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CeFi, DeFi, and Crypto Treasuries: A Recipe for Systemic Risk?

Understanding Crypto’s Interconnected World: Why ‘Systemic Risk’ Matters to Everyone!

Hey everyone, John here! Today, we’re diving into a topic that might sound a bit technical at first, but it’s super important for understanding what’s going on in the world of virtual currency and blockchain. Our friends at Galaxy Digital, a big name in the crypto space, recently put out a report that talks about something called ‘systemic risk’ getting higher in the crypto world. Don’t worry, we’re going to break it all down so it makes perfect sense, even if you’re completely new to this stuff.

What in the World is ‘Systemic Risk’?

The report highlighted that interconnections within crypto lending are making “systemic risk” a bigger concern. Now, that’s a mouthful, isn’t it?

Lila: John, ‘systemic risk’ sounds really serious. What exactly does it mean?

John: Great question, Lila! Imagine a bunch of dominoes standing in a long line. If you push one domino, it knocks down the next, and the next, until the whole line falls. In the world of finance, ‘systemic risk’ is similar. It means the risk that the failure of one company, one market, or one part of the financial system could trigger a cascade of failures across the entire system. It’s like if one big bank in the traditional financial world went bust, and because other banks were connected to it, they might start having problems too, leading to a much bigger crisis. In crypto, it’s about how a problem in one area could spread and affect the whole crypto market.

Meet the Players: CeFi and DeFi

The report specifically talks about how “centralized and decentralized crypto lending” are becoming more intertwined. These are two big ways people interact with crypto finances.

What is CeFi (Centralized Finance)?

CeFi, or Centralized Finance, is probably the easiest to understand because it’s quite similar to how traditional banks work. When you use a CeFi platform, you’re trusting a company (like an exchange or a lending platform) with your crypto. They hold your assets, manage your loans, and essentially act as a middleman.

Lila: So, CeFi is like a regular bank, but for crypto?

John: Exactly, Lila! Think of it like this: when you put your money in a traditional bank, you trust the bank to keep it safe, manage your accounts, and give it back when you ask. CeFi platforms work similarly for crypto. You send your Bitcoin or Ethereum to them, and they handle everything for you. They’re a central company you rely on, just like a bank or a credit union. They offer services like:

  • Lending: You can lend out your crypto to others through them to earn interest.
  • Borrowing: You can borrow crypto or traditional money by putting up your crypto as security.
  • Trading: You can buy and sell different cryptocurrencies.

What is DeFi (Decentralized Finance)?

On the other hand, we have DeFi, or Decentralized Finance. This is where things get really interesting and a bit different from traditional finance. With DeFi, there’s no central company or middleman. Instead, everything is run by computer programs called “smart contracts” on a blockchain. These programs automatically execute agreements when certain conditions are met, without human intervention.

Lila: No company? So who’s in charge with DeFi?

John: That’s the beauty of it, Lila! Nobody is “in charge” in the traditional sense. Imagine a super-smart vending machine for financial services. You put in your crypto, select what you want (like a loan or an exchange), and the machine (the smart contract) automatically gives you what you asked for, following its pre-programmed rules. There’s no person approving your loan or holding your funds; it’s all done by the code on the blockchain. This means:

  • Transparency: All transactions and rules are recorded on the blockchain for everyone to see.
  • Automation: Services run automatically without needing human approval.
  • No middleman: You interact directly with the code, not a company.

The Tightening Web: Leverage and Interdependencies

The report from Galaxy Digital points out that these two worlds, CeFi and DeFi, are becoming increasingly connected, leading to “leverage interdependencies.”

Lila: Oh no, more big words! What’s ‘leverage’ and ‘interdependencies’ mean in this context?

John: Good catch, Lila! Let’s break them down.

Leverage is simply using borrowed money to make a bigger investment. Think of it like using a small amount of your own money, plus a big loan, to buy a very expensive house. If the house value goes up, your profit is much larger than if you had just used your own money. But if the value goes down, your losses can also be much larger, potentially more than your initial investment! In crypto, people use leverage to borrow more crypto to buy even more crypto, hoping its value will go up. It amplifies both potential gains and losses.

Now, for interdependencies. Imagine that spiderweb analogy again. If you tug on one strand of the web, it affects the tension and position of all the other strands. In finance, interdependencies mean that different parts of the system are relying on each other. So, if something goes wrong in one part (say, a large CeFi lender), it can quickly spread and cause problems in another part (like a DeFi lending pool that lent money to that CeFi platform, or other platforms that borrowed from it).

The Billions in Debt: Crypto-Collateralized Lending

The report estimated that as of March 31, over $39 billion in crypto-collateralized debt was outstanding across these platforms and also from “crypto-backed stablecoin issuers.” That’s a huge amount of money!

So, what’s ‘crypto-collateralized debt’? It’s like getting a loan, but instead of putting up your house or car as security, you put up your cryptocurrency. For example, you might put up 1 Bitcoin as collateral to borrow 10,000 USD (in stablecoins). If you don’t pay back the loan, the lender gets to keep your Bitcoin. This is happening a lot, both in CeFi and DeFi.

The report also mentions “crypto-backed stablecoin issuers.”

Lila: What are stablecoins? Are they like regular virtual currency?

John: That’s a super important question, Lila! Most virtual currencies like Bitcoin or Ethereum can have wild price swings – they can go up or down a lot in a short time. Stablecoins are a special type of virtual currency designed to have a stable value, usually pegged to a traditional currency like the US dollar. So, one stablecoin called “USDT” or “USDC” is generally meant to be worth exactly one US dollar. They’re called “crypto-backed” if the company issuing them holds actual crypto assets (like other cryptocurrencies or even traditional assets like cash or bonds) to back up the value of the stablecoins they create. People use them because they offer the speed and flexibility of crypto without the price volatility, making them useful for things like loans and payments.

Why Does This All Matter?

The big takeaway from the report is that because CeFi, DeFi, and these large crypto treasuries (which are basically big holders of crypto) are all lending and borrowing from each other using leverage, the whole system becomes more interconnected. It’s like they’re all holding hands. If one big player faces a problem, like a sudden drop in the value of the crypto they hold as collateral, or if many people suddenly want to withdraw their funds at once, it could create a ripple effect. This ripple effect could cause other players to also struggle, leading to a much wider issue for the entire crypto ecosystem. That’s the essence of systemic risk in action.

John’s Final Thoughts

Reading this report really highlights the maturing yet still fragile nature of the crypto market. While innovation in DeFi and CeFi is exciting, the growing interconnectedness, especially with leverage, means we need to pay close attention to how risks might spread. It’s a reminder that even in a decentralized world, the actions of large players can have far-reaching consequences.

Lila’s Take

Wow, it’s like the crypto world is growing up, but it’s also facing some growing pains. It’s good to know that even though it sounds complicated, understanding things like ‘systemic risk’ and ‘leverage’ helps me see the bigger picture. It makes me realize that everything is linked!

This article is based on the following original source, summarized from the author’s perspective:
Systemic risk on the rise as leverage interdependencies
tighten between CeFi, DeFi and crypto treasuries

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