Avoid GBTC: Premium due to reversal (OTCMKTS: GBTC)
The Grayscale Bitcoin Trust (OTC: GBTC) is a closed-end fund (CEF) passively invested in Bitcoin, providing investors with exposure to the cryptocurrency in the form of a security. Bitcoin is the only asset in the fund and therefore the price of GBTC should, in theory, reflect the value of the bitcoins held in the fund.
While GBTC periodically issues new shares similar to other CEFs, there are currently no stock buyback options.
Recently, investors have become increasingly optimistic about Bitcoin’s prospects, pushing it to near all-time highs. While investors can buy bitcoin directly on a crypto exchange, many investors find it easier to trade bitcoin through the stock market, fueling excessive relative demand for GBTC, causing its price to exceed the net asset value of about 30 %. On Friday, December 4, for example, GBTC closed at $23.2, but the underlying value of each stock was only $17.8.
We believe the GBTC premium should reverse and investors looking for bitcoin exposure should look elsewhere.
Bonuses can quickly turn into discounts
Just as investor exuberance can cause a CEF to trade at a premium to NAV, if sentiment on the underlying reverses, prices can quickly swing into a discount.
Fund managers understand that the change in net asset value is unattractive, especially for large investors who place a high value on liquidity. To solve this problem, CEF managers usually offer a redemption function in which investors can automatically receive an amount usually between 95% and 100% of the net asset value per share. The Sub-Funds may offer redemptions on a continuous or periodic basis.
Some investors might view the current 30% GBTC premium as the cost of easy “commodity” exposure with insider custody. While this may currently be the case, a range of new products (examples follow below), both liquid and transparent, and a well-regulated futures market with the CME, all offer bitcoin exposure with convenience. similar and less variance compared to bitcoin. We believe this will leave GBTC as a relatively unattractive option.
Why no redemption?
In our view, there are no significant regulatory hurdles preventing Grayscale from providing a reimbursement mechanism. In his registration statementGBTC reveals how an SEC review of their buyout methodology in 2014 resulted in a fine (a tiny $53,756) and a cease-and-desist order in 2016. The fact that the SEC put two years to force GBTC to stop repurchasing shares tells us that the violation was minor.
We believe Grayscale has no incentive to offer a buyout option to shareholders. First, Grayscale collects 2% of the net asset value and, all other things being equal, the more shares in the fund, the higher the fees Grayscale collects.
Second, the lack of a buyback feature also makes possible a scenario where Grayscale could profit if the CEF trades discounted. Grayscale could buy its own shares on the market at a discount. For example, Grayscale could accumulate shares at, say, a 30% discount to NAV, and then offer a redemption feature. The result would be an immediate gain of 30%.
This is not a far-fetched scenario. There are hedge funds and investors who buy CEFs at deep discounts, force the funds to liquidate or transition to an open-ended structure, ultimately recouping the difference in net asset value.
Several existing Bitcoin funds are seeing increased interest and new options are hitting the market.
Take for example the Canadian Bitcoin Fund (TSX: QBTC). QBTC offers redemptions on a monthly basis that pay slightly less than NAV, as described below. The fund also offers annual redemptions that pay 100% of net asset value.
QBTC goes a step further and also offers the possibility to “recirculate” redeemed shares. A broker dealing on behalf of the fund may seek a buyer for the redeemed shares. If the buyer pays more than what the redeeming shareholders are owed under the regular redemption terms, the shareholders pocket the difference. Monthly redemption (as opposed to annual redemption) pays the lower of 95% of QBTC’s closing price and net asset value. So if 95% of the market price is below the net asset value, but the alternative buyer agrees to pay the net asset value, the redeeming shareholders realize a gain.
Another fund soon to be launched in Canada is sub-advised by Michael Novogratz’s Galaxy and managed by major asset manager CI Investments (C$200 billion AUM). One can imagine a strong demand for internal CI accounts alone. So while this may be a new fund, we expect it to grow in size quickly with an established account base and a large, trusted manager backing it.
And with QBTC, these two funds have lower management fees than GBTC (1.85% and 1.95% compared to 2% at GBTC).
An even bigger name that will soon enter the bitcoin fund space is Fidelity, which is several times bigger than CI Investments. There is no registration statement yet for this fund, so we cannot comment on the redemption option and fees, but Fidelity is unlikely to launch without a high level of confidence of a size 10 digit initial.
The many well-backed new bitcoin funds are going to provide much-needed alternatives to GBTC as a vehicle to gain exposure to bitcoin via the stock market. We believe that much of the money that would otherwise have been invested in GBTC will flow into these alternatives, and lower demand for GBTC will likely put pressure on its premium.
Other GBTC red flags
Although the no-redemption feature is the main reason to avoid or sell GBTC shares as soon as possible, it is not the only one.
Potential conflicts of interest: large funds (closed and open) use brokers as intermediaries for the creation and redemption of shares. These intermediaries are called “authorized participants” (AP).
GBTC has only one AP – Genesis Global Trading. Grayscale reveals that Genesis is an affiliate, but we believe they are not distant relatives. Grayscale and Genesis are not only owned by the same company (Barry Silbert’s Digital Currency Group), but they also reside on the same floor of the same office building.
The fact that Grayscale and Genesis are closely affiliated is a concerning signal in our view. Independence between a fund manager and authorized participants should be sought by fund investors in general.
We also think it’s concerning that Genesis is the only AP. Most CEFs have multiple access points that can create and redeem shares. Typically these are established brokers who, by signing up as an AP, actually provide a stamp of approval towards the legitimacy of the fund.
We think Genesis is the only AP for Grayscale’s fund, as more established brokers might dispute the lack of a redemption feature.
We are also concerned that GBTC is still trading over-the-counter. With such a liquid stock (10-20mm shares in daily volume or $250-500m in total size) and constantly issuing new shares, we expect Grayscale to be eager to get listed on the stock exchange. . However, Grayscale told us that it has no plans to request an update at this time. We believe this is due to several reasons.
One of the “benefits” of OTC trading is that it is much more difficult to short OTC names. Fewer brokers will facilitate borrowing and fewer custodians will allow short positions. The harder it is to short GBTC, the lower the downward pressure on the price.
It is equally important that OTC names do not have options listed. If options were available, at least some investors would choose them instead of buying GTBC shares, thereby reducing the number of investors buying new GTBC shares.
We also note that unlike GBTC, the previously mentioned QBTC trades on the main TSX list, not the OTC.
We think GBTC is a trap. In addition to the current 30% premium, GBTC has many disadvantages compared to other (and soon, many more) alternatives. We think CEF doesn’t make much sense for investors looking for bitcoin exposure.
Due to the availability of alternative options to express Bitcoin longs and the possibility of a reversal in sentiment, we believe that GBTC’s premium will eventually compress. And if bitcoin crashes like it did in December 2017, the premium will quickly turn into a discount, and investors will be locked out for lack of a redemption option.
Because Grayscale’s incentives are not fully aligned with its shareholders, investors seeking exposure to bitcoin should avoid GBTC. Current shareholders should sell their shares as they trade at a premium and let Grayscale rack up fees on other investors’ money.