PEOPLE

Taking Celsius as an example, it teaches you how to judge the quality of investment products and avoid hidden risks step by step.

2022/7/14

This article is authorized to be reprinted from James Z Investment

Table of Contents:

How to Determine the CP Value of an Investment
Risk Premium
Is the Return Source Business Model Reasonable
Using Celsius as an Example

Celsius Thunderbolt Analysis
The Last Straw that Broke Celsius

Most of us invest with the goal of making money, and surely no one hopes to invest a sum of money only to not receive the expected return, or even lose the principal. After reading this article, I believe it will help us avoid some fatal investment mistakes and learn how to determine the investment target with the highest CP value.

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Table of Contents

How to Determine the CP Value of an Investment

When we buy things, we judge their value for money, similarly, when buying financial products, we also need to consider their value for money. But what exactly is the CP value of financial products?
An item with a higher CP value is defined as having greater efficacy for the same price. Therefore, when we buy financial products, we hope that their efficacy will help us make money, so the "return rate" is our C, and P naturally becomes "risk."

The higher the return rate and the lower the risk, the higher the CP value of the financial product we seek. However, with a wide variety of financial products available, how can we judge whether its return rate and risk are reasonable, or whether its CP value is high or low? This can be determined by the risk premium.

Risk Premium

Risk premium (also known as risk spread) is simply the expected return corresponding to the risk when it occurs, usually compared to the risk-free rate and presented as a percentage.
For example, the risk of investing in stocks is higher than investing in U.S. bonds, and the expected return on stocks minus the expected return on U.S. bonds is the risk premium for investing in stocks.

We can break down the return rate of any investment product into various risk premiums. Starting from the risk-free product defined in textbooks such as U.S. bonds, the return rate on longer-term U.S. bonds is higher than that on shorter-term U.S. bonds due to liquidity risk; similarly, the return rate on other country's government or corporate bonds is higher than that on U.S. bonds due to default risk.

For longer-term corporate bonds, compared to U.S. bonds, they will have additional liquidity risk and default risk, so their return rate will be stacked with two risk premiums on top of the risk-free rate.

The concept conveyed by the above examples is that regardless of the risk, the market will provide the corresponding risk premium. Conversely, high returns are accompanied by a lot of inherent risks.

After understanding the above concepts, the concept of risk premium can be used to analyze whether the return rates offered by financial products are reasonable and to compare the CP values of similar products.

Reasonableness of the Source of Returns and Business Model

Any financial product can be benchmarked against a leading target, typically the safest or most representative (largest market capitalization) within the same category of products, such as U.S. government bonds for bond products or the S&P 500 index for stocks.

Going a step further, deposit rates can also serve as a benchmark. For example, in Taiwan, the deposit rates offered by the post office for current and fixed-term deposits are benchmarks that people refer to, given the backing of the national government and the lowest probability of default compared to domestic banks.

For investors, the return model for fixed deposits is similar to that of bonds, where interest is paid regularly and the principal is returned at maturity. However, the underlying business models for these two types of products are quite different. The return rate for fixed deposits is supported by the total amount of bank loans and interest rates, while the interest on bonds depends on the business operations of the debtor.

Normally, the return rate for bank fixed deposits is much lower than that for corporate bonds for reasons that can be referred to in the previous section on risk premiums. Therefore, if a situation arises where a product with a business model similar to a bank offers a higher fixed deposit rate than corporate bonds, it can be inferred that this return rate definitely includes an element of risk premium.

The Business Model Must Support the Return Rate

With the above analysis, we can essentially formulate a process to assess the reasonableness of the return rate of an investment (product):

Determine the type of investment product
Identify the benchmark return rate for similar products
Compare the differences to find the risk premium
Analyze the business model behind the return rate (risk premium)
Can it generate sufficient cash flow or expected returns

After going through the above 5 steps, it is possible to easily determine whether the current investment product is a good choice or whether it might potentially collapse, resulting in the loss of invested funds.

If a high return is seen but the business model of the project is opaque, or if the source of profits for the project cannot be identified, it is best not to allocate too many assets to it.

Using Celsius as an Example

On June 13, 2022, the cryptocurrency yield platform Celsius announced the suspension of withdrawal functions, causing users' assets to be trapped on the platform and unable to be withdrawn. In traditional financial market terms, this is similar to an online bank closing withdrawal functions, thereby preventing users from withdrawing their assets stored on the platform.

Celsius' business is straightforward; they collect users' cryptocurrency assets and provide fixed returns, then lend out users' cryptocurrency to institutions in need at higher rates, similar to banks primarily earning interest rate differentials through lending operations.

Here is a brief overview of their scale (official public data as of May 17, 2022): founded in the summer of 2017, managing user assets of $11.8 billion (peaking at over $20 billion), with over 2 million users, over 200 employees, and operations spanning over 100 countries.

Main Business Introduction on Celsius Website

For comparison, a domestic bank in Taiwan, Shin Kong Bank, had total deposits in the first quarter of this year of around $34.8 billion, with 3,800 employees, ranking among the top 10 banks in Taiwan.

Celsius Collapse Analysis

1. Determine the Type of Investment Product

For users like us, Celsius offers current deposit services with compounding weekly. They offer deposit services for BTC, ETH, USD stablecoin, and other cryptocurrencies, with interest rates ranging from 2% to 10%.

Here, taking USD stablecoin lending business as an example, from the demand perspective, other cryptocurrency lending businesses have greater risk for Celsius than USD stablecoin. For us, this type of investment product falls under the category of USD deposits earning interest.

2. Identify Benchmark Return Rates for Similar Products

Currently, domestic banks offering the same service provide an annual return rate of 0.56% for one-month fixed deposits (without special promotions), while Celsius offers approximately 9% to 11% annual return rates for current deposits.

3. Compare the Differences to Find the Risk Premium

Firstly, stablecoins are different from USD and carry exchange rate risk. Furthermore, stablecoin issuers face risks such as bankruptcy, runs, and regulatory issues that may prevent them from being exchanged for USD. Additionally, while stablecoins have good liquidity, they still carry liquidity risks compared to USD. Lastly, cryptocurrencies themselves have their own systemic risks, such as regulations, miner strikes, and network attacks causing paralysis.

Comparing service providers, domestic banks, under strong regulation, are unlikely to encounter issues unless there is a systemic risk. However, Celsius is not publicly listed, does not disclose comprehensive data, and regulations and supervision are not clearly defined, thus facing operational risks and the risk of exit.

4. Analyze the Business Model Behind the Return Rate (Risk Premium)

Overall, Celsius' published business model involves users depositing cryptocurrency and earning interest, serving high-net-worth clients by providing them with collateralized loans or customized loan services.
However, it is widely known that idle funds should be utilized efficiently, so organizations with similar businesses usually invest some idle funds, but risk control in investments must be carefully managed.

5. Can it Generate Sufficient Cash Flow or Expected Returns

In markets with good liquidity, abundant opportunities, high borrowing demand, and full confidence, I believe Celsius' business model is sound.

For example, when simply holding coins for a few days can yield a 2x profit, there will be a demand for leverage in the market, and borrowing rates will become very high. In such a scenario, offering a 20% interest rate is not a problem, and people's willingness to deposit will not be too high (yes, I'm referring to UST).

For professional trading institutions, there are many arbitrage opportunities, such as price differences in the same commodity on different exchanges, arbitrage opportunities in derivative products, arbitrage opportunities due to information asymmetry, etc. With more available funds, one can make risk-free profits, and there is substantial demand for borrowing.

However, when market liquidity is poor, investment opportunities are scarce, borrowing demand is low, and confidence is lacking, this is when Celsius will be put to the test.

Poor market conditions can lead to reduced borrowing demand, but Celsius still needs to pay interest, forcing it to seek higher-risk investments. This move is actually beyond the scope of its officially declared business, as investment operations are not Celsius' forte. Therefore, it is necessary to consider whether to continue receiving the same return rate while accepting higher risks.

The Final Straw that Broke Celsius

A few days before Celsius announced the suspension of withdrawals, two pieces of information were exposed.

Firstly, in June 2021, Celsius incurred losses on assets held due to technical issues, but the official announcement did not disclose this information, damaging its reputation.

Secondly, Celsius uses users' assets for investment, but the risk control mechanism is not perfect, exposing it to potential attacks.

These revelations have caused users to worry about the safety of their assets, leading them to gradually withdraw their assets. However, this action is precisely what all banking institutions fear the most— a run. Typically, banks have risk control mechanisms, such as reserve requirements. Still, Celsius, not subject to full and strict supervision, ended up overexposing itself to excessive risks in investments outside its core competencies. When liquidity is poor, it can only freeze withdrawals, implement emergency measures, and wait for others to come to its rescue.

Conclusion

To determine the reasonableness of an investment, one must first understand the concepts of return rate and risk associated with the investment.

Subsequently, one can compare it with similar products, identify benchmark products of the same type (usually the safest), analyze the reasons for differences in return rates, and list whether each risk premium is within one's acceptable range.

Lastly, study the business model behind the service provider, whether it can generate sufficient cash flow or expected returns.

Celsius is just one example of a project that collapsed during the bear market. UST was the previous example, and I expect that in this market environment, there will be more examples to come. What we can do is carefully review our investments, see if there are safer products with similar return rates, and whether the same product can maintain the same level of risk in changing market conditions.

Lastly, I hope this article helps you avoid the next potential collapse.

James Z Investment