BlackRock Bitcoin Trust: Mixed Results

On June 15, BlackRock submitted an S-1 filing to the U.S. Securities and Exchange Commission (SEC), a registration report that detailed its proposed Bitcoin Trust product. Technically, the product is not an ETF, but it is functionally equivalent to an ETF because it supports daily subscriptions and redemptions.

This development is notable in part because BlackRock has close relationships with regulators and insiders who tend not to act without certainty of the outcome. In fact, the SEC has approved 575 of BlackRock’s 576 ETF applications over the years. So there’s reason to be excited.

The SEC has yet to support a spot (rather than futures) based Bitcoin ETF. A “spot” Bitcoin product is one that holds actual Bitcoin on behalf of the investor; whereas a “futures” Bitcoin product holds a derivative contract (a bet on the future price of Bitcoin) without actually holding the actual asset. “Spot” products generate demand for actual Bitcoin, which is limited in supply, and are therefore inherently bullish on Bitcoin; whereas “futures” products do not, and are inherently neutral, although they can be particularly useful during bull markets to bet against retail investor enthusiasm (and dampen that enthusiasm through selling pressure).

Due to these facts, it is widely believed that the SEC’s rejection of spot-based ETFs, while allowing futures-based ETFs, demonstrates the U.S. government’s reluctance to help Bitcoin become a competitor to the U.S. dollar.

But that hasn’t stopped demand for bitcoin, and Wall Street firms have been sitting on the sidelines.

Obviously, these big players don't want to miss the next bull run.

1. Grayscale Optimization

BlackRock specifically designed the new Bitcoin Trust/ETF to improve upon Grayscale's existing Bitcoin exposure vehicle, Grayscale Bitcoin Trust (GBTC). The biggest problem with GBTC is that the trust does not allow for in-kind redemptions. In other words, investors can buy trust shares and own a representative share of the underlying spot Bitcoin, but they can never withdraw those Bitcoins. All they can do is sell their shares to someone else and use the money to buy spot Bitcoin.

Such a transaction creates a taxable event, which could be subject to a 30% tax. Brutal. But it doesn't have to be.

There is nothing that strictly prohibits Grayscale from supporting physical redemptions, and maintaining this structure—allowing dollars to flow into GBTC and be converted into Bitcoin, but never allowing Bitcoin to flow out—is very much in the interest of Grayscale founder Barry Silbert.

This way, Barry can collect 2% management fee every year. Since GBTC has absorbed 600,000 Bitcoins in nearly ten years of operation, that means Barry collects 12,000 Bitcoins ($300 million) every year. It is really a goose that lays golden eggs. This is great for Barry, but terrible for customers.

2. BlackRock’s Bitcoin ETF

BlackRock probably understands the ETF business better than anyone, so they almost certainly realized that the grantor trust model was viable for them. Regardless, BlackRock’s proposed Bitcoin Trust is the second of its kind.

In some ways, BlackRock’s new trust is a good product to buy into the price of bitcoin. (BlackRock manages about $10 trillion in assets, 20 times the total value of bitcoin, which is $500 billion. Some of BlackRock’s AUM may soon be used to buy bitcoin.)

In other ways, it is a bad product that seriously undermines customer rights and threatens the core value of Bitcoin.

The BlackRock Bitcoin Trust is an investment vehicle whose overall quality for investors depends on two fundamental components: the trust mechanics and the trust’s custody and governance. Like the two wheels of a bicycle, these two important components can be evaluated on their own merits, but must be properly combined to serve the interests of users.

Here is the BlackRock Bitcoin Trust as an investment vehicle:

(1) Advantages: Grantor Trust Model

In short, the grantor trust model is very much in the client’s interest. BlackRock highlights two key benefits to investors:

Tax considerations

- "For U.S. federal income tax purposes, owners of the stock will be treated as owning a proportionate share of the trust assets."

- This means that, for tax purposes, owning shares of the BlackRock Bitcoin Trust is equivalent to owning the underlying asset - Bitcoin.

· Redeem in kind

- There are several sections in the BlackRock Trust Proposal that describe the in-kind redemption policies and procedures.

- In-kind redemptions ensure that any premium or discount to NAV can be arbitraged, eliminating a major pain point for GBTC investors.

Overall, these terms are better than those of Grayscale and similar funds, especially because the grantor trust model allows for the withdrawal of Bitcoin without paying taxes.

This is the good side, a normal round wheel. The bottom is a wobbly square wheel...

(2) Disadvantages: Black Rock custody and governance

The main problem with BlackRock’s proposed Bitcoin Trust is that it is managed by BlackRock. Specifically, this means that the trust is managed in a manner typical of the traditional asset landscape and the politicized licensed finance brand that BlackRock is known for.

In- kind redemption – traps:

- The S-1 document contains a specific description: "The Trustee will deliver to the Redemption Authorized Participants the amount of Bitcoin corresponding to the Redemption Basket... Shares may only be used to redeem (whole Bitcoin)". Only registered brokers that have entered into a separate contract with BlackRock are designated as "Authorized Participants". In other words, the privilege of being able to withdraw Bitcoin from the Trust is reserved for investment firms that are favored by BlackRock, and this list may change at any time. Physical redemptions of Bitcoin can only be made by submitting whole Bitcoin redemptions (through "Authorized Participants"), and partial Bitcoin cannot be withdrawn from the Trust.

Re-mortgage

- In the traditional asset world, ETFs usually operate by lending assets from the pool they are responsible for to market participants (such as short sellers). BlackRock will naturally extend this practice to its Bitcoin Trust, as there is nothing in the proposal document that prohibits rehypothecation.

- Obviously, the problem here is that investors in the BlackRock Bitcoin Trust will have title to Bitcoin that was supposed to be held by BlackRock but was in fact loaned out. In this case, the trust investors only have a claim on Bitcoin that BlackRock no longer holds.

- This means that BlackRock’s Bitcoin Trust will become a huge source of paper Bitcoin creation. When FTX went bankrupt, they owed customers $1.4 billion in paper Bitcoin claims, but had no Bitcoin to distribute to these accounts.

- I'm not sure about you, but I would rather invest in Bitcoin trusts that do not support Bitcoin rehypothecation because the assets are still held in on-chain vaults.

Fork

- BlackRock’s filing explicitly states: “In the event of a fork, (BlackRock) would … determine which network is generally accepted as the Bitcoin network and should be treated as the appropriate network and treat the underlying assets as Bitcoin for purposes consistent with the trust objectives.”

- To be fair, this is the kind of language that could be used to address the possibility of a fork (i.e., when a splinter group changes the Bitcoin code and tries to convince enough people to follow the modified version of the code to consider it the “real” Bitcoin).

- However, this language also allows BlackRock to impose its own views on what constitutes “real” Bitcoin.

- This is particularly concerning given Bitcoin’s history of corporate-led forks and BlackRock’s history of politicized finance. In 2017, the Bitcoin Cash fork was driven by large interests in the Bitcoin space — some speculated by government interests. Similarly, BlackRock is the originator of the “ESG score,” a kind of corporate social credit score, undoubtedly developed and promoted in collaboration with government interests.

- Altogether, this creates a plausible scenario: BlackRock’s ETF could become a very successful investment vehicle for institutions to gain exposure to Bitcoin, and expand to own a large portion of the total Bitcoin supply. BlackRock could suddenly decide that it will support a new ESG fork of Bitcoin and will disregard the existing Bitcoin network as not the “real” Bitcoin.

- While I don’t think this attack will be enough to convince well-informed, hard-line Bitcoin investors to align with BlackRock’s political goals, it could mean that countless clients of BlackRock’s Bitcoin Trust will involuntarily become hostages in BlackRock’s power play. Ultimately, BlackRock’s clients could suffer the same fate as Bitcoin Cash investors.