Following the bankruptcy of FTX, the crypto lending platform Genesis fell into a liquidity crisis, which involved the well-known Bitcoin trust fund Grayscale and its former owner DCG (Digital Currency Group), involving billions of dollars in assets. This crash is potentially related to the collapse of Terra LUNA in May. After all, everyone is a creditor who transfers money from one hand to the other. Unlike before, since Grayscale is a trust regulated by the SEC and Genesis is a link for institutional investment in cryptocurrencies, the failure of the two may cause the risks of the cryptocurrency circle to overflow into the traditional financial field, with disastrous consequences.
From Genesis to Grayscale to DCG
Web3 users may know about exchanges such as FTX/Binance, but know little about institutional investors. Genesis is a prime brokerage for crypto assets. In the traditional financial sector, PB provides customers with a package of "steward services", including clearing and custody, margin trading, and trading services. Crypto PBs like Genesis provide lending and over-the-counter trading services for digital assets. In a nutshell, it is the pimp of large institutions in the cryptocurrency circle.
GrayScale is a Bitcoin Trust, or GBTC. Traditional investors can buy GBTC like an ETF to gain exposure to Bitcoin without having to touch the cryptocurrency itself. Unlike an ETF, GBTC has no arbitrage mechanism to bring supply and demand back into balance. Its shares cannot be redeemed for physical Bitcoin or cash and can only be sold to other buyers through the over-the-counter market. Grayscale needs regulatory approval to implement a stock repurchase program. This is in line with our common sense that trusts need to be held for the long term.
The US cryptocurrency community has been striving for the SEC to approve the listing of cryptocurrency-related ETFs, and Grayscale has repeatedly appealed, hoping to convert GBTC into a Bitcoin ETF, thereby reversing the discount trend of GTBC through repurchase. However, as Canada and Hong Kong have successively approved cryptocurrency ETFs, the SEC has refused to approve them, citing concerns about potential fraud and manipulation on unregulated exchanges where transactions take place. Graysale has now appealed to the SEC — — You should know that GBTC maintained a positive premium for several years from 2015 to March 2021. Qualified investors subscribe to GBTC through Grayscale with cash or BTC, and can sell it on the OTC market after 6 months to complete arbitrage; however, starting in March 2021, the GBTC premium disappeared, and it is better to purchase GBTC directly on the OTC market, and no one has subscribed since then. As of November 24, the premium of GBTC has dropped to -39.2%.
Genesis and Grayscale are both wholly owned subsidiaries of DCG. Other subsidiaries of DCG include the well-known media CoinDesk, Bitcoin mining company Foundry, Luno exchange, data provider TradeBlock, and wealth management company HQ Digital. Among them, Grayscale is the egg-laying hen of DCG, which manages tens of billions of dollars of BTC and enjoys 2% management fees every year. So what kind of interaction do they have? What is the relationship with the Genesis liquidity crisis?
Old debts paid in new terms
Genesis (also a subsidiary of DCG) is the primary lender to Three Arrows. Genesis essentially lent Three Arrows at its single counterparty limit, according to a July analysis of public SEC and investor documents by DataFinnovation. The analysis speculates that Three Arrows would borrow BTC from Genesis in exchange for collateral, return BTC to Genesis to create GBTC (Genesis is the only authorized person who can create GBTC shares), and then return GBTC to Genesis, over and over again. When GBTC trades at a premium to BTC, Three Arrows is essentially making money and using the profits to increase exposure to GBTC and other crypto assets. Assuming the premium continues, Three Arrows could theoretically repeat this arbitrage process forever. DCG also made a lot of money on this transaction by increasing the AUM of Grayscale's BTC trust to increase fee income.
Unfortunately, as GBTC selling pressure increased and demand for the product decreased, this premium turned into a discount. Coupled with the death spiral of Luna (previously a sizable investment position in the Three Arrows portfolio), the end result was an insolvency of Three Arrows. Genesis is unlikely to fully recover its outstanding loans to Three Arrows, and given the lack of sophisticated counterparties in crypto, they likely have non-negligible counterparty risk to Three Arrows. Existing lending relationships and counterparty risk with potential Three Arrows (or other insolvent crypto funds) create ongoing liquidity pressures for Genesis and a source of risk of bankruptcy default.
On the retail side, Genesis has been scavenging the liquidity of Web3 users through DeFi pools such as Circle’s yield program and Gemini Earn, using this as the principal for lending. In order to provide similar services to traditional PB companies, Genesis needs strong solvency and liquidity. If we look back at traditional PBs such as Goldman Sachs, we will find that the situation is much more optimistic — — Goldman Sachs will not expose itself to the price fluctuations of the underlying securities, but will simultaneously establish a long position with JPMorgan Chase, offering its customers a price (sell price) slightly higher than what it gets (buy) from JPMorgan Chase. As a pioneer in the crypto OTC and prime brokerage markets, Genesis does not have the same opportunities as traditional financial institutions to enter the strong inter-dealer market, that is, it does not have a good partner like Morgan Stanley, so it can only use high-yield pools to attract users to obtain short-term funds.
This is why people who deposited money to Gemeni Earn and Circle Yield were affected. The collapse of FTX also stimulated the market's demand for liquidity of funds locked in the trading platform, which greatly reduced the willingness of crypto ecosystem users to borrow from centralized black boxes, resulting in a reduction in Genesis's available sources of funds. Unfortunately, Genesis (much like a bank) has long loan terms and does not have enough liquidity to meet the abnormally large number of withdrawal requests after the FTX crash.
As of November 26, some new revelations about the relationship between DGC and its subsidiaries came to light through a letter from CEO Barry Silbert to DCG shareholders. The note came amid reports that DCG was looking to raise $1 billion and then another $500 million in funding to help keep Genesis afloat. In the letter, Barry revealed that DCG has more than $2 billion in liabilities, including $575 million in debt to Genesis. This figure also includes the $1.1B in debt that the company absorbed from Genesis after the bankruptcy of Three Arrows Capital. The structural leverage of the cryptocurrency circle ranges from retail to institutional investors. If Genesis or DCG falls, the potential impact will form a bigger disaster than FTX.
