White Man

(Any views expressed in the below are the personal views of the author and should not form the basis for making investment decisions, nor be construed as a recommendation or advice to engage in investment transactions.)

Reflections

Last week I described how Sam Bankman-Fried was the right kind of white boy, and how he leaned into this persona to convince the Western financial establishment and the crypto industry alike to overlook his shortcomings and not ask too many questions. Here is how he describes what he did in his own words to Vox:  

“Ya. Hehe. I had to be. It’s what reputations are made of, to some extent. I feel bad for those guys who get f—ed by it, by this dumb game we woke westerners play where we say all the right shibboleths and so everyone likes us.”

Of the fallout that we began to see this week from SBF’s apparently epic fraud, perhaps the most significant casualty is the likely insolvency and potential bankruptcy of crypto lender Genesis, which could be mega enough to also bring down its parent company, prominent venture capital firm Digital Currency Group (DCG). The Genesis/DCG melodrama – which also includes Genesis’s sister firm, digital asset fund Grayscale – is particularly impactful because it directly affects the largest Bitcoin investment product listed on any exchange, GBTC. The reason why GBTC is so important to us crypto traders is that it holds one of the largest stashes of Bitcoin. Should investors – willingly or not – be allowed to redeem GBTC shares for BTC or USD, it could spark the next brutal leg down in the fiat price of Bitcoin and other shitcoins.

Now that the peerless image of SBF has been shattered, investors have recovered their ability to do maths and read public statements. They have begun to ask questions of everyone, and afford no one the benefit of the doubt because of some aspect of social conditioning that allowed their rational brain to silence their gut instinct or lizard brain.

The entire point of these essays is to alter your thinking for the future. When the next person comes along who says the “right” things, wears the “right” clothes, went to the “right” schools, speaks / looks the “right” way, hangs out with the “right” people, and is promoted by the “right” media outlets, I hope that you disregard all of that and focus on the truth that is self-evident in the maths and public statements presented. 

In this essay, I’ll be delving into the digital money management business and breaking down the Genesis/DCG/Grayscale soap opera … G G G G-Unit! And as the essay comes to a close, I’ll lay out a rubric for evaluating a potential means of profiting off of this carnage.

But first, similar to how I began part one of this series, let’s revisit Pax Americana and do a little bit more racial theorising. Barry Silbert, the man atop this shaky DCG / Genesis / GBTC  empire, is just a foil for a broader point I’m trying to make throughout this series on how stereotypes hinder investors’ ability to properly manage risk. All the information that is presented in this essay has been public for many years – but no one bothered to ask questions because Barry Silbert fit the mould as the type of guy that you trust in the Pax American business world (i.e., a confident white guy saying all the right things). To be clear, I’m not saying that his whiteness was in some way a driver of the actual events taking place with Genesis / DCG / Grayscale (GBTC). All I’m saying is that because he’s white, he appeared trustworthy, and as a result, investors followed him blindly without digging deeper into how all of the pieces of his empire fit together. This is not at all an indictment of being white – it’s an indictment of the system and its willingness to overlook someone’s shortcomings because they look a certain way and say the “right” stuff. I don’t know the man – we aren’t even acquaintances – and I have no financial exposure to his kingdom. With that, let’s jump in and start by looking at how this broken system works, and how some folks engender the trust of their peers without raising further questions.

Pepe Village Needs A Money Manager

Unless you want to store your wealth in physical cash or gold and conduct all transactions face to face, it is impossible to self-custody your assets in the analog TradFi system. You simply have to entrust your assets to banks and money managers. These intermediaries allow money and assets to move from point A to point B.

As we know, there is a significant amount of trust involved. You trust that the bank is not making bad loans that will impair its ability to pay back your deposit. You trust that the person or organisation that manages your money won’t just steal it, or send it into dodgy investments.

In light of the need to trust your financial intermediaries, how do you choose which person or organisation should manage your money? Let’s conduct a silly little thought exercise.

Imagine there is a village called Pepe Village. The inhabitants of Pepe Village are green frog-man creatures. Pepe Village is quite isolated. They don’t get many regular human visitors, but they are connected to our civilisation through trading memes with us. Selling these memes to humans nets the Pepes lots of money, which they want to use to invest for the future.

The village, while not visited very often by humans, watches a LOT of TV. The shows on air come from Pax Americana, so Pepe Village is very up to date with Pax Americanan culture.

One day, eight sales people visit Pepe Village. Each person’s goal is to convince Pepe Village to allow them to manage the village’s wealth.

There are two sales people, a man and a woman, that Pax Americana calls “white”.

There are two sales people, a man and a woman, that Pax Americana calls “black”.

There are two sales people, a man and a woman, that Pax Americana calls “Asian”.

And there are two sales people, a man and a woman, that Pax Americana calls “Hispanic”.

These monikers would be strange to the villagers if it weren’t for the large amount of TV they watch. The villagers have watched enough TV to know what these terms mean in Pax Americana.

The Pepe Village Council of Elders met to receive each sales person and hear their pitch. 

Each pitch was exactly the same.

“Hello, my name is blah, blah, blah.”

“I work for blah, blah, blah.”

“You should trust me because I studied finance at blah, blah, blah.”

And finally (and most importantly):

“I charge a 2% management fee, and my track record is blah, blah, blah.”

After the eighth person presented, the Chair Pepe called the meeting to order so that the council could decide which person to entrust with the village’s savings.

“Wow, I’m confused,” said the Chair Pepe. “Apart from the different genders, each salesperson had the same name, went to the same university, studied the same thing, wore the same clothes, and underperformed the market by the same amount. They even all charge the same price.”

“Wait a minute – these people come from different races,” one of the other council members, Wojak, chimed in. “That’s what they call it on TV. The TV presents each race differently – so if we just follow what the TV tells us, surely we will be able to pick the most trustworthy person.”

“That’s a great call, Wojak,” Chair Pepe responded. “I know you watch the most TV of anyone in the village. Can you tell us which race the TV says is most trustworthy?”

“I do indeed watch a lot of TV,” said Wojak. “Typically, this is what I have learned. The male Hispanics seem to always be doing manual labour like construction or landscaping. The female ones are housekeepers or nannies. Their bosses are usually the whites. None of these things to me says that Hispanics know anything about managing money.”

“The Asians seem to be good at maths and science. I always see them playing roles where they are good students in these subjects. And I also see them operating lots of small businesses in parts of the city the big white-owned businesses won’t touch, like the black inner-city ghettos. While the TV says they are smart and hard working, I don’t really see them ever managing the money of others to a large extent. They are also presented as meek and socially awkward sometimes.”

“The blacks seem to always be poor. They are always fighting in their dilapidated parts of town. There is a lot of violence whenever I see shows featuring the blacks. But sometimes I see them dribbling or throwing and catching balls and the whites seem to enjoy watching them do athletic pursuits. But I never really see them managing money or running large, important companies.”

“The whites seem to always be in charge. It doesn’t really matter the circumstance – the white characters are always in a position of power and it appears everyone looks up to them. I think they must know how to manage money the best and are the most trustworthy.”

Chair Pepe looked quite pleased with Wojak’s analysis. “Well, there you have it. We should pick either the male or female white salesperson. Wojak, what does the TV tell you about whether men or women are more trustworthy?”

“We should definitely trust men more than women when it comes to finance,” Wojak responded. “I watch these financial entertainment channels and they always have attractive women interviewing powerful men who seem to run all the major financial businesses.”

Chair Pepe nodded, and added, “Does anyone on the council oppose choosing the white male salesperson to manage our assets?”

No one challenged Chair Pepe.

ABCs of Asset Management

With that little thought experiment out of the way, let me hop off my soapbox and  jump into the meat of how this DCG / Genesis / GBTC (the G-Unit) situation came to pass.

Because it is impossible to self-custody your wealth in the TradFi system, you must entrust it to an asset manager. This means that everyone in the industry can be terrible at their jobs and still make money. And because it’s much easier to be bad at your job than good at it, asset managers have to erect moats around their businesses to protect their ability to continue being mediocre.

It is very hard and expensive to open an asset management business. There are lots of rules you must follow, and to ensure you are in accordance with these rules, you must employ a wide range of specialists who each focus on one specific area – which can get very expensive. 

The only way to win the game is to manage a large pool of assets. This is because for someone looking to hire an asset manager, the biggest differentiating factor tends to be management fees – and fund managers with larger AUMs have much more flexibility when it comes to setting their fees. (As a quick aside, you would think track records and past performance would be the biggest differentiating factor – but the reality is that it is so difficult to outperform the market over an extended period of time that asset managers’ track records tend to be very similar and tough to distinguish between.) 

The costs to run the business do not vastly increase as your assets under management grow. Operating a fund with $1 million of AUM is not significantly more expensive than operating one with $1 trillion of AUM.

This means that the larger their AUM, the more a manager can lower prices and still have high profit margins. The outcome of that is a natural oligopoly in the market. Because the costs are relatively fixed regardless of AUM, large funds can easily put smaller AUM managers out of business by lowering their fees to levels below what the smaller managers can afford to charge.

Therefore, for new entrants to successfully break into the asset management game, they need to offer a product their competitors won’t touch. Remember that just a few short years ago, crypto was untouchable for firms like Blackrock and Fidelity, even with the significant demand for a Bitcoin tracker product. 

At the time, there were many people who wanted to enjoy the financial return of Bitcoin but did not wish to actually use the technology. Setting up a wallet, safely storing their private key, and finding a trustworthy exchange on which to purchase Bitcoin was too much of a hassle. Just like most other commodities or currencies, these investors wanted an exchange-traded product they could simply purchase with fiat in their brokerage account. And for this privilege, they were willing to pay exorbitantly high management fees.

Whom shall the prospective Bitcoin investors trust to manage their Bitcoin exposure? Well, there exists such a white man, and his name is Barry Silbert. I like to refer to him affectionately as Mr. Shillbert, because he is a shameless promotor of himself and his financial products. He knows the ABCs:

Always

Be

Closing

In Bitcoin We Trust

Despite many efforts by many different groups to secure approval for one from the SEC, it eventually became clear that an exchange traded fund (ETF) – whereby a manager accepts cash or Bitcoin from an investor and uses it to create units of the ETF, which then trade on a stock exchange in the capital of Pax Americana, New York City – was not in the cards for US investors. Recognizing that the lack of an ETF had created significant pent-up demand from less tech-savvy investors looking to get in on the BTC action, Mr. Shillbert found a way to create the next best thing. 

He developed a trust – the Grayscale Bitcoin Trust (or GBTC)  – which investors could create shares of by tendering USD or BTC. After six to twelve months, an investor could convert their shares in the trust to a security that traded on the pink sheets. Oh, and I forgot to mention –  this product was a bit like Hotel California. Once you checked in, you couldn’t check out. It was (and remains) impossible to redeem your GBTC shares. Once you are invested, the only way out is to sell GBTC at whatever price it fetches in the market. If there are no buyers, you are stuck.

While it wasn’t on the NYSE’s main board, anyone with a brokerage count capable of trading US stocks could buy GBTC. With its creation, lots of investors who wanted to reap the benefit of Lord Satoshi’s vision without actually buying into his teachings could now get in on the action.

Perhaps the most important thing to remember about  GBTC is that it carries an extremely high management fee of 2.00%. To put that into context, the SPDR S&P 500 ETF – one of the most traded financial instruments in the world – charges 0.0945%. Mr. Shillbert is able to charge so much because it’s such a complicated, expensive and time-consuming process to set up a trust of this type, no Bitcoin ETF product has been approved, and no traditional asset managers wanted to touch Bitcoin in the beginning – meaning that no bigger firms have been able push him out of the market by offering lower fees. In short, people have been willing to pay the fee because there hasn’t been any competition and they were desperate for exposure when the price of Bitcoin was appreciating.

As a result, GBTC is a money printing machine and the crown jewel of Mr. Shillbert’s crypto empire. The fees that Grayscale throws off fund everything else Mr. Shillbert does in the industry. Mr. Shillbert constructed whole businesses around growing the AUM of GBTC. Once the money entered, it couldn’t leave, and it was ripe to pay management fees to Mr. Shillbert.

Circles

I want to thank DataFinnovation for this article, which lays out the little games that Mr. Shillbert was likely playing with DCG, Grayscale, and Genesis.

According to them, here is how Mr. Shillbert’s little game of smoke and mirrors worked.

The Goal: Grow the AUM of GBTC and clip 2% management fees on the trapped capital.

Let’s walk through what this chart illustrates.

Step 1 – Get Capital into Genesis

Genesis and Gemini entered into a partnership whereby Gemini would lend its customer’s capital to Genesis for a fee. This was called the Gemini Earn product. As a Gemini user, you could pledge your BTC or USD and receive interest from Gemini. Gemini took those funds and lent them to Genesis at a higher rate than it paid to users through Earn. Now, Genesis had lots of capital to lend. Remember – Genesis is in the business of crypto lending. 

I don’t know if this was the only way Genesis funded its loan book. The job of a lender is to borrow cheaply based on the perceived strength of its balance sheet / risk management acumen, and lend at a higher rate. I have to assume that Genesis was able to borrow from other firms at attractive rates based on the perception that up until recently, it was the best managed and largest centralised crypto lending firm.

Step 2 – Create GBTC with Borrowed Money

Genesis would lend Bitcoin to firms like the now defunct Three Arrows Capital (3AC) and BlockFi, and those firms would turn around and give their borrowed Bitcoin to Grayscale to create GBTC shares. (We know that 3AC was the largest firm doing this trade as they held so many shares they had to declare them to the SEC.)

Screenshot of a historical quarterly record of the largest holders of GBTC

3AC and others participated in this trade because the GBTC shares they created traded at a premium on the open market. GBTC traded at a premium because it took six months to create shares – which meant that, even as demand for GBTC increased during the recent bull market, the only shares available to buy were those created six months prior. This led to a situation in which there was more demand to buy GBTC than there were willing sellers. As a result, buyers were prepared to pay more than what the underlying Bitcoin assets were worth in order to get their hands on what little GBTC was available and gain exposure, without having to go through the process of buying Bitcoin itself.

Basically, the process looked like this: 

1. 3AC borrows BTC from Genesis.
2. 3AC hands the BTC to Grayscale and creates GBTC shares for itself.
3. In six months, 3AC receives the GBTC shares and hopefully sells them at a premium on the market.

Step 3 – Lend USD against GBTC collateral

Remember that Genesis is borrowing USD from Gemini and its Gemini Earn product. It is paying a fee for this USD, so it needs to find someone to lend the USD to so it can turn a profit. Genesis turned around to firms like 3AC and said, “Hey, thanks for creating all those GBTC shares with my sister company Grayscale! Since they won’t turn a profit for you until you can sell them six months from now, how about you hand them over to us as collateral in exchange for a USD loan?” 3AC agreed, and was happy to get immediate, USD liquidity on the profit it wasn’t expecting for another six months. We know that 3AC borrowed up to $2 billion using this circular method, generating a lot of fees for Genesis. Mr. Shillbert doesn’t fuck for free.

And that $2 billion is how Su Zhu and Kylie Davies, the principles behind 3AC, got to live out their Big Pimpin’ fantasy. Unfortunately for them, like most dreams, they woke up and went bankrupt before taking delivery of their yacht.

Step 4 – Market, Please Don’t Go Down

Unfortunately, this whole circular jerk fest was predicated on GBTC continuing to trade at a premium. As the premium turned into a discount in 2021, firms like 3AC and BlockFi couldn’t afford to pay for the USD loans they had taken out from Genesis. Because they had given GBTC to Genesis as collateral for their USD loans, when the value of GBTC dropped, they were in danger of needing to put up additional collateral to cover GBTC’s loss in value. 

To put this in layman’s terms:  when you take out a loan of this type, you give the lender some amount of assets in return so that if you can’t repay the loan, they can at least repossess the assets you pledged – also known as your collateral – and recoup some of their losses. If the asset you pledge falls in value, you need to provide more of it in order to maintain the agreed upon value of your collateral. Why? Well, if lenders simply allowed the value of a borrower’s collateral to continue falling without requiring them to put up more, it could hit zero, and it would negate the whole point of holding collateral in the first place – which is to have insurance against losing the entirety of the money you lent out. 

Being required to put up more capital in this fashion is also known as being margin called. If a borrowing entity facing a margin call fails to put up more collateral, it defaults on its loan.

Since the value of the other assets they owned was simultaneously blowing up – see TerraLuna –  3AC, BlockFi, etc. were in danger of not having the funds necessary to pay up for a margin call.   

In steps DCG, the owner of Grayscale and Genesis, who didn’t want the 3ACs and the BlockFis of the world to be margin called (because then they wouldn’t be able to recoup the funds they had lent to those companies). To avoid this, DCG attempted to stop the price of GBTC from falling further by raising equity and using cash on its balance sheet to apply buying pressure and purchase GBTC it in the open market. Unsurprisingly, they failed.

As you can see in the above screenshot of GBTC holdings, DCG is now the largest holder of GBTC. The DataFinnovation post lays out a timeline on how DCG stepped in as the buyer of last resort.

One question that always bugged me is how DCG financed its purchases of GBTC. Mr. Shillbert is a seasoned financier. And in finance you always, always, always use other people’s money. Now, we know that DCG borrowed money from Genesis. While it is not confirmed what DCG used said funds for, it is possible that DCG borrowed from Genesis so that it could purchase GBTC. It would explain why DCG needed to borrow hundreds of millions from Genesis, while Grayscale was throwing off hundreds of millions of dollars worth of management fees. 

DCG was able to borrow cheaply on the back of Genesis’ sterling reputation as the best crypto lending shop. As an investment firm, if DCG had gone out to the market on its own to raise this capital, it would have been asked a lot more questions about why it needed to borrow money and ultimately pay a higher rate in much smaller size.

Bad Debt

In a bid to corral as much capital as possible into GBTC, Mr. Shillbert and his collaborators effectively destroyed Genesis and DCG. That is because 3AC, BlockFi, and many others who put this trade all defaulted on their loans. They defaulted because:

1. GBTC went from a premium to a discount. GBTC was the collateral underpinning all these loans, and when GBTC lost value, the loans became bad.
2. The Terra collapse affected many of Genesis’ borrowers such that any other collateral provided for their BTC and USD loans was also in the dumpster. Remember that Bitcoin, Ether, and the whole shitcoin complex declined 50% to 90% in the weeks after the Terra ecosystem collapsed.
3. And the coup-de-grace was the stupendous con job executed to perfection by do-gooder white boy SBF. Alameda also borrowed from Genesis, and I can’t imagine they didn’t have the GBTC premium trade on as well.

PAUSE

These are all Genesis issues, not DCG or Grayscale issues. How did this credit contagion metastasize into stage 4 credit cancer and become life threatening to the entire G-Unit? Mr. Shillbert provides some clues in a recent update.

Remember folks, Mr. Shillbert is an excellent financier and accountant. Here is my guess as to what is going on with these intercompany loans.

In a credit crunch, bad loans are only recognised as such once the lenders stop lending. Loans to 3AC on Genesis’ balance sheet were always poorly underwritten. However, even after the 3AC bankruptcy, there is still a chance for recovery. But no one knows what the recovery percentage will be –  and therefore, the recovery percentage is whatever someone is willing to trade at. For example, if DCG is willing to purchase 3AC loans at par, and DCG assumes over a ten-year time horizon that 3AC will be able to pay them back in full due to a rise in crypto prices. Then, Genesis gets to sell a 3AC debt asset to DCG at 100 cents on the dollar (rather than, say, 0 or 10 or 20 cents on the dollar).

Mr. Shillbert told us that DCG assumed 3AC loans from Genesis’ loan book – so the only question is, what did DCG pay for them? In a purely accounting sense, if DCG pays par, then Genesis is solvent. That’s good … right? However, how did DCG pay for the asset? Mr. Shillbert told us that Genesis lent DCG the money with which to purchase assets on Genesis’ balance sheet at, I believe, the most favourable valuation for Genesis (which is par). This is a bit of a left hand, right hand fugazi transaction. The bad debt just got shuffled from one member of the G-Unit to the other. But if you are trying to preserve the appearance that Genesis is a solid lender, then executing this accounting sleight of hand achieves that goal.

Well, surely then, Genesis would charge a member of its G-Unit family a market rate of interest? Again, we actually don’t know, because Mr. Shillbert didn’t tell us the exact rate, or anything beyond that it was an  “arm’s length transaction”. But Mr. Shillbert has T-Rex arms, so I wouldn’t be too comforted by that statement. 

Contrary to what we believed several months ago, DCG did not put any new hard cash into Genesis. The radioactive 3AC loans were just moved out of sight and out of mind until FTX / Alameda blew up. Genesis had exposure there as well. 

Other DCG debts include:

1. $575 million borrowed from Genesis to do “investments” and buy back DCG stock.
2. $375 million credit facility.

DCG sure is loading up on a lot of debt – around $2 billion in total. Now, this isn’t much of an issue when your crown jewel GBTC is throwing off $400 million per annum in management fees, as it was on track to do before the summer crypto crisis when BTC was at $30,000. But now that the run rate is $200 million at BTC $16,000, the DCG Jenga game is a bit more wobbly.

Now, Lil Wayne told us what to do situations:

They go wobblety wobblety, wa a wobblety wobblety

Wa a wobblety wobblety

Drop Drop It Like It’s Hot

Obviously the further drop in Bitcoin, Ether, and shitcoin collateral – coupled with what is probably a Jupiter-sized hole in Genesis balance sheet following the FTX / Alameda blow up – was too much for Mr. Shillbert to financially engineer his way out of. If it were any other way, surely Mr. Shillbert would play the same trick with DCG buying Genesis’ bad debt by borrowing money from Genesis. 

I’m guessing here – but I suspect that whoever was supplying the capital for Genesis to lend out probably shut off the taps. And without access to outside dry powder, the film credits started rolling on the G-Unit.

Finally, cold hard maths and excessive leverage forced socially conditioned muppets to snap out of it, and become discerning investors once more. There are so many questions about what is actually going on inside the G-Unit. But I know one thing, reading what I have read about the situation, and using my noggin, DCG and Genesis are untouchables. And obviously my sentiments are shared otherwise Genesis wouldn’t be teetering on the verge of bankruptcy.

The result of all of this is that DCG has some tough choices to make. Will Mr. Shillbert allow new money to take a cut of his GBTC management fee stream of income? Will Mr. Shillbert dump more GBTC onto the market to raise cash to plug capital holes in the G-Unit? Mr. Shillbert adroitly used other people’s money up until now. Will he dip into his own deep pockets to save his empire?

All roads lead to GBTC and the Grayscale trust. Grayscale is the only good asset that throws off serious cash within the G-Unit. Will the GBTC discount widen as DCG is forced to possibly sell it? Will something happen with Grayscale that would either dissolve the Trust which would allow holders of GBTC to capitalise on the 40% discount?

Now that we understand the machinations of this particular white man, can we make some money? The next section of this essay will be a technical discussion on how to trade this dislocation in the market.

The Trade 

GBTC is at a discount. There are two trades here that we must evaluate.

Trade 1 (Bitcoin / USD price neutral):

1. Sell USD, buy GBTC.
2. Open a short Bitcoin / USD perpetual swap or short Bitcoin / USD futures position to hedge the Bitcoin / USD exposure.
3. Wait until either the discount swings into a premium or GBTC can be redeemed at par.
   1. If GBTC swings to a premium, sell GBTC, buy USD. Then close the short derivatives position.
   2. If GBTC can be tendered for either BTC or USD, redeem GBTC. If you receive BTC, sell it for USD. Then close the short derivatives position.

Trade 2 (Long Bitcoin / USD):

1. Sell USD, buy GBTC.
2. Wait until either the discount swings into a premium or GBTC can be redeemed at par.
   1. If GBTC swings to a premium, sell GBTC, buy USD.
   2. If GBTC can be tendered for either BTC or USD, redeem GBTC. If you receive BTC, sell it for USD.

Financing / Hedging Costs

All rates are per annum
USD Opportunity Cost	5%
GBTC Management Fee	2.00%
Derivatives Cost	0.55%
Time Horizon (years)	2
Total Financing Cost	15.10%

The derivatives cost is the annualised discount taken on 23 November 2022 of the BitMEX 30 June 2023 Bitcoin / USD futures contract, XBTM23.

Whenever we evaluate arbitrage trades we must consider the financing and opportunity cost of capital.

GBTC must be fully funded. Your broker will not give you leverage. Therefore, you need to either borrow USD, or use USD capital that you own outright. In either case, there is a cost. Let’s assume that you would use USD you own free and clear to purchase GBTC. Given that I can purchase a two-year U.S. Treasury note at approximately 5% per annum (PA), that is my cost (or opportunity cost) of capital.

Next, we have to consider how much it would cost to hedge our Bitcoin / USD risk if we conduct this trade price (or delta) neutral. Right now, the perpetual swaps and futures contracts are trading in backwardation. That means the futures price is lower than the spot price. Therefore, as a short contract holder, we pay for the privilege of profiting if the Bitcoin / USD price declines. 

Unfortunately, there is not much liquidity in futures contracts with maturities longer than six months. That means that derivatives funding cost cannot be knowable a priori. If it takes a long time for the GBTC discount to swing to a premium, or for GBTC to be redeemed at par, then we are subject to the price of rolling our futures contracts.

If we are conservative and assume it will take two years to realise an acceptable exit from this trade, then the table above lists the costs of this trade. The income is the 40% discount (as of 23 November 2022), or whatever your executed level is, of GBTC in the market. At current levels, this trade has 25% of juice in it (40% income from buying at a discount and eventually selling at par vs. 15% cost of financing and hedging the position).

The premium or discount of GBTC is positively correlated with the rate of change of the price of Bitcoin. If the Bitcoin price is accelerating quickly to the upside, GBTC will trade at a premium. If the Bitcoin price is accelerating quickly to the downside, GBTC will trade at a discount. It is important to understand that the nominal price of Bitcoin is not relevant. GBTC at $16k Bitcoin is at a discount today because Bitcoin came off a high of $69k. GBTC at $10k Bitcoin back in 2020, when Bitcoin was coming off a low of $3k-$4k, was at a premium. This is a path-dependent variable.

Bitcoin / USD (yellow) vs. GBTC Premium / Discount (white)

Therefore, if you believe that a bottom has been reached in the price of Bitcoin, all it would take is for the direction of the price to change, and GBTC could swing into a premium. Therefore, for those who believe that we are at the bottom, this is a great way to juice up a long biassed trade. That is because you get the extra kicker of the GBTC discount. Financing costs are still applicable. Let’s say you believe the sentiment will change in the next 6 months, with Bitcoin rallying quickly from $16k to $30k and GBTC swinging from a 40% discount to a slight premium.  

Discount to Premium Income	40%
USD Opportunity Cost	5%
GBTC Management Fee	2.00%
Time Horizon (years)	0.5
Total Financing Cost	3.50%
Total Income	36.5%

The fact that Bitcoin doubled is not extra income. That is because you could have just purchased physical Bitcoins outright without engaging in this strategy. Therefore, the incremental extra income for a directional long bet on Bitcoin is 36.5%.

“Cryptohayes, are you doing any of these trades?” 

My answer? Not at this time. There is another unquantifiable opportunity cost of capital risk that is evident in either scenario – locking up scarce USD capital into a trade with an undetermined time frame. I do not know when Bitcoin’s price action will reverse, nor when, if ever, I will be able to redeem my GBTC shares at par.

I am happy to sit in US Treasuries with my spare fiat. That is because the Treasury market is the most liquid in the world. Should there be a serious distressed crypto asset that is puked out of one of these bankruptcies, I want to stand ready with dry powder. The GBTC trade will be liquid right now as volatility in its price and discount increases on the way down. As crypto winter sets in and volatility plummets alongside trading volumes, all types of crypto assets and derivatives will become illiquid, and GBTC will not be an outlier. In short, it’s a big door in, small door out. And as an experienced trader in emerging market equities, I know to steer clear of these trading setups.

As always, that is just my opinion, not financial advice – please Do Your Own Fucking Research.

How to Redeem

The inability to exit the GBTC roach motel is a good and a bad thing for the crypto capital markets. It’s a good thing because, if there was an easy way to redeem GBTC at these heavily discounted levels, it would mean a huge amount of physical BTC selling would occur. Holders of GBTC would either redeem their shares to capture the premium and then dump BTC they receive, or the Trust would dump the BTC on their behalf and give investors USD in exchange for their GBTC. Either way is Bad News Bears.

Because it is basically impossible to redeem GBTC, this capital is ripe pickings for Mr. Shillbert’s management fee collecting machine. I took a detailed look at the GBTC prospectus to stress test this assumption. Here is what I found out about the avenues through which GBTC can be redeemed:

Redemption Path 1: 75% or more of the shareholders vote to dissolve the Trust

This is a very high hurdle to force a closure. Therefore, I consider it highly unlikely that a disparate number of shareholders could be convinced to vote to redeem the trust. Given that not all of the shares are publicly traded in the Trust, even if you wanted to buy up all the GBTC publicly  available and vote for dissolution, you still wouldn’t be able to accrue enough to meet the 75% threshold.

If DCG was not on board, given they hold approximately 10% of the shares outstanding, then you would need 83.33% of remaining shareholders to vote yes. This makes it even tougher to prevail.

Redemption Path 2: The sponsor elects to dissolve the Trust

As of 23 November 2022, the Trust had assets valued at approximately $10.2 billion. That means Grayscale – and by extension, Mr. Shillbert – clip $204 million each year in management fees. The amount of work it requires to receive said monies is close to zero. Therefore, why in the fuck would you ever voluntarily decide to dissolve the trust? Obviously, you wouldn’t. 

Redemption Path 3: The SEC grants a regulation M exemption

This exemption basically allows holders of GBTC to redeem at the NAV of the fund. Grayscale is currently suing the SEC to get this exemption for the Trust. The argument is simply that because the SEC won’t allow GBTC to convert into an ETF, that the SEC should grant an exemption. I cannot handicap the likelihood that this lawsuit will prevail, but in any case, we won’t get more clarity on the thinking of the court until Q1 2023. So, it’s impossible to know the likelihood of success of this avenue and, if successful, how long it will take. 

But, let’s assume there is a 50% chance of success within the next one year. That means there is a 50% chance you pay full financing and management fees for a year and are able to redeem – and on the flip side, there is a 50% chance you pay full financing and management fees for a year and are unable to redeem.

Exemption Approved			Exemption Denied
USD Opportunity Cost	5%		USD Opportunity Cost	5%
GBTC Management Fee	2.00%		GBTC Management Fee	2.00%
Derivatives Cost	0.55%		Derivatives Cost	0.55%
Time Horizon (years)	1		Time Horizon (years)	1
Total Financing Cost	7.55%		Total Financing Cost	7.55%
Discount Income	40%
Total Income	32%		Total Income	-8%
Probability	50%		Probability	50%
Expected Value	12.45%

All that work and risk for 12.45%. This is far from a slam dunk trade, but it might be worth a nibble. That said, I still wouldn’t do this trade as my scarce fiat capital would be locked up for 1 year and unable to participate in other unknown distressed crypto opportunities.

Maturity

Our cucumber munching do-gooder little white boy is just a boy because his con was too flagrant. As a parasite, you don’t want to kill the host. It is better if the host lives and you bleed them slowly.

The white man was a boy once, but he learned the value of patience. The GBTC management fee scheme is a much better operation than blatantly stealing $10 billion dollars of your customers’ money. It is much better to earn your daily bread from willing participants. Mr. Shillbert never forced anyone to invest in GBTC. Every owner of this product did so willingly. And while they might hoot and holler about why it’s against the best interests of the investors of GBTC to retard the redemption process, when it comes down to it, everyone who owns this product knew they couldn’t get out when they purchased it. Furthermore, if they want to get out, they have a public market they can turn to where there are buyers, albeit at a very lower price, willing to buy GBTC should they wish to sell.

If you find this tale a bit sketchy, weird, and funny, then boycott the TradFi parasitic financial markets that allow this behaviour. If you want crypto, go to your favourite exchange and purchase Bitcoin or other cryptos and immediately withdraw them to your own hardware wallet like a Ledger. Stop buying fugazi financial products like GBTC. Don’t continue to enable smooth operators like Mr. Shillbert. Lord Satoshi gave everyone the tools to become their own financial institution. If you refuse to bask in the light of the Lord, be not upset when you must dine with the devil.

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