Insight
December 2, 2022
This week saw another victim claimed from the fall of FTX with the bankruptcy filing of service provider BlockFi. BlockFi was an early pioneer in yield generation for holders of cryptocurrencies, including bitcoin and stablecoins. The company got into hot water with state and national regulators for its practices, which resulted in a $100 million fine imposed by the SEC in February 2022. Even before that fine, however, something was amiss with a trade promulgated by the now infamous Three Arrows Capital (3AC), the “Grayscale arb.” This trade refers to the purchase or borrowing of bitcoins that were to be contributed to the Grayscale Bitcoin Trust (GBTC) at the current net asset value (NAV), the shares of which could then be unlocked 6 months later and sold at a premium to NAV. At least that was the theory. In February 2021, the GBTC began to trade at a discount to NAV with the appearance of bitcoin ETFs in Canada which traded very close to NAV. Since that time, GBTC has traded at an increasing discount to NAV, breaching 45% at its recent nadir, resulting in losses for those engaged in the trade or, transitively, those engaged in funding the trade. BlockFi had participated in both lending spot bitcoin for active managers engaged in the Grayscale arb trade and in the trade itself. Losses associated with this activity, as well as counterparty risk that emerged in the market correction in 2Q, necessitated a lifeline for BlockFi that was extended by FTX via a $250M revolving credit facility. With the recent bankruptcy filing of FTX, this support was wiped out, resulting in the bankruptcy filing by BlockFi itself.
As we have pointed out several times, much of the market volatility over the past 6 months has its roots in the reach for yield, which was embodied in trades such as the “Grayscale arb” trade. This desire for yield on an asset like bitcoin that pays no dividend has driven companies to engage in investment activities that were often marketed as riskless in name, as the term arbitrage implies, yet relied on significant risk. On a base level, this hunger for yield, whether it be in DeFi or CeFi, was responsible for significant losses sustained by funds invested in it, plus firms that lent to funds engaged in the trade.
The biggest lender in the industry, Genesis Trading (Genesis), has recently found itself in financial distress, halting redemptions from its lending arm. Genesis sustained a $1.2B loss associated with the failure of 3AC in 2Q and now recently sustained losses on credit exposure to Alameda ($7.7M) and with funds kept on FTX to facilitate trading ($175M). Genesis has long been an important cog in the crypto market structure, but even before this recent news of financial stress, its loan book had fallen to $2.8B by the end of 3Q, down from a high of $14.6B at the end of 1Q. This indicates that its current liquidity crunch, however it may ultimately be resolved, is likely less systemically impactful than it once was.
Complicating matters a bit, Genesis is owned by Digital Currency Group (DCG), which is also the parent of Grayscale, the sponsor of GBTC. While we do not have full clarity on the financial situation here, we understand that DCG has borrowed $575M from Genesis for investment purposes, assumed the $1.2B loss Genesis sustained with loans to 3AC, and used over $770M buying GBTC shares in the secondary market in an attempt to narrow its discount to NAV. DCG could perhaps sell GBTC shares in the secondary market to help with the liquidity issues at the Genesis subsidiary, and maybe it has since the 3Q SEC filing, but that would likely exacerbate the original problem DCG wished to alleviate, GBTC’s widening discount to NAV.
If 2022 has taught us anything, it is that investors should have a keen eye on how returns and yields are generated to better understand the risks undertaken. Yield and return generation practices that have come to light throughout this episode range from economically unsustainable (re: Anchor Protocol’s 19.5% UST yield on LUNA) to misappropriated from the world of traditional finance, such as this “arbitrage” trade. This grab for yield often belies significant risks in crypto markets that may not be evident at first glance.
The good thing is that market volatility seems to be dying down following the FTX collapse, with the resolution of the Genesis liquidity issues (and its secondary impact on Gemini’s Earn program) the only known overhang right now. We hope that these liquidity issues are solved in short order, and the industry continues to distance itself from the tumultuous events of 2022. Appropriate regulatory safeguards can be put in place, we can build safer technologies and institutions, and investors can gain the confidence they need to engage with the industry.
Last week, on Thanksgiving in the US, a new version of Bitcoin Core was released. This latest version, version 24.0, contained a number of updates, tweaks, and additional features to Bitcoin. As a refresher, Bitcoin can be thought of as a collection of software programs that interoperate because they adhere to the same rules, hence the idea of Bitcoin as being a protocol. The canonical example or reference implementation of Bitcoin, however, is the Bitcoin Core software program. The open-source developers that collaborate and collectively bring new features to Bitcoin are known as “Core developers” not because they are working on the essential features of Bitcoin, although they are, it is because they are literally working on the Bitcoin Core software program.
Version 24.0 of Bitcoin Core brings about several changes and with it some debate, chiefly around a feature called Replace by Fee (RBF). RBF is a feature first implemented in 2016 that allows users to rebroadcast transactions they’ve sent to the mempool, the waiting room of unconfirmed transactions that have yet to be included in a block by miners, to increase fees to encourage block inclusion. RBF previously required users to flag their transactions as an RBF transaction and thus potentially replaceable. The new version of Bitcoin Core allows users to opt into a feature called full-RBF, allowing any users to replace any transaction without the RBF flag they see in the mempool (mempools are specific to individual nodes), and sends RBF transactions by default.
The debate is that many service providers, such as merchant transaction processors, assume the transaction they see first in the mempool will be the one ultimately included in a block, a dangerous practice known as “zero confirmations,” literally it has not been confirmed in a block. The reason they do that is for enhanced user experience. Once they see a transaction in the mempool, which can happen very quickly, they consider it done, rather than wait the 10 minutes on average it takes to build a new block and include the transaction. With full-RBF, these zero-confirmation transactions become even more dangerous because they are more likely to be replaced without the warning of the flag that was required previously. Full-RBF still is not enabled by default, but its presence resulted in significant discussions across the community.
Other updates include improved user privacy through zero change transactions and change output randomization and improved ways to download and sync the blockchain, to name a few. A full overview of Bitcoin Core v24.0 updates can be found on Bitcoin’s GitHub page here.
The price of bitcoin was up 2.2% on the week as the asset continues to recover from the fallout of the FTX and Alameda collapse. In addition, most major asset classes benefited from dovish language from Fed Chair Jay Powell on Wednesday. The S&P 500 rallied 1.3% and the Nasdaq Composite rallied 1.8% while gold jumped 3.2% and oil jumped 4.2%. Bonds also benefit from the dovish rate tone, with Investment Grade Corp Bonds up 1.3%, High Yield Corporate Bonds up 1.0%, and Long-Term US Treasuries up 2.7%.
Investing:
BlockFi Bankruptcy Filing - PACER
BlockFi Sues SBF Owned Entity - PACER
Genesis Creditors Seek Options to Keep Crypto Brokerage Out of Bankruptcy - Bloomberg
Online News Site CoinDesk Attracts Suitors Amid Crypto Crash - Semafor
SBF Interview at NYT Dealbook/Summit - YouTube
Good Morning America Interview with SBF - Twitter
Regulation and Taxation:
Why Congress Needs to Act: Lessons Learned from the FTX Collapse - US Senate Ag Committee Hearing
‘Inaction is paralysis’: CFTC Chair Rostin Behnam calls for regulation in the Wake of FTX’s collapse - Fortune
NYDFS Proposes Charging Crypto Businesses for Supervision - American Banker
Companies:
Apple Blocks Coinbase Wallet iOS Update - Twitter
An Embeddable and Customizable Fiat-to-Crypto Onramp - Stripe
Dec 13th - November CPI release
Dec 13th - Senate Hearing into FTX Collapse
Dec 14th - FOMC rate decision
Dec 30th - CME futures expiry
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