Certainly the bankruptcy of FTX was the event that made the most news in 2022, in reality there were other major implosions including Genesis headed by Digital Currency Group.
To understand the Grayscale Bitcoin Trust issue and its repercussions we must go back to 2013, when Barry Silbert founded this trust. For many years GBTC was the only way for stock market investors to gain exposure to Bitcoin as it was structured as a trust (without an ETF-like redemption mechanism), GBTC traded above its NAV during its first years of activity.
This basically means that the fund's value in the market was higher than its underlying assets (BTC). Equity investors didn't have much of a choice, so they were willing to pay a premium on GBTC to gain exposure to Bitcoin. GBTC shares are created by offering Bitcoin and then 6 months later you receive the equivalent GBTC shares. Since GBTC was trading at a premium to NAV (up to 40%), arbitrage trades became possible (i.e. shorting Y BTC and giving Y BTC to Grayscale. 6 months later you could cover your short by selling the GBTC it was trading with a premium compared to Y BTC). Generally if there is a "premium" on a product like GBTC, it means that the trust's shares are trading at a price higher than the net value of the underlying asset (BTC). Traders exploit this price difference by executing an arbitrage strategy. For example, they could buy Bitcoin directly on the market and simultaneously sell shares of the trust to profit from the price difference.
THREE ARROWS CAPITAL ARBITRATION
Several market participants recognized how profitable and risk-free this trade was (as GBTC had always traded at a premium to NAV) and began accumulating. In particular two of these participants: the hedge fund Three Arrows Capital and the lending platform BlockFi (both now bankrupt).
Three Arrows Capital not only farmed the GBTC premium, but also enhanced its trading by leveraging not only its own capital but by borrowing huge amounts of Bitcoin to multiply its returns. But who did they borrow these BTC from? From Genesis.
GENESIS LOANS TO THREE ARROWS CAPITAL, ALAMEDA AND BLOCKFI
Genesis was one of the companies owned by Digital Currency Group (parent company created by Barry Silbert to imitate Berkshire Hathaway's corporate structure). Along with Grayscale, Genesis was one of DCG's flagships.
Genesis was the largest, most prominent, and essentially only broker in the cryptocurrency market. It had both a Trading/Derivatives arm (GGT) and a Lending arm (GGC) but under the same company.
Genesis took Bitcoin from holders, large and small, offering them an interest rate on their BTC. He then lent them at a higher interest rate and earned on the spread. Who did Genesis lend to? Alameda (FTX), BlockFi, and Three Arrows Capital, among others.
It should be remembered that DCG directly controlled GGT (the trading and derivatives branch of Genesis) and GGC (the latter relating to loans). GGC had no board until June 2022, when a board was appointed with two out of three members from DCG.
There was a massive incentive to encourage making loans in BTC that would be used for GBTC arbitrage because those BTC would flow into Grayscale and then get stuck there (since there was no ETF redemption mechanism).
Once those BTC were locked, Grayscale got a 2% fee per year for “managing the fund” (essentially doing nothing). GBTC currently has over 620,000 BTC, meaning that Grayscale collects over 12,000 BTC in fees every year (Grayscale's profits flow to parent company DCG). This highlights some important conflicts of interest between DCG, Grayscale and Genesis. In fact, Grayscale was even aware of the loans Genesis was making to fuel the flow of funds into GBTC.
ARBITRATION NO LONGER PROFITABLE
Over time, new means of gaining exposure to Bitcoin have become available to the stock market (Microstrategy stocks, futures ETFs, foreign spot ETFs). The new competition, along with the huge number of GBTC stocks created by arbitrage, began to sink GBTC's premium. On February 23, 2021, GBTC's premium went negative (at a discount) for the first time. It has never been more positive since then and at one point the discount was as high as almost 50%, meaning the fund was only worth half of its underlying assets.
THE TERRA COLLPASE AND THREE ARROWS INSOLVENCY
With the end of GBTC premium arbitrage, Three Arrows Capital has lost its most reliable way to make money. Subsequently they moved on to another very risky operation: the carry trade on TerraUSD (Ust). They essentially borrowed funds at low interest and rented Ust. Meanwhile, Genesis continued to lend them. On May 7, 2022, the Terra ecosystem collapsed, with Luna and the Ust stablecoin going to 0 (Ust was shorted, Luna was inflated to try to get Ust to recover the peg, all in vain). Given its use of leverage, the collapse of Luna and Ust left Three Arrows Capital deeply insolvent. The insolvency of Three Arrows created a huge hole for the companies that gave them loans, the largest of which was obviously Genesis which had given them a loan of over 2 billion. With proper risk management and the use of collateral, these types of risks would have been mitigated. However, Genesis' risk management was terrible. In mid-June 2022, Three Arrows defaulted on its Bitcoin loan from Genesis.
THE GENESIS HOLE
After liquidating an incredibly small amount of collateral it held, Genesis found itself with a $1.2 billion hole in its balance sheet.
It was now insolvent too. At this point, if the lenders who had provided BTC to Genesis attempted to withdraw them, Genesis would not be able to meet its obligations. Instead of filing for bankruptcy, Genesis CEO Michael Moro hatched a plan with Barry Silbert, CEO of parent company DCG, to hide the losses on Genesis' balance sheet. In this way they were able to alleviate the concerns of Genesis' lenders, thus minimizing withdrawals. In exchange for filing for bankruptcy against Three Arrows (which was now worth almost nothing due to its complete implosion), DCG would give Genesis a $1.1 billion "promissory note". Moro meanwhile reassured the market by saying he had "attenuated the losses". The bill was, in truth, a complete sham. Instead of injecting real capital to fill the hole in Genesis' balance sheet, Barry Silbert provided a piece of paper that paid a below-market interest rate and that could not be redeemed for a decade. It is quite clear that Silbert knew that the promissory note did not resolve Genesis' insolvency because in Genesis' subsequent bankruptcy he valued that same promissory note at a small fraction of the $1.1 billion that Genesis claimed it was worth. The hole in the budget had therefore never been filled. Meanwhile, Genesis executives worked hard to convince their customers that it was solvent by falsely claiming that the promissory note they were given was a current asset (equivalent to cash). This raises the question of why DCG intervened. Why take the risk of committing an act of criminal fraud when they could have let Genesis fail? In reality, DCG was one of Genesis' largest borrowers and used the company as a piggy bank. In fact, soon after the Three Arrows implosion blew a hole in Genesis' balance sheet on June 18, DCG took a massive loan of 18,697 BTC from the already insolvent Genesis. DCG also did premium arbitrage. If DCG had let Genesis fail, it would have been involved in the bankruptcy process and would have been forced to repay the large loans it had taken from its subsidiary company. Instead Barry Silbert and DCG chose to hide the holes somewhat.
THE INSOLVENCY OF GENESIS
Genesis' insolvency was exposed in November 2022, when FTX imploded and customers across the Crypto space rushed to withdraw their BTC from any centralized entity.
Genesis was unable to meet its customers' withdrawal requests and suspended withdrawals on November 16, 2022.
Even after freezing withdrawals, Genesis claimed that it was not insolvent and that it had enough capital to meet withdrawal requests but they were not immediately available. On January 19, 2023, Genesis was forced to file for bankruptcy and slowly reveal the extent of its shenanigans to its creditors. Creditors were faced with the painful realization that the insolvency had never been resolved by DCG. On October 19, 2023, the New York Attorney General filed a civil complaint against Genesis, DCG, and personally against Barry Silbert and Michael Moro. The complaint alleges a massive conspiracy to defraud hundreds of thousands of investors.
COMPARISON WITH FTX
Barry Silbert and Michael Moro could potentially go to prison too with FTX's Sam Bankman Fried. Moro was forced to leave after perpetrating the bill fraud. The DCG advisor also left shortly afterwards, probably sensing that something very suspicious was going on internally. The Genesis implosion has many parallels to the FTX exchange fraud:
-False public statements used to reassure investors
-Misleading financial statements
-A group of insiders who perpetrate financial fraud
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