Dear readers,
On Monday, SEC Chair Gary Gensler stated that bitcoin was a commodity.
Yesterday, the SEC rejected yet another spot bitcoin ETF.
Despite the safety that the word commodity implies, the SEC rejected Grayscale’s bid to convert its closed-end bitcoin fund into a spot bitcoin ETF, which would cause shares to better track the bitcoin price.
In today’s post, we’ll be covering the GBTC discount to net asset value (NAV), why converting to an ETF is in the best interest of GBTC investors, and some possible scenarios for GBTC as Grayscale enters into a legal battle with the SEC.
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GBTC’s discount to NAV, and why an ETF would ameliorate it
Converting GBTC into an ETF would have solved the ongoing problem with the product—its persistent and widening discount to the market value of its underlying bitcoin holdings.
GBTC functions like a closed-end fund, in which new shares cannot be created and redeemed in line with fluctuating demand (which is how an ETF functions). An ETF has what’s called a redemption mechanism—a method for reconciling the difference between net asset value (NAV) and market value. This process prevents shares of an ETF from trading at a discount or premium to its underlying asset holdings.
In this chart, the blue line is GBTC’s NAV, the white line the share price, and the GBTC discount/premium to NAV is on the bottom pane. You can see the deep negative ratio:
GBTC is trading at a 28% discount to NAV. This spread represents an ~$8 billion unrealized shareholder value.
This occurs because bitcoin was added to the fund as new investors demanded GBTC; as demand waned and GBTC was sold, bitcoin that was locked in the fund wasn’t sold at the same rate as demand waned, causing shares to trade lower than the NAV of the trust.
A narrowing discount or flipping into a premium would indicate increased demand due to an imminent spot ETF approval or another positive catalyst, while a widening discount indicates continued sell pressure.
Converting GBTC into an ETF would close this discount and allow GBTC to track the bitcoin price.
That said, investors in GBTC would experience an appreciation of their holdings equal to the size of the discount, which could continue to widen if a spot ETF becomes increasingly less likely and investors continue selling.
GBTC asset allocation
Grayscale automatically sells 2% of the fund every year as a management fee, which is 35 BTC/day of its 648,070 BTC (3% of the total bitcoin supply) in AUM. This is more than double the management fee taken by the ProShares Bitcoin Strategy ETF (which holds CME-traded bitcoin futures).
Grayscale holds only bitcoin in GBTC.
3AC is the largest holder of GBTC
Three Arrows Capital (3AC), a crypto hedge fund recently entangled in major liquidity issues, holds 38,888,888 shares, equating to $530 million - or 75x the average daily traded volume of $7 million in GBTC.
3AC was recently ordered to liquidate all remaining assets by a court in the British Virgin Islands after failing to meet several loan obligations totaling well over $1 billion.
GBTC simply isn’t a liquid enough market for 3AC to dump its holdings without severely hampering the price and widening the discount to NAV.
In the coming days and weeks as 3AC liquidates its remaining GBTC, expect the above scenario to play out and for the trust to sink into an even deeper discount to NAV. Note: we don’t know how much of this liquidation has already taken place and how much is left to come.
Converting GBTC into a spot bitcoin ETF would eliminate the discount and cause the shares to track the price of bitcoin. If you’re viewing an eventual spot ETF conversion as highly probable, buying (soon-to-be) fairly-priced bitcoin exposure at a 28% discount is an enticing opportunity.
Implications of an ETF conversion
Institutions locked into legacy financial system rails have no way of deploying capital into a vehicle tracking 1:1 with bitcoin. This is both a travesty and a function of a young, misunderstood asset. An ETF would allow for billions of dollars of capital locked within traditional institutional instruments to gain exposure to genuine bitcoin movements.
If you’re a holder of GBTC, there are a few things you should know:
You cannot convert your GBTC into BTC directly.
This means you cannot self-custody your GBTC as you would ordinary BTC, introducing elevated counterparty risk and present insolvency risk if Grayscale’s parent company (DCG) were to go belly-up.
If you’re extremely underwater, don’t panic yet. The discount is poised to narrow as the timeline for a spot ETF in 2023 or 2024 approaches.
If you decide to purchase GBTC looking to nab (potential) fairly-priced bitcoin exposure at a 28% discount, understand the risks we’ve outlined in this post. The internals suggest that this arbitrage will eventually pay out, but are investors willing to wait up to two years?
The SEC has no basis for these continued rejections
The SEC has rejected countless spot ETFs of bitcoin despite approving several derivatives ETFs. The ProShares Bitcoin Strategy ETF, Valkyrie Bitcoin Strategy ETF, and VanEck Bitcoin Strategy ETF are all funds holding CME-traded bitcoin futures. If the SEC feels comfortable with investor exposure to derivatives of bitcoin that lack the immutable governance of bitcoin (bitcoin is undeniably safer), what’s the hold-up in approval of a spot ETF?
The SEC cites potential fraud and manipulation as the reason for its frequent spot ETF rejections—it is much more comfortable allowing CME-regulated futures to be held by bitcoin ETFs, as their regulation is in the hands of a centralized legacy financial institution, lessening the chances of fraud under the CME’s purview.
This is a baseless reason for vetoing Grayscale’s spot ETF bid. First of all, Grayscale has had no solvency issues whatsoever in the nearly nine years of GBTC trading publicly. Its healthy balance sheet is visible to everybody who wishes to view it in quarterly and annual financial reports filed with the SEC. Fraud and manipulation seem more like a cookie-cutter rejection than reasoning specific to Grayscale’s trust.
The SEC has no problem with synthetic bitcoin derivative ETFs. The SEC has no problem with a short bitcoin-linked ETF. It’s illogical for them to have a problem with a perfectly solvent and reputable trust such as Grayscale taking a spot ETF to market.
Grayscale v. SEC lawsuit could take 12-18 months
With yesterday’s decision to enter into a lawsuit with the SEC, Grayscale could be looking at a lengthy and costly court battle which it is unlikely to win, according to Bloomberg.
For now, add GBTC to the bitcoin spot ETF graveyard, where seven other attempts have been laid to rest in 2022 so far.
Severe mispricing has caused GBTC to falter in the eyes of investors from a logical alternative for bitcoin exposure into a deeply undervalued and illiquid claim on bitcoin which continues to be battered by regulatory limbo. It’s the SEC’s stated objective to protect investors, but closed-end funds that are highly illiquid and trade at a steep discount to bitcoin objectively threaten investors. Deep cognitive dissonance is going on at the Securities and Exchange Commission.
SEC delaying spot ETF after spot ETF is not motivated by fear of bitcoin’s fundamentals as a digital commodity, but rather by unsubstantiated fears of fraud and market manipulation in a relatively illiquid market that would be made exponentially more liquid with a spot ETF approval. Frankly, it’s embarrassing that the SEC is dragging its feet thirteen years on, rejecting proposals in a rapid-fire fashion like it has an underlying agenda.
Its dismissiveness has turned to panic, and its panic has turned into an offensive affront, intentional or otherwise, to bitcoin adoption.
Bitcoin is antifragile—its fire grows stronger as the gasoline of negative externalities is poured upon it. The SEC is one of bitcoin’s most formidable enemies yet, adding excessive downward pressure through multiple mispriced derivative vehicles.
What do you say, Gensler, is it time to protect the investor?
Until next time,
Joe & Nik
This post was sponsored by Voltage, provider of enterprise-grade Bitcoin infrastructure.