Reckless – Chapter 14: Crypto Credit Market Structure

Chapter 14 of the book Reckless: The Story Of Cryptocurrency Interest Rates is published below. The full book is available on Amazon. The book was written before the bankruptcy of FTX and therefore does not include coverage of this event. However, the book does provide useful commentary in the run up to the failure of FTX, which provides context for the eventual calamity.


Grayscale is a leading cryptocurrency asset management platform and part of Barry Silbert’s Digital Currency Group (DCG). In October 2015 Sibert announced that DCG raised money, with funding from Bain Capital Ventures, Transamerica Ventures, FirstMark Capital, MasterCard, and New York Life. Silbert first rose to fame in the Bitcoin space in 2014, for winning an auction to purchase Bitcoins confiscated from the darknet market the Silk Road, which was conducted by the US Marshals Service.

Grayscale provides US listed cryptocurrency exchange traded products (ETPs), in the form of trusts. The group’s main product was the Grayscale Bitcoin Trust (GBTC). This product was extremely successful, attracting considerable inflows from investors. As the following chart indicates, the product achieved a market capitalisation of almost US$40 billion in 2021.

The product was expensive, it had a large 2% annual management fee on the net asset value. Grayscale’s business was therefore extremely cash generative. For example, if the average GBTC net asset value in a year was US$10 billion, this could generate US$200 million in very high profit margin revenues for Grayscale. Grayscale and DCG therefore quickly emerged as one of the key financial powerhouses within the industry. The company is likely to have had a very strong balance sheet and therefore the group was one of the counterparties others could trust and depend on.

GBTC Market Capitalisation – US$ Billions

Source: Bloomberg

GBTC was an extremely poor product from the point of view of investors. The key weakness is that it was a trust and the Bitcoin backing the fund could not be redeemed. This means that the fund can continue to accumulate Bitcoin reserves and its reserves can never decline. One would think that with a structure like this, the trust would trade at a steep discount to the underlying asset, however as the following chart shows, for most of its life, the trust traded on a large premium to the underlying Bitcoin.

GBTC Premium/Discount to the Net Asset Value

Source: Bloomberg

As the above chart illustrates, the tracking performance of GBTC has been outrageously poor. The premium has on occasions been over 100% and for years at a time the premium has sustained at a level over 30%. More recently, the trust has been trading at a steep discount to the value of the underlying Bitcoin in the trust.

Given the lack of a redemption mechanism, explaining the premium can be challenging. The theory is that investors purchase the trust on the market, because there are limited options available when trying to obtain Bitcoin exposure in one’s normal brokerage account. It is this lack of competition, particularly in the US market, which may have driven up the premium. Purchasing a traditional trust is far easier than buying real Bitcoin for most investors, given the challenges involved in managing private keys. In particular, institutional investors who are required to comply with various regulations may be unable to purchase Bitcoin directly, while they may be keen on exposure due to Bitcoin’s rapid price appreciation and success in the period. Therefore, some investors were willing to purchase the trust at a large premium. It is also possible some investors were poorly informed and did not know the vehicle was trading at such a large premium, these non-sophisticated investors may have just wanted Bitcoin exposure.

One may ask why arbitrageurs cannot simply profit from this and narrow the spread. Some accredited investors can create new units of the fund at the net asset value, however the process of creating new units can take up to six months. Therefore, although some trading firms were conducting arbitrage and closing the gap, clearly most of the time the trust still traded at a large premium as the arbitrageurs could not keep up with the demand for Bitcoin.

The arbitrage trade worked as follows. An authorised investor such as a large trading firm would borrow Bitcoin, perhaps by providing US Dollars as collateral to its lender. Using this Bitcoin, they could then subscribe to the Bitcoin Trust, waiting around six months for their shares to be issued. Once GBTC shares were issued, these could then be sold on the market for US Dollars at the premium price. Bitcoin could then be purchased in the spot market and the loan could be repaid. If the premium was 40%, that represents an annualised return of almost 96%. The GBTC premium could therefore be converted into a quasi-interest rate, for the lucky few who were allowed to subscribe. However, remember, one needs to deduct the interest costs of borrowing Bitcoin before one can make a profit. But the Bitcoin interest rate was always quite low, never much more than say 5% and due to the earn model, many retail investors wanted to earn yield on their Bitcoin and there was plenty of supply.

Because the trading firms conducting this trade typically borrowed the Bitcoin, rather than purchasing it, they were never supposed to be exposed to the Bitcoin price during this process. This reduced the risk of the arbitrage trade significantly. The only major risk remaining and it was a very significant risk, was that GBTC loses its premium price within the subscription period. As the premium persisted for many years, this trade was extremely attractive and was one of the major factors driving demand to borrow Bitcoin. The same entities were doing this trade again and again over several years, generating strong returns and using more and more capital and leverage.

Grayscale had other cryptocurrency products and the premium to net asset value in some of these other trusts was even more extreme than Bitcoin. For instance, the Litecoin Trust traded at a peak premium to NAV of 5,871% in late November 2020, according to Bloomberg data. It should be noted that Grayscale’s fees are charged on the value of the underlying assets, not the market price of the trusts and therefore the extreme volatility in the premiums of these products does not impact Grayscale’s income. Many market analysts blame the Securities and Exchange Commission (SEC) in the United States for the popularity of these flawed products, due to the constant refusal to approve a Bitcoin Exchange Traded Fund (ETF). An ETF would be able to track the price of Bitcoin far more reliably than the non-redeemable trusts.

Genesis Global Trading

When it came to the over the counter (OTC) spot market and the OTC lending market for cryptocurrency trading shops and earn platforms, Genesis Global Trading was considered as the central node and key player. Genesis, is another subsidiary of DCG. Genesis was the largest OTC trading company in the space, facilitating large trades and using spot and derivative exchanges to manage Genesis’ exposure and facilitate client demand. Genesis also provided loans across the cryptocurrency ecosystem to various entities. These entities included: proprietary trading shops, hedge funds, market makers, dealers, passive cryptocurrency funds, miners, corporates adding Bitcoin to their treasuries and high net worth individuals. Genesis’ early entrance to the market and its parent’s strong balance sheet, in part due to Grayscale, made Genesis Global Trading the key trusted financial powerhouse in the cryptocurrency industry. The following chart indicates Genesis’ strong growth and success. At the peak in Q4 2021, the company originated almost US$50 billion of loans in just one quarter.

Genesis Global Trading Loan Originations – US$ Billions

Source: Genesis Global Trading Quarterly Reports

The following chart indicates Genesis’ growing balance sheet. At the peak at the end of Q1 2022, the value of loans outstanding stood at almost US$15 billion. It is easy to say with the benefit of hindsight, but the exceptional growth appears to indicate that Genesis’ balance sheet expanded too fast.

Genesis Global Trading Outstanding Loan Balance – US$ Billions

Source: Genesis Global Trading Quarterly Reports

It should be noted that for the most part Genesis did not have trouble financing the loans. There were plenty of counterparties willing to lend Genesis money. If anything, especially with regards to Bitcoin and Ethereum, there was a surplus supply of coins. As Genesis explained in its Q2 2021 market commentary letter:

One of the reasons Genesis is able to source cheap BTC and ETH to power our institutional borrowing network is that we are connected to deposit-aggregating retail platforms, including Gemini Earn, Luno, Ledn and BitcoinIRA. These companies provide a gateway for their users to earn yield. We have seen the retail supply side of the market develop much faster than the institutional demand side, with most retail supply in the form of BTC and ETH.

Genesis Global Trading Loan Book Composition By Coin

Source: Genesis Global Trading Quarterly Reports

As the chart above indicates, in 2018 there was significant institutional demand to borrow Bitcoin. Almost 75% of Genesis’ loan book was Bitcoin. This was driven by demand to use Bitcoin on trading platforms such as BitMEX and the GBTC trade. One could argue that if the funds were to be used in the GBTC trade there was a potential conflict of interest here, since Genesis and Grayscale were part of the same group of companies. Genesis may have been keener to lend to entities who were creating GBTC units, such that Grayscale could earn higher fee income. On the other hand, while GBTC was trading at a premium, one could also argue that the companies in the group had a responsibility to help improve the quality of the GBTC product and reduce the premium. From this point of view, lending Bitcoin to facilitate the creation of more units of GBTC was legitimate and should have been encouraged.

By 2019 demand to borrow US Dollars began to catch up as the stablecoins began to dominate on the cryptocurrency trading platforms. Bitcoin started losing its crown as the most borrowed institutional currency in the crypto system. Then in early 2021, demand to borrow Ethereum started to grow. It looked as if Ethereum was set to replace Bitcoin as the dominant lending currency. However, by the end of 2021 US Dollar stablecoins showed their strength and overtook both Bitcoin and Ethereum, as the most popular coin for institutional borrowers.


The next company we will look at, which is crucial in understanding the structure of the lending markets, is the cryptocurrency trading firm and investment fund Three Arrows Capital (3AC). The two co-founders and managers of the fund were Su Zhu and Kyle Davies. Su and Kyle both had careers in the investment banking industry in the Asia Pacific region, working at Deutsche Bank and Credit Suisse respectively. Su was also a trader at FlowTraders, a specialist ETF market maker. In their banking careers, both engaged in arbitrage trading. They both developed skills in profiting from anomalies and discrepancies in prices across various instruments. This is the approach they took to 3AC. They targeted markets with inefficiencies which could be exploited for profit. In particular, inefficiencies which occur again and again so that the profits stack up. In 2012 the pair set up 3AC, not to trade cryptocurrencies, but to engage in trading strategies to take advantage of mispricing in traditional markets. The fund traded primarily with their own capital, which at the time was around US$1.2 million. The area of focus was Non-Deliverable Forward (NDF) contracts. Establishing the banking relationships to trade these instruments could not have been easy and it’s impressive that 3AC managed to get all the necessary accounts set up. 3AC appears to have been quite successful with this strategy for a number of years.

After a few years, perhaps by around 2017, 3AC started to deploy capital into the cryptocurrency space. The first strategy they deployed is likely to be going short Bitcoin in the perpetual swap contract and earning the funding rate. Bitcoin and cryptocurrency is of course alluring to many and 3AC appeared to have caught the bug. At some point they began to build long positions on tokens and companies in the ecosystem. Su Zhu established himself as one of the thought leaders in the cryptocurrency space. He had strong knowledge about Ethereum and was a host on the popular Uncommon Core cryptocurrency podcast, with industry analyst Hasu. There they had in depth discussions about various issues such as the cultural state of the Ethereum community. Su was clearly intelligent. This helped boost the brand and reputation of 3AC, who established themselves as one of the smartest, most trusted, well capitalised and well-connected companies in the cryptocurrency space.

In order to improve the return on equity for the fund holders, at some point 3AC began to borrow capital. When the fund borrowed capital, it paid the lender in the form of interest, however the lenders did not have a stake in the profits of the fund. As long as the investment returns were above the interest rates, investors in the fund got improved returns. Therefore, while borrowing may be appealing to 3AC, it is not clear if it was the best decision from the point of view of the lenders. One could argue it was a heads they win, tails you lose type situation. If the bets win, 3AC equity holders get better returns, if the bets lose, lenders may not get their money back. On the other hand, 3AC was not expected to lose. They were the smart guys in the space and knew what they were doing. There was also a view that 3AC were primarily engaged in market neutral trading strategies, bets that would work regardless of which direction cryptocurrency prices moved. In the bull market of 2021, 3AC was successful and is likely to have had strong returns. At its peak, the group’s AuM is believed to be as high as US$10 billion or US$18 billion according to some sources.

The GBTC Trade

The most significant trading strategy 3AC participated in was the GBTC trade, mentioned earlier in this chapter. A trade they could repeat again and again and earn handsome returns. Su and Kyle had demonstrated their hustling capabilities in the NDF market and now they appeared to have a strong and lucrative relationship with Grayscale. However, the GBTC trade is risky, because while the trust traded at a premium to NAV for years, it could lose the premium and trade at a discount. There were rumours circulating in the industry, which speculated that 3AC somehow had some clever way of conducting the GBTC trade, while mitigating or eliminating the risk, perhaps due to a special arrangement with Grayscale. Exactly how this could be achieved was never clear and with the benefit of hindsight, it is unlikely 3AC did successfully mitigate this risk.

According to regulatory filings, which may be slightly unreliable, especially with regards to the exact dates of the positions, 3AC held 39 million units of GBTC. This represents around 5.7% of outstanding units in the trust. The market valuation of this holding, at the peak, may have been around US$2.3 billion. This made 3AC the largest investor in GBTC. This is larger than the holding of Cathie Wood’s Ark ETF funds, which had a peak holding of around 18 million units, according to data from Bloomberg. This trade was financed, in large part, by Genesis. 3AC was even able to obtain these loans from Genesis, in part, by placing units of GBTC up as collateral. The timing of the creation of the units is not entirely clear and it’s not easy to determine if 3AC had exposure to Bitcoin or if it was always hedged. However, given that GBTC units were used as collateral, to conduct a trade which depended on the premium of GBTC, it seems the risks here may be even more elevated.

At the end of February 2021 GBTC switched from trading at a premium to a discount. It is not clear exactly what caused this, be it the plethora of alternative Bitcoin exchange traded products that launched in the year or the emergence of MicroStrategy [MSTR] as a listed proxy for Bitcoin which may have contributed. Whatever the reason, GBTC now traded at a discount to the underlying Bitcoin and the discount was getting larger and larger. This is likely to have been very painful for 3AC and the other funds conducting the GBTC trade. Even if 3AC did not lose that much money as a result of the discount, they certainly lost a lucrative trading strategy.

In early June 2022, 3AC were raising money for a new investment strategy. Again, taking advantage of the mispricing of GBTC, which was at this time trading at a 33% discount. 3AC was asking investors to provide Bitcoin and if the discount closed, then the fund would make profits. This trade was even more simple, all one had to do was borrow Bitcoin and buy GBTC in the market. The discount could close to zero if the SEC allowed the trust to convert to an ETF. The investors would this time share some of the upsides of the strategy, after paying 3AC a large performance fee. Just as before, rumours were circulating that 3AC had a strong relationship with Grayscale and that this could somehow mitigate the risks of the trade. Rumours about 3AC’s superior knowledge about the likelihood of SEC approval of a Bitcoin ETF also circulated among potential investors. With the benefit of hindsight, these rumours were probably untrue.

The Luna Trade

Another core investment strategy for 3AC was Luna and a trade linked with the associated stablecoin UST. At the start of 2022, 3AC invested US$200 million into Luna, providing capital for the LFG. The total value of the investment in Luna is believed to be around US$600 million. Su Zhu was also said to be close friends with the Luna founder Do Kwon. Su talked of his closeness to Do and how he believed that Luna was “going to do big things”. Do can be considered as a persuasive, confident and articulate individual and his powers of persuasion appeared to have had an impact on Su Zhu.

The UST trade was incredibly simple. All 3AC had to do was borrow USDC from their counterparties at around 6% to 12% and then convert the USDC into UST. The UST could then be deployed into the Anchor protocol, earning 20%. Given the leverage involved the returns to Su and Kyle must have been extremely attractive. With this trade being so simple, one could ask why the lenders were prepared to finance this, rather than doing it themselves.


For all the excitement in the market about DeFi, the main structure of the crypto credit market was reasonably simple. It can be described, in a highly simplified form, as follows:

  1. Retail customers placed coins on deposit at the earn platforms.
  2. The earn platforms lent coins to Genesis.
  3. Genesis then lent the money to 3AC.
  4. 3AC then deployed the funds into the GBTC trade or into the Anchor protocol

Some of the earn platforms bypassed Genesis, going straight to 3AC. Examples of this include companies such as Voyager and Celsius, who directly lent the customer deposits out to 3AC, rather than going through Genesis. BlockFi even bypassed both Genesis and 3AC and engaged in the GBTC trade directly itself. Of course, the above model is an oversimplification and funds were also lent to other counterparties.

This is not to say the entire earn business model was flawed. Many of the customer funds were lent out, either directly or indirectly, to high quality genuinely market neutral crypto currency market makers and arbitrage funds. A market neutral fund can generate positive returns whether markets are moving upwards or downwards, because they are conducting price arbitrage or other strategies which don’t depend on price trends. However, one can argue that even the best of these market neutral funds require a lot of retail investment flow to generate these solid low risk returns at scale. Therefore, sophisticated and well-run funds can earn high returns in a cryptocurrency bull market when retail money is flowing into the space in a frenzied fashion. Then, when the markets calm down and the bull market ends, the investment returns of these funds should gracefully decline towards zero, due to a lack of arbitrage opportunities, without losing any money at all. These funds could then return the capital to the earn platforms, who could then lower the yields provided to their customers. The customers could then withdraw, without anyone losing any money. There were many well managed funds in the space that were genuinely market neutral and there were some high quality earn platforms that only lent to these funds.

It is possible the earn market could have been constructed entirely in this robust and safe fashion. However, this did not occur. Some of the investment funds became greedy and complacent in the bull market. Not all of them were as market neutral as they claimed and some didn’t even claim to be totally market neutral. At the same time some of the earn businesses became complacent with their lending standards. Again, perhaps influenced by greed and DeFi related hype.

As the bull market continued, the exposure and the sizes of the balance sheets grew and grew. There was significant risk in the system and retail was exposed to that. For the most part that risk was traditional in nature, with many similarities to the 2008 global financial crisis. It was not the genuine DeFi projects that were the epicentre of risk, which is what many analysts had thought, but the same old mistakes that happen in finance again and again. There was bad risk management, too much leverage, poor incentives, too much greed, too many conflicts of interests, insufficient regulation when taking retail deposits and the proliferation of unsustainable investment strategies. It was no longer a question of if the bubble will pop, but when? And the sooner it happened the better, because the longer the bubble lasted, the more retail investors could get hurt.