Grayscale: the end of the Bitcoin regulated monopoly in the United States

Grayscale operates the largest cryptocurrency investment vehicle in the world. However, the drop in that vehicle’s share price is staggering, having gone from trading above 100% of its fair value (132% in 2017) to dropping below 20% last month. How do you explain this?

What is Grayscale?

Grayscale is an unregulated company that manages digital currency funds. Its parent company is Digital Currency Group, a U.S. venture capital firm also focused on the digital currency market and which maintains the Coindesk information portal as a subsidiary.

Grayscale raises funds through its Investment Trust investment vehicles, which are companies that own a specified amount of an underlying asset. Those companies are owned by its shareholders, who acquire shares in the trust and become owners of the underlying assets in the proportion that these shares represent of the total assets under management (AuM). The trust is managed by a management company (Grayscale), which in return charges a 2% annual fee to investors, reducing the trust investors’ profitability. The shares are traded on the OTCQX, which is a top-quality OTC market for trading shares of companies that are not listed on traditional exchanges, and which requires compliance with a series of rules and regulations required by the U.S. Securities and Exchange Commission (SEC).

The capitalization model of a trust is rigid, as it lacks a share redemption system in the secondary market. This means that any investor accessing a private financing round contributes the underlying asset to the investment vehicle and subscribes a share of the trust in the primary market. After 60 days, these shares can be sold on the market. However, the trust, being regulated as a closed-end vehicle, cannot vary the volume of underlying assets, so that the investor cannot redeem his share to the vehicle itself and obtain the underlying that constitutes the contribution. In other words, the only way for the shareholder to exit the market is by disposing of his own shares in the secondary market.

In the case of Grayscale, a Trust has been set up for each of the cryptocurrencies acquired, reaching a volume of assets under management of around 30 Bn USD as of June 2021, with GBTC or Grayscale BTC, which refers to the Bitcoin Investment Trust, as the most relevant one. The GBTC, which tracks the price of Bitcoin based on the TradeBlock XBX Index, held in April 2021 around 650,000 BTC, or 22 Bn USD.

Investing in cryptocurrencies through the various trusts offered by Grayscale has been the only regulated way in which investors could gain exposure to cryptocurrencies without direct acquisition along these years, thereby avoiding the associated operational, reputational and cybersecurity risks. However, because it is not classified as a stock, the Investment Company Act of 1940 does not cover trust investors through the national investment guarantee scheme, nor can they be classified under Commodity Futures Trading Commission regulation.

The Grayscale share acts as a market sentiment, because the share price can predict upward or downward trends depending on the degree of demand, since the higher the demand, the higher the premium required for entry into the trust. Thus, in contexts of higher demand, the fair value of the trust’s shares may be higher than the fair value of the investment vehicle’s assets, with the shares trading at fair value + premium. On the other hand, in environments of contraction in demand, the shares may trade at a discount. This has been the case, as noted in the article’s introduction, during these years, with GBTC’s premium peaking at 132% in 2017 to the May 2021 level of -20%.

What is an ETF?

Before delving into the causes of the collapse, it is necessary to refer to another type of financial instrument that, as we shall see, has similarities with the trust, although it is the differences that make it the most efficient alternative for exposure to cryptocurrencies. What is an ETF?

An ETF or Exchange Traded Fund is a hybrid investment instrument between funds and shares, combining the diversification offered by a fund’s portfolio with the flexibility of being able to enter and exit the fund with a simple stock market transaction. And unlike traditional fund shares, which can only be subscribed or redeemed at their net asset value (total value of the fund’s portfolio — expenses / number of units) calculated at the close of each session, ETFs are bought and sold on the stock exchange, like any share, with the same commissions. In addition, ETFs have specialist brokers who undertake to act as counterparties, offering bid and offer prices throughout the session, thus guaranteeing the instrument’s liquidity.

The fall of Grayscale

Once the basic characteristics of a trust and an ETF have been explained, the reasons for the fall of the premium to current negative levels are shown and analyzed:

  • Competition: in the context of the taxonomy of synthetic Bitcoin products, especially in the United States. Until now, the monopoly had been exercised by Grayscale through trusts, which channeled the interest of retail and corporate clients in regulated exposure to cryptocurrencies. However, the arrival of ETFs in 2021 in Canada (Purpose Bitcoin ETF, as the first product), the emergence of regulated exchanges (Coinbase) and the recent applications launched by various companies (Fidelity, SkyBridge, WisdomTree, Valkyrie) threaten Grayscale’s dominant position.
  • Cost structure: in terms of financial products, the main difference between the structuring of synthetic exposure to cryptocurrencies through trust or ETF is in the transaction costs. In this regard, the ETF presents management costs of around 1%, while the trust increases to 2%. The alternative of synthetic products under a common regulatory framework has unleashed a race for positioning as a reference instrument for institutional and retail investors with a higher risk appetite, whose decision metrics are established in terms of efficiency. And in this respect, ETFs are the best-performing product. For this reason, Grayscale wants to restructure its trusts into ETFs, and other companies have already launched their application processes with the SEC.
  • Arbitrage: the rigidity of trusts prevents the exercise of arbitrage mechanisms correctly. In other words, as mentioned above, the trust shareholder cannot redeem the share and acquire the underlying, so it is difficult to reverse the discounted share price through arbitrage. If it were possible, any investor could acquire the trust share at a discount, redeem it and obtain the underlying, which, once sold on the market, would generate a profit.

Conclusions:

For these reasons, in my opinion, Grayscale’s premium moves into negative values. Perhaps the premium value is too aggressive, as the flow discount calculated as the trust’s transaction cost (2%) times the number of years held, and an add-on for negative market sentiment (current downtrend) may explain the very low values it has reached. Also, as previously noted, the impossibility of redeeming the trust’s shares versus the flexibility of ETFs significantly determines the share price, because, unable to arbitrage such inefficiency, the investor rejects the investment in Grayscale.

On the other hand, and by way of review, during this year, and until the listing of Ethereum on CME for futures trading, the GBTC premium was lower than the GETHE premium (Ethereum trust). The reason was that the channeling of exposure to Ethereum occurs exclusively through the trust, while Bitcoin allowed exposure through the trust and the futures market. And that, among other reasons, is why the Ethereum listing has increased supply and consequently softened demand, leading to the premium reduction.

In any case, Grayscale has already announced the intention to convert its trusts into ETFs, eliminating the advantages in terms of efficiency of the latter and benefiting from the economies of scale that the volume of assets Grayscale keeps under management can allow it. The race to launch the first ETF in the United States, and attract all the savings of investors interested in exposure to cryptocurrencies has begun, and it will be the SEC that will determine, once it has verified compliance with the required regulatory standards, which company gets the first mover advantage.