Grayscale Beat the SEC. Can Bitcoin ETFs Be Far Behind?

It looks like Grayscale’s win over the SEC at the district court level will finally open the door for a retail Bitcoin
BTC
ETF that actually holds the cryptocurrency. And if that happens, other ETFs for Ethereum
ETH
and other cryptos will quickly follow.

Grayscale Bitcoin Trust is a publicly traded trust (ticker: GBTC) holding about $16 billion worth of Bitcoin cryptocurrency which has been trying for years to convert into a retail ETF. However, the Securities and Exchange Commission continually shut them down in the past on the grounds that Bitcoin as an asset class lacked sufficient consumer protections. Grayscale’s counter argument was that a Bitcoin ETF would be safer for investors because the Bitcoin blockchain does not move at the same speed as current stock-trading technologies.

Arguing that the SEC’s ruling was arbitrary and capricious since the agency had previously approved ETFs which own Bitcoin futures, but not the cryptocurrency itself, Grayscale took the issue to court. And won. Now, the ball is back in the SEC’s court, but there are basically two possible results—the SEC could just throw in the towel and give approval to cryptocurrency ETFs, or it can appeal, possibly all the way up to the Supreme Court, where it is likely to lose again. The SEC has until mid-October to decide on its next move, which is also the timeframe the Commission has given itself to rule on a separate group of spot bitcoin ETFs.

That alone would make the story compelling, but the most interesting fact about the Grayscale Bitcoin Trust is how it has traded at such a steep discount to the underlying value of the Bitcoin it holds. That number has fluctuated over time but, at the bottom of the trough earlier this year, the price discount was ~50% below the value of its underlying Bitcoin holdings.

GBTC has started to appreciate but is still trading at a healthy discount of ~17%. The situation presents an interesting play, not just on cryptocurrency, which was about the most distressed asset class sector last year, but also on the arbitrage between what the trust owns versus what it’s theoretically worth.

Either way, GBTC looks like an interesting investment since it trades at such a wide discount to NAV and, with that, an investor can generate a reasonably safe return by simply purchasing GBTC long and hedging away the risk of Cryptocurrency exposure. That investor could generate arbitrage profits by short selling Bitcoin directly, or via one of the ETFs which own Bitcoin futures, to eliminate the Bitcoin Cryptocurrency risk and thereby lock in an arbitrage profit given the spread between current GBTC market prices versus the value of the trust’s underlying assets.

And if GBTC ultimately wins SEC approval to convert from its current trust structure into an ETF, then that discount would likely disappear since the mechanism ETFs to create and redeem shares constantly balances out arbitrages in pricing. Should the SEC allow Grayscale to convert into a retail ETF, investors could make a riskless profit by simply redeeming shares of the trust in exchange for underlying Bitcoin. The profit opportunity generated by those riskless transactions would automatically help bring the two prices much closer into alignment.

Grayscale’s success in court does not really seem to have had that much of an effect on the price of Bitcoin. There was a short-lived spike in the price immediately following the ruling, but it remains considerably below the YTD high it hit in mid-July and about where it was the day before the ruling was announced.

And although there are lots of fund companies which have expressed interest in launching spot Bitcoin ETFs, and both BlackRock
BLK
and Franklin Templeton currently have applications pending, there is still a lot of uncertainty around cryptocurrencies as an asset class.

The collapse of FTX last year showed the potential for fraud and mismanagement in the mostly unregulated cryptocurrency arena. The effects of that disaster rippled through the crypto sector leading to a number of Bitcoin exchange blow ups, which in turn contributed to the Silvergate and Silicon Valley bank failures earlier this year.

Nevertheless, the cryptocurrency sector appears here to stay. It is an interesting segment because it represents a collective investor universe looking for an alternative to fiat currencies which central banks around the world have been printing in unlimited amounts.

The attraction is not hard to see. Cryptocurrencies appeared to offer a new way of hedging against inflation and taking out the risk of holding US dollars, which have lost real value due to expansionist monetary policies that went into effect long before the Covid-related emergency.

And to show how interconnected the whole crypto world is, Alameda Research, FTX founder Sam Bankman-Fried’s hedge fund, filed a lawsuit in March against Grayscale claiming that it had suffered “hundreds of millions of dollars in harm” from Grayscale since its sponsor, Digital Currency Group, had enriched itself “at shareholders’ expense.”

More recently Alameda has joined with other GBTC shareholders, including Fir Tree Partners, Owl Creek Asset Management, and Aristides Capital, to demand a return of their investments due to what they say are Grayscale’s “exorbitant management fees in violation of the trust agreements and hiding behind contrived excuses to prevent shareholders from redeeming their shares.” Grayscale’s response to these activist shareholders has been to delay addressing their claims directly while staying focused on its litigation with the SEC over ETF approval. It has stated publicly that, if it loses the SEC case (including potential appeals up to the Supreme Court), it will initiate a large tender offer for up to 20% of its shares to eliminate the NAV trading discount.

For the time being, GBTC still looks like an interesting investment because it trades at such a big discount to NAV. There are a couple of different possible outcomes given the ongoing litigation. Investors may be able to make a relatively safe return by simply buying it and waiting to see what happens. Those who are worried about the cryptocurrency sector in general and what might happen with Bitcoin might consider a hedged position by shorting Bitcoin directly or through one of the ETFs that own Bitcoin futures.

Crypto remains a highly speculative and loosely regulated asset class. However, it’s one that has generated lots of investor enthusiasm and that will likely continue to grow once the SEC finally approves a retail spot Bitcoin ETF.

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