Why is Grayscale's GBTC premium only 2.77%? Does it mean that institutions are bearish?

On January 22, the premium of Grayscale Bitcoin Trust product GBTC in the secondary market compared to the primary market hit a new low of 2.77% since 2016. In other words, the premium of GBTC price compared to BTC is only 2.77%. The previous premium of GBTC was as high as 132%, and in the second half of last year, the average premium was about 17%.

This round of Bitcoin bull market is recognized to be led by institutions, and GBTC is an important entry point for institutions. Of course, not all institutions that buy GBTC are optimistic about Bitcoin, because of the mechanism designed by Grayscale Trust, some institutions enter the market only for arbitrage.

Rhythm BlockBeats This article will explain why the premium of GBTC is only 2.77%, how institutions can conduct simple arbitrage, and the possible impact after the premium drops.

Grayscale Trust Operation Model

Unlike what many investors understand, Grayscale itself does not directly purchase or hold Bitcoin. The Bitcoin Trust established by Grayscale supports users to redeem trust shares GBTC through BTC or cash. Each GBTC corresponds to a corresponding BTC, which is held in Coinbase Custody.

This means that the BTC currently held by Grayscale belongs to the institutions or individuals, large and small, behind it that hold GBTC, rather than Grayscale.

In 2014, Grayscale Bitcoin Trust was scrutinized by the SEC for its redemption method, and was subsequently fined $50,000 and closed the GBTC redemption method for BTC in 2016.

Currently, there are three ways to obtain GBTC:

The first is to purchase GBTC directly in the OTC market. The GBTC obtained in this way has no lock-up period and can be bought and sold at will;

The second method is to use the BTC in hand to apply for GBTC from Grayscale. The GBTC obtained in this way needs to be locked for half a year, and can be sold through the OTC market after half a year;

The third method is to use cash to apply for subscription from Grayscale (Grayscale will use cash to purchase BTC). The GBTC obtained in this way also needs to be locked for half a year, and can be sold through the OTC market after half a year.

Grayscale’s daily new holdings of tokens mainly come from the second and third subscription methods.

GBTC becomes an institutional arbitrage target

According to Grayscale's fourth quarter report for 2020, institutions accounted for 93% of the funds flowing into Grayscale in the fourth quarter of 2020, or approximately US$3 billion.

The entry of a large number of institutions does not mean that they are optimistic about Bitcoin. It may also be profitable because there is arbitrage space between the primary market and secondary market of Grayscale Bitcoin Trust's GBTC.

As GBTC is listed on the world's largest and most liquid U.S. stock market, it enjoys a certain liquidity premium. In addition to the liquidity premium, because Grayscale Bitcoin Trust is one of the few channels for compliant financial institutions to invest in Bitcoin, this also lays the foundation for GBTC to generate a premium in the secondary market.

Since there is a price difference between the primary and secondary markets, investors are driven to engage in arbitrage to offset the price difference.

Arbitrageurs borrow physical Bitcoin and open short orders of equal value at the same time, then withdraw Bitcoin spot to Grayscale to purchase GBTC. After 6 months, they sell GBTC to get cash, and use the cash to buy the Bitcoin borrowed at the beginning, and close the short order while returning the Bitcoin. In this whole set of operations, arbitrageurs earn the price difference between Bitcoin futures and spot and the price difference between GBTC primary market and secondary market.

Why is the GBTC premium only 2.77%?

On January 22, 2020, the GBTC secondary market premium fell to 2.77%, the lowest since 2016.

GBTC secondary market premium, source: Bloomberg

Why is the GBTC premium only 2.77%? There are two main reasons for this. One of them is the recent decline in the primary market of Bitcoin, which has intensified panic and led to the liquidation of crypto assets worth $1.34 billion.

Bitcoin recent market trends

Another more important factor that led to the reduction of GBTC premium is the expiration and unlocking of the huge amount of GBTC in Grayscale Trust. Grayscale officially announced on January 15 that it would issue (unlock) 37,036,200 shares of GBTC, totaling about 35,000 bitcoins, worth more than US$1.2 billion. The number of GBTC unlocked this time accounted for 5.47% of the total.

According to dcresearch data, the lowest premium of GBTC since its inception was -0.3%, which occurred in 2015.

GBTC premium historical data, source: dcresearch

However, the total market value of Bitcoin in 2015 was only a few billion, which is incomparable to the current market value of 600 billion. Moreover, it is a consensus among many investors that this round of market is an institutional bull market led by institutions. This shows that institutions are an important part of market participation.

Among the institutions participating in GBTC, there are arbitrage institutions that are extremely concerned about the premium.

Once the negative premium is long-term or too high, it will be a devastating blow to the operation of arbitrage institutions. As described above, the main profit of arbitrage institutions comes from the premium between the primary and secondary markets of GBTC. Once the premium disappears, the number of subsequent arbitrage institutions entering the market will decrease. If there is a negative premium, institutions using high leverage arbitrage may face the risk of being liquidated, which will cause the price of Bitcoin in the primary market to continue to weaken, forming a death spiral.

Of course, once a negative premium is formed, Grayscale Investments can allow Bitcoin spot redemption if permitted by regulation, thus avoiding the possibility of highly leveraged arbitrage institutions being liquidated.