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A story about mixing prop-trading, third-party brokerage and custody duties
The original sin of crypto came from the fact that nascent centralized exchanges also operated their proprietary prime brokerage or trading businesses. Although, it was almost a necessity to animate their market liquidity, it came at a great expense of conflict of interest, loop risk, and ultimately undermined their clients’ interest.
Let’s look at the fallen dominoes and their mutual relationships.
The first domino, DeFi summer 2021. The first layer of crypto had been built with Uniswap, Compound, MakerDAO, and Aave all relying on fairly automated and relatively low-risk financing mechanics. DeFi summer built on top and brought “degen trading”, or a massive build-up of crypto casinos, whereby new protocols established leveraged strategies on their own native tokens. In short, it worked as long as the native ecosystems grew, and buying interests expanded. As soon as redemptions exceeded demand, it collapsed.
This is exactly what it did, slowly then massively. The ponzi-nature of “degen trading” climaxed with the $8bn failure of Anchor Protocol. This was patient number one, and this is where the contagion started. In short, Anchor Protocol was farming UST out of their own LUNA coin, and was setting an artificially high, and subsidized, staking rate of ~20% to force retention. Their scheme was put to the test after the crypto token market had suffered a 40% drawdown from Nov21 to early ’22, therefore weakening hedge funds’ long-only strategies.
👉More on Anchor Terra here
The Anchor debacle took a few candid hedge funds with it, such as Three Arrows Capital (“3AC”) that left a $1.1bn hole at Genesis, and $80m at Blockfi, out of a total $8bn wipe-out. These cracks still reverberate to this day, as Genesis is now on the brink of bankruptcy, BlockFi filed for Chapter 11 on 28Nov22, and Celsius, Voyager are under liquidation.
Another massive domino, FTX. It stands out not only by the sheer size of the asset fallout, $10bn, but also by the huge deception that SBF had engineered among the allegedly most sophisticated investors. After raising $400m at a $32bn valuation in Jan22, it collapsed magnificently in Nov22 after it was revealed that the company’s balance sheet was relying on leveraged trade on an illiquid and huge FTT position. Further investigations, carried out by former liquidator of Enron, revealed misappropriation of funds, absence of risk management and control, and total disregard for clients’ assets safety. Same-same but different, as creditors are owed collectively another $10bn. Again here, the incestuous relationship between Alameda Research (the trading arm) and FTX (the exchange) was to blame. The two entities were trading conflict of interests with no supervision, no risk management, or even a remote sense of compliance.
👉More on FTX demise here
Digital Currency Group (“DGC”) appears to be next. As it happened, DGC is the parent company of Genesis Trading, and had already extended a $1.1bn-note to cover for 3AC’s impact. Now creditors of Genesis are potentially calling on DCG to honour their IOU, forcing the group to look for immediate liquidity.
It appears that DCG, who had borrowed by half a billion from Genesis itself for share buyback, is not that liquid either. Their only crown jewel is Grayscale, the first to launch a BTC trust and reaped hundreds of millions for it. Now, it looks like Grayscale has problems of its own.
Genesis Trading was a liquidity provider for GBTC. This exclusive position allowed Genesis to mint GBTC. This capacity was put to good use, as Genesis was lending BTC to hedge funds, notably 3AC, which were then bringing the BTC back to Genesis to mint GBTC. From 2019 to Mar21, 3AC was then selling GBTC at a ~15% premium in the market. This strategy collapsed in FY21, as BTC direct access became easier. This probably left Genesis with a few losses, and a few questions about the overlap of its trading business and its role as a liquidity provider.
Genesis as a liquidity provider was also authorized to own BTC addresses on behalf of GBTC. Although all BTC seem to be accounted for under the purview of Coinbase, the custodian, it may be the case that creditors of Genesis could claim the BTC that Genesis owns under its name. Only speculations for now, more to follow. The sole difference here is that Genesis and DGC seem to have the trust of the wider ecosystem, which makes a classic bank-run less likely. This makes all the difference between a “liquidity crisis” and an “insolvency”.
In all instances, it is clear that comingling custody, third-party brokerage, and prop-trading don’t go well together. This is a lesson that TradFi has learned at its expense 90 years ago, which led to establish the Securities Act of 1933, complemented by the Investment Advisers Act of 1940. Those things actually matter for crypto investment too.
About –
360 Advisory LLC is a Boston-based RIA managing investments, including crypto
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Sources –
👉 https://www.capitalfundlaw.com/blog/crypto-funds-strategy
👉https://twitter.com/hodlKRYPTONITE/status/1595324566783819776?s=20&t=UmB545XmI5NwsMX2Um0tgw
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