Description

This may be a somewhat unusual investment opportunity for VIC members. If Bitcoin or cryptocurrencies are not your thing, you may want to skip this and move on. The rest of you may find this informative.

This is an investment that is uncorrelated to other asset classes and provides a reasonably attractive yield in an otherwise zero yield (or negative if you’re in Europe) / low return environment.

How would you like to make 8.6% interest on your cash?  Well, you can… with a catch.  You can earn 8.6% interest (https://blockfi.com/rates/) on your cash that is denominated in USDC or GUSD . at the “bank” of BlockFi, a cryptocurrency financial institution founded in 2018 and funded by some of the top venture investors in the space such as Valar Ventures (Peter Thiel), Winklevoss Capital, Galaxy Digital, Susquehanna, Akuna Capital, Fidelity, Morgan Creek Digital (led $50mil Series C in August 2020) (https://blockfi.com/investors). 

USDC is a cryptocurrency stablecoin backed by US dollars created by Circle Financial and supported by Coinbase (recently made a confidential filing to go public), two leading exchange / financial intermediary companies in the crypto space with institutional backing from Goldman Sachs, among others.  GUSD is a competing cryptocurrency stablecoin backed by US dollars created and supported by Gemini, another leading crypto exchange founded by the billionaire Winklevoss twins of Facebook and Bitcoin fame.  Stablecoin means the value of the crypto is pegged to the US dollar so its price doesn’t fluctuate.

Of course, BlockFi is not actually a bank and the funds you deposit into BlockFi are not FDIC insured so it’s nothing like earning interest in a traditional bank account. Rather, you are lending money to BlockFi to fund its lending activities, not unlike what it was like having a depository account with a bank before the existence of FDIC insurance where retail depositors were taking credit risk of the bank.

You may be wondering how BlockFi is able to offer 8.6% interest on USDC and GUSD when traditional US banks are paying 0.1% to 0.5% interest on US dollar fiat denominated bank accounts. BlockFi is effectively doing regulatory arbitrage between USD denominated in fiat and USD denominated in crypto (via stablecoins).  

The CEO Zac was recently on a podcast where he describes how BlockFi works and how his firm is able to provide such high interest rates:

https://awealthofcommonsense.com/2020/11/talk-your-book-investing-in-bitcoin/

(description of how BlockFi pays high interest rates starts around minute 18).

Only a small number of banks (Silvergate, Silicon Valley Bank) in the US (and now specially licensed banks in Wyoming, the new frontier jurisdiction for crypto) will touch anything to do with crypto.  There are a number of larger US financial institutions sniffing around in the space that have yet to jump in. The traditional financial services sectors pretty much completely shuns the crypto industry -- hence, the opportunity for BlockFi. Companies and individuals that operate in the crypto space are hampered by the lack of financing and capital that would normally be available to businesses from traditional financial institutions.

Because of the regulatory restriction around crypto, BlockFi is able to lend to institutions and individuals at rates much higher than they would otherwise be able to charge in a normal fiat currency environment. The first type of lending BlockFi engages in is collateral-based lending to institutions. BlockFi lends to institutions that are transacting in crypto such as market makers, hedge funds, prop traders, and other financial institutions that buy and sell crypto. The traditional prime brokers that would normally provide financing for equities and bonds do not offer financing for crypto transactions, so institutions turn to players like BlockFi if they want to be making markets, shorting crypto, etc. On the podcast referenced above, the CEO gave an example of how BlockFi would lend to an institution at around 10% and borrow from retail depositors at 8.6%. The rates vary quite a bit from institution to institution and depend on the amount of collateral and perceived credit risk of the borrower. Our understanding is much of the lending to institutions was on a very short term basis (mostly overnight), such that BlockFi could call its loans and collect them within 2-3 days. 

The second type of lending BlockFi engages in is collateral-based lending to individual crypto holders (retail borrowers). These individuals are often HODLers who have very large embedded gains in their crypto holdings and don’t want to sell their holdings and trigger a capital gain but want some type of liquidity. For example, a HODLer that bought Bitcoin at $1,000 and doesn’t want to sell it at $30,000 and pay a huge capital gains tax but wants to have some liquidity to remodel his house will put up his Bitcoin as collateral and borrow from BlockFi. The borrowing rates from BlockFi depend on the level of collateral and the term of the loan. The typical borrower will provide 20%-50% collateral (e.g., Bitcoin, Ethereum, etc.) and take out a 12 month loan. In 2020, a sizable percentage of these loans were originated when Bitcoin was at $5,000 and were collateralized at less than 50%, and as of 1H20 the company held a mix of about 50% institutional loans and 50% retail loans. This mix may have skewed more towards institutional as the AUM has grown throughout 2020. As the company scales, retail lending is becoming a smaller portion of the business as the company is expanding the institutional side of the lending over time. 

The most important consideration for this investment is understanding and getting a sense of how well BlockFi is managing risk. There’s no mandatory disclosure required of BlockFi. There’s no disclosure about how much equity capital it holds relative to the amount of money it lends out or the level of liquidity mismatch between borrowing from retail depositors and lending to institutions and retail borrowers. We’ve been following BlockFi since 2019 and have gotten comfortable with their risk management process and culture. This is purely a qualitative assessment, but here are some ways to get a feel for BlockFi’s risk management:

1. There are a number of videos on YouTube (see links below) that feature the CEO and other executives where they discuss the various risk management processes they undertake. It’s not perfect, but listening to the founder and executives talk about risk management and how seriously they take the issue provide some comfort that this is not a team of fly-by-nights. The company has built out a legitimate executive team to deal with risk and compliance associated with the crypto space (https://blockfi.com/team/). Unlike some of the more rogue players in the crypto space, BlockFi definitely has the feel of a company that takes risk seriously and has a culture of compliance.

YouTube video links: 

https://www.youtube.com/c/BlockFi 

https://www.youtube.com/watch?v=SYMF2yjn8TQ

https://www.youtube.com/watch?v=dVlzE5hKWkk

2. There numerous risk management protocols in place to reduce risk when there is volatility in the underlying crypto collateral. The company functions like an equity security margin lender when collateral values drop. For example, when the collateral value drops on a loan, the company issues a margin call at 70% LTV and tries to work with the borrower to post additional collateral or pay down the loan. At 80% LTV, it will initiate a collateral sale via a network of exchanges throughout the world (such as Coinbase, Gemini, etc.) and OTC counterparties. Only on very rare occasions does borrower collateral have to be liquidated. The company tries its best not to have to liquidate collateral and actively reaches out to borrowers and works with them to avoid this scenario.

3. The company has been lending since early 2018 and has experienced 0% loss to date. That is pretty impressive given that Bitcoin dropped in price from $15,000 in early 2018 to $3,300 in Dec 2018 and experienced pretty gut-wrenching short-term volatility on multiple occasions in the last three years. There was a short period in Nov 2018 when Bitcoin puked from $6,000 to $3,300, but the company did not have any losses and the risk management system worked fine. In the middle of March 2020 in the early throes of the pandemic, we stress tested the company’s risk management system when the price of Bitcoin dropped 30%+ over the span of a few days by doing a withdrawal during this time and talking to the company to get a sense of how it was handling the volatility. The company provided liquidity as promised when we withdrew our deposit in the middle of this drawdown. Our sense was that it was a stressful time for the company, but the team was able to manage through the volatility.

4. The company has limited leverage. Unlike a traditional bank that is highly levered, BlockFi generally only lends out stablecoins that it receives from depositors. However, the company does do some level of rehypothecation of collateral for USDC and GUSD loans to retail customers.

5. BlockFi is domiciled in the US (unlike some competing firms) and has been fully vetted by, and raised significant equity capital from, some of most successful venture investors, particularly in the crypto space, such as Peter Thiel’s Valar, Fidelity, Galaxy Digital, Winklevoss Capital, Morgan Creek, etc. In 2020, the company raise $50mil in August for its Series C and $30mil in February for its Series B. A liquidity crisis or a run-on-the-bank scenario could wipe out the equity of all of these investors as well as the equity of the founders and employees, so the team and the board have a strong incentive to manage risk to avoid such a fate.

6. BlockFi uses Gemini as its custody agent (which holds 95% in cold storage and 5% in hot wallets) so there’s much less risk from hacking or theft versus other crypto firms. However, having a large % in cold storage creates some limits on the liquidity available for withdrawals. Currently, withdrawals less than $1mil are processed next day but withdrawals of over $1mil require 7 days to process because the funds have to be retrieved from cold storage.

As there is no financial disclosure, there is no way to do traditional credit analysis on BlockFi, so the best way to get comfort is through reliance on the state-level government regulation of crypto firms (with which BlockFi complies) and some of the qualitative factors discussed above.

If you’re worried about a big selloff in crypto (e.g. just had a 25%+ drawdown in Bitcoin last week), you may want to monitor BlockFi (or any of the competing platforms) during the next significant drawdown and see how it manages through it before committing any funds.

There are a number of competing players in the space.

• https://www.circle.com/en/features/yield (just started a waitlist of customers for a product similar to BlockFi but hasn’t launched yet).

• https://celsius.network/earn-interest-on-your-crypto/

• Numerous other firms of varying quality/transparency.

• Direct lending to institutional players in the crypto space. One example is Genesis Trading (https://genesistrading.com). Genesis offers both borrowing from, and lending to, counterparties at relatively high rates like BlockFi and at high denominations. Genesis offers some level of transparency into its financials for counterparties to be able to assess its creditworthiness.

• DeFi is an alternative option for earning interest in the crypto space, but it’s a totally different ball of wax.

Risks

• There are many risks with holding crypto, such as regulatory risk, volatility, etc.

• Liquidity risk and run-on-the-bank risk.

• Credit loss.

• No disclosures.

• The company may change its risk management policies as it scales.

Catalyst

• Interest payments