Grayscale’s Faustian Bargain

Grayscale announced this morning that it's creating five new trusts -- for Basic Attention Token, ChainLink, Decentraland, Filecoin, and Livepeer. The asset manager has been ramping up hiring, new trust creations, and flirting with bona fide ETF products, even as it paused new creations for its flagship bitcoin trust.

Today, we’ll look at Grayscale's Faustian bargain, and why it’s one most investors will continue to make. Before we dive in, though, note that I wrote at length about the Grayscale trade in our year end theses, and Ty also covered the mechanics in detail here.

A quick recap:

Grayscale is crypto’s largest asset manager, with $45 billion in assets under management. Over 95% of assets are held in their Bitcoin and Ethereum trusts, which charge a 2% annual management fee ($900 million annualized! With absurd EBITDA margins!) Grayscale trusts are “quasi-ETFs” in that their shares trade publicly, but as closed-end funds. With an ETF, broker-dealers ("authorized participants”) create and redeem baskets of shares each day to ensure that the ETF shares accurately reflect the value of the underlying assets they represent. They will create new shares if prices get ahead of underlying “net asset value”, and redeem them if shares trade at a discount to assets held within the trust.

The SEC did nothing proactive to approve crypto ETFs in the past five years, so we had the emergence of Grayscale, which leveraged a loophole (Rule 144) to replicate the creation/redemption process in slow motion and access the public markets through a side door: accredited investors create baskets of restricted shares that represent units of BTC/ETH/etc. directly with Grayscale’s authorized participant, Genesis Trading (a sister company). Grayscale deposits the corresponding amount of crypto into their closed-end trusts. Trust investors face a six month lock-up period, but can then sell their shares via OTC Markets. That’s when 40 Act funds and retirees can invest in public floating shares from their brokerage accounts.

The free floating shares are “GBTC", which have historically traded at a high premium to net asset value. So there’s historically been a bias for investors to go long via creations at Grayscale to capture the spread six months later. A lot of companies have levered up on this trade, and are now paying the price. (I explained why the Litecoin trust was the most sensible way to play this trade in our theses.)

Lenders like BlockFi and a number of hedge funds bought Grayscale bitcoin shares, used those shares as collateral for loans with Genesis Trading, and thought they would clip the premium spread in six months. That is, they thought the premium of GBTC would remain greater than their interest and holding period costs (20% spread in six months - 10% holding / interest costs = 10% yield on the trade). That worked for a while, but then GBTC suddenly turned to trade at a discount, and those counterparties started getting blown out on the trade. (5% discount - 10% holding / interest costs = -15% yield on the trade).