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Things Hidden Since Digital Assets Entered Financial Markets
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Imagine that one state in the U.S., let’s say Ohio, decided to prevent any resident of that state from holding Apple’s stock in a retirement account. This wouldn’t prevent some people in the state from wanting to hold the stock in their account. Instead, it would simply make it illegal to do so. Knowing that people still want to own the stock, some entrepreneur might set up a trust. The trust would finance itself by issuing publicly-traded shares and use the money to purchase nothing but shares of Apple. To argue that it was compliant with the law, the trust could have a provision that prohibits owners of the shares to redeem shares of the trust for shares of Apple stock.
This sort of arrangement could be quite lucrative for the trust. For example, they could charge a fee equal to, say 2 percent of the total value of the Apple shares it owns. The trust would also be desirable for the people of Ohio who want to own Apple’s stock in their retirement account. In fact, the people of Ohio might be willing to pay a premium for this service (i.e. they might be able to pay a little bit more for shares of the trust than the value of the corresponding shares of Apple).
If you are the trust, you don’t necessarily like the premium. The people operating the trust earn fees based on the net asset value of the trust, not the market price. If the market price is greater than the net asset value, then the trust is potentially missing out on fees. But the people who operate the trust are entrepreneurial, so they might want to figure out how to profit from this.
One thing that the operators of the trust could do is announce that anyone who gives them Apple shares will be given a corresponding amount of shares in the trust. This would create an arbitrage opportunity. People who own Apple shares could deposit their shares in the trust and receive shares of the trust. They could then sell the shares of the trust, buy shares of Apple, and have money left over as profit. This process of arbitrage should eliminate the premium on the shares of the trust. But more importantly for the trust, the net asset value of the trust increases and so do its fees.
That seems fine. However, there is a way that the trust could generate even more revenue. The trust could go out and borrow shares of Apple and then loan those shares of Apple to their friends. The friends could then deposit the shares in the trust in exchange for shares of the trust, sell those shares, buy shares of Apple, pay back the trust for the loan, and keep what is left over as a pure arbitrage profit. The trust could then pay back its loan of Apple shares as well. This seems convoluted, but it is the revenue-maximizing strategy for the trust. This process eliminates the premium, increases the net asset value (and therefore the fee revenue), and allows the trust to make a little extra revenue from the difference between the interest rate they receive from lending Apple shares and the interest rate they pay to borrow Apples shares.
I am not a securities lawyer, so I cannot say whether any of this is legal. My hunch is that at least some part of this scheme is probably not legal. And even if it is legal, my hunch is the U.S. Securities and Exchange Commission would probably spend a lot of time trying to demonstrate that it is illegal.
As an economist, I can tell you how this sort of thing can go wrong. The most obvious way it can go wrong is if there is (a) a waiting period before people can sell their new shares in the trust, and (b) the premium disappears during that time interval. If this happens there is a problem. The friends of the trust will not be able to generate enough money by selling shares of the trust to pay back their loan. Thus, these friends either have to take a loss or they have to default on the loan (if they don’t have sufficient cash on hand, they will have no choice but to default). Defaulting on the loan is bad because that means that the trust might not have the cash on hand to purchase Apple shares to pay back its own loan. And the shares that it borrowed are now locked in the trust and cannot be redeemed.
Conceivably, since the shares are locked in the trust and the trust collects a 2 percent fee on the net asset value, it could pay back the loan with the fees if the fees are high enough or if the lender is willing to wait. But that is a big “if.”
A good entrepreneur might have the foresight to see such problems. Thus, the owner of the trust might decide to put the lending business into a separate company. The lending business would borrow Apple shares and lend Apple shares and profit from the interest rate difference. In the event that people cannot pay back the loan, the firm can just file for bankruptcy. Now, at least in theory, the trust is protected from the borrowing and lending scheme blowing up.
This all seems so convoluted. One might wonder where I could get this sort of idea. But loyal readers of the newsletter likely know where this is going.
Digital Currency Group is the parent company of five companies. One of those companies is Grayscale Investments, which operates the Grayscale Bitcoin Trust (GBTC). This trust gives people the ability to have exposure to bitcoin even when they are not able to purchase and hold bitcoin directly in their account. The company charges 2 percent of the net asset value for maintaining custody of the bitcoin. Shares are not redeemable for bitcoin. (It also operates the Grayscale Ethereum Trust that does the same thing for the cryptocurrency ether.)
Another company owned by Digital Currency Group is a company called Genesis, which operates an institutional lending service for digital assets. In particular, Genesis would partner with various crypto companies to borrow digital assets from their customers. It would then turn around and lend those digital assets out to institutional investors.
One thing that these institutional investors were doing was borrowing bitcoin from Genesis, depositing the bitcoin into the Grayscale Bitcoin Trust, and then selling the shares at a premium after a lock-up period. This was pretty lucrative until it wasn’t. The premium on the shares of the bitcoin trust disappeared and suddenly the firms suffered losses. Three Arrows was the first to go. The Wall Street Journal reported back in July 2022 that Three Arrows owed Genesis $1.2 billion. Then, in January, the WSJ reported that Genesis had filed for bankruptcy and was owed hundreds of millions of dollars from FTX. The bankruptcy filing also came just a week after the Securities and Exchange Commission charged Genesis with the exchange and sale of unregistered securities through its partnership programs with crypto companies that offered yield programs to their customers.
This DCG/Grayscale/Genesis arrangement sounds a bit like the fictitious trust I described above with Apple shares replaced by bitcoin. As I stated above, I am not a securities lawyer, so I can’t speak to the legality of any such scheme — and certainly the legal treatment of digital assets makes any type of legal analysis difficult, even for the experts. For the record, Grayscale CEO Michael Sonnenshein denies Grayscale having any knowledge of what Genesis was doing. (This stretches the imagination, but you can listen to the linked interview and decide for yourself.) Regardless, one could make the case that Digital Currency Group had to know that this was going on given their oversight of both companies, but DCG CEO Barry Silbert has largely been silent. Regardless of who knew what and when, it certainly seems like this scheme was at the heart of the massive collapse in crypto over the last 18 months. What was hidden is now revealed.