The World's Biggest Bitcoin Fund Is Broken

The World's Biggest Bitcoin Fund Is Broken
Reda Farran, CFA

almost 3 years ago5 mins

What’s going on here?

With a market capitalization of over $35 billion, the Grayscale Bitcoin Trust (ticker: GBTC) is the world's largest bitcoin investment fund, popular with retail and institutional investors alike. Ark Investment Management is in fact the fund’s biggest holder: institutional investors’ rules usually don’t allow them to purchase bitcoin directly, so GBTC provides a handy alternative entry point.

That’s one reason why GBTC’s shares have consistently traded at a big premium to the value of the bitcoin it holds. Late last month, however, the fund sank to a record discount to its bitcoin investments’ value – one it’s since failed to recover. In light of this fact, I thought I’d explain what caused the flip, as well as the implications if you're an investor – prospective or current – in GBTC.

GBTC’s assets under management began jumping in late 2020 (Source: YCharts)
GBTC’s assets under management began jumping in late 2020 (Source: YCharts)

What does this mean?

When a fund trades at a premium to the value of its underlying holdings, investors are prepared to pay more for exposure to those investments than they’re actually worth. That might be because there’s no other way to gain exposure to the asset in question: remember, GBTC is one of the very few ways institutional investors can invest in bitcoin.

Small-time retail investors might also choose to invest in GBTC because of its straightforwardness: the fund (and by extension its bitcoin) can be bought and sold using your normal brokerage account, avoiding the hassle of signing up for a crypto exchange or setting up a digital wallet. And when there’s a lot of hype and the price of bitcoin is on fire, investors may be particularly happy to pay a markup just to ride the cryptocurrency’s rally.

These reasons likely explain why GBTC has persistently traded at a large premium to the bitcoin it holds ever since its 2013 launch. And that premium has given rise to a highly lucrative arbitrage trade popular with numerous hedge funds. These investors borrow bitcoin and then deposit the cryptocurrency with GBTC in exchange for newly created shares that are more valuable than the borrowed bitcoin itself. They can then pocket a profit by selling the premium-priced shares once the six-month buyer’s lockup period expires.

Say in six months’ time the price of one bitcoin is $30,000, while one GBTC share (which represents approximately 0.001 bitcoins) costs $33. In this example, GBTC will therefore be trading at a 10% premium: $33 x 1,000 = $33,000.

For every bitcoin the hedge fund deposited with GBTC when they opened the trade, they would have received a thousand new GBTC shares. Now the six-month lockup has expired, the hedge fund can sell its shares for $33,000, using $30,000 to buy a bitcoin and return it to the party they originally borrowed it from. The $3,000 difference is the hedge fund’s profit

Such a lucrative arbitrage trade will inevitably attract ever more hedge funds. But remember, these hedge funds are receiving newly created GBTC shares which they can only sell six months later. And if there isn’t enough demand for GBTC shares to match all the supply from hedge funds looking to sell, the price of those shares will fall.

That’s exactly what’s happened. Demand for GBTC shares has dropped as bitcoin’s rally has stalled – while a host of new bitcoin funds means GBTC is no longer the only way to gain easy exposure to the cryptocurrency. The Bitwise 10 Crypto Index Fund, the Osprey Bitcoin Trust, and the SkyBridge Bitcoin Fund have all launched within the past three months, while two bitcoin exchange-traded funds – a structure yet to be approved by US regulators – began trading last month in Canada, with a third on the way.

GBTC’s price has flipped from a premium to a discount to the bitcoin it holds (Source: YCharts)
GBTC’s price has flipped from a premium to a discount to the bitcoin it holds (Source: YCharts)

Making matters worse is the fact that GBTC doesn’t allow “redemptions”: shares can only be created, not destroyed. When the shares are trading at a premium, new shares allow hedge funds to arbitrage that premium away – but when the shares are trading at a discount, there’s nothing hedge funds can do to arbitrage that away.

Why should I care?

There are two main reasons why all this matters to existing or would-be GBTC investors.

First, it serves as a cautionary case study: buying into a fund meant to replicate a certain asset doesn’t necessarily mean one-to-one exposure to that asset’s price. Other than allowing hedge funds to arbitrage shares trading at a premium, there’s no guaranteed link between GBTC’s price and the value of its bitcoin holdings. If more people want to sell GBTC than buy, its share price will fall regardless of what bitcoin’s doing. Although of course if the discount grows big enough, investors may be enticed by the prospect of a bargain…

That brings us on to the second takeaway. GBTC could well be an interesting way to invest in bitcoin at a discount. But – and this is a big but – that’s only true if you think GBTC’s discount can be addressed. The fund’s managers could, for example, allow shares to be destroyed and thereby let hedge funds arbitrage the discount away. Or the managers could prop up the value of GBTC shares by buying them in the open market – something they recently announced, albeit at too small a scale to make much difference yet.

Of course, GBTC’s premium may also reemerge if bitcoin’s rally reignites, resulting in the same red-hot demand for crypto exposure that caused the fund’s premium to balloon late last year. Only time will tell…

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Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.

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