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Retail investors have been gaining exposure to bitcoin through the Grayscale Bitcoin Trust (GBTC). Finding it bizarre that despite the existence of avenues for buying bitcoin directly, investors were choosing to buy GBTC which trades at a 25% premium to bitcoin, I decided to investigate further.
The conclusion I arrive at is straightforward- "GBTC enriches institutional investors at the cost of retail investors and it is advisable to sell your GBTC while the premium still exists and buy actual bitcoin with the proceeds."
How does GBTC work?
Let me start with an over-simplistic explanation.
Accredited Investors (wealthy people) by depositing their bitcoin with the Trust can participate in a private placement and buy equal value of new GBTC shares. After a lock-in period of 6 months, they can sell their GBTC shares in the stock market. Historically GBTC has almost always traded at a premium. At the current 25% premium, these investors would have made a profit of 25% in 6 months. This option is not available to retail investors.
=> In other words, rich people have the option of buying bitcoin at par and selling it at a premium while poor retail investors must buy at a premium.
The above explanation glosses over the risks to institutional investors and I’ll describe those in detail below.
Basic GBTC-Arb Trade
Accredited investors create GBTC by depositing bitcoin.
There is a risk to institutional investors if the price of bitcoin falls or the premium reduces or turns to a discount. Let's understand with numbers assuming that 1 bitcoin is worth $20,000 and premium is at 30%.
Accredited Investors (Institutions and wealthy individuals) can create new GBTC shares by depositing 1 bitcoin or depositing $20,000 (which is converted to bitcoin) with the Trust. After a 6 month lock-in period:
A. If the price of bitcoin is flat and GBTC is trading at a 30% premium then they can sell their GBTC shares at $26,000 and pocket a profit of $6,000.
B. If the price of bitcoin climbs say to $30,000 during this time and the GBTC premium remains at 30% then they will be able to sell their shares at $39,000 and pocket a profit of $19,000.
C. If the bitcoin price falls to say $15,000 during this time and the GBTC premium remains at 30% then they will be able to sell their shares for $19,500 and make a loss of $500.
D. If the price of bitcoin falls, there is a greater chance of the premium falling or even turning to a discount). So if bitcoin price falls to $15,000 and GBTC moves to 10% discount then they will be able to sell their shares for $13,500 and make a loss of $6,500
In the above 4 scenarios, the retails investor would have been at 0 profit in scenario A, $13,000 profit in scenario B, $6,500 loss in scenario C, and $12,500 loss in scenario D.
=> Net-net, if you factor in the risk of bitcoin price falling and of premium reducing then institutions face a loss. However, one can also clearly see that retail investors in the same situation face a much greater loss.
Hedging
Institutions can hedge away the risk of a drop in price by selling futures
Let us see how this trade is executed- Create GBTC shares at $20,000. Short 6 month futures at say $25,000. 6 months later, sell GBTC at market price and cover the short futures.
A- If the price of bitcoin is flat and GBTC is trading at a 30% premium, then the profit from the trade increases for the institution as it makes an additional profit on the futures.
B- If the price of bitcoin climbs say to $30,000 during this time and the GBTC premium remains at 30% then the institution’s profit will fall from 19,000 to 14,000 as there will be a loss of $5,000 in the futures
C. If the bitcoin price falls to say $15,000 during this time and the GBTC premium remains at 30% then the $500 loss for the institution will change to a $9,500 profit as it’ll make a $10,000 profit on the futures.
D. If the price of bitcoin falls and GBTC moves to a 10% discount then the institution will go from a $6,500 loss to a profit of $3,500 as it’ll make a $10,000 profit on the futures.
(6-month futures are not very active and institutions will most likely have to sell 3-month futures and roll in 3 months which adds risk. I mention 6 months only for simplicity sake)
Using leverage
Often, accredited investors lever by borrowing funds from Genesis (a Grayscale associated organization) to create these shares and use these very shares as collateral. Borrow cost are 10-12% pa (or 5-6% for the 6-month period).
With borrowed funds, the percentage return jumps as the upfront capital is much lower. The basic scenario A is profitable as long as premium is higher than the borrow cost.
In the above analysis, I’ve assumed no management fees. 2% management fees for Grayscale must be added.
What is the risk of GBTC premium reduction?
There is a steady supply of GBTC shares in the market as institutions prefer to sell when the lock-in expires. Despite the steady supply, GBTC has almost always traded at a premium. This is because retail investors have been swooping in to buy. This could change in the future due to the following reasons:
* SEC Approval to ETFs (Exchange Traded Funds) - The SEC has been unwilling to approve cryptocurrency ETFs on the grounds that cryptocurrency prices can be manipulated and that would hurt retail investors. The SEC appears to have fallen flat on the face of its noble intention of "saving" retail investors, as retail investors are enthusiastically buying all the GBTC they can lay their hands on.
=> If and when crypto ETFs become available, there will be competition for retail funds reducing the GBTC premium.
* Better avenues to buy the underlying bitcoin- While in the past, there were few avenues to buy bitcoin, this no longer holds true. Retail investors are discovering that there are several safe and convenient places to buy cryptos. Exchanges like Coinbase, Gemini, and Kraken are backed by reputed teams and are on the right side of regulation. Retail investors can also buy cryptos on Paypal and Square.
=> Retail investors are under the mistaken belief that GBTC is the best way to get bitcoin exposure. When they finally realize that they can get the same exposure without paying a premium, the demand for GBTC should dry up.
* Increase in GBTC supply - GBTC AUM (Assets Under Management) have jumped from $5bn in Oct'20 to $16bn in Dec'20. This means that there could likely be a lot of GBTC supply starting in Mar'21 when the 6-month lock-in over which might put pressure on the premium. Having said that, when the lock-in period ends, institutional investors will want to create further GBTC shares using the proceeds of the maturing shares and that would push up the price of the underlying. Usually when bitcoin price rises, the premium increases. Hence the impact of increased supply is not clear.
Profitable for Grayscale
If you're wondering why if Grayscale offering such a lucrative trade to institutions, then the answer is that this product is lucrative for Grayscale as well.
1. Since it is structured as a close-ended fund where funds can only be deposited and not redeemed, the AUM keeps climbing. Grayscale charges a 2% management fee on this. At an AUM of $16bn, that works out to $320mn. If the price of bitcoin climbs to $100,000 as many are predicting, that would mean $1bn in Grayscale's coffers.
2. Genesis Trading makes money on the funds borrowed by accredited investors. (Genesis and Grayscale are both part of the conglomerate - Digital Currency Group)
Final Words
If you want exposure to bitcoin, then buy bitcoin. Not GBTC. This will have 2 advantages:
1. You save yourself the premium
2. With time as you become more comfortable with the underlying, you can earn a return on your bitcoin through lending (Blockfi, Amber, Nexo), or yield farming by using tokenized bitcoin (WBTC) in DeFi protocols (Yearn Finance, Compound, Aave).