Breaking Down the Influence of Genesis Global on the Broader Cryptocurrency Space

Genesis Dec 17, 2020

Grayscale is a wholly owned subsidiary of Digital Currency Group, with the latter essentially holding a near-monopoly on the entire blockchain industry (one would imagine that this provides a significant level of reassurance for larger investors).

Genesis Global (and its other subsidiaries / tied companies) are of the same ilk - they just handle different facets of the Digital Currency Group operation (i.e., trading, loaning, borrowing, and derivatives as well as some dabbling into the derivatives markets).

The Purpose of the Litecoin Trust

We're taking a special look at the Litecoin Trust since its traded at such a significant premium to the price of Bitcoin this year .

Similar to the Bitcoin trust, the purpose of this trust is to grant investors exposure to one of these crypto assets through purchasing shares in a company.

In a nutshell it works this way:

  1. Grayscale sets up a fund / entity that acquires X amount of a crypto asset (let's say that said asset is Litecoin here).
  2. Since owning shares = equity in the company itself and this investment body owns a significant portion of Litecoins, an investment in the company (i.e., Grayscale ; purchasing shares), should serve as a backdoor means for individauls to get direct exposure to Litecoin (or whatever other asset underpins that relevant Grayscale product

Throughout the year several users have noticed that there are noticeable discrepancies between the strike price of the shares to the reference asset in question (by thousands of percentage points).

Evidence of the Gap Between Grayscale Litecoin Trust's Strike Price and Reference Exchange Rates

Below is a photo provided by the Telegram channel 'Cosima Capital':

In the photo above, we can see that there was a 5,826% premium on Litecoin at one point in time (as well as a 1,000%+ premium on Bitcoin Cash).

There were premiums on the other cryptoassets in the photo as well - to be fair - but their premiums were nowhere near what we saw for Bitcoin Cash and Litecoin.

Questions

  1. Is this bullish?
  2. Are those that are investing in this 'Trust' so incompetent that they cannot perceive the premium before deciding to invest in this financial vehicle?
  3. Do these investors know some crazy information that the rest of the general public does not know that would lead to this result?

Public SEC Filing by Genesis Markets May Provide the Answer

That public filing can be found here: https://www.sec.gov/Archives/edgar/data/1588489/000119312519295206/d735049dex991.htm

[1]

Genesis actually lays out explicitly why this premium exists, stating:

"Because of the holding period under Rule 144 and the lack of an ongoing redemption program, there is no arbitrage mechanism to keep the price of the Shares closely linked to the Bitcoin Index Price and the Shares may trade at a substantial premium over, or substantial discount to, the Bitcoin Holdings per Share."

Even though the above excerpt refers to Bitcoin, there's no reason to assume that those very same factors would not hold an equal impact for Litecoin.

Reading further along, there is an example given that outlines how the general illiquidity of the Trust at various times have created this premium too.

Specifically, it is stated:

"For example, in the past, the price of the Shares as quoted on OTCQX varied significantly from the Bitcoins Holdings per Share due in part to the suspension of redemptions."

This is the statement that's going to send us down a rabbit hole, because we need to understand what they're talking about in terms of "redemptions". Up to that point, our understanding of Grayscale Bitcoin Trust was that they were merely an investment vehicle manufactured a rather 2-dimensional purpose.

However, further research suggests a significantly expanded role beyond this.

Referring to Research by 'The Block'

This may be one of the rare times that 'The Block' has ever served as a useful source of information in the blockchain sphere, so make sure to frame this article when we're done gleaming the necessary information from this piece. Refer to the references appended at the bottom for a link to the article in question. [2]

Shifting focus back to the article, the scene is set in the immediate aftermath of the massive market downturn we saw in mid-March. Specifically, an individual from 'The Block' was interviewing the CEO of Genesis whom explained the entire situation.

At the beginning of the year, bitcoin futures [were] trading at a premium to the spot market. As a result, Genesis counterparties would typically borrow U.S. dollars, purchase crypto assets in the sport market, and then sell them in the futures market to capture the arbitrage opportunity."
"[But] due to bitcoin's dramatic price decline that week, traders began to return their borrowed dollars to borrow bitcoin and the futures market started trading at a considerable discount. Traders followed a new strategy: short the spot market, buy the futures, and then wait till the expiry date to collect the spread."

Well that's a ton of information that we were not aware of before - but this helps us in understanding the inter-connection between some additional pieces in the blockchain space that are not commonly discussed.

Genesis Global Trading

This entity is at the forefront and should remain the primary target for the remainder of this investigation if we want to get a better idea of what is being conveyed in that SEC press release we dissected in the prior sections.

Genesis Global Trading as a Lender

Despite the name 'Genesis Global Trading' it appears that they are heavily involved in the lending of assets to numerous financial institution and larger level players in the market ('whales' as one would call them).

Breakdown of Lending Activities by 'Fintech Magazine'

In a piece published on April 26th, 2020 (just a few short months ago from the time of writing), it was revealed that Genesis Global Trading had loaned over $1.5 billion in cryptocurrency at that point (which is a considerable amount). [3]

Perhaps what makes this total even more staggering is the fact that Genesis Global Trading has only been in operation as a meaningful entity in he blockchain since 2015 (with the lending services not picking up momentum until 2018).

Of note is the characterization of Genesis Global Trading at the end of that piece as a, "Company [that] **aims to make it easier to buy and sell large blocks of digital currency."

Non-Crypto OTC Markets

Most in the blockchain space are familiar with OTC markets (casually referred to as 'over-the-counter' markets in Bitcoin and blockchain). However, few understand the relationship between various OTC brokers, their affiliated OTC networks and the related consequences (good or bad) for the blockchain space.

More importantly, we're going to attempt to assess what their concrete impact is in the blockchain space.

Taking a Brief Look at the Genesis Global Trading Reports

Most likely the information repeated below can be found in several of the Genesis Trading reports, but the excerpt in which the following statements were found can be sourced in the Q2 2019 report by Genesis.  [4]

Specifically, they note the increased incidence of "cash borrowing" in the Bitcoin spot and futures markets.

The report asserts:

"As markets became more bullish, market makers priced the forward curve higher than spot to reflect the expectation of price increase."
"This development increases the demand to borrow cash for two primary reasons. First, investors leverage their holdings by borrowing cash against BTC collateral and then use the cash to buy more BTC. If the price increases, the value of the collateral may increase relative to the value of the loan, allowing investors to draw down on more cash and continue leveraging long."

Following these statements is a chart that shows the volume of cash borrowing vs. Bitcoin's price:

Forgive the quality, this comes from their quarterly report

Of equal importance is the second reason that they attribute to increased cash borrowing.

Specifically it is stated:

"The second reason for increased cash borrowing is the opportunity to capture a basis spread between futures and spot, where the premium often outweighs the cost to borrow cash. This trade is also attractive to many traditional firms familiar with trading in other asset classes because it is a relatively low risk to exploit the steep forward curve...Further, if the market flips bearish and forward curves become more in line with spot, the trade converges to profitability much quicker, making the effective annual realized return significantly higher than the cash borrow rate."

If the above sounds confusing, don't worry about it - let's just put that to the side for now.

All we really need to take away from the information is that:

A) When the market is bullish, traders are willing to borrow cash (from outside resources) in order to obtain Bitcoin.

B) This borrowing and subsequent purchasing creates a premium on the price of Bitcoin in the futures markets that have been created by Genesis for Bitcoin.

C) In turn, there is also a premium on the price of Bitcoin in the "spot markets" as well (the spot markets are not referring to regular cryptocurrency markets)

The only detail in dispute / obscurity here is how they define the "spot markets".

More Information on These OTC and Spot Markets

For those that are unfamiliar with institutional finance and investment, many of these terms and concepts may seem a bit confusing - especially since they intermingle an asset / currency that we are already familiar with (Bitcoin, Ethereum, etc.) with alternative financial instruments that are not offered to the general public at large.

Fortunately, there is one piece out there that can seriously help us parse what's going on, and that's an article titled, 'Why Genesis Made Over $1 Billion in Bitcoin, Ethereum and XRP Loans', by Michael del Castillo from Forbes. [5]

In the piece, Michael observes:

"Charging interest rates that ensure that its pockets get lined regardless of whether a customer loves or hates crypto, the company is leading the way as a rising tide of crypto startups compete to stay cash positive in this epic bear market." (keep in mind that this was written and published at the beginning of 2019, which is immediately after we saw Bitcoin hit its low from the [now broken] ATH set back in December 2017)

In essence, Michael was marveling at how Genesis Global / Trading was able to remain so profitable even despite the massive sell-off of Bitcoin.

Its been a while since Bitcoin was trading around this price range, so to put this sell off in context, take a look at the chart below:

As we can see above, Bitcoin shed nearly 50% of its value in a little over a month - which is really significant when considering this -50% price drop came after Bitcoin had already suffered a -68% depreciation in the bear market up to that point:

So how was Genesis able to clock in so much money at this point?

Interest rates.

But these interest rates were on cryptocurrency loans. And that's the part that sounds confounding (if left isolated in a vacuum like this Forbes writer did). The reason why this fact should sound confounding is simple - if Bitcoin is decreasing in price, then there's no reason why people should be scrambling to then go borrow more of that asset.

Think of the situation as similar to what we see on MakerDAO. In theory, borrowing more DAI using Ethereum (or WETH), is essentially the equivalent of placing a "long bet" on Ethereum because traders are only obligated to return that equivalent amount of DAI they borrowed in order to get their Ethereum back.

So if they used 1 ETH to borrow 500 DAI and suddenly ETH rockets up to $1,000 per unit, then those borrowers would be in a position to pay back the loan (+interest) and still receive the ETH back, resulting in profit.

Thus, if one thought that ETH was going to lose a ton of value in the near future, there's little incentive for them to then borrow against it...unless there were a divergence in the assumed price of Ethereum on that derivatives market vs. the real "spot markets" (either on exchanges or elsewhere).

And, as noted above, that's exactly what happened.

Couple of Principles to Take Home With Us

Whenever there is a premium on the futures market, there should be an expected increase in the purchase of the relevant asset (as buyers attempt to arbitrage the difference). Genesis stands in as a middleman to facilitate this exchange, making their profit from the interest rates that they charge.

If there is a consistent difference between the premium priced on a cryptoasset and the spot price on 'reference exchanges' (i.e., Kraken, Binance, etc.), then that gap more than likely represents the profits that Gensis Global is making from the entire process.

Knowing this information creates a different sense of importance on the futures spread that we see in the markets. To be specific, when we say 'futures', we're not referring to BitMex or OKex here - although they absolutely do play a role in the grand scheme of what's going on here.

We're instead referring to the CME, OTCQX (over-the-counter exchange), as well as the CME (Chicago Mercantile Exchange).

Conclusion

It was tempting to call this 'part 1', but this will be left as a 'one-off' that will eventually stand as one in a series of articles compiled within a recurring theme.

References

[1]:
https://www.sec.gov/Archives/edgar/data/1588489/000119312519295206/d735049dex991.htm

[2]: https://www.theblockcrypto.com/post/61305/genesis-crypto-credit-suspends-extension-market

[3]: https://www.fintechmagazine.com/financial-services-finserv/genesis-has-loaned-more-dollar15bn-cryptocurrency

[4]: https://genesistrading.com/wp-content/uploads/2020/05/GenesisCapital_Q2_2019_Insights.pdf

[4]: https://genesistrading.com/wp-content/uploads/2020/11/GenesisQ3QuarterlyReport-3.pdf

[5]: https://www.forbes.com/sites/michaeldelcastillo/2019/01/30/why-genesis-made-over-1-billion-in-bitcoin-ethereum-and-xrp-loans/?sh=1f83d88750df

Tags

cryptomedication

Happy to serve and help wherever I'm needed in the blockchain space. #Education #EthicalContent #BringingLibretotheForefront

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