Leverage Unwind Recap
Clearly, the most challenging part of analyzing cryptoassets this year has been the opaque parts – the lending, borrowing, trading, and siphoning of assets that have occurred off-chain.
This year, we have seen a deleveraging event throughout the global crypto market spurred on by the centralized elements of crypto. First, we saw the de-pegging of UST and the incineration of $50 billion in market value with the downfall of LUNA.
Sure, this was technically an on-chain failure, but a significant portion of the capital locked in the Anchor Protocol was from centralized yield providers, which took retail money and either directly or indirectly were harvesting yield from this Anchor application. Further, many funds that locked capital into Anchor were clearly leveraged on their LUNA/UST positions. This is the reason that we witnessed additional fallout from the unwind of 3AC shortly after the LUNA unwind.
Then, in what seemed to be the final shoe to fall, FTX was revealed to have been cosplaying as a solvent exchange and Alameda as an outperforming hedge fund, only to be found to have papered over similarly excessive losses seemingly incurred throughout the previous 12 months. Their downfall (which was, by the way, only discovered due to on-chain sleuths) wiped out billions of additional market value and trapped billions in customer funds indefinitely.
Now, after what has felt like an endless year of watching reportedly smart people go up in flames, we are yet to find out what lies ahead for the entity from which all this leverage supposedly started – Digital Currency Group.
GBTC Trade Recap & The Failure of 3AC
The frothiest parts of 2020 and 2021 were sparked by the gains enabled by the GBTC arbitrage trade. In essence, funds borrowed BTC from Grayscale’s broker-dealer Genesis, used it to create shares in the GBTC trust, held those shares for the predetermined lockup period, then sold those shares at a premium in the secondary markets, then repaid the BTC loans from Genesis.
These funds were printing money hand-over-fist with this trade. We discussed this following the unwind of 3AC, but some firms (most notably 3AC), did not sell their shares of GBTC once they were unlocked. In fact, they were used as collateral and pledged to borrow more capital. Once bitcoin started to fall in price, and these losses were compounded by a widening discount to NAV, this collateral value essentially vanished, forcing margin calls and the eventual default on billions in loans by 3AC.
We can trace a direct line from this overleveraged behavior to much of the frothiness throughout crypto since the borrowed money was used to fund projects throughout the industry. Now that the tide has pulled out and asset values have gone down significantly, we are left with a scenario in which the final player in this chain of leverage is facing possible insolvency or, at the very least, has a serious liquidity issue and must figure out a way to restructure billions in debt.
DCG Risk Update
On November 18th, we highlighted DCG as the major remaining idiosyncratic risk embedded within the crypto ecosystem. At the time, we had more questions than answers. In many ways, this is still true. However, we viewed the risk to crypto spot markets as low due to the likely ability of the company to raise a fresh round of capital. All things being equal, that is still true. However, a new variable has entered the equation in the form of a legal complaint filed by Fir Tree Partners, investors who have recently become famous for their ill-advised shorts on Tether and their lack of counterparty diligence, as they were left with their collateral on this Tether trade stuck on FTX.
However, last week, they made a very interesting legal move against Grayscale, which may potentially cloud the financing picture for DCG moving forward and lead to either headline-induced selling or, in the worst-case scenario, forced selling catalyzed by redemptions or dissolutions of their trusts.
You can read it in its entirety yourself, but essentially the complaint requests access to information and alleges that the Sponsor (Grayscale) of the GBTC trust has not operated in the interests of GBTC shareholders. The core thesis centers around the refusal of Grayscale to allow redemptions for trust shareholders to redeem GBTC in exchange for the underlying bitcoin backing the trust. This would allow shareholders to arbitrage the current 50% discount to NAV away by redeeming their shares for bitcoin and selling the spot bitcoin. This likely causes the market value of GBTC to move higher and the spot price of BTC to move lower due to incremental selling pressure in the BTC spot market. Fir Tree also highlighted the exorbitant 2.0% fee, which is what makes Grayscale a strong cash-flowing business, to begin with.
To summarize, this complaint (if it has legs) basically implies that:
- Grayscale is violating its stated purpose and, therefore, should allow redemptions and lower its fees on AUM. The net effect of this action would be lower forward revenues for DCG.
- Lower forward revenues for DCG would imply more difficulty in raising capital from new lenders or equity investors.
- An inability to source new capital might result in (1) a sale of the Grayscale business to another entity, (2) the sale of all GBTC shares owned by DCG, or (3) the potential dissolution of Grayscale trusts, which would provide DCG with much-needed liquidity in the event of a bankruptcy. The dissolution of said trusts would cause extreme selling pressure in the spot market.
Below we walk through the current situation, mapping out the entities involved, using estimates of liabilities based on round figures released by the press. To be clear, we are not inside the war room negotiating with lenders, DCG, Genesis, or their representatives. Therefore, much of this is speculation based on limited public knowledge. However, despite the risk of any of this being untrue, we find it appropriate to investigate these matters, given the stakes at hand.
How the chain of liabilities (broadly) looked prior to the assumption of 3AC debt by DCG
Immediately following the downfall of 3AC, the known liabilities relevant to the current situation are outlined below.
- 3AC owed approximately $1.1 billion to Genesis, which, as we will see below, has since been assumed by DCG.
- Genesis owed at least $900 million to Gemini Earn users and at least $900 million to other creditors.
- DCG owed $575 million in the form of an intercompany loan to Genesis and a $350 million credit facility to Eldridge.
DCG Assumes Genesis Debt and Issues Promissory Note
As noted above, following the collapse of 3AC, and with a path to liquidity seemingly attainable, DCG assumed the 3AC liability from its subsidiary and issued a callable promissory note in exchange. This promissory note appears to comprise a significant portion of Genesis’ assets and means that DCG owes Genesis $1.1 billion, or $1.7 billion in total, when including the existing intercompany loan.
This brings us to where we are today. Following the collapse of FTX, the path to liquidity for Genesis was less clear than it was before. Thus, questions about bankruptcy started to emerge.
Bankruptcy would be very unfortunate for those involved with Genesis. They were pioneers in the space, having created the first successful OTC desk in crypto nearly 10 years ago and scaling up from there. But from the market risk perspective, this would not affect prices considerably since bankruptcy proceedings lock assets up for a considerable amount of time. The forced selling that we are primarily concerned about would be limited.
However, the promissory note issued by DCG complicates the matter since this is an intercompany loan. It is doubtful that Genesis would be able to declare bankruptcy without Grayscale also declaring bankruptcy. If this were allowed, it would result in a significant moral hazard since it implies that parent companies can issue debt to subsidiaries without recourse at the parent company level. Therefore, we are left with the current situation in which we are relying on DCG to find a way to restructure its current debt load and raise cash to see that both entities can make it through to the other side.
The good news is that, as it stands, Grayscale is a cash-flowing business whose annualized November revenues from GBTC and ETHE were over $300 million, and DCG has a wide-ranging, illiquid, but likely impressive venture portfolio. Thus, raising capital exclusive of any developments related to this Fir Tree complaint is the most probable scenario for the company. However, our level of certainty in this upside scenario has decreased in recent days.
Below is an important excerpt from the complaint filed by Fir Tree Partners. It alleges that the inability to allow redemptions is a ruse and harms shareholders. While we disagree with the spirit of this assertion – we like to think the folks at Grayscale are genuinely pushing for conversion to an ETF which is in the best interest of the entire space – it does not quite matter what we think. It only matters what potential investors think about this complaint. If the market views it as legitimate, then it is legitimate.
Thus, with less certainty pertaining to the future cash flows of the DCG business, the future of any deal might be in jeopardy.
With the above nuance now added to the equation, we could see a world in which the bankruptcy path for DCG is chosen, and consequently, the trusts are liquidated to provide the company with liquidity to fund the company through bankruptcy proceedings.
To summarize, we are now a month removed from Genesis halting withdrawals from its lending platform. Our base case remains that DCG can find $1.7 billion in liquidity to either restructure its debt to Genesis or to allow Genesis to unwind peacefully without harming the DCG parent company. With this added Fir Tree wrinkle, the odds of bankruptcy at the DCG level may have increased, and consequentially, the odds of forced selling entering the market have also increased. We continue to monitor the situation and will update our view on the matter as time progresses.
Outflows, Questionable Exchange Practices, and Asymmetries
A Renewed Appetite for Self-Custody is a Good Thing
One of the easiest ways to rationalize being long crypto over a time horizon of 5-10 years is that the asymmetries skew to the upside. Your total possible losses are 1x, while your potential gains are orders of magnitudes higher. This is what has brought many to the space, to begin with.
Beyond long-term portfolio allocation decisions, countless other decisions deal with asymmetries that we can make on a daily basis. One of these decisions that have come to the forefront in recent months is the choice of where we store our cryptoassets. The general framework for this decision is as follows:
- The risk of storing them on a single, large exchange is low but non-zero, and the consequences are dire.
- The risks of storing them in a self-custodial manner are also non-zero but can be mitigated through self-determined actions (good private key storage, MPC, etc.).
Therefore, it has been encouraging to see the recent exodus of coins from exchanges. Although the impetus of this behavior was a tragedy, the benefit of people favoring self-custody for the majority of their assets is a long-term positive development for the space.
Below are two charts that show all BTC and ETH held in known exchange wallets over the previous few years. Interestingly the trend of moving coins off of exchanges actually began in 2020, but the pace was clearly accelerated by the recent implosion of FTX.
Speculation of an Insolvent Binance
This rush to the exits has caused many exchanges to provide some version of proof of reserves. This is a good thing and is a topic that we might dive deeper into in future notes, but for now, it is important to understand that a sound audit and proof-of-reserves is a challenging task since it requires tallying both assets and liabilities and making sure that there are no duplicate claims over any of the reserve assets.
Binance, the largest crypto exchange in the world, recently performed its own proof-of-reserves and limited audit of BTC customer liabilities. While many applauded the directionally sound efforts, others raised questions about the validity of the findings. There have also been questions surrounding the portion of Binance’s assets held in its native $BNB token, which has been sinking in price recently – reminiscent of how FTX’s exchange token performed leading up to its eventual demise.
Travis Kling, a victim of FTX, summarized recent questionable actions by Binance in the list below.
Outflows from Binance and Comparisons to FTX
The consequence of this skepticism has been outflows in the billions from Binance. Below, we see that the net flows in/out of Binance have equaled $2.5 billion over the previous 7 days.
While this trend must be respected (hence the space in this note dedicated to Binance), the magnitude of these outflows deserves some added perspective. Many are quick to draw comparisons to the run on FTX, but we are not exactly close to mirroring those flows on a relative basis.
First, this is a mere fraction of the total assets held in Binance wallets (assets estimated below from Defi Llama). While this does not preclude duplicative claims on these assets, understanding the relative size of Binance compared to FTX is an important place to start.
Zooming out and using labeled exchange wallets to observe trends in exchange flows, we see that the recent decline in total BTC held on Binance is relatively innocuous as compared to the total amount of BTC held on the exchange.
Yes, if we zoom in, we can see that there is a clear, steep drawdown in total BTC on the exchange, but overall, still not a material drawdown compared to total reserves held.
To offer some perspective, we can review the exchange balances of FTX prior to and leading up to its eventual collapse and see that the drawdown in reserves was persistent, steep, and began in Q1, not a month ago, like Binance.
Further, a comparison of ETH Reserves looks quite similar. Binance’s recent decline is relatively tame compared to its overall asset base.
While FTX witnessed massive fluctuations, culminating in a huge drawdown just prior to its folding.
In summary, our takeaways on Binance’s situation are as follows:
- Binance has acted strangely in recent days, has witnessed significant outflows, and holds a large percentage of assets in an exchange token, similar to FTX. This should cause concern.
- It is likely that Binance is completely solvent and has customer assets backed on a 1:1 basis.
- There is a non-zero chance that Binance does not have all customer liabilities properly backed and would go belly-up in the instance of a complete bank run.
- Points 1-3 above do not matter because the asymmetry of keeping funds on Binance is to the downside. Thus, to easily mitigate any risk of asset loss or seizure, one should remove all funds from the exchange.
We brushed over many of the details pertaining to Binance’s audit, the audit’s shortfalls, and the questionable practices surrounding the exchange’s proof-of-reserves. That is because the ultimate point of this commentary is that, despite the high likelihood that Binance is fine from a solvency perspective, the asymmetry of keeping a significant amount of user assets on the exchange is to the downside. Thus, we would recommend diversifying asset custody away from Binance for the time being. Any healthy exchange should welcome this behavior, as formidable stress tests on exchange operations are healthy for both the exchange in question and the overall space.