faced a huge impact during the stETH decoupling event. With the value of stETH declining and the platform's liquidity issues worsening, it encountered a severe bank run driven by panic, forcing it to sell stETH to meet user redemption demands, ultimately having to enter "HODL mode," suspending all account withdrawals and transfer activities. (Note from BlockBeats: A detailed introduction to the stETH and Celsius crisis can be found in "How Serious is the Risk of stETH During Institutional Withdrawal from Lido?")

Even more seriously, as the market continued to decline, Celsius's hundreds of millions of dollars in DAI loans on the MakerDAO platform also faced liquidation risks. Over the past two days, Celsius has been adding wBTC collateral to Maker and repaying nearly 50 million DAI, raising the collateralization ratio to 219%, barely escaping liquidation risk.

Faced with the dire situation, Nexo, another CeFi lending platform, extended an olive branch to Celsius, expressing a willingness to acquire its "remaining qualified assets," but the Celsius team did not respond. This blockchain revolutionary, who once shouted "the banks are bankrupt," now had to rely on suspending withdrawals and restructuring lawyers to seek a way out.

Just a day after Celsius's crisis, discussions about Three Arrows Capital facing liquidation began to surface on Twitter. People noticed that its usually vocal founder, Zhu Su, had not posted for several days, deleted his Instagram account, and changed his Twitter bio.

Soon after, Zhu Su broke his silence, stating, "We are in communication with relevant parties and working hard to resolve the issues," which ignited a frenzy in the community. Three Arrows Capital, once a $10 billion asset holder and one of the most active and influential investment firms in the industry, now found itself in the spotlight, becoming the focus of public scrutiny, with its past activities and various details being dug up.

According to The Block, Three Arrows faced a total liquidation amount of at least $400 million with top lending companies and still needed to repay loans to other lenders after this liquidation. It is worth noting that Three Arrows was a major backer of Luna and suffered significant losses during the UST collapse. Over the past month, it has consistently appeared on the list of top losers on Bitfinex. During the stETH decoupling and sell-off, Three Arrows's "activity level" far exceeded that of Celsius, as it sold off large amounts of stETH to repay debts.

Like Celsius, Zhu Su, who previously touted super cycles and promoted new L1 public chain ecosystems, has now become unusually silent, removing token tags from his Twitter bio and admitting to his misjudgment of the market.

However, it is worth noting that there seems to be a connection between Celsius's liquidity crisis and Three Arrows Capital's liquidation. In addition to the "top lending platforms" mentioned in The Block's report, KOL trader Degentrading also pointed out on Twitter that Three Arrows was Celsius's largest lender, with lending positions on mainstream CeFi lending platforms like Genesis and BlockFi.

Although Three Arrows's liquidation does not benefit lenders, the issues exposed by Celsius indicate that these "crypto banks" urgently need to address the liquidity demands of users redeeming their deposits. In the face of its own liquidity crisis, liquidating its borrowers for liquidity seems like a reasonable choice.

Perhaps for this reason, Celsius issued a Margin Call to Three Arrows, turning it into a "sacrificial offering" to resolve the crisis. Meanwhile, other lending platforms like Genesis and Nexo rushed to release messages to reassure user confidence to prevent the situation from spreading.

The liquidation of Three Arrows also forced more institutions to become "collateral damage." Just yesterday morning, a trading firm under Three Arrows reported that Three Arrows had taken $1 million from its trading account, clearly to fill a funding gap elsewhere. This morning, DeFiance, a capital firm closely related to Three Arrows, also seemed to encounter problems, with its founder Arthur posting a crying emoji on Twitter.

From the decline of Celsius and Three Arrows, it is not difficult to see that the collapse of Luna and the decoupling of stETH had a significant impact. Using the Luna incident as a watershed, the situation of crypto institutions has changed dramatically before and after.

Two Mistakes: Luna and stETH

Since the start of this market cycle, terms like "faith," "fundamentalism," and "All In" have appeared more frequently than ever before. When investing, people discuss narratives rather than facts, and for a time, the meme "Irresponsibly Long" even became a badge of honor for visionary investors.

This atmosphere is particularly evident among institutions, where everyone has built an "unshakeable" consensus around hot narratives. On Twitter, the Lunatic army led by Delphi Digital and Galaxy Digital is everywhere, and Anchor's 20% APY has become recognized as the "best safe haven in a bear market"; OG communities like Bankless often post to recharge faith in Ethereum 2.0, and liquid staking has become the perfect solution for Ethereum 2.0 node validation.

However, it was precisely this strong consensus that led institutions to make fatal mistakes with Luna and Lido. Similar to the 2008 subprime mortgage crisis, the problem stemmed from excessive optimism and confidence. Before the Lehman Brothers collapse, the market was overly optimistic about "rising housing prices," and no one wanted to believe that seemingly "risk-free" mortgage securities could encounter problems. Perhaps convinced by their own rhetoric, institutions took matters into their own hands and truly became "Irresponsibly Long." Before the collapse of Luna and the stETH decoupling, no one believed that these established DeFi leaders would still pose fatal risks.

For Luna, the success of UST made institutions forget basic economics. The continuously stable APY brought a strong Lindy effect to UST, causing people to overlook Anchor's terrifying lock-up ratio and Luna's astonishing market cap. More and more funds continued to flow in, and even protocols specifically designed for UST Looping leverage emerged, resulting in the vast majority of UST's market cap being used to leverage in Anchor.

Celsius was also a major holder of UST, using the high APY offered by UST for yield arbitrage. The platform initially offered around 10% APY for stablecoins like USDT and USDC to attract user assets, then exchanged them for UST to deposit in Anchor for a 10% yield arbitrage, all unbeknownst to users. It was only after the UST bank run that people realized Celsius was the "big seller" of UST and lost a significant amount of user assets during the UST collapse.

Meanwhile, VCs and market makers like Three Arrows, Galaxy Digital, and Jump Trading selectively ignored Luna's strong financial attributes, placing the Terra ecosystem, dominated by Anchor, into the public chain narrative alongside ecosystems like Solana and Avalanche, continuously promoting "Solunavax." According to FatMan, a member of the Terra research forum, Three Arrows once purchased 10.9 million LUNA for $559.6 million. Now, they are worth only $670.45.

After the evaporation of a $40 billion financial empire overnight, the collapse of UST created significant ripple effects, causing several smaller stablecoins to decouple. Panic sentiment continued to rise, and eventually even USDT experienced a brief bank run, with this highly liquid crypto asset temporarily decoupling due to liquidity issues.

To some extent, USDT's brief decoupling has already sent a strong signal from the market: after hundreds of billions of dollars evaporated, liquidity is rapidly contracting. Many stablecoin projects and ecosystems have responded to this, with NEAR and TRON's stablecoins USN and USDD adopting full or even over-collateralization models. However, the impact of the UST incident goes far beyond this: as UST has developed into a cross-chain asset, its collapse will trigger varying degrees of liquidation across different ecosystems. In other words, the collapse of Luna ignited the fuse of liquidity contraction.

Yet institutions were overly optimistic about the liquidity and demand for stETH, and no one expected that the liquidity fuse would burn to stETH, which has no connection to stablecoins. Since the "collateral" for stETH is ETH 2.0, it cannot be withdrawn until Ethereum completes its merge. Therefore, unlike other liquid staking tokens, stETH is a futures token for ETH 2.0 and does not necessarily maintain a 1:1 peg with ETH; its price is entirely determined by market demand.

A few months ago, there were no liquidity issues in the market, and the stETH-ETH pool prepared by Lido on Curve could fully meet demand. As a result, people simply understood stETH as an asset pegged to ETH. One of the most popular strategies among institutions at that time was to borrow ETH at a low interest rate of around 2%, stake it on Lido to earn around 4% in stETH, and then use stETH as collateral to cycle borrow ETH on Aave, thereby increasing leverage in this seemingly low-risk manner.

As one of the largest holders of stETH, Celsius exchanged a large amount of user assets for stETH, which could not be easily entered or exited from the market through liquidity pools. As shown in the image below, Celsius held nearly 450,000 stETH at its peak. The platform would deposit these stETH into Aave as collateral and borrow stablecoins or ETH to meet user redemption demands. Once the liquidity issue was triggered, the consequences would be severe, as any decline in stETH would, in strict terms, put Celsius in a state of insolvency.

However, when Celsius realized this problem, it found that the liquidity on Curve could not meet the platform's needs. Selling would trigger panic and a bank run, while not selling would fail to meet user redemption demands, putting it in a dilemma. Three Arrows was no exception; earlier this year, it built up a large position in ETH and staked it on Lido specifically for stETH. Under the liquidation pressure from Celsius, Three Arrows exchanged multiple stETH at a discount for wETH and then sold all of it for DAI to repay debts.

Of course, the mistakes that "buried" Celsius and Three Arrows Capital also occurred among countless retail investors, and the issues exposed by Luna and stETH reflect two ongoing threads surrounding the crypto market over the past few months.

Two Threads: High Leverage Crisis and Liquidity Exhaustion

Yesterday afternoon, news about the liquidation of Three Arrows Capital's ETH assets was released in succession by various sources. According to the Aave platform, a wallet address suspected to belong to Three Arrows Capital (starting with 0x7160) had nearly $200 million in loans facing liquidation at any time, and this address was continuously repaying debts on-chain to avoid large-scale liquidation.

At that time, rumors of Three Arrows's liquidation were rampant, and everyone viewed it as Three Arrows's "self-defense counterattack." However, according to disclosures from KOLs on Twitter, this address might actually belong to a wallet related to Longling Capital. This market liquidation also allowed people to witness the "spectacular scene" of whales collectively diving.

In addition to stETH, Three Arrows also had a large amount of loans used to purchase GBTC positions. Since last year, the GBTC premium has continued to deteriorate, currently at -30%, which has severely shrunk that portion of Three Arrows's assets, also facing liquidation risks.

We can't help but ask, how much leverage was there during last year's second round of frenzied price increases? From the overall TVL of DeFi in the chart below, we can get a glimpse. The left red box shows the collapse of Luna in early May, during which the total TVL of DeFi dropped from $200 billion to around $120 billion, losing $80 billion; the right red box shows the liquidation of institutions like Celsius and Three Arrows triggered by the stETH incident, with TVL losing another $45 billion.

It is evident that the liquidation of mainstream ecosystems and institutions has caused the overall credit scale of the market to shrink rapidly, which may lead to ongoing deleveraging. Just like Celsius's capital recovery, many other lending platforms will also protect themselves by pulling credit from the market, further reducing the capital flowing in the market and exacerbating liquidity exhaustion. For example, TRON's stablecoin USDD, despite receiving hundreds of millions of dollars in support from the Wave Reserve, could not escape the fate of decoupling, dropping to around $0.96 yesterday.

Undoubtedly, the crypto market is experiencing its own Lehman moment. To prevent further deterioration of liquidations, external capital is often needed to step in, but unfortunately, we are facing a historically rare wave of interest rate hikes: last night's FOMC meeting saw the Federal Reserve raise the benchmark interest rate by another 75 basis points to a range of 1.50% to 1.75%; in Europe, Italian government bond yields continued to rise, and the European Central Bank held an emergency special meeting yesterday to discuss response strategies and early interest rate hikes.

Recently, U.S. Treasury yields have also been climbing, and U.S. stocks have been on a downward trend, clearly exhibiting a "Correlation of One" situation: when the overall economy faces severe liquidity contraction, people are often in a state of "selling what they can sell" rather than "selling what they want to sell." As a highly volatile market, crypto will undoubtedly be one of the areas where liquidity tightens the fastest. Renowned macroeconomist and Real Vision founder Raoul Pal also pointed out that when important collateral like U.S. Treasuries experiences unprecedented volatility, Margin Calls will be everywhere.

The current crypto market faces a dual tightening of internal and external liquidity, and bleeding events may continue. Celsius and Three Arrows Capital are not the first institutions to fall, nor will they be the last.