Bitcoin Magazine PRO Contagion Report Preview
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PREPARED BY:
Dylan LeClair, Head of Market Research
Sam Rule, Lead Analyst
Intro
This special edition Bitcoin Magazine Pro report will be focused on the contagion that has spread amongst counterparties in the cryptocurrency industry. The report will begin with a detailed explanation of what transpired leading up to the crises, including a thorough evaluation of the actors, services, and investment vehicles in particular that contributed to the industry-wide liquidity/solvency crisis.
The 2020/2021 Bull Market
Following the blow-off top of 2017, where the price of bitcoin appreciated by a factor of 100 in a mere 28 months, a sharp drawdown and period of consolidation occurred over the next two and a half years. As price traded between $3,000 and $14,000 throughout 2018/2019, the massive fiscal and monetary stimulus that occurred due to the COVID-19 economic lockdowns had investors around the world scrambling to find a hedge against inflation, and there stood nascent yet absolutely scarce bitcoin.
What followed was a raging bull market, fueled first by natural demand, and later powered by layers of opaque leverage, excess liquidity and arbitrage strategies. In this report we’ll detail how many of the dynamics that stoked the flame of the raging bull market contributed to the ultimate crash and unfavorable market conditions seen today.
The Reach For Yield
The fundamental cause of the contagion crises that has plagued the cryptocurrency industry over the last six weeks has been an unwind of leverage brought about due to massive reach for “yield” by various industry players and platforms. This dynamic, and the reach for “risk-free” yield in an industry built around a yieldless bearer asset was doomed from the start. Its widespread growth following the 2020 bull run introduced systemic risk that few if any truly fully understood, leading to crashing exchange rates, mounting insolvencies, and future regulatory intervention.
The concept of “yield” in the cryptocurrency space is entirely misunderstood, which has led to the large amount of pain felt by participants in recent weeks. Yield refers to the earnings generated and realized on an investment over a period of time on a percentage basis. The most common example of yield in the investment world today would be the coupon payment one receives for buying sovereign bonds.
Example:
You, the investor, lend a nation your capital for a defined period of time, and they agree to pay you back the
face value of the loan on a specific date. Due to the time value and opportunity cost of your capital, the debtor will also pay you periodic interest payments along the way. This excess return on capital is defined as the yield.
This is quite different from how “yield” is/has been generated in the bitcoin/crypto industry, which necessitates a closer look. The following passages will be an overview of the dominant “yield” generating strategies that arose since 2020, and the current state of those strategies and the second order effects of their proliferation.
GBTC Arbitrage
The GBTC arbitrage trade was one of the largest drivers of the bitcoin bull market of 2020, and ironically it has since shown to be one of the biggest bear market tailwinds. Let us explain.
The Grayscale Bitcoin Trust was the first company to launch a publicly-traded Bitcoin fund in the U.S., and given the product’s first-mover advantage, steadily grew in size and notoriety since its launch in May of 2015. Shares of the trust, which trade in OTC markets (over the counter), represent a fixed amount of BTC (currently: 0.00092242 BTC), with an annual fee of 2%.
The trust did not (and still does not) operate like an ETF, where institutions can exchange shares of the product for the underlying and back again. Shares of GBTC have a one way redemption mechanism, the Hotel California of bitcoin if you will. The trust worked by converting accredited investors’ bitcoin or dollars into shares of GBTC, with a six-month lockup period following the creation of shares.
Because of bitcoin’s nascency, shares of GBTC trading on OTC markets were the only way to gain exposure to bitcoin for individuals/firms operating within the walls of the legacy financial system. Due to the lack of other available options for the U.S. market, shares of the product long traded at a premium to net asset value.
Due to shares of the trust trading at a premium, an arbitrage opportunity arose where investors could bring dollars or bitcoin to Grayscale and receive shares (that were locked for six months).
Many funds pummeled capital into the strategy, with some shorting bitcoin futures or bitcoin-like exposure (although few accessible products yet existed) to remain market-neutral, while some funds just used the premium to simply mark up their books for 2020 year’s end (i.e., send $100 to Grayscale and receive $120 in locked GBTC assuming 20% premium), what wasn’t to like?
It is worth noting that firms could short bitcoin equivalent exposure upon the creation of shares to remain USD market neutral (in theory), or sell GBTC upon the conclusion of the 6-month lockup and buy bitcoin to harvest bitcoin native alpha (if there was still a premium).
Three Arrows Capital (3AC) entered this trade in massive size in 2020, becoming the largest holder of the trust with 38,888,888 shares of exposure (approximately 35,871 BTC) in its December 2020 filing.
A staggering 394,398 bitcoin was purchased and locked in the trust from the start of 2020 until February 18, when the trust first began to trade at a discount to NAV (net asset value). For context this figure was 79.26% of new total supply mined over the same time period, coming from just one buyer.
