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Analysis: The Crypto Dominoes Are Still Falling The Crypto Dominoes Are Still Falling… | View Comments ()
After the highs of 2021, cryptocurrency crashed to the ground in 2022. One by one, multiple large crypto firms toppled, dragging many minor firms down along with them in a small-scale replay of the 2008 financial crisis. It’s a collapse that has taken out fortunes, or supposed fortunes, worldwide—and it isn’t over yet.
TerraUSD, a “stablecoin” token used in place of real dollars, which had reached a supposed value of $18 billion, collapsed in May. Its failure took out crypto hedge fund Three Arrows Capital (3AC) in June. Lending platforms Celsius and Voyager followed in July. FTX, one of the largest crypto exchanges, fell in November. Its founder and two top executives have been charged with fraud.
All of these firms relied on a modern-day form of check kiting to make themselves appear solvent when they were not. Only instead of writing checks between different accounts to temporarily inflate them with non-existent funds, they were making loans to each other and counting each loan as an asset. FTX was both borrowing from and lending money to crypto lender BlockFi, which also went bust. In his bankruptcy documents detailing how Celsius became insolvent, CEO Alex Mashinsky doesn’t clearly spell out who the loans are to or from.
After the highs of 2021, cryptocurrency crashed to the ground in 2022. One by one, multiple large crypto firms toppled, dragging many minor firms down along with them in a small-scale replay of the 2008 financial crisis. It’s a collapse that has taken out fortunes, or supposed fortunes, worldwide—and it isn’t over yet.
TerraUSD, a “stablecoin” token used in place of real dollars, which had reached a supposed value of $18 billion, collapsed in May. Its failure took out crypto hedge fund Three Arrows Capital (3AC) in June. Lending platforms Celsius and Voyager followed in July. FTX, one of the largest crypto exchanges, fell in November. Its founder and two top executives have been charged with fraud.
All of these firms relied on a modern-day form of check kiting to make themselves appear solvent when they were not. Only instead of writing checks between different accounts to temporarily inflate them with non-existent funds, they were making loans to each other and counting each loan as an asset. FTX was both borrowing from and lending money to crypto lender BlockFi, which also went bust. In his bankruptcy documents detailing how Celsius became insolvent, CEO Alex Mashinsky doesn’t clearly spell out who the loans are to or from.
The cryptocurrency lobby attempts to confuse users and regulators with claims that “technology” makes everything different. This is false. Crypto tokens have all been new forms of existing financial instruments used in the service of old shenanigans—whether it’s money laundering, overleveraged trading, asset inflation with nonfungible tokens (NFTs), or pump-and-dumps, using decentralized finance tokens as penny stocks.
Now, another large domino, Barry Silbert’s Digital Currency Group (DCG), may be about to topple. The crypto conglomerate had managed to survive a remarkably long time with a relatively clean legal record, making Silbert somewhat of a business genius in the crypto world. But on Friday, Genesis, a major part of DCG, filed for bankruptcy. The fall of the once-acclaimed DCG could be the final nail in the coffin of crypto’s credibility. It could also lead to a systemic collapse in crypto, as DCG is one of the biggest investors in the space.
A former Wall Street banker, Silbert started amassing his pile of cryptocurrency in 2012, when bitcoin was trading at $11 per share. He founded DCG three years later and began investing in other crypto firms. DCG’s portfolio now includes 200 companies.
DCG is the parent company of three key players in the crypto space: Genesis, a crypto lender and broker; Grayscale Investments, an asset manager that helms a multibillion-dollar bitcoin fund; and CoinDesk, one of the most popular cryptocurrency news sites. (I wrote as a freelancer for them from 2016 to 2017.) Both Genesis and Grayscale were founded by Silbert in 2013, even before DCG existed. DCG bought CoinDesk in 2016 and has a history of directly pressuring the outlet’s employees to promote its interests and portfolio. Although given to promotion of anything that might plausibly sound like good news for crypto, CoinDesk has scored some journalistic wins such as the report that took down FTX and its sister company, hedge fund Alameda Research.
Genesis Global Capital, the lending arm of Genesis, which launched in 2018, had a massive hole in its books after 3AC imploded in late June. DCG tried to patch the hole by shifting the 3AC claim to its own books and issuing Genesis a $1.1 billion promissory note, payable in 10 years. That is: DCG and Genesis counted an internal IOU as money to claim that Genesis was still solvent.
DCG hoped that the IOU would stave off a bank run and give it sufficient time to raise the funds. Then FTX crumbled in November and Genesis lost the $175 million it had on the doomed exchange. This seems to have wiped out the last of Genesis’s liquidity for customers. After trying and then failing to raise an emergency $1 billion, Genesis was left with no choice but to freeze withdrawals.
Authorities are now looking into DCG and its subsidiaries. The U.S. Securities Exchange Commission (SEC) and the U.S. Attorney’s Office for the Eastern District of New York are reportedly scrutinizing money flows between DCG and Genesis.
When Genesis froze withdrawals, that also blocked Gemini Earn, a crypto interest account offered by Gemini, the cryptocurrency exchange run by Tyler and Cameron Winklevoss, most famous for their role in the early history of Facebook. The twins had partnered with Genesis to offer retail customers up to 8 percent interest. When Genesis halted withdrawals, this left 340,000 Gemini Earn customers out $900 million.
Genesis lent money to accredited and institutional investors. But since February 2021, Genesis had been using Gemini Earn as a passthrough to offer ordinary mom-and-pop investors otherwise-unavailable interest rates. Genesis would then lend out the Earn crypto to large investors, such as 3AC, and rehypothecate those loans, using previously pledged collateral as collateral for new loans, giving crypto firms infinite leverage, 2008 style. These crypto firms often used their own made-up tokens as collateral.
Gemini Earn was obviously an investment contract under the Howey test, a legal precedent in the United States that determines whether something counts as a security, such as a stock, bond, or mutual fund, and therefore falls under the SEC’s regulatory umbrella. But Gemini did not register it as such with the SEC. So in the midst of a public spat between Cameron Winklevoss and Silbert over the missing funds, the SEC charged both Genesis and Gemini for selling an unregistered security.
As well as the $1.1 billion note, DCG owes Genesis another $525 million in hard currency and bitcoins, due in May 2023. Genesis is in dire need of those funds, as it reportedly owes creditors more than $3 billion.
“The Promissory Note is like a noose wrapped tight around the neck of DCG. If Genesis goes over the cliff, it drags DCG with it,” said Ram Ahluwalia, the co-founder of crypto investment advisor Lumida, speaking before the bankruptcy filing.
DCG is now frantically rummaging through its portfolio to see what it can sell. But almost all of the companies DCG invested in only have illiquid, unsaleable crypto assets. So DCG has to look at its more valuable assets—and its most valuable asset by far is Grayscale.
Grayscale manages the Grayscale Bitcoin Trust (GBTC). The trust holds $12.3 billion in bitcoin, and Grayscale’s annual management fee is a whopping 2 percent—over $240 million a year.
For years, GBTC traded at a premium to its underlying asset as part of an arbitrage while the price of bitcoin was going up. But in early 2021, the premium evaporated. GBTC is currently trading at a 40 percent discount to bitcoin, up from a discount of 48 percent in December. The trust has no redemption mechanism, leaving holders stuck with an underwater asset.
Grayscale spent 2020 running national TV ads and marketing GBTC to retail investors as if it were actual bitcoin. Many people bought GBTC for their retirement accounts, betting on its future. But in the last two years, GBTC has lost 60 percent of its value and is currently trading at a little more than $11 a share, down from its February 2021 high of $57.
Grayscale told investors that the plan all along was to convert GBTC to a normal exchange-traded fund (ETF), which trades closer to the price of its underlying asset—if only it could persuade the SEC. In April 2022, Grayscale bought all of the ad space in Union Station in Washington, D.C., and New York’s Penn Station, urging Amtrak commuters to write the SEC in support of Grayscale’s ETF application. The campaign failed, and the SEC rejected the application, as it had almost every bitcoin ETF put before it to date, due to correct concerns over fraud and manipulation. Grayscale is now suing the regulator.
Grayscale does have other options. After flooding the market with GBTC shares for years, Grayscale stopped issuing new shares in March 2021. According to the rules governing Grayscale’s grantor trust, that opens the door for Grayscale to pursue a redemption program—if it wants.
But GBTC is trading at such a steep discount that almost all holders would likely jump at the chance to redeem their shares. This could shrink the size of the trust substantially, cutting into Grayscale’s profits. And too many bitcoins flooding the market could crash the price of bitcoin, dropping the value of the trust even more and wreaking havoc on the rest of the crypto world.
“As a simple response to financial incentives, it makes sense that Grayscale does not want to do anything to disrupt their cash cow,” Gene Grant, founder and CEO at Levelfield Financial, a financial services company in Houston, told Foreign Policy.
If Grayscale is forced to liquidate GBTC, Silbert’s empire will lose its last reliable income stream. If the fund isn’t liquidated, DCG will continue to collect its juicy management fees, but irate GBTC holders will remain stuck with huge losses.
GBTC is a registered security overseen by the SEC. But the SEC could and should have done more to warn the public about the risks. Similarly, the SEC failed in its proper oversight in the leadup to 2008. In August 2017, Citron Research accurately predicted GBTC’s collapse: “As Bitcoin goes higher, the more likely it is that GBTC becomes irrelevant and alternatives are rushed to the market.” This is exactly what happened in early 2021 when the Purpose bitcoin ETF launched in Canada.
Genesis was marketing its lending program to accredited investors, which was fine. But when it began lending through Gemini to retail investors, that was not. Gemini Earn was obviously a security and should have been shut down immediately—but the SEC waited two years, until retail investors suffered actual harm, to file charges against the two companies.
Crypto promoters often portray crypto as not having clear regulation. Teams building decentralized products “don’t want to break the rules, and right now they don’t know what the rules are,” Brian Armstrong, the CEO of Coinbase, the largest crypto exchange in the United States, said following the collapse of FTX. In fact, cryptocurrency does have regulatory clarity in the United States—securities laws have been in force for decades, and the Howey test is simple and broad. What regulators have lacked is resources, although that is changing. In May 2022, the SEC doubled the size of its crypto assets and cyberunits division to 50 staff members. But this still is not enough.
Regulators need better funding and legal tools that can be applied more effectively in the case of such clear and obvious violations. Regulators in the United States and other nations need to create an environment where crypto firms that offer high interest rates had better have a convincing reason for actually doing so, or a clear understanding that the consequences for fraud will be severe.
Will crypto bounce back? Only if regulators don’t act quickly to quash it before another huge crypto bubble funnels money from new retail investors to old bitcoin holders.
In the meantime, the crypto collapse isn’t over yet. Several more crypto firms will go bust in 2023. Silbert’s DCG is another. Crypto promised freedom from the financial middlemen who caused the 2008 crisis and then constructed its own mini-2008. The collapse continues.
 
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