Connecting the Dots on Grayscale
A majority of our conversations with hedge funds currently involve at some point discussing Grayscale. We spent some time connecting the dots on what is a focus point for institutional investors.
The Grayscale Bitcoin Trust is a private, open-ended trust regulated by the SEC allowing passive exposure to bitcoin.
Accredited investors can participate in daily private placements allowing them to subscribe to shares struck at NAV in cash or bitcoins directly. There is a six months lock up period before investors can sell their shares in the secondary market. Grayscale shares are listed on OTC Markets under the ticker GBTC. There is no redemption mechanism, allowing investors to redeem their shares for the underlying bitcoins.
Since its inception in 2013, Grayscale has been growing in popularity. The story accelerated this year with the number of bitcoins under custody more than doubling to 550k bitcoins and assets under management crossing the $10bln mark very recently. This is 2.5% of the total number of bitcoins that will only ever exist - capped at 21 millions.
GBTC consistently trades in the secondary market at a significant premium to NAV, on average 19% over the last year.
In theory, assuming bitcoin doesn’t move for six months and the premium remains the same, accredited investors such as hedge funds can subscribe to the shares in the daily placement and sell their shares six months later in the secondary market collecting the premium.
How liquid are the GBTC shares? The shares trade on average $145mln a day and materially more since November. There is substantial secondary market liquidity to trade the shares post the lock up period.
The assumption the price of bitcoin would not move for six months is not realistic and GBTC shares are notoriously difficult to borrow. However, CME Bitcoin futures are highly liquid and happen to also trade at a significant premium to spot, on average 10% annualised over the last three months for three months rolling futures.
This is a function of a lack of dollars in an industry that has been historically crypto rich and cash poor with very few banks involved. As a result, supplying dollars to this market generally comes with some extra income. It’s not unusual to see US Dollars being borrowed at 10% annualised on various platforms.
As a result, leveraged funds positions are making new net record shorts almost every week on CME, according to the weekly Commitment of Traders report. They are not outright shorts but likely hedging, for instance a cash position - cash and carry - or a Grayscale allocation.
Worth noting, the net short positions on CME Bitcoin futures is 24.3k bitcoins currently, very far from the 550k bitcoins in the Grayscale trust. Not all allocations in Grayscale are hedged through CME.
The premium has historically been here but there is no guarantee of it. There is also no redemption mechanism currently to exchange the shares for bitcoin. This means, the shares could trade at a discount to NAV. It hasn’t happened during the 2018/2019 crypto winter but it is a possibility in the future.
As subscriptions have increased rapidly this quarter and could be related to the premium monetisation, it will be important to monitor how the shares trade in Q2 next year post large vestings. This will also be a function of sentiment towards bitcoin at the time which impacts demand for GBTC in the secondary market.
The premium is a function of the following: exposure to bitcoin in a regulated vehicle without having to deal with the challenges of custody, eligibility to some tax efficient schemes, strong distribution through regular brokerage accounts, lack of alternatives such as an ETF.
Institutional investors also often do not have permission to hold physical bitcoins for regulatory reasons and are left with two options: GTBC or bitcoin futures. The operational and financial cost of periodically rolling a long future exposure plays in favor of GBTC for longer term holders.
Cryptocurrency markets have become more sophisticated since 2017 when bitcoin first hit $20k. Lending markets have in particular developed tremendously, culminating with the emergence of the so-called yield farmers and the rise of DeFi this summer. This remains mostly a retail phenomenon.
How are institutions creating returns at scale to pay interest rates to their lenders? Grayscale seems to be one of the answers. Firms such as BlockFi, offering high rate saving rate accounts for retail, and Three Arrows Capital, one of the most active hedge funds in the lending / borrowing market are the two largest holders of GBTC. Both filed 13G disclosure forms this year as they owned more than 5% of the total GBTC share count (source 1 and 2).
The fact that you can’t redeem the shares for bitcoin is key. As the rising market sustains the Grayscale premium at a hefty level, more capital is being committed to monetising it which leads to subscribing to new shares of GBTC in the primary market. This leads to an increasing number of bitcoins being taken “out” of the market, building a reinforcing feedback loop that has the potential to materially reduce the free float of bitcoin over time. There are already 550k bitcoins in the Grayscale Trust and there will only ever be 21 million bitcoins.
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