[Feature] In the Darkest Hour, D-Day Looms for DCG Empire

Recently, due to FTX’s implosion, crypto brokerage Genesis is on the brink of collapse. Along with it, various negative news about their head office, Digital Currency Group (DCG) and fellow subsidiary Grayscale have surfaced in the market as well.

One of those circulating was that DCG owed over US$1.1 billion to its subsidiary Genesis through a previously undisclosed promissory note, hidden from potential investors. The company's operating status remains skeptical.

And when news that Genesis’s emergency financing target was reduced from 1 billion to 500 million US dollars, it seemed to confirm that there was a problem with this company and its close upstream and downstream connections,

As the crypto contagion spread, Grayscale, a subsidiary under DCG also came under fire as everyone began to doubt Grayscale's asset reserves and solvency. Following Grayscale's announcement and Coinbase's confirmation, it was thankfully confirmed that 635,000 BTCs and 3 million ETHs do exist in their reserves, ensuring Grayscale’s solvency in this contagion.

However, due to widespread negative sentiments, the market's suspicion of DCG has not dissipated. Subsidiaries in DCG have been frantically issuing announcements and refuting any rumors from the people.

Furthermore, DCG would also rather keep Grayscale than Genesis. Grayscale is DCG's flagship and main revenue generating business, with about $300 million in fee revenue annually, according to Bernstein.

What is the relationship between DCG, Grayscale and Genesis?

Whether it is a state of panic or a crisis of trust, for the entire DCG group, DCG, Grayscale and Genesis have always been the focus of attention. We will break down the structure of the entire empire and how these subsidiaries are interconnected.

DCG owns two main companies, Grayscale and Genesis.

Grayscale is responsible for issuing and managing GBTC funds. They also work with and are regulated closely by the US SEC. In the entire market, Grayscale's capital is the largest fund, and it ranks second among similar funds in the commodity industry. (BTC is a commodity in the United States)

Genesis offers lending services in BTC, GBTC and USD, and is the only full-service prime broker in the crypto space, playing a key role in enabling large institutions to acquire and manage cryptocurrency risk.

DCG Group's Vision of "Borrowing", "Transforming”, and "Developing"

Below is an introduction to the main security in the Grayscale ecosystem - GBTC.

Grayscale Bitcoin Trust (GBTC) C is a security registered in the United States.

Due to a premium in the price difference between GBTC and BTC, there will be opportunities to make profits. This, combined with the DCG mission that integrates borrowing, transforming and developing, the following model will be generated.

1) Borrow: Loan BTC by mortgaging Genesis assets

2) Transformation: Genesis then sends borrowed BTC and authorizes it to be locked by Grayscale to exchange for GBTC

3) Developing: Obtain the interest rate difference by trading the premium GBTC

4) Then use the interest rate difference to continue the cycle

If GBTC trust maintains a relatively long-term premium transaction, anyone who can issue GBTC with BTC only needs to survive the 6-month lock-up period to finally sell and cash out. In this way they can profit from the spread, obtained through the premium of GBTC to BTC.

The true "Athlete" of DCG Group

So, in this way, why doesn't the entire system of the DCG Group just end up collecting money endlessly? Mainly because it is highly regulated by the US Securities and Exchange Commission (SEC).

But in such a "perfect" arbitrage model, with the referee, players and sponsors all being yourself, if you can't get off the field, can you find an athlete to complement and strengthen your team?

Three Arrows Capital was the perfect athlete for this.

Once again following the arbitrage model above:

1) Borrow: Loan BTC by mortgaging Genesis assets

2) Transformation: Genesis then sends borrowed BTC and authorizes it to be locked by Grayscale to exchange for GBTC

3) Developing: Obtain the interest rate difference by trading the premium GBTC

4) Then use the interest rate difference to continue the cycle

(This picture comes from the Internet)

(Remarks: For example, mortgage 0.2BTC assets on Genesis to obtain 1BTC; convert 1BTC to 1GBTC at Grayscale, due to the premium differences, the price of 1GBTC at this time is approximately equal to 1.3BTC, and then redeem after the transaction to earn 0.3BTC; or continue to hold the 1GBTC and use it to get a USD loan worth 1.3BTC from Genesis, and continue the cycle.)

According to public data, Three Arrow’s GBTC holdings once reached 6% (institutional holdings accounted for no more than 20% of the total circulation), which was a very sizeable amount. Genesis Trading provided more than $2.36 billion in financing for Three Arrows Capital, according to Bloomberg.

The confidence in GBTC's high premium

This seems to be a very perfect way to arbitrage indefinitely, but why does GBTC continue to have such a high premium?

Here we first explain the advantages of GBTC.

The first advantage is that GBTC can be purchased directly through the US 401(k) (a fully funded pension insurance system established by employees and employers with joint contributions). Due to relevant US tax policies, GBTC purchased through this account has no tax.

The second advantage is that traditional institutions cannot directly purchase BTC for investment due to regulatory issues, but they can purchase GBTC.

The third advantage is that there were no competitors in the market at that time previously that produced similar securities to GBTC.

These three advantages complement each other and ultimately led to a positive premium between GBTC and BTC. For various institutions, if there is a positive premium, they can arbitrage according to the above model.

Then the basic support for the GBTC premium comes out

1. Institutions buy BTC spot on a large scale and deposit it into Grayscale to become GBTC

2. After the unlocking period of GBTC is over (6 months), it will be dumped to retail investors and institutions in the secondary market at a higher price.

3. The market supply continues to decrease, the price of BTC will rise, and the price of GBTC will follow along.

4. GBTC price rises, investors continue to invest in GBTC

A perfect cycle.

The high premium of GBTC disappears, and the crisis of DCG Group emerges

Logically speaking, there was no problem with this arbitrage model until the presence of a new competitor - Canadian Bitcoin ETF. The advantages of GBTC were completely lost, and the premium of GBTC disappeared.

On February 19, 2021, the first-day trading volume of the Canadian Bitcoin ETF (BTCC) reached 200 million Canadian dollars (about 155 million U.S. dollars), breaking Canada's record. BTCC soared to the top five in the history of U.S. ETFs.

After BTCC went online, institutional investors sold GBTC aggressively, hoping to monetize the GBTC premium. This selling pressure not only put downward pressure on GBTC’s premium relative to NAV, but also put downward pressure on Bitcoin’s price at the time due to GBTC’s high trading volume.

Under the massive sell-off, GBTC’s premium was lost, and the price of GBTC plummeted into negative premium.

At this time, DCG entered the market, and from March 2021, began to purchase GBTC on a large scale. 3AC sold about half of the GBTC to DCG.

At the same time, Three Arrows Capital mortgaged the remaining GBTC to Genesis. In April 2021, the rapid rise in the price of BTC reached a peak of more than 64,000 US dollars. For Three Arrows, even with a negative premium, it had obtained loans worth more than 1 billion US dollars due to the strong bull market.

The downfall of Three Arrows, starting from GBTC

In 2022, the market has been in a state of weak rebound. Since May 6, Bitcoin and other cryptocurrency markets have fallen sharply. The price of GBTC has also plummeted, falling from above $40,000 to around $29,000, which also led to margin calls for the loans backed by GBTC.

However, due to other black swan events such as Luna collapse, Three Arrows no longer has the assets for the margin call. Finally, in June, various platforms began to liquidate the collaterals of Three Arrows.

From June 15th to June 18th, 2022, in just three days, the Three Arrows Empire fell into a spiraling death.

Ultimately, GBTC caused the death of Three Arrows

For Three Arrows Capital, although the liquidation of various platforms has left it struggling, Three Arrows still had the final reversal card - GBTC ETF (elaborated below).

As early as October 2021, Grayscale submitted an application to the US SEC to convert GBTC into a bitcoin spot ETF (GBTC ETF). The deadline for the SEC to approve or reject the application is July 6, 2022.

The approval of the GBTC ETF application is a great move for the industry. Hence, although GBTC has always had a negative premium during this period, DCG Group has always maintained the purchase of GBTC as they believe in the successful ETF approval.

There is also another arbitrage model here. A deeply negative premium can be used for reverse arbitrage, because after GBTC becomes an ETF, the ETF will effectively track the price of BTC. In other words, the premium and negative premium of GBTC will disappear, and eventually follow the BTC price in a tight trajectory.

The negative premium model is as follows:

1) Buy GBTC at a negative premium of 30%, that is, 0.7GBTC=1BTC

2) Wait for GBTC's ETF locked up period to pass

3) The price of GBTC is anchored to the price of BTC, and the original price of GBTC purchased at a 30% discount is sold at the original price.

4) To attain 30% profit

After eventually having the approval of GBTC ETF, the value of GBTC assets will increase by 40%, which will effectively solve the solvency crisis of Three Arrows.

However, this scenario played out:

1) DCG purchased 15 million GBTC between March 2021 and January 2022. An additional ~3 million GBTC were then purchased between February 2022 and March 2022.

2) On March 10, 2022, Grayscale announced that it would repurchase USD 250 million of GBTC.

3) On April 3, 2022, Grayscale issued a statement stating that it will turn GBTC into a truly redeemable BTC ETF.

4) At the beginning of May, it was said that an additional 500 million would be added, and the total repurchase would be 750 million.

5) However, the SEC took away all hope for DCG and thus Three Arrow succumbed to insolvency.

On June 29, the U.S. Securities and Exchange Commission (SEC) rejected Grayscale’s application to convert its $13.5 billion Grayscale Bitcoin Trust (GBTC) into a spot Bitcoin ETF. In the report, the SEC said the filing failed to answer the SEC's questions about preventing market manipulation, among other concerns.

This rejection letter took away all hopes of Three Arrows Capital and took away the ambitions of the entire DCG Group.

On July 2, Three Arrows Capital applied for bankruptcy protection in a New York court.

As the largest lender of Three Arrows, Genesis once provided a loan of US$2.36 billion to Three Arrows Capital. When there was no sign of recovery for Three Arrows, Genesis immediately liquidated the collateral of Three Arrows Capital, but there was still a gap of US$1.2 billion. Genesis hence sued bankrupted Three Arrows Capital over this excess of $1.2 billion in court.

DCG Group's Darkest Hour

The $1.2 billion that Genesis lost due to Three Arrows Capital is likely to exceed the total historical net income of Digital Currency Group (DCG).

Grayscale has a total net revenue of approximately $1 billion. Messari estimates Genesis revenue of $50 million in 2020, and assuming a 5-fold increase in revenue last year and a consistent 30% margin, an additional $200 million would wipe out all net revenue from the product line.

The entire DCG Group also fell into chaos because of the collapse of Three Arrows. Grayscale canceled Three Arrows’ status as the authorized participant of the Genesis trust product. The DCG Group also restructured and adjusted, while laying off 10% of its employees.

The ambition of DCG was destroyed, but it can still survive. However, with the secondary implosion by FTX, it once again caused a devastating blow of 170 million US dollars in deficit to Genesis.

The negative premium of GBTC also skyrocketed due to the market, as well as various issues Genesis was facing. This month, the negative premium rate of GBTC was as high as 45%. At present, the negative premium of Grayscale Bitcoin Trust has risen to 40.17%, the negative premium of Ethereum Trust has risen to 42.65%, the negative premium of ETC Trust is 70.21%, and the negative premium of LTC Trust is 49.7%.

Conclusion

Today, the only subsidiary holding up DCG Group is Grayscale.

For Grayscale, the failure to convert GBTC into an ETF meant that the Grayscale profits will be reduced by more than 200 million US dollars per year.

GBTC has always maintained a very high negative premium, and it cannot compete with other ETF products (which have positive premiums) on the market for a short time.

Genesis, the other subsidiary of DCG Group, is currently unable to protect itself, with a cumulative loss of nearly 1.4 billion US dollars and is already facing the problem of bankruptcy and liquidation.

DCG currently has more than 1.1 billion US dollars in liabilities.

The original arbitrage model has failed, and the remaining DCG subsidiaries have fallen into an unsustainable state. Henceforth starts the collapse of the DCG Group.