SEC Chair Gary Gensler Too Big to Fail?

Good afternoon, 

The S&P 500 is back below the 4,000 level, while the Nasdaq and Dow Industrial Average are slipping down the same slide. Banks clearly wanted to join in on the fun, as Goldman slid the most in a year after reporting its Q4 earnings.  

The World Economic Forum’s annual meeting kicks off in Davos this week, not to be outdone by the Fed officials who had their interns hold their beers and schedule a packed week of domestic speeches. 

Let’s dive in.

Bottom Line Up Front

• Silvergate Capital reported a net loss of $1 billion in the fourth quarter (Reuters)

• Saudi Arabia is open to discussions about trade in currencies other than the US dollar (BBG)

• The Empire State Manufacturing Survey plunged in January, with business activity in NY recording the fifth worst reading in the survey’s history (NY Fed)

• JPMorgan is suing Frank, a service it acquired for $175M, for faking nearly all of its users. JP noticed irregularities when they saw that the list of users contained exactly 1,048,576 rows, the maximum allowed by Microsoft Excel (Observer)

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Deep Dive: Regulation is the New Transitory

On Saturday, Bitcoin crossed the $20,000 price mark for the first time since the downfall of FTX. Yet a day earlier, the crypto community was calling for SEC head Gary Gensler to resign.

What falls first: the economy into recession or Gary Gensler? Let’s discuss.

A crisis big enough to wake Gensler up in his chair 

With investor confidence at an all-time low thanks to the recent slew of crypto-related insolvencies, a new saga seems to be now unfolding in real time. This one involves crypto exchange Gemini’s Winklevoss twins and Barry Silbert, CEO of Digital Currency Group (DCG) — the parent firm behind crypto market maker and lender Genesis.

On January 2, Cameron Winklevoss posted an open letter to Barry Silbert reminding him of the fact that it had been “47 days since Genesis halted withdrawals” while also providing a blunt, seemingly confrontational assessment of DCG’s existing business practices:

The letter further indicated that the sum was lent to Genesis as part of Gemini’s Earn program, an offering enabling customers to earn up to 7.4% annual percentage yield on cryptocurrencies. Cameron then issued another tweet requesting Silbert “publicly commit” to solving the problem by January 8 — a request seemingly ignored by him.

After weeks of turmoil, on January 10, the Winklevoss twins sent out an email to users informing them that Gemini had terminated its flagship Earn program with Genesis two days prior. The move was the latest of many shots fired between the firm and the crypto lender. 

Barry Silbert wasn’t game to square off against the Winklevii, but Gary Gensler clearly found an intern to hold his beer. 

SEC does its job, Twitter loses its mind

On January 12, the SEC charged Gemini and Genesis with allegedly selling unregistered securities as part of the Earn offering. Gensler charged that Genesis loaned the assets accrued off of Gemini’s users while sending a portion of the profits back to Gemini, with the latter deducting an agent fee of around 4% and returning the remaining profits to its customers.

According to Gensler, Genesis was required to register the program as a securities offering. Gensler went on to add that the charges are designed to make it known to “crypto lending platforms and other intermediaries” that they need to adhere to the regulatory agency’s time-tested securities laws.

Tensions had been mounting

Genesis’ ongoing woes stem from the fact that a significant portion of its funds (estimated to be worth $175M) have been locked in an FTX trading account. Following the collapse of the once second-largest crypto exchange late last year, Genesis had to halt withdrawals on November 16. It even reportedly hired investment bank Moelis & Co. to consult on how to get out of the jam. 

So all roads are still leading back to FTX. And you, as well as most of Twitter by now, are beyond sick of hearing about it. Twitter sentiment for the trending #GaryGenslerResign last Friday can be summarized as:

Cool, some regulation would’ve been great a year ago. Thankfully you got to this before any customers got hurt.

So, at least in FinTwit’s perspective, Gary Gensler is writing tickets for drivers that run a stop sign that wasn't there. 

Amid the fallout 

Despite investor confidence being at an all-time low in the last week alone, Bitcoin increased its price by 20%. 

But it isn’t the only one rallying.

• Ethereum is up almost 14% over the last five days

• Solana a mind-boggling 68% (thanks to the useless cryptocurrency Bonk)

• Avalanche an amazing 42%

• Since January 1st, the total Crypto market has rallied 21%, from $756 billion to around $916 billion at the time of writing. 

Have crypto market participants suddenly introduced ground-breaking technological advancements to explain this increase?

No.

So what’s going on?

Explanations point more to pathological gambling and misjudged decisions, and less to logic. Logic was long lost when it came to the FOMO-driven market.

And while stocks and cryptocurrencies rallied last week, four hidden words in the Q4 earnings reports of two of the biggest investment banks in the world, albeit trying to disguise it, tell a much different story for the world in 2023.

The truth? That probably nothing should be going up.

Inflation decline and a “little” speculation

As much as your teenage cousin on Reddit will try to tell you otherwise, cryptocurrencies today are still relatively correlated to stocks. Thus, as stocks rallied, so did crypto.

But why are stocks around the world rallying?

First, let’s cover the “official” reason:

Last week’s CPI release painted a picture of declining inflation in the US of 0.1%, leaving it at a still extremely high value of 6.5%. That gave hope the Fed’s rate hikes won’t be as big as the ones we’ve been suffering for months now.

But why does this matter so much?

When central banks hike interest rates, this means that fiat currencies, like the US dollar, go up.

This, in turn, means that borrowing money becomes more expensive. It entails a tendency of consumers to spend less, and less spending means less revenue for companies. This equals lower economic growth.

Smaller rate hikes signal not only the end of this tightening, but also a potentially better scenario for the economy.

In the end, it’s all about hope.

The markets went up in hopes that recent “good” news pictures a less painful future for the economy in 2023.

However, what we call “hope” is none other than a euphemism for rampant speculation when it comes to financial markets. And it all boils down to one human trait:

The natural tendency of investors to think that they can predict the future. (Spoiler: they can’t).

The Dunning-Kruger effect

Let’s think about a light asset allocation strategy for 2023: 

We’ll let you guarantee a steady 8% annual growth, every year forever, for your savings…but you can’t invest money in anything else like:

• Individual stocks

• Alternative investments

• Startups

As it turned out, podcaster Sam Parr asked a similar question to his audience of investors. Their answers were an overwhelming “no.” They trusted themselves to beat the markets.

Compound interest, the 8th great world wonder

You most likely met compound interest in your first econ course or bank intern training. 

Let’s take a $1,000 initial investment with $150 monthly contributions over 50 years. That’d get you to $1,079,687.89 for a total contribution of $91,000 (pre-tax and fees).

So that red line is what you would have after 50 years, and the blue one would be how much you’ve committed to that investment during those same 50 years.

A million-dollar return. But there's a catch.

A guaranteed 8% over 50 years has the same probability as having a positive portfolio return in 2008 and last year.

Shocker: it happens  

Inspirational quotes from Warren Buffett wouldn’t be rammed down our throats nearly as often if he wasn’t once great at this job. Since 1965 Berkshire Hathaway, Warren Buffet’s firm, has achieved a 20.8% per return per year. Over the same period, the S&P 500 saw a 9.7% return.

That means $10k investment on the S&P 500, without considering annual fees from brokers, would have yielded $1.23M. That same investment put on Berkshire Hathaway? $185M. 

That’s not two times better. It’s 150 times better.

So thanks for allowing that Intro to How to Lose Money More Slowly refresher. In short: predicting the market is impossible for most. A shocker.

Then, if the chances of beating the market are close to none, why might you reject the initial question above? 

It’s the Dunning-Kruger effect.

Overestimating yourself

The Dunning-Kruger effect is a cognitive bias in which people who lack knowledge or expertise in a particular area overestimate their own level of skill or ability.

Now unless you’re actually an inanimate eightball (us), you just think you’re ahead of the curve.

And that’s why the recent price rally shouldn’t theoretically be occurring. There are two other things: “provision for credit losses” and “Reg M.”

Smart money knows something the majority doesn’t

Last week, banks started releasing great earning reports.

For instance, JPMorgan and Bank of America rallied as a result. But when analysts delved deeper, they found something very concerning.

Banks are provisioning billions for potential credit losses.

She’s back…Credit defaults

The 2008 crisis can be easily explained as a process from “house prices never go down, bro” to house prices collapsing after thousands of borrowers who shouldn’t have been allowed to borrow in the first place defaulted on their loans.

That is, banks lent money because, hey, we love a good bonus. Then, people stopped paying their loans (i.e. credit defaults). The banks suddenly realized they were screwed. In case you’ve never opened a textbook or don’t have a Netflix subscription to watch the Big Short, banks unscrewed themselves and survived by screwing others.

This created one of the biggest financial crises in history.

Now, banks are starting to fear that credit defaults will start trending again. And this is where credit loss provisions come in.

JPMorgan and Bank of America have provisioned $2.3 billion and $1.1 billion, respectively, to cover potential credit losses.

In short, they’re saving money in case customers stop paying to cover potential payment defaults. 

This tells us that banks are predicting things are going to start going south in 2023.

This isn’t the only thing that should have crypto enthusiasts worried.

A $1.6 billion hole and the “Reg M” procedure

Back to Digital Currency Group (“DCG”), who allegedly owes Genesis Trading a whopping $1.6 billion. The problem is that this issue also affects the world’s largest Bitcoin trust, Grayscale. It’s part of DCG in unknown but potentially scary ways.

So what’s Grayscale?

Grayscale offers closed-end funds for Bitcoin, Ethereum and a bucket of other digital currencies.

A closed-end fund is a type of investment fund that raises a fixed amount of capital through an IPO. Unlike mutual funds, closed-end funds have a fixed number of shares that are issued and traded on an exchange. This can create a disparity between the prices of the shares and the prices of the underlying assets.

For instance, in Grayscale’s Bitcoin trust, its shares (GBTC) are currently trading below the value of the underlying Bitcoin at a 44% discount.

Consequently, GBTC investors hold an investment that’s performing 44% worse than if they bought Bitcoin directly. Grayscale’s Ethereum trust is no better, trading at a 47% discount.

A potential collapse

So DCG is having major liquidity issues. It could be forced to turn its trusts according to Reg M procedure.

This would allow Grayscale clients to redeem their crypto in a 1:1 ratio, allowing Grayscale to then sell its shares at a discount in an effort to raise money to keep the lights on.

That would mean that the two largest Bitcoin and Ethereum trusts in the world could collapse, introducing 632k Bitcoin (valued at $11B) and 3.04 million Ether (valued at $3.81B) into the markets. “Introducing” doesn’t mean sell, but adds pressure to.

This could crash the value of both cryptocurrencies, as panic would flood the markets.

Will markets stay bullish if that happens? And is the potential for this priced in?

Much of that is still up to Gary Gensler. The good news is that, based on Thursday’s cringeworthy YouTube statement on “protecting investors,” here’s to hoping his eyes continue to shift more towards Washington before a potential economic crash.

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