Grayscale Bitcoin "Ten Questions": Who is buying? How to arbitrage? Will it crash the market?

On November 21, 2020, the price of Bitcoin broke through US$18,960, approaching its historical high of US$19,763.

Data shows that in the six months since the Bitcoin halving on May 13, the number of Bitcoins held by Grayscale is basically equal to the amount mined during the same period. On November 20, Grayscale Bitcoin Trust once again increased its holdings by 10,550 BTC, and the total holdings have reached 526,765 BTC......

It is said that 2017 was a bull market for retail investors, while 2020 is a bull market for institutions, and Grayscale is considered to be the biggest engine of this bull market.

Investors are no strangers to the name Grayscale, but there are still many questions about Grayscale: Why does Grayscale keep increasing its holdings of BTC? How do institutions arbitrage through Grayscale's GBTC? Will Grayscale crash the market?

Next, we will use ten questions to uncover the secrets of grayscale.

What is Grayscale?

Grayscale Investments was originally a Bitcoin investment fund under the private equity trading platform SecondMarket. In 2014, Barry Silbert, the founder of SecondMarket, separated the Bitcoin investment fund from the original company and established Grayscale Investments.

In 2015, Grayscale Investments was merged into the newly established Digital Currency Group (DCG). In addition to Grayscale Investments, DCG also has two subsidiaries, Genesis, an over-the-counter cryptocurrency broker, and CoinDesk, a blockchain media platform, as well as more than 150 other blockchain companies/projects.

In addition to the Bitcoin Trust Fund, Grayscale Investments has also launched trust funds for cryptocurrencies such as ETH, BCH, ETC, LTC, XRP, as well as a composite cryptocurrency trust fund (Grayscale Digital Large Cap Fund) that includes mainstream currencies.

Grayscale product establishment timeline Source: Grayscale Investor Deck October 2020

What is Grayscale Bitcoin Trust (GBTC)?

Grayscale Bitcoin Trust (GBTC) is the largest cryptocurrency trust product under Grayscale, accounting for more than 90% of Grayscale's overall asset management scale.

GBTC is essentially a private trust fund. It conducted its first private placement in 2013 and has been open for subsequent primary market subscriptions from time to time. Initially, only qualified investors could participate, with a minimum subscription amount of US$50,000. In March 2015, GBTC was publicly traded on OTCQX, officially announcing that the shares of the GBTC private trust fund were listed on the secondary market, and all general investors could participate.

There are two ways to invest in GBTC: cash investment and physical investment (Bitcoin). Buying GBTC is equivalent to buying the corresponding share of Bitcoin held by Grayscale. After GBTC was investigated by the SEC in 2014, Grayscale stopped the redemption mechanism of GBTC on the grounds that the SEC would not approve it. Therefore, the GBTC shares subscribed by investors of both investment methods cannot be redeemed.

In addition, Grayscale will also charge a 2% custody fee, which is also its main profit method. The fee is deducted from the number of bitcoins held, that is, the management fee is charged in a currency-based manner. Statistics show that according to its current asset management scale, Grayscale charges custody fees of about 7,000 bitcoins each year.

Model for investors to participate in GBTC share subscription

Grayscale's latest asset management scale

Why does Grayscale continue to increase its holdings of Bitcoin?

According to the latest data officially released by Grayscale, as of November 20, excluding the lost bitcoins, the total holdings of Grayscale's Bitcoin Trust are close to 3.4% of the BTC circulation, reaching 526,765 coins, continuing to push BTC towards its historical highest price.

In fact, GBTC does not "time" the investment in Bitcoin, but aims to track the price trend itself and serve its investors. Therefore, its Bitcoin investment strategy is "passive". Why?

1. The source of demand for increasing holdings of BTC is the continuous entry of large institutional funds for arbitrage, which prompts Grayscale to increase its holdings after buying up all the GBTC shares. But the ultimate source of demand still comes from the secondary market. The extremely high premium attracts many institutions to engage in arbitrage activities, which is often more obvious in bull markets. Therefore, when Grayscale continues to increase its holdings of Bitcoin, it means that arbitrage institutions have optimistic expectations for the premium of GBTC.

2. The non-redeemable mechanism of Grayscale Bitcoin Trust means that the holdings it manages will become larger and larger, and the 2% management fee makes Grayscale earn a lot of money.

Why buy GBTC instead of buying Bitcoin directly?

The purpose of GBTC is to reduce the cost of asset management for investors. By purchasing GBTC directly in the U.S. stock market, investors can purchase and hold Bitcoin in a simplified and secure way without any learning barriers. While enjoying the investment opportunities brought by the high volatility of Bitcoin prices, there is no need to bear the risks that may exist in trading Bitcoin on your own:

1. There is a risk of information leakage when opening an account on a digital currency trading platform: You may receive harassing calls from fake customer service representatives of major trading platforms every day, and even your personal privacy may be stolen or used illegally.

2. Buying and selling Bitcoin on digital currency trading platforms involves risks such as price manipulation, withdrawal restrictions, and exchanges “running away”: Opacity is a common problem of centralized platforms.

3. Storing Bitcoins involves risks such as loss or theft of wallet private keys.

Furthermore, GTBCs operate similarly to stocks and bonds, providing tax convenience for investors and easy transfer to beneficiaries under inheritance law.

Who is buying Bitcoin through Grayscale?

Data shows that 80% of those who purchased GBTC were institutional investors, and as of November 2020, a total of 23 companies (29 institutional accounts in total) held Grayscale Bitcoin Trust shares. Crypto asset lending company BlockFi is the largest holder of Grayscale Bitcoin Trust, holding approximately 24.2355 million trust shares; the second largest holder is Three Arrows Capital, one of the most active cryptocurrency hedge funds.

It is worth noting that hidden among the institutions on this list are accounts of well-known private wealth management institutions or family offices, including the investment company of the famous Rothschild family (Rothschild Investment Corp).

Grayscale investor structure by type Source: Grayscale Digital Asset Investment Report Q3 2020

As of November 9, a total of 23 institutional investors disclosed their holdings. Source: Fintel. Chart: Chain Hill Capital

Why does GBTC have a higher premium relative to BTC price in the long term?

Since GBTC can be traded in the secondary market, its share price has long been at a premium to BTC itself. The current GBTC latest net value (NAV) is $17.46, and the price of Bitcoin per share during the same period is about $21.24, with a premium rate of 21.56%.

The premium is generated when the market circulation value of each GBTC is greater than the value of the embedded Bitcoin for the following reasons:

1. Low flexibility and no substitutes. The U.S. stock market lacks investment tools for Bitcoin and crypto assets. As long as the SEC does not approve the Bitcoin ETF, GBTC has basically no competitors.

2. The mechanism of GBTC's regular issuance, non-redeemable nature, and 6-month lock-up period that cannot be resold, as well as the continued optimism in market sentiment, have resulted in a higher risk premium.

Two factors have led to a shortage of GBTC, resulting in a long-term premium for GBTC relative to Bitcoin.

Data shows: GBTC has a long-term premium over BTC

How to arbitrage through GBTC premium?

Over the past five years, the average premium of GBTC was 38%, reaching a maximum of 132%, leaving considerable arbitrage space.

There are currently four common GBTC arbitrage models, cash lending arbitrage, physical lending arbitrage, share lending arbitrage and locked premium arbitrage:

1. Cash lending arbitrage. Investors use cash or Bitcoin to buy GBTC shares, and sell them in the secondary market after the 6-month lock-up period. The risk of this method is greatly affected by the decline in Bitcoin prices. Only when the GBTC price is higher than the initial cost can it be profitable.

2. Physical lending arbitrage. Institutional investors borrow Bitcoin from lending platforms and give it to Grayscale to exchange for primary market share. After the 6-month lock-up period, they sell it at the right time and buy Bitcoin back to the lending platform. At this time, the premium income from the sale of GBTC minus interest and other fees is the arbitrage profit.

3. GBTC share lending arbitrage. Investors directly borrow GBTC shares and sell them in the secondary market at the right time. At the same time, they use cash or Bitcoin to exchange for GBTC shares in Grayscale, and repay the borrowed GBTC shares after the lock-up period. There are two fees involved here, one is the borrowing cost of GBTC, and the second fee is the 2% custody fee. If the GBTC premium exceeds the sum of the two fees, it is possible to make a profit.

4. Lock in premium arbitrage. Investors use cash or Bitcoin to exchange for GBTC at Grayscale, and borrow GBTC over the counter and short it when the market price of GBTC is higher than the net asset value. In the end, whether GBTC rises or falls, the profit is fixed. The final premium minus the borrowing cost and custody fee is the profit margin.

To summarize the four arbitrage methods, the first one is more dependent on the current price of Bitcoin. The higher the price of Bitcoin, the higher the return. The second and third strategies are more dependent on the GBTC premium. The higher the premium, the more people will realize arbitrage, and the higher the demand for Bitcoin. The fourth one is very suitable for hedge funds. The operation is relatively complicated, but the premium income can be locked in in advance, and the market risk is relatively small.

Why can't Bitcoin ETF be approved, but GBTC can exist?

The existence of GBTC is inseparable from the US regulatory environment. Since the SEC believes that the price of Bitcoin can be manipulated, the application for Bitcoin ETF has never been approved. But why did GBTC get approved? The reasons are as follows:

1. The United States allows trusts to invest in crypto assets such as Bitcoin and Ethereum, and allows such trust shares to enter the over-the-counter market.

2. The United States allows digital currency trading platforms to operate in compliance and accept Bitcoin quotes (GBTC’s current quoters include Coinbase Pro, LMAX Digital, itBit, Kraken and Bitstamp).

3. The United States allows digital currency custodians to operate in compliance with regulations. Coinbase Custody, the custodian of GBTC, is a trustee in compliance with the New York Banking Law and a qualified custodian for the purposes stated in the provisions of the U.S. Investment Advisers Act.

4. Many law firms and auditing firms are willing to provide services for GBTC.

Will Grayscale crash the market?

First, the long-term positive premium of GBTC has created an arbitrage space between the primary and secondary markets. As long as institutions maintain an optimistic expectation of the risk premium of GBTC, the holdings managed by Grayscale will become larger and larger. In addition, GBTC has a "non-redeemable" mechanism, which directly eliminates the liquidity crisis of Bitcoin sellers and does not give GBTC investors the opportunity to sell and dump the market.

Secondly, the management fee settled in the currency standard will make the number of bitcoins corresponding to each GBTC share held by investors continue to decrease. Therefore, bitcoins will also slowly transfer to Grayscale, and in the long run Grayscale will become one of the largest bitcoin holders in the market.

It can be seen from this that Grayscale actually controls the "power of life and death" over Bitcoin trading.

If the price of Bitcoin continues to rise, the arbitrage costs for institutions will become increasingly high, and the high premium of GBTC will continue to exist, leading to a short-term game between the Bitcoin demand generated by institutional arbitrage and the number of Bitcoins cashed out by Grayscale; Grayscale can also reduce the premium on its own to balance the Bitcoin supply and demand relationship it affects and stabilize market sentiment.

If a bear market comes, Grayscale can pay to maintain the premium, continue to attract institutional arbitrage, and use the 6-month GBTC lock-up period to sell; or directly smash the Bitcoin price to the lowest and continue to wait for a new bull market.

At present, in the bull market, as long as institutions maintain optimistic expectations on the premium of GBTC, Grayscale has no motivation to dump the market.

How to evaluate "Gray Bull"

Based on the non-redeemable mechanism of Grayscale Bitcoin Trust, the two forms of investment in cash and in-kind, and the clever cross-market separation of issuance and circulation (cryptocurrency market and U.S. stock market), the high premium of GBTC shares in the U.S. secondary market provides a lot of room for institutional cross-market arbitrage. The participation of arbitrage funds successfully realizes the ideal closed loop of "selling pressure (GBTC) transferred to U.S. stocks and funds brought back to the currency circle."

If there are no global factors that wipe out the GBTC premium in the short term, Grayscale will continue to increase its holdings of Bitcoin. This makes Grayscale Bitcoin Trust a "buy only, no sell" bull force in the market, and Bitcoin will continue to rise in the short term.