Professional Investor Report - January 2023

This was originally published February 16, 2023, and was part of a paid newsletter for professional investors interested in bitcoin or bitcoin credit facilities. The price of bitcoin was $24,000. This is being republished for archival purposes. They will also be referenced in future writings.

This one is rather regulation heavy. If that's not your thing, I put the non-regulatory stuff first.

I know this month's Pro Report is being published later than usual. The significant amount of regulatory activity required additional time in order to process it all and provide quality analysis. This is also the largest Pro Report to date.

I appreciate you reading this report every month and I am looking forward to being a small (or large) part of your 2023.

-Johnny

TL;DR (Too Long; Didn't Read)

• In just the first 15 days of 2023, $450 million in bitcoin shorts were liquidated.
• Futures volume is now above $30 billion daily, breaking a lull last seen in 2020.
• A new on-chain offering will give digitally native investors access to US Treasuries.
• Financial advisors and buy-side investors are short-term bearish, long-term bullish.
• 63% of (the above-mentioned) believe that the price of bitcoin will fall this year and 60% think it'll be higher in five years.
• Binance, Galaxy Digital, BankToTheFuture, Cumberland DRW, and Novawulf submitted bids for the assets of Celsius.
• BankProv took $27.5 million in losses from bad loans to the crypto industry.
• Metropolitan Bank announced it will completely exit its crypto-related business.
• Caitlin Long's firm, Custodia, was denied access to The Federal Reserve System.
• The SEC sued Gemini, Grayscale, and Genesis.
• The White House is pushing for stronger regulation and investor protection in the industry. Public comments are open until March.

$800 million in Liquidations

In just the first 15 days of 2023, movement in the spot market forced $450 million in short liquidations. Another $350 million of shorts were liquidated in the second half of January.

It's safe to say the market was not expecting positive movement.

Spot long holders (i.e. directionally long holders of real bitcoin) cheered bullish sentiment with a strong thesis to fall back on; reduced leverage = increased spot volume and supply demanding a higher price.

Futures volume this month increased and regularly maintained daily volume above $30 billion.

I would expect this volume to be the new norm. We are now coming out of a period where futures volumes were as low as they were in 2020 before bitcoin derivatives had become the hot thing on the streets. In combination with the flushed leverage from 2022, new volume upward trend, and increased institutional interest, I would not be surprised if we saw record high derivatives volume this year.

Marrying US Treasuries and Crypto

Ondo Finance has built a product that brings short-term U.S. Treasuries into the digital asset ecosystem. With a 30bp management fee, a minimum of $100k in USDC, and $20 billion in AUM to provide ample liquidity, the offering is pretty attractive. Especially for digitally native firms that hold a mix of digital assets and their cash position in USDC/T.

Treasury bills, largely considered to be the lowest risk and safest investment option, provide a quick reference for a risk-free rate in real terms. Until now, firms engaged in crypto who wanted to access products like short-term government bonds would have to go outside of crypto/on-chain in order to do so. The ability to put idle cash (in the form of USDC/T) to work inside an existing ecosystem is well worth the 30bp fee.

In terms of risk on yield, this appears to avoid the risks associated with liquidity pools or other yield providers (CeDeFi). Remember, Ondo is run on Ethereum. Exploit risk (from the contract), systemic risk (from the stablecoin), and key management risk are not mitigated.

Thought about security on Ethereum.

Something that is interesting to think about; because you have to do KYC/AML and complete the subscription agreement, Ondo has all of your information, and they control the OUSG token which represents ownership in the ETF (I'm overly simplifying that, I know), what if you experience an exploit and your private keys are compromised and you can't access your OUSG (or the tokens are stolen). Can Ondo just fork the chain or vote to reverse the transaction?

I can't say I will be using Ondo anything soon, but I absolutely see the value.

Financial Advisors + Crypto in 2023

Bitwise and VettaFi released their 5th annual, Benchmark Survey of Financial Advisor Attitudes Toward Crypto Assets. The survey reached 491 RIAs, broker-dealers, planners, wirehouse reps, and buy-side institutional investors. The data was overall bullish with an emphasis on bottom-up demand, i.e. clients are the ones driving the conversation as opposed to advisors starting the conversation.

The sentiment shared by the respondents is in line with most of the industry right now; short-term bearish, long-term bullish. 63% of respondents believe that the price of bitcoin will fall this year. 60% think it'll be higher in five years.

90% of advisors received a question about crypto from clients last year (2022).

Every survey I have ever seen has included this "what is preventing you?" question and it's the most important part of the findings.

The SEC and our friends in DC are holding hundreds of billions of dollars on the sidelines. That being said the new category, "failures of centralized institutions" didn't help.

Not surprisingly, everyone wants an ETF and regulatory clarity.

This survey provided another confirmation that advisors are keeping crypto exposure below 5% stating, "95% of those with crypto exposure have less than 5% of their portfolios allocated to crypto."

Importantly, there is a strong divide between advisors who are allocating to crypto and those who are not. 78% of advisors who have already allocated to crypto in client accounts plan to maintain or increase the exposure in 2023. Of those advisors who have not allocated for clients, 74% are not planning on adding exposure in 2023.

When asked, "Do you own crypto in your personal portfolio?" 37% of respondents reported "yes." This is up from 17% in 2020, but down from 47% in 2022.

Bitcoin always beat out "crypto" when given the option.

This survey is in line with previous reports from Bloomberg and Coinbase that we saw in Q4 2022. The major hurdles for advisors and buy-side are regulation and access.

Bids for Celsius Assets

Tiffany Fong, a journalist who made headlines for publicizing information from insiders during the collapse of Celsius, shared details of the bids for Celsius assets. Tiffany received information on the bids in early December, but "refrained from sharing the bids publicly to avoid disrupting the bidding procedures or negatively impacting customer recoveries." On January 24th, during a bankruptcy court hearing, Celsius attorneys claimed the bids "have not been compelling."

Binance, Galaxy Digital, BankToTheFuture, Cumberland DRW, and Novawulf submitted bids for the assets. To see all the details subscribe to Tiffany's SubStack. Below is a summary of the bids.

Binance

They're buying users, placing a value on a user somewhere between $38 and $60.

BankToTheFuture

They're buying liquid assets and collateral. Creditors will receive 100% equity in illiquid tokens, mining, and equity investments of Celsius.

Galaxy Digital

Only after the illiquid and staked ETH assets. All cash deal purchasing the staked (illiquid) ETH at an 83% discount.

Cumberland DRW

$1.8 billion deal for most assets. $333mm for stablecoin. $583mm for liquid tokens (a 15% discount to market value). $854mm for illiquid tokens (excluding CEL). $11mm for alternative investments (I assume this means the mining equity/equipment).

Novawulf

All assets go to NewCo. NewCo is 100% owned by creditors. NewCo issues two tokens to creditors, a rev-share token and an asset token. Tokens are used to incentivize users to hold long-term, maintaining the underlying assets, thus allowing Novawulf access to assets in order to "re-open" parts of the Celsius business such as mining, prime brokerage, and new lines of business such as private equity and venture portfolio.

Implications post-bankruptcy.

If Binance wins, its users, assets, trade volume, and gross revenue increases. More importantly, Binance gains a stronger hold on the market, especially the US market. This will attract more regulatory attention in the form of anti-trust questions.

If Novawulf wins, the rev-share token and asset-backed token are going to be the hot new thing in the market for a few days. I would suspect that ETH rival platforms such as Polygon would place bids to be the chain of choice. Regardless, as tokens are distributed and price discovery begins we will see a very volatile market around those assets as investors capture arbitrage and spread between the underlying assets of the tokens and their spot counterparts.

In their current form, the rest of the offers would have less of an effect on the market. Moving forward we'll be watching who wins the bid, what their plans are for the assets, and how the market reacts.

Banks Taking Losses & Regulators Talk Risks

The month opened with The Fed, FDIC, and Office of the Comptroller of the Currency, issuing a joint statement on the risks of crypto-assets to banking organizations. The statement touches on risks of fraud, scams, concentration risk, volatility, and (my favorite) interconnectedness.

They also restate that crypto-asset and banking organizations are looked at on a case-by-case basis and, "the agencies continue to build knowledge, expertise, and understanding of the risks crypto-assets may pose to banking organizations, their customers, and the broader U.S. financial system."

Based on this statement, I still believe regulators continue to be in the learning phase. Given the amount of time they have had to see the market cycles, see all the bad, and see all the innovation, they are likely to exit that phase this year and issue official rulings and guidance.

The statement follows deposit losses from crypto firms related to the "crypto winter" and bad loans issued by banks engaging with crypto firms. Provident Bancorp Inc, "BankProv", took $27.5 million in losses from bad loans related to the industry. BankProv repossessed mining rigs to satisfy the loans in default. Silvergate saw a 68% decline in deposits, an $8 billion liquidity run, and they announced they will be cutting staff by 40%. Metropolitan Bank announced it will completely exit its crypto-related business. Of total revenue, the bank only saw 1.5% come from its crypto business, so the impact is minimal.

For new firms, securing a banking partner is a huge hurdle. It took me six months to find a bank that was reasonably priced and willing to work with me. That was during a bull market, I couldn't imagine what new firms are going through dealing with banking.

Custodia Denied Access to Federal Reserve System

Custodia, a special purpose depository institution (SPDI) registered in Wyoming, was denied access to becoming a member of the Federal Reserve System following 18 months of waiting. In 2019 the Wyoming legislature passed HB 74, which authorized the chartering of SPDIs. These institutions are banks that receive deposits and conduct other incidental activities, including fiduciary asset management, custody, and related activities, but cannot lend customer deposits and must instead hold customer deposits 100% in reserve.

The Fed stated, "The firm's novel business model and proposed focus on crypto-assets presented significant safety and soundness risks."

Custodia founder and CEO, Caitlin Long, responded with, "Custodia offered a safe, federally-regulated, solvent alternative to the reckless speculators and grifters of crypto that penetrated the U.S. banking system, with disastrous results for some banks. Custodia actively sought federal regulation, going above and beyond all requirements that apply to traditional banks. The Board's denial is unfortunate but consistent with the concerns that Custodia has raised about the Federal Reserve's handling of its applications, an issue we will continue to litigate."

Custodia raised $44 million in funding since its inception in 2020. The hopeful bank claims over 2,500 inquiries into opening accounts (of which I am one). Unfortunately, I don't see the Fed shifting its tune anytime soon and welcoming another Custodia application. Custodia does have an open lawsuit against the KC Fed regarding its delay in providing an answer on the bank's master account application. The KC Fed has cried "novel risk" for over two years since the application was submitted.

SEC v. Everyone

The SEC and Nexo announced $45m in fines related to allegations that Nexo offered unregistered securities in the form of its interest-bearing accounts. This follows Nexo's announcement that the company will be exiting the US market due to "good-faith dialogue with US state and federal regulators which has come to a dead end." This "dead end" appears to end with a $45m fine.

In the press release announcing the fines, SEC enforcement director, Gurbir Grewal, said, "We are not concerned with the labels put on offerings but on their economic realities. And part of that reality is that crypto assets are not exempt from the federal securities laws."

The SEC also took action against Gemini and Genesis. The SEC charged both companies with the sale of unregistered securities and failure to register. The security, referring to the Gemini Earn Program. "The SEC's complaint alleges that the Gemini Earn program constitutes an offer and sale of securities under applicable law and should have been registered with the Commission." Gary Gensler then followed up with this statement,

"Today's charges build on previous actions to make clear to the marketplace and the investing public that crypto lending platforms and other intermediaries need to comply with our time-tested securities laws. Doing so best protects investors. It promotes trust in markets. It's not optional. It's the law."

Tyler Winklevoss, Gemini co-founder, said on Twitter that the Earn Program was regulated by The New York Department of Financial Services (NYDFS). NYDFS is the regulator that issues the ever-coveted "Bitlicense."

2/ As a matter of background, the Earn program was regulated by the @NYDFS and we've been in discussions with the SEC about the Earn program for more than 17 months. They never raised the prospect of any enforcement action until AFTER Genesis paused withdrawals on November 16th.

— Tyler Winklevoss (@tyler), January 12, 2023

Assuming all that Tyler is saying is true, it does appear that in this case, the SEC is a hammer looking for a nail. The SEC is going on an enforcement spree cracking down on anyone offering products to retail investors.

SEC v Grayscale made progress this month with oral arguments scheduled for March 7th. The SEC's argument that the spot market is not sufficiently regulated, thus causing volatility, market manipulation, and other concerns were met with a reply brief from Grayscale. Grayscale called the SEC's case, "arbitrary to its core," and the arguments "illogical" due to the approval of futures-based products which derive their value from the underlying asset.

Grayscale's strongest argument is in regard to the "surveillance-sharing agreement." After reading all of the briefs, I think the SEC is stretching to make this one stick. Grayscale's attorneys point to other ETPs that have not been held to the same standard, such as gold. The SEC argues that CME's surveillance "can reasonably be relied upon" to detect attempted manipulation of CME bitcoin futures, but the SEC also acknowledges that manipulation of the market can come from "unregulated futures platforms that permit higher leverage." It's hard to logically draw a line from CME surveillance to safe markets while also acknowledging that the market can be affected by outside forces and CME surveillance does nothing.

The SEC is trying to catch institutions offering products to retail clients on the grounds of systemic risk that would have to be accepted anyways and then trying to wrap that in securities laws from 1933. The SEC put this industry in a difficult position as they have unclear guidance on digital assets and no clear process for registering such offerings.

White House Crypto Risk Mitigation

The White House has, "spent the past year identifying the risks of cryptocurrencies and acting to mitigate them..." The press release addressed the ongoing work the Administration has done to direct the executive branch agencies to investigate and "ramp up enforcement where appropriate and issue new guidance where needed."

The only actionable information from the press release is the request for information (RFI) from The Office of Science and Technology Policy (OSTP) seeking to "requests public comments to help identify priorities for research and development related to digital assets..." The Administration said in the following months, priorities will be released with an emphasis on "protecting consumers by default." The RFI is accepting comments until 5 p.m. ET on March 3, 2023.

As I stated before, the regulation of this industry is going to be a topic of conversation in the next presidential election. It won't have the same attention and passion as social issues or international policy, but we are moving out of the "bitcoin = weird libertarian people" phase of adoption.

Sincerely,
Johnny DeMaddalena