• bg22

Grayscale Bitcoin Trust Sees Significant Discount Risks Highlighted

Grayscale Bitcoin Trust Sees Significant Discount Risks Highlighted

As the global digital currency market crashed in May, the price of bitcoin plummeted, also triggering the world’s first bitcoin spot trust to dive in price and show a significant discount relative to its net worth.

The world’s first compliant bitcoin managed product is the Grayscale Bitcoin Trust (ticker GBTC), which was launched by Grayscale Investments, LLC, as sponsor (Sponsor). According to premium movements disclosed by ycharts.com, GBTC has been diving downward since March 2021, with a maximum discount of 34% by June 2022. It is really 30 years of river east, 30 years of river west, this product in the past years to maintain a premium, the highest even more than 130%.

The GBTC “trust” is not the same concept as the family trust we are talking about, but can also be translated as “trust fund” in mainland China and Hong Kong. According to the Grayscale website (https://grayscale.com/startinvesting/), GBTC was first listed on September 25, 2013. It is not a registered security under the U.S. Securities Act of 1933, and therefore cannot be offered to the public.

When the trust first debuted as a bitcoin investment trust, it was only available for private placement to qualified investors (similar to “professional investors” in Hong Kong). The trust later received approval from the Financial Industry Regulatory Authority (FINRA) to trade on the U.S. over-the-counter (OTC) market as a qualifying stock, and thus received the GBTC ticker symbol. The U.S. OTC market is still not open to the general public (individual investors need to trade through professional market makers), so GBTC is actually still traded among professional investors, but there is finally a regular code GBTC.

The Design of the World’s First Bitcoin Physical Fund

Despite the fact that GBTC can only be traded in the niche OTC market, it still stunned the world with its appearance. Because it was designed purely to hold bitcoins only, the intrinsic value of its trust shares are calculated based on the actual number of bitcoins held at the bottom, minus the expense fees that need to be paid.

This was strictly the first compliant bitcoin spot investment fund – it was fundamentally different from the bitcoin futures ETFs that were later approved by the SEC.

Simply put, each trust share of GBTC has an actual bitcoin spot quantity corresponding behind it, such as 0.00092065 bitcoins per GBTC share as of July 29, 2022.

Bitcoin futures ETFs are different in that the assets they correspond to are simply the number of bitcoin futures contracts held by the ETF, and none of these futures (at least as of this writing’s deadline), are likely to deliver actual bitcoins, but only gain or lose over the holding period of the futures contract.

Moreover, as of this writing, the SEC has never yet granted a single bitcoin spot ETF, meaning that GBTC is the only product that is actually a fund product that holds physical bitcoin as its underlying asset.

According to Grayscale’s sales materials filed with the SEC (https://www.sec.gov/Archives/edgar/data/1588489/000119312517013693/d157414ds1.htm#tx157414_15a) Grayscale’s Bitcoin Trust has two subscription options. One is a physical creation, in which eligible investors submit bitcoins (worth at least $50,000) directly to an “Authorized Participant” of the trust, who makes a request to Grayscale to redeem shares in the fund.

The other way is cash creation, where the investor gives the money to the Authorized Participant, and the Participant makes a request to the Fund’s Administrator (currently The Bank of New York Mellon) to exchange it for shares of GBTC. The Administrator hands over the money to the Fund’s Liquidity Provider, which trades cash for bitcoin in the market on behalf of the participant, and then hands over the corresponding bitcoin exchanged for the cash to Grayscale, which then issues the corresponding GBTC shares to the investor.

GBTC used to be redeemable, but as of October 28, 2014, the GBTC redemption mechanism was suspended due to the SEC’s conviction of Grayscale for violations under Guidelines 101 and 102 of Regulation M because it arranged for its own affiliate (sister company Genesis) to conduct share repurchases and cancellations while conducting a private share sale (and Genesis was interested in (and that Genesis had significant decision-making power over the conversion price of Bitcoin to GBTC).

The legal dispute between the two parties continued for years until an agreement was reached on July 11, 2016, in which Grayscale pledged a penalty of $51,650.11 in redemption fee revenue, while announcing the suspension of the redemption mechanism until a subsequent resolution of this issue. As of now, it appears that to restart the redemption mechanism, Grayscale can only request a waiver from the SEC, but it is understood that Grayscale has no intention of submitting such a plan for the time being.

Prior to August 8, 2015, the custodian acting as a trustee for Grayscale’s bitcoin was DCG Holdco, Inc. (“DCG Holdco”) (formally known as SecondMarket Holdings, Inc.). Since August 9, 2015, the custodian acting as the Grayscale Bitcoin Trust is Xapo, Inc. a digital asset custodian founded in 2014 that provides Bitcoin cold wallets, repositories, and Bitcoin-based debit card services.On August 16, 2019, Xapo’s institutional business was acquired by Coinbase Custody. As a result, the actual custodial voice of GBTC is currently Coinbase.

GBTC is required to pay a management fee to the sponsor, i.e. Grayscale, calculated as 2% of the net value of the total value of its assets less its liabilities (the “Consolidated Fee”). The Consolidation Fee accrues daily in Bitcoin and will be paid in Bitcoin at a time determined by the Sponsor in its sole discretion, but it is expected that the Consolidation Fee will be paid on a monthly basis.

In consideration for receiving the Omnibus Fee, Grayscale will assume and pay the following fees and expenses of GBTC: marketing fees, escrow fees, management and sponsor fees, shareholder communication center fees, transfer fee proxy fees, trustee fees, fees not to exceed $600,000 per year related to the OTCQX public transaction (including legal and audit fees and expenses), etc.- -The portion in excess of $600,000 remains the responsibility of GBTC.

GBTC was initially subject to a 12-month lock-up period, but in January 2020, GBTC officially became an SEC-disclosed company, so the lock-up period was shortened from 12 months to 6 months, and shares subscribed in the primary market are freely transferable after 6 months.

GBTC product risks should not be underestimated

Grayscale describes GBTC as a traditional investment vehicle. While the trust itself is not an exchange traded fund (ETF), Grayscale has emphasized to outsiders that it is modeled after popular commodity investment products, such as the gold trust SPDR Gold Trust, which is also a physically backed ETF.

While the Gold SPDR is indeed a common alternative investment vehicle, the risk of this product, GBTC, is quite different from the Gold SPDR and should not be underestimated.

For one, its price is highly deviated from the net value for a long period of time. As a trust fund, the price of GBTC is determined by the net value of its underlying commodity, bitcoin, yet it is also affected by trading conditions and the supply and demand for GBTC itself. As a result, there is often a deviation between the price of GBTC and the net value (NAV), which represents the true value of the assets it holds.

From historical data, GBTC embodies a price deviation from NAV that far exceeds that of other similar products. GBTC’s premium has remained high for a long time, peaking at over 130%, but since March 2021, as the collapse of the global digital currency market accelerated, GBTC’s deviation from NAV quickly shifted from a premium to a discount, and by June 17, 2022, the premium fell to a near one-year low level of around -34%.

In contrast, the premium level of the Gold Trust SPDR, as claimed by GBTC, usually fluctuates steadily between plus or minus 0.5%.

There are a number of main reasons for the price deviation from NAV, to name just three.

First, is that such trust fund products are restricted to eligible investors and are bought and sold on an over-the-counter (OTC) basis, and cannot be bought and sold by ordinary retail investors, which usually means that the liquidity of the product is lower than that of a typical stock, which can easily cause the price of the product to deviate significantly from the underlying physical.

Second, GBTC does not support share redemption, which means that once an investor subscribes to GBTC, they cannot redeem GBTC to grayscale to reclaim their bitcoin, but can only sell GBTC on the secondary market in the U.S. stock market after a six-month lock-up period. this further limits the secondary market liquidity of GBTC, which can lead to significant price deviations when there is a slight demand.

Again, GBTC currently traded in the U.S. OTC market is one of the few compliant BTC trading products currently available and is the only bitcoin spot product, so there is a huge market demand for it. This can cause an influx of more investors when the underlying product bitcoin price rises, pushing up the premium rate; and when the bitcoin price plummets, more people will want to pull out, leading to panic selling and bringing a larger degree of negative premium levels.

All of the above reasons show that GBTC has a large room for price volatility relative to net worth in the secondary market, which is not a safe product for the average retail investor.

Secondly, GBTC charges the trust holders an annual management fee of 2%, calculated daily. This fee is paid with the bitcoin held by the trust and is calculated daily and paid at a time determined by Grayscale. This rate is not low for current market conditions, especially since later-issued bitcoin futures ETFs often have management fees of less than 1%.

One consequence of the high management fee is that since GBTC does not generate any revenue, the daily accrual of the management fee equates to it experiencing daily losses, which, after deducting other compliance expenses and distribution costs, means that the amount of bitcoin represented by each GBTC share will continue to decline, and thus for investors denominated in bitcoin, holding GBTC is a constant downward yield for the For investors denominated in U.S. dollars, they can only hope that the price of bitcoin against the U.S. dollar will continue to rise, so that the dollar income they receive when they sell GBTC will be higher than the dollar cost they paid when they first purchased it.

Third, the liquidity risk associated with the inability to redeem GBTC, which has been closed since 2014, means that investors can only sell their shares in the secondary market to realize a return on their investment. Moreover, due to the inability to redeem, the most investors can do is to resell their shares to other investors, while the underlying assets held by GBTC, bitcoins, have not exited the entire trust asset pool, and therefore are still calculated at the value of all bitcoins when calculating the management fee, which is equivalent to locking in a very substantial and long-standing management fee for Greyscale to enjoy.

It is also because of this status quo that many overseas investors have criticized the SEC, arguing that their delay in agreeing to Grayscale’s conversion of the trust into a full-fledged redeemable spot ETF has actually harmed investors’ interests.

Fourth, the net value of the product may not reflect the value of the underlying assets. Although GBTC’s only asset is bitcoin, it does not equal bitcoin, and its net worth does not correspond one-to-one with the value of the underlying asset, bitcoin.

According to the sales materials filed by Grayscale with the SEC, the bitcoin held by each share of GBTC is settled and announced based on a daily 4:00 p.m. after market close, while the spot price in the global bitcoin market is 24 hours a day for 7 consecutive days, so the net value of GBTC only reflects the value of the underlying asset at a fixed point in time, while the actual value of the underlying bitcoin is a constantly changing value. The disconnect between the two is inevitable. Using the price of GBTC to represent the return on bitcoin investments can be risky for investors.

Fifth, there is a potential conflict of interest between the gray affiliates and their customers. GBTC products, while cleverly designed, meet the requirements of a compliant product. However, under a closer look, it will be found that this product has more serious conflict of interest issues.

Grayscale Trust GBTC is initiated by Grayscale as the sponsor, and customers must go through an authorized participant before they can invest in GBTC, and the cash invested by customers needs to be converted into bitcoins by the liquidity provider to the authorized participant based on the market price.

If the authorized sponsor, the participant and the liquidity provider are three separate institutions, the above structure can provide some protection to investors. However, the only authorized participant in GBTC is Genesis Global Trading, Inc. (Genesis), which is actually a grayscale sister company. Their parent company, Digital Currency Group, Inc. (DCG Group), is both the sole shareholder and parent company of Grayscale and the sole shareholder and parent company of Genesis.

Genesis is also the sole liquidity provider and sole product distribution and marketing agent for GBTC, according to the GBTC website’s product report as of August 2022.

GBTC requires quote providers to reference bitcoin to U.S. dollar quotes when calculating how much bitcoin investors can convert their invested funds into, using quotes from the Coinbase exchange (but grayscale sales materials state that quote providers will not rule out adopting Genesis as a liquidity provider in the future).

The sales materials show that DCG Group also holds shares in Coinbase, and that DCG also holds shares in custodian Xapo.

Thus, it is basically possible to assume that Grayscale and its sister companies could, in extreme cases, underwrite all aspects of subscriptions, distribution, transaction pricing, and redemptions – a major conflict of interest suspect for investors.

Grayscale makes no secret of this in its sales materials, but says “the sponsor has not established formal procedures to address all potential conflicts of interest. Grayscale says that investors may have to rely on the “goodwill” of potential stakeholders to resolve these conflicts “fairly”; but at the same time, it says, “While the sponsor attempts to monitor these conflicts, it is important for the sponsor to It is extremely difficult, if not impossible, for sponsors to ensure that these conflicts do not actually have adverse consequences for the trust.”

The most blunt reminder from Grayscale is that prospective investors should be aware that the sponsor (i.e., Grayscale) believes that by subscribing to this product, the investor has actually acquiesced to the existence of any such conflicts of interest. This move could be considered litigation prevention for Grayscale itself in advance.

GBTC launches a lawsuit against the SEC

Of course, Grayscale is also thinking of ways to mitigate the risks of the product.

Take the suspension of redemptions, for example. Grayscale has been requesting the SEC to release physical ETFs and plans to convert GBTC into a physical ETF. grayscale believes that if GBTC is converted into an ETF, it will quickly solve the redemption problem, which in turn will solve the current problem of significant net worth discount of the product and bring wealth appreciation to investors.

But U.S. regulators have been slow to unbundle bitcoin spot ETFs, making it difficult for GBTC to achieve redeemable operations. Most recently, on June 29, 2022, the SEC denied Grayscale’s request to convert GBTC into a physical ETF. Grayscale expressed its displeasure and requested a rehearing by the SEC that same day. Michael Sonnenshein, Grayscale’s executive officer, then took to his personal Twitter account to say that a lawsuit had been initiated with the SEC.

In an interview, Donald said, “The SEC’s failure to apply consistent treatment to similar investment vehicles is arbitrary and capricious, in violation of the Administrative Procedure Act of 1934 and the Securities Exchange Act. Procedures Act and the Securities Exchange Act …… We look forward to resolving this issue in a productive and expeditious manner.”

However, even if the issue of product conversion to ETFs is resolved, Grayscale still needs to consider how quickly it can address potential related party conflicts of interest.


Post time: Sep-06-2022