Not sure if you noticed, November has not been that kind to the crypto industry!
The outlook this week also seems less rosy, as people wonder whether Genesis is about to face disaster.
Let's take a look at what's going on with Barry Silbert's Digital Currency Group.
Last week, Genesis froze withdrawals from its lending business.
Crypto Twitter began spreading rumors of an impending disaster at Genesis.
Not only has the solvency of Genesis, the only full-service prime brokerage in the crypto industry been called into question, but the backing of the Bitcoin trust product GBTC has come under similar scrutiny. Previously, Grayscale, the product's fiduciary, said it would not share its reserve audit proof , citing "security concerns".
What do Genesis and Grayscale have in common?
Both companies are subsidiaries of the Digital Currency Group (DCG).
DCG is rumored to be running out of liquidity after injecting $140 million in new capital into Genesis last week. The move was necessary after Genesis' lending arm lost $175 million locked in FTX accounts, and in the wake of this incident, Genesis' lending platform froze withdrawals.
All of this has crypto-twitter wondering: How bad could things possibly get?
Today we got the answer : Genesis is on the verge of bankruptcy...
As of this writing, Genesis currently has no plans to file for bankruptcy. Seems optimistic, but unfortunately, probably not.
(November 23 news, according to people familiar with the matter, Genesis Global Capital has hired investment bank Moelis & Company to explore options including bankruptcy. The report said that no final decision has been made, and the company may still avoid filing for bankruptcy protection.)
The collapse of FTX and the ensuing crunch in crypto credit created a credit crunch across the industry, leading to a bank run on Genesis. The current bailout includes an additional $500 million infusion , half of the $1 billion the company initially asked for, with Binance being considered a potential source of funding (however, according to people familiar with the matter, concerns that some of Genesis' businesses could be lost A conflict of interest arises in the future, and Binance decides not to invest.)
What is Genesis?
Let's take a step back and take a closer look at what Genesis is and the company's potential sources of financial risk. For a more detailed description of what Genesis offers, see this amazing Twitter thread by Ram Ahluwalia (which I summarize below).
Genesis performs many of the same functions as a traditional broker, while tailoring its offerings for institutional clients. Services offered by prime brokers like Genesis include lending and over-the-counter trading services.
In traditional financial markets, prime brokers such as Goldman Sachs offset positions with counterparties. Suppose a client of Goldman Sachs wants to go long $100 million in U.S. Treasuries: If Goldman fulfills this order without hedging, they will be short $100 million in U.S. Treasuries. If yields start to fall, Goldman will be in the red, but if yields continue to rise, Goldman will profit on the position.
Rather than exposing itself to price fluctuations in the underlying security, Goldman Sachs simultaneously entered into a long position with JPMorgan, quoting (the ask price) to its client a slightly higher price than it received from JPMorgan (the bid).
This allows traders to capture the bid-ask spread without taking directional risk when executing client orders.
As a pioneer in the OTC and prime brokerage markets for cryptocurrencies, Genesis does not have access to the robust inter-dealer market that traditional financial institutions have. Genesis attempts to provide the same services as its traditional peers, despite lacking similar risk management solutions.
Sources of Risk for Genesis
We are aware that Genesis is no longer honoring withdrawal requests. But why?
Genesis is facing liquidity problems -- and possibly solvency problems.
liquidity problem
Just like banks rely primarily on demand deposits as a source of funding, Genesis relies on short-term sources of funding, including Circle’s Yield program and Gemini Earn. Additionally (much like a bank), Genesis engages in maturity transformation of assets, which means they use these short-term deposits to make long-term loans.
The longer term of the loaned funds allows Genesis to capture the difference between the cost of funds and interest income, providing the basis for a potentially profitable business model. However, this strategy carries the risk that the bank-like entity does not have enough liquidity to satisfy an unexpectedly large number of withdrawal requests.
During times of economic uncertainty, lenders typically seek to recover outstanding credit where possible and build up their own cash/liquid asset reserves. Short-term deposit sources like those funding Genesis, which allow users to withdraw funds on demand, are one of the go-to places for lenders to find liquidity.
Just before Genesis froze withdrawals, individuals and institutions with funds on FTX (including Genesis) suddenly lost what they considered liquid capital. Additionally, FTX’s mismanagement of user funds has reignited outrage over cryptocurrency lending practices and increased calls within the industry for a re-examination of undercollateralized and off-chain lending practices.
The implosion of FTX triggered the market’s liquidity demand for funds locked in the exchange platform, and reduced the willingness of crypto ecosystem participants to lend money to centralized black boxes, reducing the available funding sources of Genesis.
Unfortunately, Genesis (much like a bank) extended loans to borrowers with longer terms and did not have enough on-demand liquidity to satisfy the unusually high number of withdrawal requests that followed the FTX crash.
solvency problem
Genesis may have counterparty exposures related to duration management activities and hedging of positions.
Duration is a measure of the sensitivity of asset and liability values to changes in interest rates. Longer durations mean prices are more sensitive to interest rate fluctuations, with higher rates having a negative impact on valuations and lower rates having a positive impact on valuations. The use of shorter-term funding sources (shorter duration) and longer-duration loans (longer duration) exposes financial entities to maturity mismatch problems.
For Genesis, this means that any change in interest rates will have a greater impact on Genesis' assets than on its liabilities.
Before managing the duration gap, Genesis' solvency was negatively correlated with interest rate changes. Given the frozen state of crypto credit markets and rising risk-free rates driven by tight monetary policy, Genesis, without hedging, will struggle in terms of its solvency if not hedged.
While Genesis may be hedged against rising interest rates, the insolvency of key counterparties to its duration management strategy would expose Genesis to directional risk, increasing its own insolvency risk.
Remember those bitcoins Luna Foundation Guard bought with UST?
Genesis received $1 billion in UST from this exchange! While Genesis may attempt to hedge its exposure to UST, the insolvency of such hedged counterparties will create directional exposure to UST.
Today, that $1 billion UST has a market cap of just $23 million!
Every crypto hedge fund storm increases the likelihood of Genesis' directional exposure to crypto assets, including unsold UST.
For Genesis, counterparty risk was a much bigger threat than liquidity issues. Liquidity issues mean that Genesis has enough assets to fully repay all users, just not yet, and counterparty risk directly affects Genesis' solvency.
Failure of risk management strategies due to counterparty insolvency will negatively impact Genesis' solvency and result in reduced payouts to its creditors!
suspicious connection
Genesis, 3AC, GBTC and DCG. What do these 4 have in common?
They are all involved in complex, intertwined GBTC transactions.
Grayscale, a DCG subsidiary, is the trustee of GBTC. In exchange for its services, Grayscale charges an annual management fee of 2% of all assets under the trust's management. According to the regulatory statement submitted to the US SEC in the third quarter of 2022 , Grayscale’s fee income from GBTC has exceeded US$302 million year-to-date, compared with US$433 million in the same period in 2021.
Another DCG subsidiary, Genesis, is the lead lender to 3AC. According to a July analysis of public SEC and investor filings by DataFinnovation, Genesis essentially lent to Three Arrows Capital under its single counterparty limit.
The analysis speculates that in exchange for collateral, 3AC borrowed BTC from Genesis, returned BTC to Genesis to create GBTC (Genesis is the only authorized participant that can create GBTC shares), and provided GBTC to Genesis to restart the cycle process .
When GBTC is trading at a premium to BTC, 3AC is essentially making free money and using the profits to increase exposure to GBTC and other crypto assets. Assuming the premium stays the same, 3AC could theoretically repeat this arbitrage process forever.
This transaction has also proven to be very profitable for DCG as it increases the AUM of Grayscale BTC Trust and boosts fee income.
Unfortunately, the premium turned into a discount as GBTC selling pressure increased and demand for the product dwindled. Coupled with Luna's death spiral (which previously had a sizeable investment position in the 3AC portfolio), the end result was 3AC's bankruptcy.
Genesis is unlikely to fully recoup the outstanding loan to 3AC, and given the lack of established counterparties in the crypto space, they may have non-negligible counterparty risk to 3AC.
Pre-existing lending relationships and potential counterparty risk with 3AC (or other bankrupt crypto funds) creates ongoing liquidity pressure for Genesis and remains a source of insolvency risk.
Grayscale FUD?
Not only did DCG have to deal with issues regarding Genesis withdrawals and debt repayment, but it was also forced to defend GBTC’s support. This is 100% damage caused by DCG itself, and DCG refused to publish the wallet address holding Grayscale trust assets or its complete reserve audit certificate.
Grayscale's hesitancy to provide audit proofs of its reserves is definitely a bad idea after the FTX incident and concerns of exchanges falsifying audit proofs of reserves!
Attempts by third parties to verify GBTC holdings on-chain have traced back to about 50% of the BTC held by the trust.
However, Coinbase Custody defended Grayscale, confirming that GBTC and other Grayscale products are still fully backed by assets controlled by Coinbase Custody.
Related analysis by Nansen's Alex Svanevik found that Grayscale's ETH products may be fully backed by reserves held by Coinbase Custody, further confirming that GBTC is fully backed.
Given that such actions are fraudulent and could expose Coinbase to legal repercussions, it is unlikely that Coinbase Custody is misreporting its GBTC holdings. But in the wake of the FTX debacle and the resulting scandalous allegations, it's not entirely inconceivable that Coinbase would cheat on behalf of Grayscale's BTC holdings.
DCG crisis?
While questions remain about Genesis' solvency and Grayscale's support (and DCG's overall financial health), the failure of either of these companies would be disastrous for the crypto industry.
Genesis has a much larger business scope than FTX and provides institutional brokerage services, authorizing institutions to invest in cryptocurrencies.
A scenario that ends with Grayscale liquidating its trust funds would lead to billions of dollars in selling pressure on BTC, ETH and other Grayscale assets, an event that would hit the crypto market hard. However, this outcome is unlikely given the fee income generated by the product and the profitability of the group.
While it’s unclear how the Genesis affair will end, the near-term fate of the broader crypto industry once again hinges on the solvency of another black-box CeFi entity. If Genesis fails, there will be huge consequences, especially considering that the company is the nexus for institutional investment in cryptocurrencies.
Fasten your seat belts, the road ahead is rough!
Alex
Miyuki
Weiliang