DCG: Et Tu, Barre?

Jon Reiter -

This week Digital Currency Group (DCG) is the center of attention. They injected US$140 million into Genesis Global Trading to cover about US$175 million that got frozen on FTX. And, in related news, they halted withdrawals from Genesis Global Capital, their borrowing and lending business. That business took a big hit from 3AC and the DCG parent company covered those losses in July.

Rumours are now swirling that DCG did not fund that bailout but rather gave Genesis Capital a promissory note. Now the bill is coming due and they are struggling to raise funds.

Genesis Capital was a major player in the crypto funding markets. They were the exclusive yield source for, among other things, Gemini’s Earn product. While this was clearly explained in their T&Cs, it is going to anger people.

What happened here?

Genesis, Grayscale & 3AC

Back in July an interesting theory involving 3AC, Genesis and Grayscale (another DCG company) was floated. The details are quite convoluted but the basic idea was that public data appeared to show the following sequence of transactions occurring over and over:

  • 3AC borrowed undercollateralized BTC from Genesis
  • 3AC used these to create shares of Grayscale’s GBTC product
  • GBTC was then trading at a massive premium to BTC
  • 3AC pledged these shares back to Genesis for USD loans

As GBTC was trading at a massive premium to BTC up until early 2021 this left the situation as:

  • 3AC borrowed lots of BTC with little collateral
  • 3AC borrowed even more USD with zero additional collateral

This blog referred to it as an “infinite money pump” and the FT offered a wonderful analogy:

A fairground sells ride tokens for £1.20 each or ten for £10. Some people buy tokens individually. They’re idiots. Others buy ten tokens at a time. They’re also idiots.

Smart people borrow ten tokens from the ticket booth using £10 as security. The fair value of ten tokens is £12 so it’s a no-brainer.

But instead of going on the waltzers or whatever, they pledge the tokens back to the ticket booth as security for a £10 loan. They now have a £10 loan that’s secured by tokens valued at £12, and a loan of £10 that secures the tokens, which creates £2 of delicious equity.

The next smart thing to do is to borrow more tokens from the ticket booth using the money borrowed from the ticket booth that can be loaned back to the ticket booth.

Eventually GBTC’s premium vanished, LUNA happened and 3AC defaulted on Genesis. Back in July we were told Genesis was owed over US$2.3 billion and held something like US$1 billion in collateral against it. We were told DCG bailed out Genesis by taking on that exposure.

The original scheme was, if true, a bit crazy.  But if, when the scheme blew up, it was papered over with a fake bailout a proper description requires words inconsistent with this publication’s editorial policies.

Current events

FTX scared everybody. And so everybody called back their loans and tried to withdraw from whatever exchanges they could. This, it appears, pushed Genesis over the edge. Shuttering the withdrawal window is catastrophic for the brand and business. It is hard to believe they had any other choice.

And now DCG is trying to raise money. They are facing two problems. First, rumours are swirling they’ve misled people. And second, they will not disclose the wallet addresses of the trusts that back Grayscale’s products which are themselves by far the most valuable assets in the group.

This is beyond concerning. The entire point of a public blockchain is to make these sorts of things transparent. And anyone with even casual exposure to crypto knows that public keys do not represent a security risk. It’s in the name: public keys. Go read section 8.12 of this famous book about cryptography. If you are afraid to share your public keys you are doing something wrong.

Now, they may have some kind of privacy issue…but these trusts back public equities. That is mind bending. DCG is going to have a lot of trouble raising money if they will not prove the trusts contain what myriad SEC filings says they contain. And, perhaps worse for the industry, Coinbase custody holds their coins. If Coinbase custody has some kind of problem the wildfires are just getting started.

Confusion & deja vu

Genesis Trading, the part that is still alive, is an SEC-registered broker-dealer. This is a highly-regulated business that is unlikely to experience serious problems.  But it is a tiny business with around US$25,000 in regulatory capital. It does not matter precisely how that is calculated – it is obviously not a large business if the US government requires US$25,000 to keep things safe.

Genesis Capital is not regulated at all and is huge. We are about to find out how clearly this was explained to both investors and clients of the firm. The website genesistrading.com covers both businesses and their quarterly reports do not break this down. Yes, the disclaimers at the end explain which company is which. And yes, some variant of this is common in traditional finance. If you trade with, say, Citibank, there is a disclaimer that explains the US equity broker-dealer is different from the offshore commodity arm and the UK-based foreign exchange clearer and the NY-based deposit-taking bank. But none of those companies has US$25,000 in capital.

We have seen something sort of like this before. AIG was a giant insurance conglomerate with hundreds, and maybe thousands, of highly regulated subsidiaries. And it was brought down by a single unregulated trading business called AIG Financial Products. In the end the US government rescued the company because it performed essential functions like insuring a large fraction of the global airliner fleet.

To give an idea of scale, AIG had a market cap around US$100 billion, about a trillion in assets and this subsidiary ended up loosing tens of billions of dollars. Most people who dealt with AIG dealt with a regulated, solvent, entity that still exists today. Their licenses and regulatory compliance covered most of the company. The collapse was a massive problem – but the ensuring rescue actually made the US government over US$20 billion.