Crypto’s coming collapse Part I: DCG’s Genesis & GBTC scramble for a billion
Bad bets sink a clever scam
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Ever since major cryptocurrency exchange FTX and its evil twin Alameda Research, an investment fund, collapsed earlier this month, crypto critics and one-time true believers alike have been waiting for the fallout to spread. Bitcoin has slipped 20% or more since then, giving up its $20,000 holding pattern and slipping now to the $16,000 range. But fears that a slew of bankruptcies and failures could follow have been muted so far.
This comeuppance delayed, however, is unlikely to be denied. Several core cryptocurrency institutions are in dire trouble. Namely:
the main trading engine inside the cryptosphere (Genesis)
the main source of institutional investment into the space (GBTC)
the pipeline for real money into the system (Silvergate)
and the actual means of exchange running through the whole thing (Tether).
All may be fundamentally fraudulent, and through their interconnection the crypto world likely cannot avoid a cascading failure across all of them in the coming weeks and months.
Let’s start today with Genesis and GBTC. Digital Currency Group (DCG), a $10 billion crypto conglomerate owns both. News broke on Monday that Genesis -- a major crypto lender and the industry’s most significant market maker -- was begging investors for a $1 billion capital infusion in order to stave off imminent bankruptcy. On Tuesday, media reports confirmed earlier rumors that Genesis already received a $1.1 billion loan from parent company DCG, a bad sign when even that much liquidity could not fill the hole.
Genesis’ problems began with this summer’s collapse of 3 Arrows Capital (3AC), a major crypto hedge fund that crashed with the failure of the LUNA stablecoin. To understand what went wrong, you also need to understand Genesis’ sister company, Grayscale.
Grayscale’s most important business is running the Grayscale Bitcoin Trust (GBTC), a major conduit of institutional capital into the crypto economy. Most large investors and funds cannot invest directly into risky cryptocurrencies. GBTC gave them an entrypoint to the bubble as a public trust that took investor funds and bought up Bitcoin for them to invest in at a safe distance. Institutional investors flowed in, a source of demand that drove GBTC share prices higher than the value of the Bitcoin inside the trust.
This premium meant that savvy players could make “free money” from a simple arbitrage:
Borrow Bitcoin from a crypto lender.
Give that Bitcoin to GBTC in return for shares in the trust.
Because the shares are more valuable than the underlying Bitcoin, sell the shares (after a six-month lockup period), pay back your lender, and collect the difference.
Intrepid research into public filings from all the parties involved suggests that Genesis may have lent 3AC substantial sums of Bitcoin to play this arbitrage. Not only this, but it appears that 3AC then used the very GBTC shares they bought with the Bitcoins as collateral for cash loans from Genesis. This bears repeating: Genesis loaned 3AC money which 3AC then used as collateral for yet more loans from Genesis.
3AC then spent that money on yachts, as well as more risky crypto bets, most notably in LUNA. When that “stablecoin” depegged into a death spiral, 3AC couldn’t pay Genesis back to the tune of $1 billion or more. This left a gaping hole in Genesis’ balance sheet from both the cash loan and the collateral underneath it. The Alameda/FTX blow up added at least $175 million to their hole, spurring the crisis at hand.
Why on earth would Genesis loan money on collateral that was also borrowed from them? Because 3AC was essentially acting as a cutout for Grayscale to play its own premium arbitrage. Grayscale wasn’t legally allowed to sell itself shares, especially if it borrowed the Bitcoin used to buy the shares from its own company through Genesis.
But it could get a third party to do the play for them if that party delivered them the profits under the cover of a loan also from Genesis. 3AC could make this a win-win if it turned the loan into investment profits earned on other “assets.” When the Fed started ramping up rates and crypto investors started cashing out, the weakest links -- like LUNA -- went first, blowing up 3AC’s plans and screwing Genesis and Grayscale.
Now DCG faces serious problems. On Tuesday, CEO Bary Silbert assured investors that everything was alright, but did disclose a $575 million loan from Genesis due in May 2023. Other sources indicate that things are much messier: with 30% of Genesis’ outstanding $2.8 billion in loans owed by DCG-related parties. This is a capital structure only a Bankman-Fried could love.
As if that wasn’t enough, critics have raised serious questions about whether GBTC is committing significant fraud. When asked to disclose exactly where on the blockchain all of its Bitcoin lives, the trust said it could not do so, citing “security concerns.”
These security claims are bogus -- Bitcoin is a distributed public ledger. GBTC’s custodian, Coinbase, did put out a letter saying the trust is good for all their coins. The catch: DCG is one of Coinbase’s investors, which not only throws their promises into doubt, it reminds us just how far the mess may splash if DCG does fall into the Genesis hole.
Remember: speculation just moves money from one set of pockets to another, it does not create any value. If money is flowing out of the pocket universe as a whole, the bubble deflates fast: prices drop, forcing more cashouts, which drops the price even more. If GBTC is a fraud, Genesis goes under, and DCG collapses as a counterparty and investor in hundreds of crypto businesses, this deflation likely becomes unavoidable.
Somehow that’s not even the biggest risks for crypto! On Friday we’ll cover big questions about Silvergate and the $73 billion elephant in the room -- Tether. Stay tuned!
Our only investment advice: Literally Genesis.
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