As FTX collapsed — and the tide came in — builders, investors, aficionados and just about anyone with a passing interest in cryptocurrencies wondered: who else had been swimming naked?
All eyes are now on Digital Currency Group (DCG).
The crypto conglomerate, whose subsidiaries include some of the biggest names in the industry, is tottering in the wake of FTX’s bankruptcy. The lending arm of its crypto trading business, Genesis, suspended withdrawals last week citing liquidity issues and is reportedly exploring bankruptcy.
The question now is what effect Genesis’ troubles will have on its parent company and, in turn, DCG’s crown jewel: Grayscale, the issuer of GBTC, the world’s largest publicly traded crypto fund.
In a worst-case scenario, retail investors who have already suffered plunging cryptocurrency prices this year will be in for a world of hurt, according to Leigh Drogen, chief investment officer at Starkiller Capital.
Worst Case Scenario
“The fear is that, in the event that they [DCG] do choose to unwind Grayscale, it would, one way or the other, unlock a tremendous amount of Bitcoin and Ether,” he told The Defiant. That additional supply coming onto the market would likely send the price of both assets plummeting.
Opinions are mixed as to whether DCG faces existential doom. Nevertheless, investors are paring risk as Bitcoin hit a two-year low on Monday.
“Markets can deal with good news and bad news,” Drogen said, “but they really don’t like it when there’s this kind of big thing hanging over them.”
Barry Silbert, DCG’s CEO, was one of the earliest Wall Street-to-crypto converts. A former investment banker, he was named in Fortune Magazine’s 40 Under 40 list in 2011 for founding SecondMarket, a trading platform that allowed venture capitalists to buy and sell their shares in privately held companies.
In 2013, he founded Grayscale. In 2015, he sold SecondMarket for an undisclosed sum and used part of the proceeds to start DCG. The company’s subsidiaries now include crypto publication CoinDesk, bitcoin mining firm Foundry and, of course, Genesis and Grayscale.
With the debut of Grayscale and its flagship product, the Grayscale Bitcoin Trust, institutional investors finally had a way to gain exposure to the original cryptocurrency. Investors could exchange Bitcoin for shares in the trust, and trade those shares on the stock market.
For a while, Grayscale was the only game in town, a situation from which it benefited immensely. From 2015 to 2020, shares were consistently worth more than the bitcoin they represented. On occasion, the premium topped 130%.
“A lot of the money that went into GBTC wasn’t people actually trying to get access to Bitcoin, it was people trying to play that premium,” James Seyffart, a research analyst at Bloomberg Intelligence, told The Defiant. “So basically, there was artificial demand for GBTC shares solely because it was trading at a premium, and it was trading at a premium because it was one of the only ways to get access to Bitcoin on the traditional financial rails.”
Competition eventually emerged and the Grayscale bubble popped. Since March 2021, GBTC has traded at a discount. This week, the shares fell to a new low, trading at just 50% of net asset value (NAV).
Grayscale’s biggest problem, however, may be the Securities and Exchange Commission.
This year, the US regulator denied Grayscale’s bid to convert the trust to an exchange-traded fund (ETF), a move that would have allowed investors to redeem their shares for the underlying Bitcoin and likely caused GBTC to trade more in tandem with its underlying assets.
As of Thursday, GBTC held $10.5B in assets under management.
But Grayscale isn’t the only DCG entity to have suffered this year.
Trouble Started With 3AC
Documents filed in a Singaporean court this summer revealed that crypto hedge fund Three Arrows Capital owes 32 creditors at least $3.9B. The largest creditor is Genesis, which had lent Three Arrows $2.36B. The loan was secured by $1.2B in a mix of assets that included shares of GBTC, shares of the Grayscale Ethereum Trust, and tokens of the Near and Avalanche blockchains.
Then, on Nov. 7, FTX was caught flat-footed as customers demanded their deposited assets en masse, some of which the exchange appears to have lent to sister company Alameda Research, a trading firm. Alameda subsequently lost that money on failed venture investments, according to news reports.
When FTX halted withdrawals a day later, several firms rushed to claim that they had no exposure to the insolvent crypto exchange.
“With regard to today’s market events, we have managed our lending book and have no material net credit exposure,” Genesis said on Nov. 7.
Its story quickly changed.
“In anticipation of the extreme market volatility yesterday, we hedged and sold collateral resulting in a total loss of ~$7M across all counterparties, including Alameda,” it said on Nov. 9.
On Nov. 10: “As part of our goal in providing transparency around this week’s market events, the Genesis derivatives business currently has ~$175M in locked funds in our FTX trading account.”
Genesis Halts Withdrawals
Then, on Nov. 16, Genesis’ lending arm halted withdrawals. The move sparked fear of trouble at related companies, and observers demanded proof that Grayscale had not lent or invested customer assets, as FTX had.
News reports that Genesis had unsuccessfully sought a $1B emergency loan soon followed. On Tuesday, the New York Times reported Genesis had hired an investment bank to “explore options including a potential bankruptcy,” citing anonymous sources familiar with the situation.
Silbert tried to calm shareholders in a letter sent on Tuesday.
DCG owes Genesis’s lending arm $575M that it had borrowed for investment opportunities and the repurchase of DCG stock. Separately, DCG assumed $1.1 billion in Genesis’ liabilities in a promissory note due June 2023. Observers speculate that it did so in order to shore up the lending firm in the wake of Three Arrows’ collapse. Finally, Silbert said DCG has a $350 million credit facility “from a small group of lenders led by Eldridge.”
The question now is whether DCG is worth more than those liabilities, according to Ram Ahluwalia, founder of crypto investment advisor Lumida Wealth. Ahluwalia has followed DCG’s recent travails.
“The good and the bad news is that DCG has assets so they can eat some of the risk [from Genesis]. So in a way, they are a buffer,” he told The Defiant. “But the question is, do they have enough of a buffer? Is Grayscale a valuable enough asset to eat these costs, to absorb these losses? We need to see if DCG has sufficient capital or the ability to raise funds.”
‘DEF CON’ Scenario
If they don’t, DCG might have to “sell the crown jewel, Grayscale,” a turn of events he calls “the DEF CON scenario.”
Part of the concern stems from uncertainty surrounding if and how, exactly, Grayscale could unwind and release its Bitcoin and other assets to the market.
“Do they hand out the funds in kind? Do they ask for wallet addresses? Do they set up a Coinbase account for everybody?” Drogen wondered. “Or, do they literally sell it? And God knows, they can’t sell $10B of bitcoin without absolutely demolishing the market.”
That collateral damage makes it highly unlikely DCG would dissolve Grayscale, Seyffart said.
“There’s a lot of rumors and speculation that Genesis could bring down DCG, which I don’t think is necessarily the case,” he said.
Some observers, including Messari founder Ryan Selkis, have urged Grayscale to seek permission from regulators to liquidate their Bitcoin holdings, allowing GBTC shareholders to redeem shares for the underlying crypto. The discount would disappear, and shares would immediately double in value.
DCG is one of the largest holders of GBTC, and could, with the necessary regulatory relief — known as a “Reg M exemption” — raise far more money from selling its shares than it can now, potentially enough to plug the hole in its balance sheet.
But experts who spoke to The Defiant were unanimous in their belief the SEC would not grant such a request.
“Even if Grayscale wanted to go and [apply for] this Reg M exemption,” Seyffart said, “I’m not even sure the SEC would approve that since they’re so against anything with spot Bitcoin.”
Whether Genesis files for bankruptcy or not, the affair has outed another bad actor in crypto’s centralized finance ecosystem, Drogen said.
When DCG borrowed $575M from Genesis, it did so “in the same vein as hundreds of crypto investment firms” and structured the loan “on an arm’s length basis and priced [it] at prevailing market interest rates,” Silbert said in his shareholder letter.
On Thursday, however, the Financial Times reported that DCG had allegedly used some of the borrowed funds to buy additional shares of GBTC. As of Thursday, those shares were worth a quarter of their value at the time of purchase, according to the FT.
“It’s just another example of intercompany lending that shouldn’t be happening,” Drogen said. “And in this case, it’s slightly less icky than FTX, which was just the worst of the worst of the worst. I just can’t believe that we’re here and we have to have this conversation and that these companies, instead of just being smaller and taking less risk and cutting losses, they just keep doubling down.”