Grayscale Bitcoin Trust

Amy Castor's Welcome to Grayscale’s Hotel California is a fascinating account of one of the Alice-in-Wonderland market ecosystems that grew from cryptocurrencies:

Grayscale wants to convert its Grayscale Bitcoin Trust (GBTC) into a bitcoin ETF after flooding the market with shares. GBTC is trading 25% below its net asset value, and investors are rightfully pissed off. Grayscale wants them to be upset with the SEC, but the regulator isn’t really to blame. If anything, the SEC should have warned the public about GBTC years ago.

Below the fold, I provide some commentary:

The "Hotel California" reference is to the fact that BTC check in to the trust, whenever someone buys shares either for cash or for BTC, but once they have checked in only 2%/year can ever check out:

Legally, GBTC is a grantor trust, meaning it functions like a closed-end fund. Unlike a typical ETF, there is no mechanism to redeem the underlying asset. The SEC specifically stopped Grayscale from doing this in 2016. Grayscale can create new shares, but it can’t destroy shares to adjust for demand. Grayscale only takes bitcoin out to pay its whopping 2% annual fees, which currently amount to $200 million per year.

In contrast, an ETF trades like a stock on a national securities exchange, like NYSE Arca or Nasdaq. An ETF has a built-in creation and redemption mechanism that allows the shares to trade at NAV via arbitrage. Authorized participants (essentially, broker-dealers, like banks and trading firms) issue new shares when the EFT trades at a premium and redeem shares when they trade at a discount, making a profit on the spread.

The fact that there is a large fund that buys but essentially never sells BTC has an effect on the "price". But in November 2020's Why This Reflexive Ponzi Scheme Will Continue… Harris Kupperman explained that the effect was much bigger than simply demand (my emphasis):

What is GBTC? It is a vehicle that issues new shares daily in exchange for cash or Bitcoins. The shares are issued at the Net Asset Value (NAV), but with the unique wrinkle that they cannot be sold for 6 months. GBTC does not sell Bitcoin except to pay management fees and there is no mechanism in place for it to ever sell Bitcoin like a typical ETF. Think of GBTC as Pac-Man. The coins go in, but do not go out.

As everyone knows knew, BTC was going "to the moon!", so in six months the GBTC shares representing the trapped BTC would be worth a lot more. For this and other reasons:

GBTC currently trades at a 26% premium to NAV and has traded at a 18.7% average premium for the past year.

This spread provided for a number of ludicrously profitable trades, such as:

You buy GBTC in the daily offering and short free-trading GBTC. Six months later, it all nets out and you are left with your profits. ... You can recycle your capital twice a year and on an unlevered basis, even after paying borrow fees, you’re making north of 40% a year

Or:

sell your GBTC at today’s price and buy it back at NAV through the daily offering (which gets you long about 26% more shares for a bit of paperwork).

All of which involve the trust buying ever-increasing amounts of BTC, pumping the "price" ever higher, attracting ever more speculators to these trades, and driving the premium over NAV ever higher. This is why Kupperman calls this a "Reflexive Ponzi Scheme".

Like other Ponizi schemes, this all worked great until it didn't:

Everybody was happy until February 2021, when the Purpose bitcoin ETF launched in Canada. Unlike GBTC, which trades over-the-counter, Purpose trades on the Toronto Stock Exchange, close to NAV. At 1%, its management fees are half that of GBTC. Within a month of trading, Purpose quickly absorbed more than $1 billion worth of assets.

Demand for GBTC dropped off and its premium evaporated. Currently, 653,919 bitcoins (worth a face value of $26 billion) are stuck in an illiquid vehicle. Welcome to Grayscale’s Hotel California.

Source

Competition from Purpose wasn't the only factor that drove the premium down to -25%:

Fed by stimulus money, tethers, and a new grift in the form of NFTs, the price of bitcoin reached a record of nearly $69,000 in November 2021. Bitcoiners rah-rahed the moment.

However, the same network effects that brought BTC to its heights are working in reverse and can just as easily bring it back down again. At its current price of $40,000, amidst 8.5% inflation, bitcoin is not proving itself to be the inflation hedge Grayscale hyped it up to be.

It is easy to see why the holders of GBTC would want to convert it to an ETF that would trade close to NAV. It would give them an instant 33% boost to their current valuation. But Grayscale is in a win-win situation. No matter how unhappy the shareholders are, every year Grayscale gets their 2% fee, "currently worth around $200M", for doing nothing.

Among the unhappy shareholders are some pretty sleazy operators. For example:

Crypto lender BlockFi’s reliance on the GBTC arbitrage is well known as the source of their high bitcoin interest offering. Customers loan BlockFi their bitcoin, and BlockFi invests it into Grayscale’s trust. By the end of October 2020, a filing with the SEC revealed BlockFi had a 5% stake in all GBTC shares.

Customers loaned BTC to BlockFi, so BlockFi has to give them BTC back. But it can't get the BTC it used to buy GBTC back, they're in the Hotel California. So BlockFi needs to sell the GBTC in the market to get cash to buy the BTC to give back to their customers:

Here’s the problem: Now that GBTC prices are below the price of bitcoin, BlockFi won’t have enough cash to buy back the bitcoins that customers lent to them. BlockFi already had to pay a $100 million fine for allegedly selling unregistered securities in 2021.

In a similar vein, Sam Bankman-Fried, the CEO of the FTX exchange, in a Bloomberg interview explained DeFi's "yield farming". Molly White summarizes:

Bankman-Fried launched into an explanation in which he compared it to a box that "they probably dress up to look like [it's] life-changing" but it "does literally nothing". He explained how people put money into the box "because of, you know, the bullishness of people’s usage of the box". "So they go and pour another $300 million in the box and you get a psych and then it goes to infinity. And then everyone makes money."

[Matt] Levine responded, "I think of myself as like a fairly cynical person. And that was so much more cynical than how I would’ve described farming. You’re just like, well, I’m in the Ponzi business and it’s pretty good."

Castor concludes:

I encourage anyone reading this to submit your comment to the SEC regarding Grayscale’s application for a spot bitcoin ETF. Jorge Stolfi, a computer scientist in Brazil, has provided an excellent example of how to do this. Quality over quantity is key. Use your own words, tell your own story. Submit your comments here.

Here is my comment:

Please DO NOT authorize the Grayscale bitcoin ETF. The reasons why you rejected previous ETF proposals are still valid and should be sufficient to deny this one (and any future ones) as well.

The constant pressure to approve a spot Bitcoin ETF exists because Bitcoin is a negative-sum game - Bitcoin whales need to increase the flow of dollars in so as to have dollars to withdraw. The SEC should not pander to them.

My recent talk to Stanford's EE380 course started by pointing out that cryptocurrencies' externalities include:

Bitcoin is notorious for consuming as much electricity as the Netherlands, but there are around 10,000 other cryptocurrencies, most using similar infrastructure and thus also in aggregate consuming unsustainable amounts of electricity. Bitcoin alone generates as much e-waste as the Netherlands, cryptocurrencies suffer an epidemic of pump-and-dump schemes and wash trading, they enable a $5.2B/year ransomware industry, they have disrupted supply chains for GPUs, hard disks, SSDs and other chips, they have made it impossible for web services to offer free tiers, and they are responsible for a massive crime wave including fraud, theft, tax evasion, funding of rogue states such as North Korea, drug smuggling, and even as documented by Jameson Lopp's list of physical attacks, armed robbery, kidnapping, torture and murder.

I went on to discuss in detail the potential for mitigating these externalities and concluded:

Although the techniques used to implement decentralization are effective in theory, at scale emergent economic effects render them ineffective. Despite this, decentralization is fundamental to the cryptocurrency ideology, making mitigation of its externalities effectively impossible. And attempts to mitigate the externalities of pseudonymous cryptocurrencies are lijkely to be self-defeating. We can conclude that:

1. Permissioned blockchains do not need a cryptocurrency to defend against Sybil attacks, and thus do not have significant externalities.
2. Permissionless blockchains require a cryptocurrency, and thus necessarily impose all the externalities I have described except the carbon footprint.
3. If successful, permissionless blockchains using Proof-of-Work, or any other way to waste a real resource as a Sybil defense, have unacceptable carbon footprints.
4. Whatever Sybil defense they use, economics forces successful permissionless blockchains to centralize; there is no justification for wasting resources in a doomed attempt at decentralization.

Gateways between cryptocurrencies and the real economy should be illegal, as they impose massive externalities on the real economy. The US is far behind China in realizing this.