Thanks for the great response to our first newsletter. I appreciate everyone reading and I’d love to hear your opinions. On to it…
(Big Idea: Regulation)
Yesterday, the SEC once again refused to approve a Bitcoin ETF, this time denying Greyscale’s request to convert their closed-end Bitcoin fund (GBTC) to an ETF. They cited possible market manipulation (never mind precious metals markets where manipulation is just accepted) and investor protection (never mind the existing harm done to investors via the existing alternatives). Greyscale has responded by suing the SEC, but the bottom line is that broadly accessible investment vehicles aren’t coming to crypto anytime soon.
This has been a long and torturous path, with the first Bitcoin ETF application dating back nearly a decade. In the meantime, Canada, Germany, Switzerland, France, Australia and Singapore have approved spot ETFs. The SEC has approved an options based Bitcoin ETF (which carries significant drag) and even recently approved an inverse Bitcoin ETF that allows you to bet on the price of Bitcoin going down.
Investors love ETFs since they provide an accurate, inexpensive, broadly available means to get exposure to a specific asset class. Without crypto ETFs, investors have been stuck with crappy alternatives. Greyscale and Bitwise offer closed end funds, but they come with high fees (2-3% annually) and poor tracking of their underlying assets. GBTC is currently trading at a 29% discount to the value of the Bitcoin that it holds. 18 months ago, it was at a 35% premium, but for more than a year, it has traded significantly below Net Asset Value (NAV).
ETFs have an inherent redemption process that allows investors to convert shares into the underlying asset which helps maintain their peg. GBTC on the other hand is essentially permanent vehicle with no means of redemption, netting Greyscale $258 million a year in fees from GBTC alone (not to mention their other suspect crypto funds) and sapping incentive to convert particularly expediently.
Bitcoin proponents have long held out hope that a spot ETF will usher in the next big wave of incoming capital, driving Bitcoin to its proper place in the stratosphere. As the market has matured and institutions in particular have started to find alternative solutions for holding crypto, I think this narrative has lessened. Still, there is little doubt that it is much easier to trade Bitcoin in a traditional brokerage account accessible to every significant investor in the U.S. vs. opening a Coinbase account or, god forbid, buying Bitcoin in your PayPal or Venmo account.
(Big Idea: Crypto Transparency)
As it happens, GBTC’s illiquidity almost certainly played into two large crypto entities blowing up in the past month. First, Celsius, a neo-crypto-bank/token (?), then Three Arrows (3AC), an enormous crypto hedge fund, collapsed in just a few weeks.
Charlie Munger’s quote has been getting a lot of play lately, “Smart men go broke three ways - liquor, ladies and leverage.” Both Celsisus and 3AC took money from depositors/investors, levered the eff up and then put the money in either bad investments (Luna/UST) and/or illiquid or long duration investments (GBTC, stETH that we talked about last time). When markets turned down and liquidity thinned, both were screwed. 3AC, in particular, happened to borrow money unsecured from much of the industry and has, in turn, screwed a bunch of them, blowing holes in balance sheets around the world.
This is one area where crypto isn’t particularly innovative. Much of this has been seen dozens of times before in TradFi (traditional finance) from banks runs to Long-Term Capital Management. What is especially interesting here is the crypto angle. Of course, critics are saying I told you so and there is some truth to that. Celsius probably should have been regulated as a bank and should have had more equity and shouldn’t have speculated foolishly. [As an aside, here’s your daily reminder that if someone is offering you 5x the current market yield, you should have a pretty good idea where that is coming from before depositing your life savings.]
But with crypto, we got to see some of this play out real time. For example, you can see on-chain transactions where Celsisus moved $50 million of ETH and $85 million of (essentially) Bitcoin a few hours before freezing customer transactions. While 3AC was refusing to communicate, you could watch them liquidate anything they could. This happened with the Terra/Luna implosion as well, where you could see the rats leaving the ship a few days before things really got bad.
(Big Idea: DeFi)
Ultimately, much of this gets to the CeFi (Centralized Finance) vs. DeFi (Decentralized Finance) debate in crypto. CeFi refers to entities like Coinbase, Celsius and BlockFi that touch crypto, but operate like traditional financial institutions. They custody your money for you, offer customer service (?) and, in theory, are on the hook if something goes awry. DeFi represents the “true” crypto world of self-managed funds, permissionless applications and effectively zero regulation.
Obviously, not everyone wants to lose their funds if they forget their password and regulation plays a critical role in establishing trust and protecting users. But as the CeFi world is blowing up, the core DeFi protocols have been humming along nicely, behaving exactly as proponents have argued that they would.
Maker Protocol creates a stable coin called DAI that is intended to be always worth $1 via over-collateralized lending. Anyone in the world, can deposit their Bitcoin, Ethereum or other assets and borrow DAI in return. Rates are extremely low (0.5% for ETH, 0.75% for WBTC), but require 170% collateral (or more) to safeguard. There is currently $6.7 billion of DAI outstanding.
If the value of your collateral starts to fall (i.e. Bitcoin hypothetically loses 50% of its value), you need to either post more collateral or your vault will automatically liquidate your assets. You don’t get a call from your broker and it doesn’t matter if it’s 3 AM on a Sunday. Because of this transparency, you can see in advance exactly which vaults are at risk of liquidation at any moment and which ones might be at risk based on a certain percentage drop. For example, we can peek at one of the vaults from our friends at Celsius. They currently have 23,962 Bitcoin deposited as collateral and $224 million worth of DAI as debt. If Bitcoin dropped to $13,613, they would be automatically liquidated if nothing changed. And, in fact, we can see that they added significant collateral in May and June as the price of Bitcoin dropped below where they would have been liquidated.
Aave and Compound are two other DeFi “primitives” that have performed well. Both allow users to borrow or lend based on collateral. The term primitives refers to these open protocols that operate at a base layer of the crypto universe. You can write code to access their functionality instantly, reliability and permissionlessly. They certainly have other flaws or weaknesses, but the complete transparency and trustlessness enables a new world of possibility. I’m sure we’ll get more into the pros and cons in future editions.
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