The Key to Unlocking
If you follow Bitcoin at all, you’ve probably read a lot of commentary about Grayscale Bitcoin Trust’s upcoming lockup expiration from some of the massive subscriptions that the fund saw in January. To catch you up, last Winter Grayscale’s closed end fund, GBTC, was one of the only investment products that many retail traders could use to invest in Bitcoin using a traditional investment account. The bull market that started in the spring of 2020 and accelerated into the end of the year contributed to the fund trading at a significant premium to the Net Asset Value of its holdings, spiking as high as 40% around Christmas of 2020.
While most individual traders had no choice but to buy GBTC shares on the open market if they wanted to invest, institutional investors had a much more efficient avenue: they could subscribe to new share issues by either sending cash or actual BTC to the trust, and in return they would receive shares at NAV. With the open market price at a large premium, this created a juicy arbitrage opportunity, and there is nothing that hedge funds love more than an arbitrage. However, there was a catch. The shares issued to these institutions at NAV came with a 6 month lock up, meaning that the investors needed to hold the shares for 6 months before they could sell them, much like founder shares after an IPO in the equities market.
Investors who chose to enter this trade had several options of executing it. If they wanted to be long Bitcoin, they could simply transfer cash to Grayscale and hold the GBTC shares for at least 6 months. No doubt, at least some of the money that had gone into this trade for the last few years was doing just this, and every six months the investors could just sell their GBTC shares in the market at the premium price and use the cash proceeds to recycle them back into new GBTC shares at NAV, booking a profit on the premium while maintaining their position. This is likely the way things went for quite some time, as the market premium remained between 15%-30% for all of 2019 and 2020. It was a gravy trade that boosted returns significantly over simply holding BTC.
The trade was maybe too gravy though, and it started to get immensely popular. And as any smart hedge fund would do seeing what appeared to be an arbitrage, they looked for ways to isolate risks and add leverage to juice returns. The ability to short BTC through futures or on exchanges had been around for a while, but the emergence of BTC based borrowing and lending on large platforms came to prominence in 2019 and really took off in 2020. These platforms allowed individual crypto holders to lend out their coins and receive interest on the loans. The platforms then aggregated these coins and lent them out to hedge funds. This access to large pools of borrowed coins created a new and simple way for hedge funds to complete the circle of the arbitrage trade.
Hedge funds could now borrow BTC, send the BTC to Grayscale, receive shares at NAV, and then sit for 6 months until they could sell their GBTC shares, use the proceeds to purchase BTC on the open market, and then return the BTC to the lending platforms to close the trade. As long as the GBTC premium held above the interest that they paid on the loan, they would make a profit. Around January, interest rates on BTC loans were about 6% APY, meaning that any GBTC premium over 3% in 6 months time would be pure profit.
In the last 3 months of 2020, Grayscale subscriptions of new shares jumped by 157k BTC. During this time the price of BTC was also quickly appreciating and the premium that GBTC shares enjoyed over NAV remained well above 15%. Between Christmas and the second week of January, Grayscale briefly suspended new subscriptions to the fund. When they resumed, hedge funds deposited another 50k BTC into the fund in just a week. Despite attention grabbing headlines of the record setting inflows into GBTC, amounting to over 1.5 billion dollars worth of BTC over those two weeks, BTC spot prices saw one of the first price downtrends in months, declining from a peak of just over 40k on January 9th to just over 31k by January 21st.
While many traders were baffled by the fact that such massive inflows into GBTC did not have any follow through into BTC spot prices, to the people familiar with the arbitrage trade it was apparent that all of the money flowing into the trust was not at all about investing in Bitcoin, it was only about trying to capture the arbitrage. The vast majority of the BTC flowing into the trust was offset by equal short positions through derivatives, or more likely simply made with borrowed coins. The hedge funds smelled a free lunch and they rushed in headfirst with as much size as and leverage as they could find.
The problem with trades that are too good to be true is that they are just that. The trade became so popular and so much leverage was used to put it on that, with the benefit of 20/20 hindsight, it was bound to fall apart. When talking about the collapse of the GBTC premium in late February of 2021, when it dipped from 12% to negative over the course of a week, many commentators talk about the emergence of potential competitors to Grayscale that might charge lower fees. However, I believe that the biggest catalyst that caused the premium to turn negative, especially at that exact time, was the sudden popularity of attacking hedge funds that started with the populist movement to attack short sellers of Gamestop and AMC, but then in late February morphed into an all-out assault on seemingly untouchable funds like Cathie Wood’s ARK investments. As ARK fell, it became popular to start betting against hedge funds that appeared to have positions that were too crowded or large and left them vulnerable. I believe that the GBTC NAV trade was one of those well-known crowded trades that many hedge funds were over levered too, and as the premium declined and dipped negative, these funds would be forced into positions where they might have to liquidate. And as such the premium flipped to a significant discount and has remained at a steep discount ever since.
This leaves the question that is on everyone’s mind this week as we approach the last major unlocks of GBTC shares: what does this mean for BTC prices this week? When the premium flipped to a discount, Grayscale closed the fund to new investments (why would anyone subscribe to the fund at NAV when they could purchase shares on the open market for a discount?), so the unlocks coming up this week of the shares that were issued in the second and third week of January are the last ones on the horizon, perhaps the last ones ever. Some analysts, especially those from Wall Street who are used to dealing with lockup expirations after IPOs are calling for bearish price action, warning that the holders of the freshly unlocked shares will want to dump them, creating downward pressure on GBTC that will follow through to BTC spot. Other analysts, especially those at crypto exchanges who are focused on BTC spot supply and demand are calling for bullish price action, saying that hedge funds who borrowed or went short BTC to put on the trade will need to purchase BTC spot in order to unwind the trade.
Analysts in both camps are somewhat correct, but they tend to both be looking at one side of the trade and ignoring the other. The side of the trade that these analysts are looking at is the unwind from the hedge funds. In my opinion, it is likely that the hedge funds that really got into trouble and faced margin calls with this trade have already found a way to unload it, perhaps by selling their interest in the trade to another fund that came to the rescue. I think that any fund that still has this trade on is either well capitalized and prepared to ride out drama, perhaps hoping for an eventual ETF conversion (which Grayscale has said they are committed to executing if and when the SEC approves their application to become an ETF) which would nearly instantly push the shares in line with NAV, or their cost basis (if they came in to bail out a fund that got into trouble) is low enough that they will be happy to unwind the trade opportunistically rather than in a forced fire sale the day the shares unlock. Because of this, I don’t think that there will be the stampede to the exit that many analysts are anticipating.
The side of the trade that hasn’t received much attention is the people who will be on the other side of the trades that the hedge funds who do unwind. These are a combination of market makers and retail traders and even large investment funds like the aforementioned ARK investments. Cathy Wood has demonstrated that she has no problem accumulating Grayscale shares, as have other investment firms for whom holding BTC directly might be difficult or impossible. If hedge funds do start unwinding the trade, pushing GBTC shares down while buying BTC spot, pushing the discount to go lower, I expect that there will be plenty of interest to take the other side of the trade, either seeing the opportunity as a great chance to snap up GBTC for natural long bitcoin investors, or for market makers or other hedge funds willing to make a bet that the pressure will be transitory, and so they would be willing to short BTC spot and buy GBTC at a discount and hold until either the pressure passes or news of an eventual ETF conversion snaps GBTC to NAV. Every trade has an equal and opposite side, and if the hedge funds who got themselves stuck in this trade decide to throw in the towel and realize massive losses by liquidating their GBTC shares at a discount, then there will be others willing to step in and take over their positions at much better levels than they originally put them on. Yes, there might be a little volatility as the supply and demand side of the trade find the level that they equal out, but I expect that to happen relatively quickly.
This leaves one more important factor, which I believe is actually the biggest unknown in this whole mess: How are traders positioned for an event that they believe is significant, and what is their exit strategy after the unlock passes? As I stated above, my theory is that the conventional wisdom regarding the effect of the unlock is overestimating the impact it will have on both spot BTC prices and the GBTC discount. About 35k BTC worth of shares unlocked between June 19th and June 22nd, nearly as much as will be unlocked in the next week, and both BTC prices and the GBTC discount remained quite rangebound (though reasonably volatile within that range) during that time period. I don’t see any reason why this week’s unlock will be significantly different. The only major difference between this week and 3 weeks ago is that this unlock will be the last.
I think that the wild card in all of this is the traders who are trying to outsmart the market and might have trades on to take advantage of what they anticipate will happen. But when the unlock comes and goes, they will have no reason to keep those trades on and will look to close them. If the traders who are betting on a big dip in GBTC premium or big moves in spot are actually the crowded side of this whole trade, then they could create a move in precisely the opposite direction when they go to unwind those positions. There’s a chance that the real move, when all is said and done, will be a decrease in the GBTC discount, and perhaps the removal of an albatross that has been hanging around the neck of the Bitcoin market, perhaps paving the way for future gains.
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