Crypto Profile #3: Everything you need to know about the Grayscale Bitcoin Trust

Bitcoin’s price appreciation, along with increasing inflation, is sparking everyone’s interest.

Billionaires including Ray Dalio, Michael Saylor, Elon Musk, Cathie Wood, and Jack Dorsey all own bitcoin. Millions and millions of retail investors now own bitcoin. Even more traditional investors like the Fairfax County, VA gov’t and the South Korea teacher’s public pension funds Union pension fund are seeking bitcoin exposure.

Bottom line: people want bitcoin. 

So, you might think, “Great, I’ll go buy a bitcoin with my Charles Schwab account, right?”

Wrong. 

There’s no exchange traded fund (ETF) available for buying bitcoin in your IRA or stock brokerage account. You can buy a bitcoin futures ETF which tracks bitcoin futures derivatives… but that’s not the same as buying bitcoin via a spot ETF. Plus, futures ETFs tend to be a bad deal.

So, why can’t you buy bitcoin via a spot ETF? In short, the government won’t allow it. 

Despite numerous applications from a variety of companies, the Securities and Exchange Commission (SEC) is not issuing approval to any publicly traded funds for bitcoin spot ETFs. This is a serious problem because people want to invest in an asset that’s averaging 200% annual returns over last ten years.

Bitcoin’s price in black & new addresses added to the network over last ten years. Displayed as a log chart to show network adoption more clearly. Source: Glassnode

The SEC is the federal government agency responsible for approving & regulating publicly traded securities. Securities are basically just stocks; they represent shares of ownership in another entity. By its own declaration, the SEC’s mission is “protecting investors, maintaining fair, orderly, and efficient markets, and facilitating capital formation.” It’s unclear, however, how not approving a bitcoin spot ETF fits with this mission.

Some think that bitcoin’s volatility is why the SEC isn’t approving a bitcoin spot ETF yet. OK, but if an investment is tripling every year…shouldn’t you expect some 30% corrections from time to time? I digress. 

Anyways, the demand to invest in bitcoin remains very strong despite no spot ETF approvals from the SEC. This means that any firm finding a way to provide exposure to bitcoin in traditional IRA and brokerage accounts will have a lot of assets under management.

Well, there is a firm doing this and it’s called Grayscale Investments (“Grayscale”). By leveraging a loophole to provide bitcoin exposure to investors via traditional IRA and brokerage accounts, Grayscale created the Grayscale Bitcoin Trust (GBTC). This trust is publicly traded, invests in bitcoin, and currently holds more than $40 billion in bitcoin.

However, GBTC’s corporate structure is not ideal for investors. This means that it’s risky – but perhaps an amazing investment opportunity.

How GBTC Works

Obviously, if you purchase GBTC, you aren’t purchasing bitcoin directly. Instead, you’re purchasing shares of an investment trust that holds bitcoin.

As reported by Ty Young at crypto research firm Messari, here’s essentially how GBTC works:

  1. Grayscale raises money from accredited investors & funds.
    • These investments are made via private sales; which means that non-accredited investors (i.e. normal people) can’t participate.
  2. Grayscale uses the money to purchase bitcoin.
  3. After a 6-month “lock-up” period, accredited investors & funds are allowed to sell their GBTC shares in over-the-counter (OTC) markets.
  4. Retail investors can buy GBTC shares sold by accredited & institutional investors in the OTC markets via their stocks or brokerage accounts.

Historically, this means that something like this plays out (numbers are hypothetical):

  1. Wealthy accredited investors privately invest $1,000 into GBTC & receive 100 shares of GBTC in return
  2. GBTC purchases $1,000 of bitcoin with the $1,000 investment
  3. Six months pass & then wealthy accredited investor sell their 100 shares of GBTC to retail investors via OTC markets
  4. Since GBTC is the only way to buy bitcoin in a brokerage account, retail investors are willing to pay a premium for these shares. So, retail investors pay $1,200 for 100 shares of GBTC (which only have $1,000 of bitcoin backing them)
  5. Thus, in addition to however much bitcoin appreciated, wealthy accredited investors make an additional 20% on the backs of limited retail investors

Is this a great deal for retail investors? Not exactly, but we’ll discuss that more in a bit.

The benefits of GBTC

Admittedly, GBTC is not all bad and Grayscale is not really the bad guy here (not yet, at least). Grayscale is simply working within the rules of the game.

So, given the rules of the game, there are self-proclaimed notable advantages or benefits to owning GBTC that include:

  1. Storage & security: you don’t have to manage private keys or a crypto wallet. Grayscale does all that for you.
  2. Assets are held by regulated institution: it’s not you, your nephew, or even a newer company like Coinbase…Grayscale is an experienced manager.
  3. IRA-eligible: you can buy & trade Grayscale via your IRA or brokerage account.

These benefits are a big deal. Bitcoin is outperforming virtually all asset classes. So, even if the arrangement is suboptimal, the simplicity and sheer ability to buy bitcoin in your IRA is a huge benefit.

The risks and downsides of GBTC

To summarize the massive risks/downsides, GBTC does not offer much assurance that investors will be well-served. 

Let’s look at the terms they released in a 2020 briefing about GBTC. Can you read this?

Yeah, neither could we.

Seriously. We were forced to do a 200% zoom with our computer to be able to read this. Look, disastrous and important fine print like this, buried at the bottom of meaningless and boring information… it’s why why traditional finance needs to go the way of the dodo bird. 

Meanwhile, “shadowy super-coders” working on crypto projects publish beautiful tokenomics very clearly on their websites, like this one from multi-billion dollar crypto project Axie Infinity:

Axie Infinity token (AXS) allocation & unlock schedule from Axie’s whitepaper.

Anyways, back to the point, besides the absurd minimization of the fine print, let’s look at two of the crucial points written in small letters: 

  1. You can’t redeem your shares and they may be worth way less than the bitcoin we bought with your money. Yes, that’s basically what Grayscale says under (tiny) point #4 in the fine print. The point literally reads, “The shares of each Product are intended to reflect the price of the digital asset(s) held by such Product (based on digital asset(s) per share), less such Product’s expenses and other liabilities. Because each Product does not currently operate a redemption program, there can be no assurance that the value of such Product’s shares will approximate the value of the assets held by such Product,” I mean, what in the world? This means GBTC is like a blackhole that sucks in your money to buy bitcoin on your behalf… but provides no ability for you to ever access that bitcoin and no assurances that your irredeemable IOUs will be worth the underlying bitcoin. 
  2. We are gonna charge you really high fees for us to do nothing strategically. Not kidding. Currently, GBTC manages roughly $4.4 billion in assets. This means that GBTC will pay themselves $88 million during the next year to manage those assets. This is a *very* high expense ratio for a fund that is doing, frankly, zero strategic management. Grayscale just buys bitcoin and stores it. For the sake of comparison, a 2% annual fee for assets under management is 100% more than many actively managed funds requiring strategy & portfolio adjustments. To be fair, it’s true that managing $4.4 billion in crypto isn’t a small task. You can’t just stick all that in a single bitcoin wallet and give the password to a random employee. However, these fee levels are still alarming since GBTC asset management requires virtually no strategy beyond custody. Even more troubling, due to the Lightning Network and other decentralized protocols, there are actual investment strategies wherein Grayscale could earn yield on their assets under management. But, as it says at the start of small point #7: “The Product will not generate any income and regularly sells/distributes the digital asset it holds to pay for its ongoing expenses.” Woof. This isn’t efficient or strategic capital management. 
  3. Your shares will represent less bitcoin every year because of the high fees. That’s what Grayscale is saying at the end of tiny point #7: “…the amount of the applicable digital asset represented by each share will gradually decline over time.” Since they aren’t generating any income with the purchased bitcoin, Grayscale will gradually make your bag smaller so they can pay themselves high fees. Therefore, the amount of the applicable digital asset represented by each of your shares will gradually decline over time. That’s rough. 
Top Bitcoin on-chain data analyst Willy Woo notes the high GBTC fees. Oct21, 2021.
Source: Twitter.

How Retail Investors Got “Rekt” by GBTC

Historically, GBTC’s structure means that something like this plays out (numbers are made-up to demonstrate the point):

  1. Wealthy accredited investors privately invest $1,000 into GBTC & receive 100 shares of GBTC in return
  2. GBTC purchases $1,000 of bitcoin with the $1,000 investment
  3. Six months pass & then wealthy accredited investor sell their 100 shares of GBTC to retail investors via OTC markets
  4. Since GBTC is the only way to buy bitcoin in a brokerage account, retail investors are willing to pay a premium for these shares. So, retail investors pay $1,200 for 100 shares of GBTC (which only have $1,000 of bitcoin backing them)
  5. Thus, in addition to however much bitcoin appreciated, wealthy accredited investors make an additional 20% on the backs of limited retail investors

Practically, GBTC’s structure means that accredited investors bought $100 worth of bitcoin via GBTC shares and then sold it to retail investors for $120, $150, or even $200.

To be clear: this suboptimal structure for retail investors is pretty much entirely driven by the SEC dragging its feet on a bitcoin spot ETF as well as archaic accredited investor laws. Thus, the SEC literally made the wealthy richer at the expense of normal people.

Not fair. 

Even if GBTC continues to increase in price, the returns for retail investors will fall very short of the accredited investor returns they subsidized.

To make matters worse, GBTC shares began to trade at a discount to their net asset value (NAV) in March of 2021. For the first time ever, the GBTC shares were actually worth less than the underlying bitcoin they represented. 

GBTC percentage discount/premium to its underlying bitcoin.
Source: ycharts.com.

There may be multiple reasons for GBTC’s current price trading at a discount to its NAV, including: 

  1. investors finally understood that GBTC may never let them redeem their shares for actual bitcoin
  2. the market turned bearish and so people don’t want to pay 2% management fees + a premium to buy an asset they think could decrease by 10% or more in the next year

Regardless, the GBTC premium flipping to a discount further damaged retail investors. Many of these investors incurred losses, or at least very large opportunity costs, compared to the gains they could’ve realized via a bitcoin spot ETF or no accredited investor rules.

Ultimately, the SEC and its Chair Gary Gensler ought to be embarrassed by what’s happened with GBTC. Over and over, they talk about protecting investors. But, when it comes to bitcoin, they’ve prevented millions of people from participating in the market’s best asset class. Even worse, the SEC instead let investors get wrecked (or “rekt,” as crypto natives like to say) by GBTC. 

Again, lots of retail investors did make money on GBTC. But, even the best ones got “rekt” in terms of the opportunity cost of a bitcoin spot ETF.

Where do we go from here?

Unfortunately, the GBTC discount to underlying bitcoin may get worse before it gets better. As reported by Ryan Selkis at Messari, $5 billion worth of GBTC shares are close to finishing their lock-up period. This means that investors could dump these shares in the OTC markets and drive the price of GBTC lower.

In fact, some are speculating that this upcoming unlock of GBTC shares is perhaps why the SEC approved a bitcoin futures ETF but not a simple, clear bitcoin spot ETF. If a bitcoin spot ETF is approved and people can buy bitcoin spot ETFs rather than GBTC shares, then the price of GBTC shares could plunge even lower.

Maybe they don’t want this debacle to get worse? It’s all just speculation at this point. However, with upcoming unlocks of GBTC shares as well as possibly better options via approved bitcoin spot ETFs, GBTC’s discount could plunge even lower and further damage retail investors.

With that said, not all hope is lost.

Why GBTC could be a great investment right now

Recently, the Grayscale Investments Communications Director Jennifer Rosenthal reiterated earlier statements indicating that Grayscale plans to convert GBTC into a spot ETF via Twitter.

Grayscale Director reiterates plans to convert GBTC into ETF. Oct18, 2021.
Source: Twitter

Converting GBTC into a spot ETF would mean that the shares would be redeemable for bitcoin. So, things are all good, right?

It’s not quite that simple.

Incredibly, Grayscale’s parent company Digital Currency Group (DCG) is currently buying GBTC shares at their massive discounts to underlying bitcoin. They did this earlier in the year and recently announced that they are now authorized to purchase up to a total of $1 billion worth of GBTC.

Tweet from Ryan Selkis about DCG buying GBTC shares
Tweet from Ryan Selkis on Grayscale’s parent company purchasing GBTC shares.
Source: Twitter.

This means Grayscale is incentivized to drag its feet on converting GBTC into a spot ETF. This will give its parent company more time to buy GBTC shares at a discount before converting GBTC into a spot ETF. So, by keeping its current structure, Grayscale can:

  1. Collect high fees for managing the trust, indefinitely
  2. Make GBTC’s discount to underlying assets worse due to this poor structure. This puts pressure on retail investors to capitulate and sell their GBTC at massive discounts
  3. Buy tons of GBTC shares at these large discounts via parent company
  4. Convert GBTC into a spot ETF whenever they want and instantly see the value of those share snap back to the value of the underlying bitcoin; realizing a profit of 20% or more

Again, this isn’t criminal. Grayscale is simply playing by the rules of the game. It’s easy to argue, and in many ways actually true, that Grayscale helped retail investors gain exposure to bitcoin when no one else did and are now simply ensuring GBTC holders can find buyers for their shares.

Even still, the entire scenario is insane. It’s like Grayscale is playing two massive games of chicken. One game is with the SEC, in which Grayscale dares the SEC to approve bitcoin spot ETFs. Another game is with retail investors, in which they dare retail investors to sell GBTC shares at a discount (or even a loss).

Wow. To borrow another crypto phrase, that’s some “4-D chess.”

Takeaways

Given this whole drama, here are our key takeaways:

  1. GBTC both helped and harmed investors. They helped investors get exposure to bitcoin in publicly traded markets when no one else did. But, the structure was and is suboptimal for retail investors.
  2. Buying GBTC now vs. waiting for a spot ETF is a judgment call. There are multiple bitcoin spot ETFs awaiting approval right now. If you think some will be approved in the near future, it might be worth waiting for a spot ETF which should carry a lot less risk.
  3. If you trust Grayscale, then GBTC could be an amazing investment. If indeed Grayscale converts GBTC to a redeemable spot ETF as soon as their application is approved, the GBTC discount to its underlying assets will evaporate. This means buying GBTC right now is like buying bitcoin at a 15% discount.
  4. If you don’t trust Grayscale or have a shorter time horizon, then you probably shouldn’t purchase GBTC. Remember: GBTC is under no legal obligation to convert its fee-generating trust into a spot ETF. So, Grayscale could continue to collect its high fees indefinitely. What’s more, if bitcoin ETFs come to market, then the demand for suboptimal GBTC shares could plummet; furthering exasperating GBTC’s discount to NAV.
    • For what it’s worth, we think that it’s probably a safe bet that Grayscale will convert GBTC into an ETF at some point in the next year or so. Once the SEC starts approving spot bitcoin ETFs, it would be strange for them to deny an application from Grayscale. And, given Grayscale executives are publicly committing to pursuing ETF status, it seems unlikely that Grayscale could walk such a commitment back without serious public outcry or even possible litigation.
  5. We still prefer to invest in bitcoin & crypto directly. Unless you must invest via an IRA or brokerage account, we generally believe purchasing bitcoin outright from exchanges like Coinbase Pro, FTX.us, or BlockFi is a better play on many levels.

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Further Resources

  • How to buy GBTC via brokerage account: we recommend IBKR as the best platform for purchasing publicly traded equities like GBTC. The fees are lower than (including Robinhood, which charges you fees indirectly through higher prices) and the interface is intuitive for traditional finance. Make sure you signup via this link to receive free IBKR stock.
  • How to buy bitcoin directly: our favorite U.S. crypto exchanges for converting your USD into crypto are FTX & Coinbase Pro. Both have some of the lowest fees and widest range of options.
    • Click here to open a FTX account & receive a 5% discount on your trades.
    • Click here to open a Coinbase account & earn $10 in Bitcoin when you’ve made $100 in crypto purchases. NOTE: after creating a Coinbase account, we recommend using Coinbase Pro for lower fees and more options.
  • How to easily earn interest on any bitcoin you buy: if you want to easily earn interest on your bitcoin, then you can open an account with BlockFi here. Currently, BlockFi is paying anywhere between 1 to 4.5% on up to 0.35 BTC (roughly $20,000) deposited into their accounts.
  • How to buy bitcoin in your IRA: we recommend using Vanguard due to their low fees and trusted reputation. You can signup for an IRA account on their site here. (Sorry, no bonuses for you or us)
  • On the loophole that GBTC utilizes: Grayscale takes advantage of Rule 144 of the Securities Act. If you care, you can read more about it here.
  • On GBTC’s parent company buying GBTC shares: Messari’s Ryan Selkis released a blazing tweet thread about how this all works on October 20, 2021.. You can read it in full here.
  • On all the other crypto trusts that Grayscale runs: it’s worth noting that Grayscale also manages several other publicly traded crypto trusts; including the Grayscale Ethereum Trust (ETHE). You can view the full list on their website here.
  • On misconceptions about GBTC: here’s another solid article from Messari. This article specifically addresses a lot of misconceptions; but it’s admittedly a little old (June 2020).