Gate.io AMA: How does Grayscale Rip Three Arrows Capital and BlockFi Off?

Q: Charlie Munger, a famous investor, once said, “there are three ways to make a smart person bankrupt: liquor, ladies, and leverage.” Charlie Munger, who is used to seeing the market cycle works, has witnessed the power of leverage. But in the crypto market, upstarts such as BlockFi and Three Arrows Capital gradually drew to their end after the disorderly expansion of abundant liquidity in the bull market.
Both Three Arrows Capital, which used to be a first-tier fund, and BlockFi, which used to be once valued at $3 billion, have fallen victim to the BTC trust fund named GBTC trap issued by Grayscale.
GBTC, formerly known as the bull market’s engine, has now become the cause of tragedies happening to many institutions. How did all this happen?
A: The full name of GBTC is Grayscale Bitcoin Trust, launched by Grayscale. GBTC aims to help U.S. high net-worth investors invest in BTC within the scope permitted by local laws, in manners similar to fund investments. In fact, Grayscale Bitcoin Trust is more like a castrated “ETF-like fund.”

Normally, investors can subscribe GBTC shares using BTC in the primary issuance market, or redeem BTC with the corresponding GBTC. However, since October 28, 2014, Grayscale Bitcoin Trust has suspended its redemption mechanism. Then, after GBTC is issued in the primary market, it can only be traded in the secondary market until the expiration of a six-month lock-in period.

Q: So why do investors choose to buy GBTC with premium instead of actually holding BTC?
A: Good question. In the secondary market, most holders of GBTC are qualified individuals and institutional investors. Most individuals can purchase GBTC directly through the accounts of the US retirement benefit plan without paying income tax. Therefore, as long as the premium rate of GBTC is within an acceptable range for them, they can profit by tax avoidance. In addition, there are also some traditional institutions that cannot buy and hold BTC for regulatory reasons, so they will also make relevant cryptocurrency investments through GBTC.
One view is that Grayscale intentionally promoted the positive premium to attract more investors to participate. Just as depicted in the classic movie “The Wolf of Wall Street”, the best way to make consumers buy a pen from us is to create demand. In this case, the positive premium is “demand”, that is, the profit chased by the investors.
Positive premium for crypto institutions will be a stable interest arbitrage means. buy BTC, deposit it in Grayscale, and dump it to individuals and institutions in the secondary market at a higher price after the end of the locking period of GBTC. This is also one of the main forces that drove the rise of BTC in the second half of 2020. With fewer spots available for purchase in the market, the price of BTC rises, and American investors have more enthusiasm to invest in GBTC, which is also the reason why GBTC has maintained a positive premium for a long time.

Q: Success or failure, it’s all about arbitrage. How does Grayscale rip Three Arrows Capital, BlockFi, and other Institutions off？
A: Three Arrows Capital and BlockFi are all familiar with GBTC’s arbitrage. They once accounted for 11% of GBTC positions (the proportion of institutional holdings in the total circulation is no more than 20%). This is one of their leverage: to use the user’s BTC for arbitrage and lock it into Grayscale, which can only import but refuse to export coins. For example, BlockFi previously bought BTC from investors at an interest rate of 5%. According to the business model, it should lend out the BTC at a higher interest rate, but unfortunately, the demand for BTC loans is low, resulting in a low utilization rate of funds. Therefore, BlockFi chose to convert BTC into GBTC, a seemingly safer way to “arbitrage”, at the cost of liquidity to obtain arbitrage opportunities. By this means, BlockFi once became the largest position holding institution of GBTC but was later surpassed by the Three Arrows Capital.

Q: The news of “Three Arrows Capital becoming GBTC’s largest position holder” made it become an industry star. At the same time, more people are curious about why Three Arrows Capital is so rich and where its BTCs come from.
A: Actually, they borrowed them. Some found out that Three Arrows Capital borrowed BTC unsecured at ultra-low interest rates for a long time, converted it into GBTC, and then mortgaged it to Genesis, a lending platform belonging to DCG, to obtain liquidity. But after the launch of three ETFs of BTC in Canada, the demand for GBTC decreased so that the premium of GBTC quickly shrank and even went down to negative in March 2021. In April 2021, Grayscale announced its plan to transform GBTC into an ETF.
Secondly, Three Arrows Capital borrows from institutions, but there is not much pressure for immediate and scattered redemption; but BlockFi raises BTC from mass investors, creating more pressure for redemption. Therefore, BlockFi has to sell GBTC continuously at a negative premium to decrease positions in the first quarter of 2021. According to a practitioner of a crypto lending institution, BlockFi lost nearly $700 million on GBTC.

Q: Doesn’t Three Arrows Capital redeem them?
A: Three Arrows Capital has no pressure for BTC redemption in the short term, but the pledged GBTC has the risk of forced liquidation, and the risk will be transmitted to DCG synchronously. On June 18, Bloomberg Terminal once decreased Three Arrows Capital’s GBTC position to 0. The reason given by Bloomberg is that since January 4, 2021, Three Arrows Capital has not submitted 13G/A, and they can’t find any available data to indicate that Three Arrows Capital still holds $GBTC. So they deleted them as old data. Less than a day later, the data resumed. Bloomberg said, “until we confirm that they no longer own the position. we may need to check the 13G/A.”

Q: I heard that in October 2021, Grayscale submitted an application to the US SEC to convert GBTC into BTC spot ETF. The SEC would decide whether to approve or reject the application by July 6.
A: Yes, this is also the reason why Three Arrows Capital promised a 40% profit could be obtained in only 40 days because it made the bet that the SEC would approve the application. But for this arbitrage product, James Seyffart, an analyst at Bloomberg ETF, said, “in traditional finance, this operation is called structured notes. But in any case, they will acquire ownership of your BTC and make money with your BTC. They get your BTC and take returns from investors in any case (whether GBTC is converted to ETF or not). Even if Three Arrows Capital/TPS Capital is solvent, it is definitely a bad deal for any investors.”
It is reported that Three Arrows Capital failed to obtain too much funds injection through this product. Instead, a large liquidation may fall upon it. Although Michael Moro, the CEO of Genesis, did not directly name the “CounterParty“, the general assumption held that it was Three Arrows Capital, based on the current market dynamics and the act of Bloomberg deliberately emptying the GBTC position data of Three Arrows Capital on the same day.

Q: The star company that rose on leverage eventually fell due to leverage. As Stefan Zweig said, “maybe he was too young at that time to know that all the gifts given by fate had already been secretly priced”.
A: Under the liquidity crisis, no one can survive alone. The institutional bull market created due to the institutions’ purchase of BTC finally flopped at the liquidation of institutions’ leveraged assets. The stars will fade with the passing of time. The bear market will surely come with liquidation risks.

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