Breaking Down the Causes and Effects of Grayscale’s GBTC to Bitcoin Spread

Unleashing redemptions may be the most direct and effective way to fix the GBTC discount, but Grayscale is trying to fix it by converting to an ETF.

Written by Kai Hao, working at HashKey Capital Research
Reviewed by Chuanwei Zou, Chief Economist at Wanxiang Blockchain

Recently, Grayscale CEO Michael Sonnenshein said that converting to an ETF could solve many of the problems with Grayscale Bitcoin Trust. By converting the Bitcoin Trust to an ETF, he said, the disconnect between the price of GBTC and its bitcoin (BTC) holdings could be fixed. Looking at the arbitrage mechanism built into the ETF, any discount or premium of the stock to the net asset value of the ETF would be offset.

As you can see from this quote: first, there is a spread between GBTC and BTC, and that spread is already significant; second, Grayscale believes that a change to the status quo is needed; and third, converting Bitcoin Trust to an ETF is a viable solution. In the cryptocurrency space, Greyscale Bitcoin Trust is the largest and most well-known bitcoin investment product in terms of positions, and therefore requires an in-depth study of the price of GBTC.

Why is there a spread between GBTC and Bitcoin?
The mechanics of how the Grayscale Bitcoin Trust works have been described in detail in “The Design and Impact of Bitcoin Financial Products” (Vol. 4, No. 101, 2021). Eligible investors give BTC or USD (to buy BTC) to Grayscale and then receive the corresponding amount of GBTC (each BTC corresponds to approximately 1000 shares of GBTC). After waiting for six months, qualified investors can sell GBTC on the secondary market, but cannot use GBTC to redeem their BTC or USD from Grayscale.

The spread between GBTC and BTC is primarily a product of a combination of arbitrage mechanisms and market sentiment, among other factors. The product structure of the Grayscale Bitcoin Trust is a one-way flow, with only BTC flowing in but not redeemable. As a result, the arbitrage mechanism of the Grayscale Bitcoin Trust is not fluid, which is the root cause of the spread between GBTC and BTC. Market sentiment is also an important factor as qualified investors are able to obtain GBTC directly from Grayscale, while regular investors can only purchase it from the secondary market. The cryptocurrency market is an emerging market, and ordinary investors in the market usually do not have professional investment knowledge and experience. At the same time, cryptocurrencies themselves have relatively high price volatility, which is more likely to lead to investor greed or fear, which in turn can have a significant impact on the price of GBTC. For example, if there is a sudden and significant increase in the number of ordinary investors and the number of GBTC sold by qualified investors is limited, then there will be a significant premium for GBTC on the secondary market. Conversely, if there is a sudden decrease in the number of ordinary investors, which means that fewer investors are buying GBTCs on the secondary market, GBTCs will be at a discount.

When does the spread start to appear?
As you can see from the chart below, due to the separation of the primary and secondary markets, GBTC has a long-term premium, meaning that the price of GBTC is higher than the price of its corresponding BTC.

Breaking Down the Causes and Effects of Grayscale's GBTC to Bitcoin Spread

Figure 1: Market Value of Grayscale Bitcoin Trust Shares vs. Real Value of Bitcoin

When there is a premium for GBTC, a rational investor should buy BTC directly instead of buying GBTC in the secondary market at a higher price. so when there is a premium for GBTC, why are there still a large number of investors willing to buy it in the secondary market?

First, GBTC is a compliant product, a feature that is relatively scarce in the cryptocurrency space. Buying and holding GBTC can circumvent regulatory uncertainty and tax uncertainty. If investors want a regulated BTC trading product, GBTC is a very suitable choice. But Grayscale is only available to qualified investors, and the minimum deposit amount is $50,000, which is a very high threshold for the average investor. Therefore, ordinary investors can only take the second best option and buy GBTC, a regulated and compliant product, on the secondary market.

Secondly, there has been a lot of recent market heat in the entire cryptocurrency market, which has attracted many new investors to participate. They lack the cryptocurrency expertise to identify malicious fraudulent projects, and choosing GBTC avoids this problem and does not require them to deal with technical issues such as cryptocurrency wallets and private keys themselves.

Thirdly, investors in the secondary market are optimistic about the price trend of GBTC. They feel that the price of GBTC will continue to rise, the premium will continue to be maintained, and they will be able to receive a premium when they sell in the future. At the same time, the market volume of GBTC is relatively large and liquid, so investors will also find it not too difficult to sell in the future.

Why does it become a discount?
Since the spread between GBTC and BTC has existed for a long time, why did Grayscale only recently indicate that it would make a change? This is because GBTC has maintained a premium for a long time, but since around February this year, GBTC has become a discount (negative premium) for several months in a row, and even a negative premium of more than -20% at one time, as shown in the chart below. This has never happened before in the history of GBTC.

Breaking Down the Causes and Effects of Grayscale's GBTC to Bitcoin Spread

Figure 2: GBTC Premiums in the Last Year

As you can see from the two charts below, the amount of bitcoin held in grayscale increased dramatically in 2020, with inflows at one point exceeding the value of bitcoin mining over the same period. This was particularly evident from August to December, with many days having a net daily increase of over 5,000 BTC. GBTC is locked for 6 months, which means that from February 2021 onwards, large amounts of GBTC will continue to be unlocked and flow into the secondary market. However, the number of investors in the secondary market has not increased that much, so the supply of GBTC far exceeds the demand, thus turning from a premium to a discount.

Breaking Down the Causes and Effects of Grayscale's GBTC to Bitcoin Spread

Figure 3: Number of BTC held by Grayscale in the last year

Breaking Down the Causes and Effects of Grayscale's GBTC to Bitcoin Spread

Figure 4: Daily net increase of BTC in grayscale in the last year

At the same time, the price of BTC has increased very much in the last year. As shown in the chart below, during the period when GBTC was discounted (red box), the price of BTC was at least above $30,000, while when it was bought 6 months ago (blue box), the price of BTC was around $10,000. In other words, for qualified investors who bought GBTC from Grayscale, even with a 20% discount, they are still significantly profitable from a fiat currency perspective. Therefore, a discount of this magnitude does not affect their ability to sell GBTC.

Breaking Down the Causes and Effects of Grayscale's GBTC to Bitcoin Spread

Figure 5: Price Trend of BTC

Moreover, the GBTC premium will correlate with the price of BTC. When the price of BTC rises, market sentiment is overly optimistic and the GBTC premium increases, while when the price of BTC falls, market sentiment tends to be cautious and the GBTC premium decreases. This recent time has seen a weakening in the cryptocurrency market, which has somewhat reduced the demand for GBTC from secondary market investors.

The chart below represents the daily unlocked volume of GBTC. As you can see from the chart, there will continue to be a large number of GBTC unlocks in May and June, which will have a calming effect on the price of GBTC in the secondary market, and GBTC will likely continue to remain at a discount.

Breaking Down the Causes and Effects of Grayscale's GBTC to Bitcoin Spread

Figure 6: Daily Unlocked Volume of GBTC

What is the impact of the discount?
The nature of the Grayscale Bitcoin Trust product dictates that it will accumulate an increasing amount of BTC, which currently exceeds 650,000. The Grayscale Bitcoin Trust is the equivalent of a forced lock-in, reducing BTC selling and gradually becoming a powerful long force in the cryptocurrency market. During the upward cycle of the market, every time Grayscale increases its BTC holdings, it generates buzz and a following. But there are two sides to the coin. Once GBTC fails to reverse the discount in the long run, then the influence of Greyscale will backfire on the market and affect investors’ confidence.

According to the data published by Grayscale, most of its clients are institutions. Institutional investors are careful to control their risk exposure, and they are more likely to arbitrage through Grayscale. They buy GBTC and open short orders for BTC (such as CME’s BTC futures). This way, when GBTC is unlocked, they can sell it in the secondary market and gain a premium. It is important to note that if these institutions borrow BTC and then arbitrage it through grayscale, the discount will directly cause them to lose money.

Since GBTC is not directly redeemable, the price anchor between GBTC and BTC is not completely solid, and may even require some consensus to maintain. However, continued discounting may affect this consensus, which means that there is a possibility that the discount on GBTC will continue to get larger. At the same time, the GBTC discount may also have a direct impact on the BTC trading market.

How to deal with GBTC discount?
As mentioned above, the poor arbitrage mechanism is the root cause of the spread. So when Greyscale wants to solve the discount problem, releasing redemptions is the most effective way, and arbitrageurs will quickly flatten the spread between GBTC and BTC. Releasing redemptions has some implications for Grayscale. First, the Grayscale Bitcoin Trust charges a 2% annual management fee, which will likely be reduced after redemptions are released. Second, if the Grayscale Bitcoin Trust does not have enough funds in reserve, then it will not be able to complete the redemption (a very unlikely scenario).

Grayscale is already addressing the discount issue. in March 2021, Grayscale’s parent company, Digital Currency Group, announced that it would purchase $250 million of GBTC, however this did not reverse the discount. Recently, Grayscale has also said that converting to an ETF would solve many of Grayscale Bitcoin Trust’s problems. U.S. regulators have never approved the ETFs in question out of a desire to protect investors, as they believe the cryptocurrency market is not transparent and easily manipulated.

There are a number of new BTC products on the market, MicroStrategy has issued senior convertible bonds and used the proceeds to purchase BTC, MicroStrategy offers a low risk product that captures the value of BTC. Canada has issued three bitcoin ETFs, and these BTC products are more reasonable, as investors do not need to lock in their positions and are not exposed to the risk of BTC price declines during the lock-in period. Also, secondary market investors no longer have to buy products with spreads.

Posted by:CoinYuppie,Reprinted with attribution to:
Coinyuppie is an open information publishing platform, all information provided is not related to the views and positions of coinyuppie, and does not constitute any investment and financial advice. Users are expected to carefully screen and prevent risks.

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