Research | One article to see through the "money empire" under the gray map

With the popularity of Bitcoin market since October, Grayscale Fund has once again become the focus of attention. Labels such as "whale", "compliance" and "Wall Street" have always been associated with it, and many people think that Grayscale Fund is synonymous with "institutional investors entering the market". Even in the past few weeks, whenever Grayscale was trading normally on weekdays, Bitcoin showed an upward trend; while on weekends, Bitcoin fell. Although this phenomenon has a considerable coincidence factor, it does not prevent people from regarding Grayscale Fund as the "savior" of the Bitcoin market.

However, I recently watched "The Wolf of Wall Street" and one of the plots was very impressive: when the legendary stockbroker played by Leonardo handed a pen to the people around him and asked them to sell the pen to him, ordinary people would only talk about a lot of advantages of the pen, but his good buddy Brad said: "Do me a favor and write your name on the napkin." By creating demand, people will be willing to buy stocks. This is an important reason why Leonard can become the "Wolf of Wall Street."

For this reason, we can't help but think of Grayscale Fund, from another perspective: if we regard Grayscale Fund as an artificially created demand rather than a market supply, we will come to some interesting conclusions.

Re-discussing the “gold content” of Grayscale Fund

Whenever people talk about Grayscale Fund, it is often difficult to understand. Because it is not like ordinary open-end funds, which not only have subscription and redemption, but also secondary market transactions. The reason is that although Grayscale Fund is called "trust investment fund", it is actually a "castrated version" of ETF fund.

At present, Grayscale Fund has released 9 single-asset trust funds (BTC, BCH, ETH, ETC, ZEN, LTC, XLM, XRP, ZEC). Taking the GBTC fund as an example, like all ETF funds, GBTC is also divided into two major markets:

The primary market is the issuance market, where investors can subscribe for GBTC shares with BTC or cash; accordingly, investors can also exchange GBTC shares for BTC through the primary market, and the GBTC shares will be cancelled immediately;

The secondary market is the trading market. Investors can trade their GBTC shares in the secondary market. The trading platform is OTCQX, which adopts an inquiry trading system.

However, GBTC still differs from traditional ETFs in two ways:

First, Grayscale Bitcoin Trust has suspended its redemption mechanism since October 28, 2014. Although Grayscale Fund's GBTC has passed regulatory approval, it has not yet submitted a redemption plan to the SEC.

Secondly, in traditional ETF fund transactions, T+0 transactions can be achieved between the primary and secondary markets, that is, ETF fund shares subscribed in the primary market on the same day can be sold in the secondary market on the same day; a basket of stocks redeemed through the ETF fund can also be sold in the secondary market on the same day; however, currently GBTC's primary market subscription shares can only be sold in the secondary market after 6 months.

Of course, we should also pay attention to GBTC's secondary trading market - OTCQX.

Whenever investors mention Grayscale Fund, they can't help but label it as "high-end". An important reason for this is that all funds under Grayscale Fund can be traded on the U.S. securities market.

After nearly 200 years of development, the U.S. securities market has now formed a multi-level capital market system. Based on the quality of company stocks and the degree of market openness, the U.S. capital market system is mainly divided into the following levels:

The first tier is the New York Stock Exchange, Nasdaq Global Select Market and Nasdaq National Market, which have higher listing standards and are mainly national markets for super multinational companies;

The second layer is the Nasdaq Small Capital Market and the National Exchange, which are mainly national markets for high-tech companies and small and medium-sized enterprises in the United States. They have lower listing requirements and can meet the listing requirements of innovative companies with high risks and high growth characteristics. Most of China's Internet companies are listed in this market;

The third layer is the regional securities market in the United States, such as the Cincinnati Stock Exchange and the Philadelphia Stock Exchange, which are the main markets for trading local corporate securities.

The fourth layer is the pink sheet market, and OTCQX belongs to the pink sheet market.

So what is the pink sheet market?

There is a clip in the movie "The Wolf of Wall Street": Leonardo lost his job after the stock market crash in 1987, so he had to go to an "investor center" to work as a stockbroker. However, this "investment center" mainly does pink sheet market business (in the movie we can see that those stock quotes are printed on pink sheets).

It should be emphasized that the US Pink Sheet Market is not a stock exchange. The stocks of companies traded on the US Pink Sheet Market do not need to bear any requirements, such as submitting financial reports to the US Securities and Exchange Commission (so we see that except for the GBTC and ETHE products approved by the SEC, the rest of Grayscale's trust fund products can still be traded on OTCQX despite not submitting reports to the SEC). The companies traded on the Pink Sheet Market are often small companies held by a small number of people. These companies are generally small in scale, have less revenue, or are even bankrupt companies, so most of these companies do not meet the basic listing requirements of US trading institutions such as the New York Stock Exchange.

Therefore, although there are some high-quality stocks of companies outside the United States (mainly depositary receipts) in this market, the vast majority of the stocks in the market are "junk stocks" and "penny stocks" in the United States. For example, in the movie, Leonardo promoted the stock of a "cutting-edge high-tech company" that was about to obtain a radar detector license to his customers, but in fact it was just a "family company" in a small, dilapidated white house in the Midwest. But that's why Leonardo could get a 50% commission if he could sell these stocks successfully.

Of course, although the pink sheet market is synonymous with "junk stocks" and "penny stocks", the pink sheet market is also classified into three levels from high to low: OTC QX, OTC QB, and OTC Pink. Among them, Grayscale Fund belongs to the OTCQX trading platform.

OTCQX is the highest-level trading market in the U.S. over-the-counter market. All companies that trade stocks here must meet information disclosure, financial and management standards (these standards are not set by the SEC, but by the trading platform), and must provide proof of support from a certified third-party investment bank or legal advisor.

Therefore, from a practical point of view, the Grayscale Fund is just a "castrated version" of the ETF fund, and its trading platform is merely a "third-rate platform" of the US financial market system, and its gold content is not high.

The “Empire of Money” in Grayscale

Through the above analysis, we may be curious, since the products under Grayscale Fund are not of high "gold content", why are there so many investors flocking to them?

Perhaps many people will use the misleading statements on Grayscale's official website such as "convenience and security" and "economical and efficient order execution" to explain it. Since small and medium-sized investors can buy and keep encrypted digital currencies themselves, can't institutional investors do the same? Are institutional investors interested in "compliant channels"? Obviously not, because CME has launched "BTC futures". Is there a big difference between BTC futures with 1x leverage and BTC spot? Perhaps the transaction fee for the former for one year for extension is cheaper than the management fee of Grayscale Fund, and it can also increase leverage with closing positions, saving capital costs.

Perhaps, for those who pay attention to the Grayscale Fund, the starting point of analyzing the problem may be wrong - the public's narrative logic has always been: because institutional investors are optimistic about the future prospects of Bitcoin, they purchase Bitcoin through the Grayscale Fund, a compliant channel.

However, the more realistic situation is that institutional investors buy in large quantities because the Grayscale Fund is "profitable". The "profitability" here has nothing to do with the future prospects of Bitcoin, but the arbitrage space of the product itself.

The arbitrage space here mainly comes from the high premium of Grayscale Fund. Taking GBTC as an example, as shown in the figure below, the secondary market price of GBTC is basically consistent with the price trend of BTC, but the secondary market price of GBTC is much higher than the net value of GBTC, and has remained at around 20% in the past year.

For general ETF funds, there will not be a high discount or premium. The reason is the arbitrage mechanism of ETF:

• When the net value > market price, arbitrageurs will buy ETF shares in the secondary market, and then redeem the underlying assets (such as a basket of stocks or other assets) with ETF shares in the primary market to earn the difference;

• When the market price > net value, arbitrageurs will use the underlying assets to purchase ETF fund shares in the primary market, and then sell the ETF fund shares in the secondary market to earn the difference;

So why does the Grayscale Fund have a high premium? The reason is that the Grayscale Fund we mentioned earlier is a "castrated" ETF fund. Since the redemption mechanism is cancelled and the position needs to be locked for 6 or 12 months, the arbitrage mechanism is not smooth, so a high premium phenomenon occurs.

If we go back to the beginning of the article, Leonardo's famous saying: By creating demand, people will be willing to buy stocks. The same is true for Grayscale Fund, which attracts investors to buy Grayscale Fund by artificially creating a high premium phenomenon. This is why investors favor Grayscale Fund so much, and it has nothing to do with Bitcoin itself.

As a result, we have seen a rare “standing and making money” scene in the cryptocurrency market, which has not only won a good reputation, but also made considerable profits:

(1) Grayscale Fund, which has no redemption mechanism, can only buy BTC but not sell it, and its position is permanently locked, which is conducive to the rise of BTC prices. Even if it is not subscribed in kind, it will bring huge amounts of funds to the cryptocurrency market. The withdrawal of funds is entirely borne by the traditional capital market, which will not bring selling pressure to the cryptocurrency market.

(2) The biggest concern of fund products is redemption risk. However, Grayscale Funds, which do not have a redemption mechanism, can charge a 3% annual fund management fee “indefinitely”.

Of course, this artificially created demand not only brings huge profits to the Grayscale Fund itself, but also brings high external effects to Genesis, which is also under the DGC Group.

Currently, Genesis mainly includes four major businesses: trading business, lending business, derivatives business and custody business. In addition to the recently opened custody business, Genesis' other three businesses can all benefit from the recent rapid growth of Grayscale Fund.

First, in terms of trading business, Grayscale Fund’s cash subscription in the primary market is authorized to Genesis to buy BTC in the spot market.

Secondly, the lending business. Unlike other cryptocurrency lending platforms, Genesis can directly pledge GBTC/ETHE to borrow BTC/ETH. This means that investors can use their fund shares for lending, and then apply to purchase fund shares to increase leverage and expand returns. As long as the high premium in the secondary market is greater than the additional costs such as the management fee rate and lending rate of the Grayscale Fund, arbitrage will occur. Similarly, we can observe that since the second half of this year, with the continuous expansion of the Grayscale Fund, the scale of Genesis's lending business has also expanded rapidly, and the cumulative loan issuance growth rate has increased significantly.

Finally, there is the derivatives business, which is often overlooked by the public. At present, there is a common misunderstanding among investors in the cryptocurrency market: this part of the high premium can be arbitraged through cash/cryptocurrency. The general method is to borrow cash/cryptocurrency from the lending platform, and then subscribe to Grayscale's Bitcoin trust shares. After the 6-month lock-up period of the trust shares expires, they are sold through OTCQX. If there is a positive premium space, the remaining part after returning the principal and interest to the lender is the profit of the arbitrageur.

However, the above arbitrage scheme is very risky because it does not eliminate the price risk of Bitcoin itself. For example, Bitcoin fell 30% in a month, but GBTC has always had a high premium of 20%. Even so, investors still lose money. Therefore, for institutional investors, in addition to the above arbitrage operations, they also need to sell the corresponding cryptocurrency shorts in the derivatives market (such as CME, Genesis's derivatives business) to hedge risks.

According to Genesis' third-quarter financial report this year, its derivatives business has become one of its fastest growing businesses, reaching US$1 billion in the third quarter. The main reason is that Genesis' lending business customers need to use derivatives for hedging to reduce investment risks.

Similarly, according to the financial report submitted by Grayscale Fund to the SEC, the parent fund of the fund holds at least 1% of Coinbase's shares, and the relevant crypto assets of Grayscale Fund are all managed by Coinbase, which charges custody fees.

From the above, we can see that Grayscale Fund brings more than just 3% management fee income, but also expands the business scope of DCG Group. By creating the arbitrage product of "high fund premium", Genesis has expanded its trading, lending and derivatives business, formed the unique "Grayscale Fund moat" of DCG Group, and created a "money empire" in the cryptocurrency market.