Hi All,
Recently, I’ve been thinking about crypto ETF funds. Indeed, institutions are coming.
While this may be a bullish event - and maybe why the market has been trading flat YTD (institutional buying vs retail selling) - we can dig deeper.
Crypto ETFs were brought to the forefront following a landmark court ruling against US regulators. It has opened the door for Grayscale to launch a US-listed exchange traded fund (ETF) that tracks the price of Bitcoin.
While this may seem like a good thing, I will show you why Grayscale should have wanted to lose the case below! Winning is a poisoned chalice.
Let’s dive in.
Below is a short note on the status of crypto ETFs. It elucidates how Grayscale shoots itself in the foot.
Not advice. I'm not a financial advisor. I own crypto. The thoughts & opinions here are my own and should not be taken as financial advice or as my employer’s thoughts. Always do your own research or talk to a professional before making any financial decisions.
Summary
Grayscale Investments LLC is the largest digital currency asset manager ($21.5bn AUM) and is a subsidiary of Digital Currency Group (owned by Barry Silbert). It manages a plethora of crypto-backed trusts. The largest of these is the Grayscale® Bitcoin Trust (GBTC); a pot of Bitcoins it safeguards. The funds own $16.1bn in Bitcoin, making them the custodians of c.3.2% of all available Bitcoin.
Fees, Fees, Fees
Managing digital assets is extremely hard - even I struggle! Hence, the GBTC is helpful as it enables investors to gain exposure to Bitcoin (BTC) as a security while avoiding the challenges of directly buying, storing, and safekeeping BTC.
And you can BET that Grayscale charges a pretty penny for their trouble! It charges 2% per year on a pot of $16 billion. All it has to do is hold the funds! It then earns $320m a year! As the price of BTC goes up, the more money they make. They are literally printing money.
Grayscale (strangely) has plans to go bigger…
Mo’ Funky Structures, Mo’ Problems
While this seems like a money printer, the quirk is that… as an investor, you can’t take your money out! In other words, yes, you can create new shares by giving Grayscale Bitcoins, but you cannot reverse it. The black box may grow, but it will never shrink (unless fees are being taken). N.B: You can sell the shares but not get BTC out.
This leaves investors in a tricky spot. If you’re thinking, who would even want to own this? You’d be right. GBTC trades at a discount to the value of its underlying BTC. Though the discount has been > 40% (!), it has since recovered.
As you can see, the opposite was the case in the past, as GBTC traded at a premium. If you gave them $100 worth of Bitcoin, you would get shares back that trade for $100+. Naturally, this created an opportunity where investors POURED Bitcoin into the trust.
Assuming a 2% fee across 10 years gives you a discount of c.18% (=1/((1+2%)^10), which is very close to the current discount (pre inflation and consideration for a T-Bill hurdle rate). In other words, if there was a liquidation or the GBTC was updated to be redeemable (BTC can exit) *WINK WINK*, theoretically, arbitragers would rapidly act to redeem the trust’s shares for BTC to close the discount difference. Remember this as we will come back to this point.
N.B.: Discounting Maths as of Jul-31-23: ((GBTC Trading price/ (0.00090232*Bitcoin Price)
Enter The Grayscale ETF
Grayscale wants to convert GBTC into an exchange-traded fund. As digital assets continue to develop, to capitalise on institutions that are looking for exposure in crypto, Grayscale intends to evolve into a BTC ETF. However, the US SEC has historically rejected or delayed its approval. Grayscale sued, and a few weeks ago, it “won” in court. A federal appeals court ruled the SEC was wrong to reject Grayscale’s application to convert GBTC into an ETF.
4D Chess or Knocking over the Queen?
I think Grayscale thinks that they are playing 4D chess. From the outside looking in, here’s their logic:
A BTC ETF
wouldshould allow people to take out BTC from GBTC by cashing in their shares (speculation)In theory, this means that it pays out BTC to investors and therefore, its NAV would fall until it equals the price of the GBTC, hence closing/reducing the discount
Therefore, the price of the shares would stabilize or even increase as people buy shares to take advantage of the conversion to BTC/repricing
Hence, eventually, the premium should close as the share price is ~ NAV
If it overshoots into a premium, BTC would get deposited and the AUM may grow!
AUM increases → PROFIT
In fact, Grayscale would try to use its brand name to grow even bigger as THE way for investors to own Bitcoin
While this sounds compelling, launching a Grayscale ETF would be signing its death warrant. I mean, what if the above doesn’t work? What if the share price falls with NAV (keeping the discount at c.18%)? Will the trust be liquidated at a fee?How does the transfer work? Uncertainty may cause the price to fall further.
Fees & A Race To The Bottom
But there’s another critical nuance in this thought exercise - Grayscale isn’t the only party trying to get a BTC ETF. Other players such as BlackRock, WisdomTree, Invesco Galaxy, Wise Origin, VanEck, Bitwise and Valkyrie Digital Assets have all made an application to the SEC (which has delayed its decision to October).
If Grayscale gets an ETF, so will ETF Titans like BlackRock and Fidelity. And you know what these Titans like? Low fees! If BTC ETFs are approved, there would be a massive race to the bottom in terms of fees. Compared to GBTC’s fee of 2%, the average ETF have a fee of 0.54% across US ETFs (Bloomberg Intelligence). 0.5%!
If all the aforementioned crypto ETF applicants are approved, Grayscale are in a world of pain. If I was a betting man, I would bet that BlackRock and others have been quietly accumulating BTC; this means that they can launch quickly and keep front running BTC buys to a minimum. After all, maintenance is several USB sticks guarded by a multi-sig vs a fortified mountain required for Gold bars.
Similarly, everyone would simply buy using the platform with the lowest fees (presuming distribution of the products are similar).
Conclusion
While it might seem like a victory, Grayscale's potential conversion of GBTC into a Bitcoin ETF could bring numerous challenges, not least of which is increased competition and fee pressure.
On reflection, Grayscale has fought the good fight but I also predict that they will massively drag their feet and hold off launching the ETF. They are highly incentivised to keep their magic money tree.
They may have won the battle, but I predict that they’ll lose the war. Or maybe I’m missing the 4D chess move. Let me know what you think in the comment below or message me via Twitter DMs.
Thanks for reading,
God bless.
Joseph - 16 September 2023