GBTC was the Genesis of the Crypto Credit Contagion
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Learn how GBTC works, how its associated with the recent crypto contagion, and why buying spot bitcoin and taking self-custody helps you avoid all of?these risks today.
This year has been a?bloodbath in?the broader cryptocurrency?space. Leverage has carted off players from the field one after the?other. One by?one, we’ve seen crypto lenders and hedge funds, bodied and bloodied by?the high-interest rate environment after taking on?leverage like drunken?sailors.
We?have seen multiple lenders, hedge funds, and exchanges like Voyager, Celsius, BlockFi, Three Arrows Capital, and FTX all implode as?it?was discovered that many were woefully mismanaged or?nothing more than Ponzi?schemes. You can read more about the recent collapse in?The FTX Fiasco and the Fallout to?Come .
There were industry insiders out there who were publicly warning about the risks in?the?system…
1.) CEO of?Digital Currency Group (DCG) Barry Silbert
2.) Former CEO of?FTX and Alameda Research Sam Bankman-Fried
In?hindsight, it?appears these men were working with some inside information because both of?their companies have proven to?be?deeply ingrained in?this daisy chain of?risk. Genesis, with its poor risk management, and FTX, with its shady shell of?a?business.
It?is?well-known by?now how Sam Bankman-Fried is?tangled up?in?this credit?contagion. His Ponzi scheme, FTX and Alameda Research, is?just the latest and largest victim yet of?this overleveraged catastrophe.
But now, this contagion has spread to?one of?the largest crypto prime brokers, Genesis Global Trading, which recently halted customer withdrawals and has hired advisors and lawyers to?pursue all options to?avoid?bankruptcy. There are plenty of?rumors around about what the consequences would be?of?a?Genesis bankruptcy when it?comes to?DCG, which has its tentacles all over the broader cryptocurrency?system.
In?a?way, this contagion is?coming full?circle. Here I?will highlight a?paper trail that, in?my?opinion, shows how this entire crypto credit contagion began with Silbert’s DCG conglomerate and the SEC, and it?appears to?be?nearing its crescendo right where it?started. To?begin with, we?must go?back and look at?DCG, the companies that comprise it, the investment products it?offers, and its contentious relationship with the?SEC.
The GBTC Cash Cow
Genesis falls under the umbrella of?Barry Silbert’s crypto conglomerate DCG, which has invested in?around 200 cryptocurrency companies and projects since its founding in?2015.
Here is?a?snapshot of?only a?portion of?DCG’s portfolio to?give you some scale of?the empire Silbert has?built.
However, the most important parts of?DCG’s business come down to?only a?handful of?its subsidiaries, Grayscale Securities and Genesis Global?Trading. Below is?a?graphic that shows the corporate structure of?DCG.
The most important company that DCG owns, by?far, is?Grayscale Investments, which is?an?asset manager and the sponsor of?the largest Bitcoin trust in?the world, GBTC.
At?the current price, GBTC holds around $11.4 billion worth of?bitcoin. This equates to?635,235 bitcoin, or?around 3.3% of?Bitcoin’s circulating?supply.
GBTC is?an?absolute cash cow for Grayscale and, subsequently, DCG. It?charges a?2% management fee on?the underlying bitcoin held in?the trust.* According to?its SEC filings, Grayscale earned $68 million from this fee in?Q3 2022, and at?its peak, it?was bringing in?~$144 million a?quarter from this fee?alone. At?Bitcoin’s current price, Grayscale brings in?~$230 million in?revenue annually from the?fee. This equates to?a?substantial portion of?the $800 million in?revenue that Barry Silbert said DCG earns annually in?a?letter to?shareholders on?November 22nd.
GBTC is?a?closed-end trust that allows investors to?gain exposure to?Bitcoin without buying the underlying bitcoin?itself. It?is?a?security and has become extremely popular over the last several years because, for a?long time, it?was the only way for investors to?get exposure to?Bitcoin in?tax-advantaged accounts like IRAs and 401(k)s.
It’s important to?understand how GBTC functions to?comprehend how this led to?all the crypto lender explosions we?have witnessed this?year. Accredited investors can create shares of?GBTC at?Net Asset Value (NAV) by?giving USD or?BTC to?Grayscale. After a?6-month lock-up period, the investors can then convert the shares in?the trust into GBTC shares, which are then freely tradeable on?the open?market. Investors can never take the original BTC out of?the?trust. There is?no?redemption?clause. They can only sell their GBTC shares at?the going market?price. There is?no?mechanism by?which investors can redeem their?bitcoin.
The reason this is?important is?it?creates a?dynamic where the share price of?GBTC can trade on?the open market above or?below the Net Asset Value (NAV) of?the bitcoin that underlies the?trust. When GBTC is?trading at?a?premium, that means GBTC shares are trading at?a?higher price than the value of?the underlying?bitcoin. When it?is?trading at?a?discount, it?means GBTC shares are trading at?a?lower price than the value of?the underlying?bitcoin.
This hurts investors holding GBTC because there can be?wild fluctuations between the price of?GBTC compared to?the underlying?asset. This is?also why Grayscale has stated publicly that it?had structured GBTC legally since its inception to?one day convert into an?ETF. With an?ETF, an?authorized participant can create or?redeem shares to?bring the ETF back to?NAV. This would be?an?optimal investment product for investors because there would be?no?discounts or?premiums, the value of?the ETF shares would always track the underlying bitcoin, and the management fees would be?much lower?too.
But, alas, the SEC did not approve Grayscale’s application to?convert GBTC into a?spot Bitcoin ETF, and this market inefficiency with GBTC persisted, offering an?arbitrage opportunity for?investors. This is?where things started to?get out of?control.
Paper Bitcoin…at a?Premium
For a?long time, GBTC was the only game in?town for individuals and institutions to?gain exposure to?Bitcoin in?tax-advantaged accounts like IRAs and 401(k)s, and institutions that were legally only allowed to?buy?securities. At?the same time, demand for GBTC grew because people could gain exposure to?paper Bitcoin conveniently without the challenges and security risks associated with taking self-custody. As?the price of?Bitcoin increased, investors flooded into the only Bitcoin investment product available to?them in?their brokerage?accounts.
This led to?an?explosion in?assets under management (AUM) for Grayscale, and the fees rolled?in. At?its peak during the bull market, over $40 billion dollars worth of?bitcoin was held in?GBTC.
Due to?the lag between shares of?GBTC being created in?the trust and these shares hitting the open market after the 6-month lockup period, the increased demand created a?shortage of?GBTC shares available on?the open market, driving the price of?the shares up?to?a?large premium to?NAV as?demand for Bitcoin soared in?the bull?market.
One can observe below how GBTC traded at?a?premium for most of?its history prior to?2021.
One of?the largest drivers of?this GBTC premium was institutional investors, who began putting on?an?arbitrage trade to?take advantage of?the market inefficiency between the price of?GBTC and the underlying bitcoin in?the?trust.
This became known in?crypto circles as?“The Grayscale Trade.”
Here’s the trade:
Step 1: Borrow BTC or?USD from a?lender like Genesis
Step 2: Put the BTC into the GBTC trust and obtain GBTC shares at?NAV
Step 3: Hold the GBTC shares for the 6-month lock-up period
Step 4: Sell the GBTC shares on?the open market when the lock-up ends
Step 5: Collect the premium and profit.?
Step 6: Repeat
With the GBTC premium breaching 20% at?the end of?2020, this trade was basically free money for the accredited investors who were able to?do?it. It?was especially popular among crypto hedge funds and lending institutions, like Three Arrows Capital and?BlockFi.
In?many ways, much of?BlockFi’s business model revolved around this one unsustainable Grayscale?Trade. This was how BlockFi offered such high yields in?its interest-bearing?accounts. They would rehypothecate user funds into this GBTC premium trade, roll it?over every 6 months, and since the premium was greater than the yield offered on?its interest-bearing accounts, they could keep using this trade to?fund their?business.
After consistently putting on?this Grayscale Trade, Three Arrows Capital and BlockFi eventually became the two largest holders of?GBTC shares, collectively owning 58,741,046 shares of?GBTC as?of?Q4 2021.
To?be?clear, many other institutional investors were putting on?the same trade, but BlockFi and Three Arrows Capital were the most well-known, and they were putting it?on?with?size. As?this trade became more popular, the price of?GBTC and Bitcoin went up?and to?the?right.
This can be?observed in?the tripling of?BTC holdings in?GBTC from 2020 to?2021.
Things were going great for BlockFi and Three Arrows Capital as?they rolled over this Grayscale Trade every 6?months. It?was also going well for Genesis and?DCG. Genesis was making a?killing loaning out to?these firms to?put on?the trade, and DCG was making more money than ever before from fees as?GBTC’s AUM ballooned.
But the arbitrage trade wasn’t risk-free. It?only worked if?the GBTC premium was still there when your individual lock-up period?ended. Without the premium, the whole money-making machine falls apart for?everyone. A?firm will actually lose money putting the trade on?if?there is?no?premium, especially if?they borrowed to?put on?the trade in?the first place, which a?lot of?these firms?did. And that’s precisely what?happened.
A?Premium Flips to?a?Discount
February 24th, 2021?— a?date that will live in?infamy.
This was the day that the GBTC premium vanished, never to?be?seen?again. Since that day in?February, GBTC has been trading at?a?massive discount to?NAV.
Suddenly, the darling trade of?these hedge funds and lending firms was?gone. What made matters worse is?that these firms had to?hold these illiquid GBTC positions due to?the 6-month lockup?period. All they could do?was sit there and watch the GBTC discount?widen.
So?why did the premium?disappear?
The GBTC premium disappeared for a?variety of?reasons. Here are two potential factors:
When the Grayscale Trade disappeared, these firms started to?scramble to?raise funds and search for yield in?riskier?endeavors. This was when things all started to?fall apart behind the?scenes.
BlockFi
As?mentioned above, much of?BlockFi’s lending model depended on?their ability to?rehypothecate user funds and perform the Grayscale Trade on?the?backend. BlockFi collected a?premium above 15% for much of?2020 by?performing this?trade. They then turned around and offered retail investors 6-8% interest on?their crypto holdings and then pocketed the?spread.
It?was well known that BlockFi was performing this Grayscale?Trade. This was one of?its primary revenue sources, and the company even mentioned the GBTC arbitrage trade in?a?leaked slide from a?fundraising deck in?2021, shown?below.
In?February 2021, right before the GBTC premium disappeared, CoinDesk reported:
This boosted their GBTC shares to?36.1 million?shares. Around this time, BlockFi was also planning to?launch a?competing BlockFi Bitcoin Trust so?that they would not have to?rely on?GBTC to?put on?the?trade.
This news started to?cause an?uproar across the cryptocurrency?industry. People were not happy to?find out that BlockFi was performing this GBTC arbitrage trade in?the background, which led former CEO Zac Prince to?respond with,
When asked about the GBTC arbitrage trade, BlockFi’s Chief Risk Officer, Rene van Kesteren replied, “Locking up?Bitcoin in?Grayscale could theoretically pose a?liquidity?risk. But BlockFi discloses the arrangement to?users and takes steps to?defuse any?danger.”?— March 4th, 2021
As?the premium trade vanished and interest rates increased, BlockFi started to?gradually reduce the interest rates offered on?its interest-bearing?products. BlockFi initially advertised 6.2% APY on?its interest-bearing cryptocurrency products, and by?its last days in?business, the yield offered on?its Bitcoin interest-bearing product was only 2% APY.
When GBTC’s premium disappeared, BlockFi also raised $350 million in?a?Series D?round, giving the company a?valuation of?$3?billion. One has to?wonder if?the loss of?revenue from the GBTC premium trade played a?role in?the timing of?this?raise.
It?was around this time that BlockFi made a?rather large loan to?a?$10 billion cryptocurrency hedge fund with a?sterling reputation, Three Arrows Capital (3AC). In?a?leaked investor call in?June 2022 , it?was reported that BlockFi had loaned 3AC $1 billion?dollars.
During the investor call, it?was discovered that the billion-dollar loan made to?3AC was collateralized by?two-thirds in?bitcoin, and the remaining third were in?shares of?GBTC, worth a?total of?~$430 million at?the time of?liquidation.
According to?the call, “BlockFi was able to?easily liquidate its position in?Bitcoin but ran into problems with the GBTC because the discount had reached lows last week of?nearly?34%. As?BlockFi attempted to?liquidate its GBTC position, Pompliano explained, the price went?down.”
BlockFi’s liquidity issues with GBTC foreshadowed what was to?come for lenders with large GBTC positions during a?liquidity?crisis.
Three Arrows Capital
As?the discount disappeared, Three Arrows Capital suddenly found itself in?quite the?pickle. It?had put on?a?significant GBTC position with leverage provided by?Genesis. 3AC now had to?sell these shares at?a?discount to?pay its debt obligations. With the GBTC share price and the broader cryptocurrency markets crashing, 3AC was effectively insolvent without the Grayscale Trade available to?them.
From?3AC’s bankruptcy filings in?July , we?now know that Genesis loaned 3AC $2.3 billion?dollars. This represented nearly 50% of?Genesis’s entire loan book at?the?time! To?make matters worse, the loans were undercollateralized with GBTC and other illiquid cryptocurrencies. The loans were collateralized with a?bitcoin IOU, an?ether IOU, and two high beta centralized tokens, down an?average of?-88% year-to-date.
As?the premium switched to?a?discount, 3AC could not afford to?pay back its USD loan to?Genesis and incurred large losses as?the GBTC premium turned into a?deeper and deeper?discount.
It?was around this time when 3AC began desperately searching for anything to?fill the hole that was once filled by?the GBTC premium trade to?avoid its?downfall. They began taking out USD loans from any crypto lender that would lend to?them. BlockFi, Voyager, and Celsius all gave out loans, often collateralized by?3AC’s crypto and GBTC holdings, just like its Genesis?loan.
3AC then went searching for yield with the newly acquired funds, and where they found it?was a?promising protocol called?Anchor. The Anchor protocol was offering a?20% yield on?the Terra stablecoin, which was being promoted by?the now-wanted fugitive?Do?Kwon .
Here is?Zhu Su, Co-Founder of?Three Arrows Capital, tweeting about Terra Luna and Anchor about a?month before its?collapse.
Of?course, we?now all know how this ended up.?Terra Luna crashed ?— wiping out ~$50 billion in?value in?a?matter of?days.
3AC had massive exposure to?the Terra Luna collapse, likely in?part because they were searching for yield to?avoid bankruptcy and make up?for the losses incurred by?the GBTC premium flipping to?a?discount.
Terra Luna’s collapse led to?3AC’s implosion in?the early summer of?2022, and this, in?turn, took down many of?the crypto lenders?too. All the counterparties took massive losses on?their loans to?3AC, which ultimately contributed to?their respective downfalls.?
Voyager filed for bankruptcy on?July 12th
Celsius filed for bankruptcy on?July 14th
BlockFi filed for bankruptcy on?November 28th
Genesis is?now actively working to?avoid bankruptcy
Genesis incurred a?massive $1.2 billion dollar loss in?3AC, effectively making them?insolvent. It?turns out that the counterparty risk Barry Silbert had been warning about in?his tweet from June 2021 was actually right under his nose the whole time.
Genesis
This now leads us?to?Genesis, the largest crypto prime broker, which dished out a?whopping $130.6 billion dollars worth of?loan originations in?2021.
Genesis has been hit by?a?plethora of?losses related to?bad loans, fraudulent counterparties, and a?general decline in?the price of?GBTC and cryptocurrencies in?general.
First, Genesis presumably took a?significant loss when Terra Luna collapsed after they swapped $1 billion worth of?BTC for $1 billion worth of?UST, which will probably go?down as?one of?the worst transactions in?history. This position has presumably been marked to?zero after UST crashed.
The second event was the $1.2 billion dollar exposure to?3AC. This was the initial response after the 3AC collapse from now resigned CEO Michael Moro, with the “large counterparty” now known to?be?3AC.
Lastly was the recent exposure to?the FTX and Alameda Research Ponzi?scheme. Here is?the timeline of?Genesis regarding their exposure to?FTX.
November 8th?— Genesis denies?exposure.
November 9th?- Genesis says they have $7 million worth of?losses.
November 10th?— Genesis says they have $175 million trapped on?FTX.
November 11th?—?Genesis received a?$140 million equity infusion from their parent company DCG to?help provide some breathing?room.
November 16th?— Genesis halts customer withdrawals and new loan originations, citing 3AC and FTX exposure.
November 17th?— Reports surface that they are attempting to?raise an?emergency $1?billion.
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November 21st?— Genesis slashes its raise target in?half and warns of?potential?bankruptcy.
Since then, it?has been discovered that Genesis owes customers of?crypto exchange Gemini $900 million dollars, as?well as?a?second group of?assorted creditors another $900 million dollars,?for a?total of?$1.8 billion dollars , and that number is?expected to?grow. In?addition, it?has been reported that Genesis has hired restructuring lawyers to?help find a?way to?prevent?bankruptcy.
In?a?Genesis fundraising document?leaked to?the WSJ , we?learned that Genesis attempted to?raise emergency funds due to?a?“liquidity crunch due to?certain illiquid assets on?its balance sheet”…and…“There is?an?ongoing run on?deposits driven mainly by?retail programs and partners of?Genesis (i.e., Gemini Earn) and institutional clients testing liquidity, ”
Later on, it?was revealed that the “certain illiquid assets” on?Genesis’s balance sheet were comprised of?~39 million shares of?GBTC pledged as?collateral from the 3AC loans and multiple loans to?its parent company?DCG.
This leads us?to?the final boss of?this whole labyrinth of?leverage…DCG.
Digital Currency Group
When 3AC blew a?$1.2 billion dollar hole in?Genesis’s books, Genesis was effectively?insolvent. In?the wake of?the 3AC collapse, it?led to?this tweet from former Genesis CEO Michael Moro,
It?was later revealed that by?“assuming certain liabilities, ” DCG took the bad 3AC loan on?its books, took out a?$1.1 billion dollar promissory note due June 2032 from Genesis, and proceeded to?give the cash right back to?Genesis for them to?fill the hole in?its?books.
If?this makes you raise your eyebrows a?little bit, then you are not?alone. This kind of?intercompany loaning to?keep the company afloat is?suspect, to?say the?least.
Barry Silbert explained this loan in?his letter to?shareholders ?on?November 22nd:
"You may also recall there is?a?$1.1B promissory note that is?due in?June 2032. As?we?shared in?our previous shareholder letter in?August 2022, DCG stepped in?and assumed certain liabilities from Genesis related to?the Three Arrows Capital default. As?stated in?August, because these are now DCG liabilities, DCG is?participating in?the Three Arrows Capital liquidation proceedings on?the Creditors' Committee and is?pursuing all available remedies to?recover assets for the benefit of?creditors. Aside from the Genesis Global Capital intercompany loans due in?May 2023 and the long-term promissory note, DC’s only debt is?a?$350M credit facility from a?small group of?lenders led by?Eldridge."
On?top of?that questionable loan to?bail out Genesis from the bad 3AC loan, DCG also took out another $575 million intercompany loan from Genesis due May 2023 to?“fund investment opportunities and to?repurchase DCG stock from non-employee shareholders.”
"In?recent days, there has been chatter about intercompany loans between Genesis Global Capital and?DCG. For those unaware, in?the ordinary course of?business, DCG has borrowed money from Genesis Global Capital in?the same vein as?hundreds of?crypto investment firms. These loans were always structured on?an?arm’s length basis and priced at?prevailing market interest rates. DC?currently has a?liability to?Genesis Global Capital of?-$575 million, which is?due in?May 2023. These loans were used to?fund investment opportunities and to?repurchase DC?stock from non-employee shareholders in?secondary transactions previously highlighted in?quarterly shareholder updates. And to?this day, I’ve never sold a?share of?my?DCG stock." - Barry Silbert
This $575 million dollar loan is?most likely entirely deployed by?now, as?DCG has been purchasing GBTC shares in?an?attempt to?stop the GBTC discount from widening?more. The GBTC shares bought with this loan are likely down ~70% today.
DCG has been aggressively purchasing shares in?the last year to?reduce the discount, so?they can attract and raise?capital. DCG publicly announced a?pledge to?buy $1 billion worth of?GBTC shares in?November 2021 . 2 weeks later, DCG?raised $700 million dollars ?in?an?equity round at?a?$10 billion dollar?valuation. The round was led by?SoftBank, CapitalG, and Ribbit?Capital.
Below is?a?chart that shows the amount of?GBTC shares owned by?DCG. Today, DCG owns about 10% of?the total GBTC supply.
You can see below how BlockFi liquidated all of?its GBTC holdings by?Q1 2022, right as?DCG was accumulating?shares. DCG is?now the largest shareholder of?GBTC, with 66,972,899?shares.
From March 2021 to?June 2022,?DCG bought $772 million of?GBTC shares at?an?average price of?$40 dollars per share . With the GBTC price currently sitting at?$8.98 today, that means DCG is?down an?average of?-77.5% on?those GBTC purchases (ouch).
The real problem here is?liquidity.
Genesis needs liquidity now to?fund its withdrawals and pay its?creditors. Genesis has short-term obligations, and it?appears a?lot of?its capital was deployed into illiquid long-term investments, like?GBTC. It?will go?bankrupt if?it?does not get capital?soon. It’s possible that Genesis has already begun selling GBTC shares to?raise cash and make some depositors?whole. This could be?one reason why we?have seen the GBTC discount has dropped to?an?all-time low of?-50%.?
DCG owes Genesis $1.7 billion and other creditors $350 million and has already exhausted its liquid capital by?buying back GBTC shares and bailing out Genesis when it?blew up?from 3AC. Now DCG is?desperately trying to?raise cash to?control the fallout from?the FTX fiasco ?and help Genesis, and itself, avoid?bankruptcy.
As?you can see, this is?a?total?mess.
The questions are:
DCG’s Options
Although DCG finds itself in?a?tight spot, it?does have several options available to?them to?avoid?bankruptcy. Keep in?mind that we?are operating without all the information?here.
Here are six potential avenues DCG can take:
1.) Sell their GBTC shares to?raise cash
This could provide a?buffer for cash-strapped Genesis, but it?would not be?enough to?fix the?problem. They also are not incentivized to?do?this because it?would widen the discount even more and likely cause their AUM to?drop, reducing their fees, their primary source of?revenue.
It’s likely we?have already seen some of?this selling as?the GBTC discount has widened of?late; however, DCG and Genesis cannot just sell their entire GBTC positions. GBTC is?illiquid because there are legal restrictions concerning issuers of?a?security selling over-the-counter. This is?called?rule 144A . It?is?explained on?the SEC’s website below,
“the number of?equity securities you may sell during any three-month period cannot exceed the greater of?1% of?the outstanding shares of?the same class being sold, or?if?the class is?listed on?a?stock exchange, the greater of?1% or?the average reported weekly trading volume during the four weeks preceding the filing of?a?notice of?sale on?Form 144.” -
Due to?this rule, Genesis and DCG would be?required by?law to?provide notice of?the sale and would only be?able to?sell ~7 million shares every?quarter. For this reason, it?would take time for these entities to?unwind their GBTC positions.
All in?all, selling its GBTC shares would only be?a?bandaid for a?bullet wound and would likely only widen the discount further and reduce DCG’s fee revenue, so?this isn’t an?ideal option for DCG to?take.
2.) Raise equity to?fill the hole
The last time DCG raised funds, it?was valued at?$10?billion. This was near the top of?the bull market when Bitcoin’s price was around $60,000. Now they will need to?try to?raise a?down round in?a?challenging environment with annual revenues down >50%.
But there is?still value in?DCG beyond?Genesis. As?mentioned above, Grayscale is?a?cash cow that brings in?annual recurring revenue of?~$300 million at?today’s Bitcoin?prices. They can leverage those future cash flows to?try to?raise?capital. DCG also holds an?extensive venture portfolio, including assets like CoinDesk and?Foundry. DCG can even raise funds off of?the 10% of?the outstanding GBTC shares they own instead of?selling?them. Lastly, they have bankruptcy claims in?3AC, FTX, and Alameda Research that could fetch some value, but the details around those claims remain?unknown.
If?DCG can pull it?off, it?could raise funds to?try to?pay back the $1.7 billion it?owes Genesis creditors by?leveraging the assets they?have. But even then, it’s hard to?see how that would fill the?hole.
3.) Sell Off Assets to?Raise Capital
DCG could also sell its assets to?raise capital, including its venture?portfolio. One of?the most valuable assets that it?owns is?CoinDesk. Semafor reports that people familiar with the situation state that DCG was approached by?buyers?to?purchase CoinDesk at?a?price of?$300 million . It?is?estimated that CoinDesk brings in?about $50 million in?annual revenue, mostly from its Consensus?Conference.
They also could sell Grayscale to?another asset manager to?manage. Asset managers would need to?seriously consider this offer, given the lucrative 2% management?fee. This would not impact GBTC shareholders much either, which is?a?good thing, but it?would certainly impact?DCG. This would be?selling their main revenue?driver. It?is?estimated that DCG could sell Grayscale for ~$500 million to?the right?buyer. Yet, if?DCG sold Grayscale, it?would basically be?kissing its business?goodbye.
And still?— this likely would not be?enough to?fill DCG’s?hole.
4.) Restructure loans with Genesis creditors
Genesis could work with DCG to?restructure its loans to?give both parties more?runway.
Right now, DCG owes Genesis $1.7?billion. It’s in?everybody’s best interest if?DCG can negotiate and strike a?deal with Genesis creditors, allowing both parties to?avoid?bankruptcy.
If?DCG can work out a?resolution with Genesis creditors, perhaps they can survive to?live another?day. If?DCG can’t come to?a?resolution, then Genesis will likely go?into bankruptcy, and DCG will have to?answer to?its creditors in?the bankruptcy?courts.
DCG could raise money and inject capital into Genesis so?that they can fund some of?their depositor’s withdrawals. Or?maybe DCG could negotiate with Genesis creditors to?roll their debt into DCG warrants. This would give them a?senior claim on?the cash flow from?GBTC. This could be?enticing to?Genesis creditors, given GBTC’s annual recurring?revenues.
There are many different ways they may come to?a?deal, and I?believe it?is?in?the best interest of?both parties to?do?so. If?a?deal was worked out, perhaps both DCG and Genesis could avoid?bankruptcy. However, it’s hard to?see how any investor could trust Genesis after all of?this.
5.) Seek Reg M?Exemption
For GBTC shareholders?— this would be?a?goldilocks?scenario.
If?the SEC approved this, Reg M?would allow GBTC shareholders to?redeem their shares for the underlying assets at?a?1:1?ratio. So?if?Reg M?relief was approved by?the SEC, the GBTC discount would practically disappear overnight as?it?would allow Grayscale to?simultaneously create and redeem shares and return the fund back to?NAV.
The SEC would need to?approve in-kind redemptions for shareholders to?take custody of?the underlying?bitcoin. This could pose challenges because a?lot of?GBTC shareholders hold the security in?accounts that aren’t legally allowed to?hold spot?bitcoin. However, shareholders could still redeem their shares for cash at?NAV instead of?the alternative of?selling the shares at?a?40% discount on?the open?market.
This would be?a?positive outcome for GBTC investors, and the SEC would do?right by?shareholders to?approve this relief and allow in-kind redemptions to?protect?investors. I’m skeptical about whether the SEC will approve this because they have already denied Grayscale’s application to?convert to?an?ETF this year, which would have given Grayscale the Reg M?exemption.
By?approving a?Reg M?exemption, the SEC would risk appearing supportive of?the cryptocurrency industry in?the wake of?FTX’s?collapse. Since they already rejected Grayscale’s application to?convert GBTC into an?ETF earlier this year, it’s hard to?see them approving Reg M?relief. At?this point, it?becomes a?game of?politics instead of?a?matter of?protecting retail investors and GTC shareholders.
6.) Liquidate the Trust
This is?the nuclear option and appears highly unlikely, given that DCG would be?killing its cash?cow. By?liquidating the trust, DCG would be?losing all that annual recurring revenue from the fee, essentially ending any hope for the business to?continue.
Shareholders of?GBTC cannot vote to?liquidate the trust after the 75% shareholder liquidation provision was amended in?the GBTC charter back in?2018.
Today, the liquidation of?the trust is?at?the sole discretion of?the sponsor, and the incentive for them to?voluntarily do?this just doesn’t add?up.
The one way that a?liquidation of?the trust can occur is?in?the event of?a?DCG bankruptcy or?insolvency unless 50% of?the shareholders vote to?move the trust to?a?new sponsor?instead.
In?the event of?bankruptcy and subsequent liquidation of?the trust, it?remains unclear whether or?not shareholders would be?able to?take in-kind redemptions of?the underlying bitcoin or?if?it?would have to?be?distributed in?dollars.
I’m not a?lawyer, but the language makes it?sound like shareholders would be?able to?redeem the underlying bitcoin at?the sponsor’s discretion, which is?a?potentially positive?outcome.
If?that is?not the case, dollars would need to?be?distributed to?GBTC shareholders. This means that DCG would need to?sell all 635,235 bitcoin on?the open?market. This would crash the price of?bitcoin, and there would likely be?a?lot of?price slippage as?the sponsor sold the?bitcoin. This would result in?less value being returned back to?GBTC shareholders and would tank the price of?bitcoin in?the?process. This would not be?ideal.
All in?all, a?liquidation of?the trust is?a?last-ditch option that DCG is?unlikely to?take voluntarily. In?the event of?DCG’s bankruptcy, there is?language in?the charter that makes it?appear like in-kind bitcoin redemptions would be?possible if?the trust was?liquidated.
The real risk that GBTC shareholders need to?think about here is?whether the bitcoin that underlies the trust is?secure and accounted?for.
Coinbase is?the qualified custodian for?GBTC. They legally cannot rehypothecate or?lend out the bitcoin and have to?keep the account segregated from other?funds. Coinbase recently?announced in?a?public statement ?that all of?the bitcoin underlying GBTC was accounted?for.
Investors were unsatisfied that Coinbase didn’t show proof of?this cryptographically, and I?understand that?concern. But, excluding the non-zero possibility that DCG, Grayscale, and Coinbase are running a?fraudulent operation, I?have no?reason to?believe that the bitcoin is?not?there.
Coinbase is?a?regularly audited public company, and GBTC is?likely one of?its largest clients for its Coinbase Custody?product. If?Coinbase somehow mismanaged the bitcoin that underlies the largest Bitcoin fund in?the world, no?other entity would trust their custody solution ever again, especially now that other institutional-grade custody solutions like Fidelity and BNY Melon?exist. It?is?in?Coinbase’s best interest that the bitcoin is?there, and if?they say it?is, then I?believe there is?a?99.9% chance it?is.
In?case you are someone who understandably isn’t satisfied without on-chain confirmation, then here are?Ergo ’s findings, a?respected on-chain analyst from OXT Research.
Ergo and his team tracked down all the bitcoin on-chain that underlie the GBTC trust held at?Coinbase, and all the bitcoin was?there.
Ergo’s findings should provide a?sense of?relief for GBTC holders. The bitcoin underlying GBTC has been independently verified on-chain and is?accounted for in?Coinbase?Custody.
The Blame Game
What I?attempted to?lay out in?this piece is?evidence that a?lot of?this crypto contagion began and is?now culminating with?DCG. It?all revolved around the Grayscale Trade that was present due to?GBTC’s structure as?a?closed-end?trust. Once the GBTC premium trade disappeared, hedge funds and crypto lenders went further out on?the risk curve in?chase of?yield right as?the Federal Reserve started increasing interest?rates. It?was a?recipe for?disaster. Risk happens fast, and so?began a?wave of?bankruptcies that spread like wildfire throughout the entire broader crypto?industry.
So?who is?to?blame for this complex web of?leverage and speculation?
Sure, you can blame the crypto lenders for their shockingly poor risk?management. You can blame the hedge funds and institutional investors for putting on?risky trades with obscene amounts of?leverage?too. You can also blame the scammers and criminals like Do?Kwon and Sam Bankman-Fried for running Ponzi schemes and?frauds. You can blame DCG for providing the leverage for investors to?put on?this Grayscale Trade and letting them roll it?over every 6 months, ripping off retail investors in?the?process. You can even blame the Federal Reserve for creating this easy money, yield-chasing environment that encouraged and allowed speculation to?run?rampant.
But to?me…I think the one institution that could have actually prevented this from getting so?out of?hand, just by?doing its job, is?the?SEC.
According to?the SEC’s website, its mission is?to?“protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation.”
I?would say the SEC has failed its mission in?its refusal to?approve the conversion of?GBTC into a?spot Bitcoin?ETF. I?think the damage speaks for?itself.
If?the ETF conversion had been approved, then the premium trade would not have?existed. If?the premium trade would not have existed, these firms would not have grown to?the size they had and taken on?as?much leverage as?they?did. A?lot of?this mess could have been?avoided.
In?my?opinion, the SEC failed in?its mission by?not approving a?spot Bitcoin ETF resulting in?countless retail investors needlessly being harmed and losing their life savings in?this crypto credit?contagion.
ETFs are a?safer, better investment structure for investors than a?closed-end fund like GBTC because ETFs have no?lockups, no?premiums/discounts, lower fees, more transparency, and better tax?treatment.
Although Grayscale had selfish motives for wanting an?ETF (to?gain market share and attract capital to?its product), you have to?give them some?credit. Grayscale has been doing everything it?can to?convert GBTC into an?ETF. They became the first SEC reporting company in?2020 and thus have to?adhere to?a?higher level of?disclosure and financial reporting than other companies in?the?space.
Despite this, the?SEC rejected their ETF application this year ?and instead?approved a?CME Bitcoin Futures ETF . Grayscale is?now?suing the SEC ?for approving a?futures ETF and not approving its spot ETF conversion.
In?response, Grayscale started a?comment submission portal on?its website where investors can submit comments about the SEC’s rejection during the SEC’s 240-day review?period.
Since June 19th,?11,609 comment letters ?have been submitted, many from GBTC shareholders. Grayscale writes, “99.96% of?comment letters were submitted in?support of?the conversion.”
In?the past, the SEC has denied dozens of?similar spot ETF applications from other major players in?the space, including Fidelity’s WisdomTree Bitcoin ETF and NYDIG’s Bitcoin ETF, mainly citing 1.) a?lack of?qualified custodian solutions and 2) a?lack of?investor protections and market manipulation and?fraud.
The qualified custodian concern is?unfounded in?2022. There are several qualified custodians operating today including Fidelity, BNY Melon, State Street, Prime Trust, and?Coinbase. This problem has been solved for?years.
As?for the spot Bitcoin market manipulation and fraud, how bad could it?be?if?the SEC found it?suitable enough to?approve a?CME Bitcoin futures ETF that’s supposed to?track the underlying spot?market?
Futures contracts are inherently more expensive to?manage, don’t track the underlying spot price as?well, and are more subject to?price manipulation.
Fidelity performed a?lead-lag analysis ?and submitted their findings to?the SEC that empirically showed how the CME bitcoin futures market leads price discovery in?bitcoin futures and spot?markets.
Fidelity’s main takeaway from the analysis was,
“Our study’s finding that the CME bitcoin futures market leads bitcoin price discovery across bitcoin futures and spot markets means that an?actor trying to?manipulate the ETP?would be?reasonably?likely to?have to?trade in?the CME bitcoin futures market.”
Fidelity’s analysis shows that if?a?bad actor wanted to?manipulate the price of?bitcoin, they would have better success if?they used the futures market rather than the spot market, but yet, still no?spot Bitcoin ETF approval from the?SEC.
Even SEC Commissioner Hester?M. Peirce is?dumbfounded by?the SEC’s continued rejection of?a?Bitcoin spot product,
“The Commission’s resistance to?a?spot bitcoin ETP is?becoming almost legendary.”
"The reasons for this resistance to?a?spot product are difficult to?understand apart from a?recognition that the Commission has determined to?subject anything related to?bitcoin—and presumably other digital assets—to a?more exacting standard than it?applies to?other products." —?Commissioner Hester M. Peirce, June 2022
By?rejecting spot Bitcoin ETF applications, approving bitcoin futures ETFs, and allowing GBTC to?persist as?it’s currently structured, the SEC has failed to?protect?investors.
Lastly, regulators in?many other countries, such as?Canada, Australia, South Africa, and Europe, have all approved spot Bitcoin?ETFs. These products have resulted in?capital flight abroad as?investors seek a?better investment?vehicle. The SEC’s failure to?approve the conversion of?GBTC into an?ETF not only hurt investors, but has also negatively impacted American competitiveness.
Ultimately, some of?the blame for the wealth destruction we’ve seen across the broader cryptocurrency industry falls at?the feet of?the SEC for not allowing GBTC to?be?converted into a?spot Bitcoin?ETF. These regulators are in?charge of?protecting investors and creating fair and efficient markets, it’s about time it?got back on?its stated?mission. For all of?these reasons, it’s long past due for the SEC to?approve a?spot Bitcoin?ETF.
Conclusion
If?there are any lessons to?be?learned from this web of?leverage and fraud, it?is?this, leverage and counterparty risk?kill.
As?Custodia’s CEO Caitlin Long famously said on?a?panel with Sam Bankman-Fried at?the Bitcoin 2021 conference, “a?fool and his leveraged bitcoin are soon parted.”
All of?these institutions tried to?play fiat games on?top of?Bitcoin. Lenders tried to?offer yield on?a?disinflationary asset and got rekt doing?it. Investors tried to?chase yield by?leveraging up?to?their teeth and made riskier and riskier bets and got rekt doing it.?
Swan’s Andy Edstrom said it?best back in?May,
Another big takeaway from this daisy chain of?counterparty risk is?“not your keys, not your coins.”
What Celsius, Voyager, Genesis, FTX, and BlockFi should teach every investor is?that there is?no?substitute for holding spot?bitcoin. When you hold GBTC, or?bitcoin, on?an?exchange or?lending platform, you do?not own?bitcoin. You own paper?bitcoin. You own a?bitcoin?IOU. You are putting your trust in?a?counterparty, not an?immutable?ledger.
The beauty of?Bitcoin is, if?you take self-custody, you never have to?trust another exchange, lender, custodian, or?Bitcoin trust ever?again. If?you never want to?be?caught up?in?bankruptcy proceedings, become a?victim of?a?fraudster, or?have to?read the fine print of?a?trust charter, then take ownership of?your?bitcoin. You can avoid all of?these counterparty risks forever by?withdrawing your bitcoin into your own?possession. That is?why we?recommend buying spot bitcoin and taking self-custody to?all of?our clients at?Swan. If?you want to?avoid all of?this nonsense, then that’s all you have to?do.
It’s that?simple.
Don't trust, verify.