Notes 11/17: Collateral Damage and Derivatives

As Sam Bankman-Fried’s make-believe empire crumbles, other crypto firms are becoming collateral damage.

The lending arm of Genesis Global Trading, a funding Goliath in crypto, might become the latest domino to fall. The parent company of Genesis Global Capital, as the unit is called, announced yesterday that it was suspending redemptions and new loan originations. Genesis had already disclosed toxic exposure to 3AC, the bankrupt hedge fund earlier this year. Gemini Earn, one of the firm’s clients, said it was pausing withdrawals.  

While its announcement was hardly a solicitation, Genesis Global Capital is already receiving bids from suitors.

Binance, which is on the prowl for assets to add to its portfolio, is interested. But the frontrunner is B2C2, a London-based crypto market-making firm. Max Boonen, co-founder of the firm, told Coindesk that they are interested in loans from the asset side of Genesis’s balance sheet, meaning they are interested in the long-term loans that its counterpart has made to investors.

But he did not disclose details of a possible offer, such as the price that the firm might be willing to pay for those loans, to the publication.

A Liquidity Crisis

With little information about crypto’s opaque ecosystem, it hard to make much sense of its news. We don’t know much about crypto credit markets or the total size of lending programs in it. We also don’t know the names of tokens that were part of Genesis Global Capital’s lending portfolio. The firm has said it had $2.8 billion in outstanding loans at the end of September, down from $4.9 billion at the end of June.

Those figures hardly need explaining considering the downturn in crypto prices and the succession of crises that have engulfed crypto’s ecosystem. But they offer clues to the future trajectory of liquidity within crypto.

As I mentioned in an earlier post, very few firms dominate liquidity in crypto markets. Genesis Global Trading is one of them. [In fact, based on Boonen’s description of it, it is the “undisputed leader” in the funding business in crypto]. A scaling back of its operations can only mean more trouble ahead for liquidity in crypto markets because institutional investors, already wary of an unregulated asset class, are pulling further back from it.

In a note this morning, Kaiko Research stated that the liquidity in crypto markets is “far larger” than any other previous market drawdown. The Alameda Gap – a result of Alameda Research, another major market maker in crypto, going out of business – will persist in the short term, the firm stated. This means that many illiquid tokens, whose markets were propped up by fantastic and false valuations, will go out of business.

A New Token   

There is a new variant in town. And I am not referring to Covid.

A variation of staked Ether (stETH) – a token that itself is a derivative of ether, Ethereum’s native token – is offering yields of as much as 25.5%. The derivative is called Interest Compounding ether product (icETH) and it “enhances” staking return by using staked Ether tokens as collateral on DeFi lending protocol Aave to borrow wrapped Ether, which itself is a derivative tracks Ether price, “that is in turn used to purchase additional stETH token.” The strategy, apparently, is a popular one at Aave and is called recursive lending.

Don’t blame yourself if all of this sounds confusing and dangerous.

There are red flags galore in this narrative.

Consider that FTX held around $40 million worth of stETH tokens on its balance sheet. Consider the structural liquidity problems (see above) for illiquid and new tokens in today’s crypto markets. Consider that discounts for stETH products have deepened by over 2% since the FTX collapse, according to Kaiko Research. Consider the dangers of custody in a crypto environment where rampant rehypothecation has resulted in crypto platforms and tokens dropping like Ninepins. Consider that stETH lost its peg to ether during the Celsius scandal. Many of the current problems in crypto can be traced back to its flirtations with derivatives that interlock tokens and firms in its small ecosystem together. One would think that crypto proponents would have learned a lesson about the dangers of such tokens. But they don’t seem to have gotten the memo.

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