Malt Liquidity 65

50 Shades of Grayscale

Convergence/Divergence

A classic trade popularized by Long Term Capital Management was the convergence trade — a trade made by essentially buying and selling substantially similar assets and hoping the spread between them collapses over time. Likewise, the opposite is the divergence trade — simply reverse the positions and hope they diverge. You can do this with any number of instruments. I happened to do this with heavily weighted NQ stocks and QQQ for a while, and trading indices or BTC/ETH against each-other are valid ways to trade convergence and divergence. The main risk is that, well, these trades aren’t particularly lucrative, and the carry cost can be pricy — to scale, you might use a lot of leverage, and if your spread between positions continues to widen, you could get blown out, like what happened to LTCM during the Asian crisis of 1997.

What happens when a traded product is priced at ~60% of its NAV (net asset value)??

The $11.4 billion Grayscale Bitcoin Trust (ticker GBTC) has plunged more than 74% this year, outpacing the cryptocurrency’s 64% decline. That gap has widened dramatically over the past week, dragging the price of GBTC to an unprecedented 42% discount to the value of the Bitcoin it holds

GBTC has always fluctuated between trading at a premium or discount to its underlying bitcoin stash due to the quirks of the product’s composition.

So what’s the deal? GBTC sits on a stash of bitcoin worth far more than what its shares are priced at. Shouldn’t this be free money by buying GBTC and shorting BTC? Well, not exactly. While GBTC offers exposure to BTC in the form of shares traded on an exchange, it does not provide liquid direct exposure to BTC, as GBTC cannot sell its stash of BTC. Namely, GBTC is structured as a closed-ended trust, meaning that while it is easy to hold in a regular brokerage account, its price relative to NAV is based on the supply and demand for the exposure to the underlying. When exposure to BTC was harder to come by, the demand for GBTC exposure was high and the shares traded at a premium. Now that there are many liquid options to gain exposure to BTC, including futures ETFs, a plethora of exchanges, and, of course, the old-fashioned way of just holding the coin yourself (which became far more accessible over the course of the past 5 years), the demand for GBTC-specific exposure has slipped a lot and the discount to NAV reflects that. A proper ETF — which GBTC isn’t — can match the NAV of the underlying through the creation/redemption process (and other types of arbitrage) to keep it in line. Creation/redemption guarantees that this mismatch of outstanding units relative to demand that a closed-ended fund suffers from won’t happen, as it allows ETFs to adjust to inflows and outflows.

Certain types of trades need catalysts. An old adage of mine is “valuation is not a short thesis”, meaning that just because something is overvalued doesn’t mean that it will sink in share price. As the ZIRP market proved, as long as there are bidders, things can stay overvalued. (A related adage is the quote “The market can stay irrational longer than you can stay solvent.”) The point of my statement is that you need something — events , news, a liquidation, whatever — to impact the liquidity of whatever you are shorting so that bid does dry up and the normal upward bias of markets is impacted. Without some sort of catalyst on the horizon, you are punting money by shorting.

Similar to this, if you are trading the convergence of GBTC to its NAV, there needs to be some kind of catalyst that increases the demand for the specific type of liquidity GBTC offers. Specifically, you’d look for a catalyst that allows GBTC to redeem the excess shares that it provides that nobody wants — aka a conversion to an ETF.

While ETFs based on bitcoin futures exist, there isn’t a spot bitcoin ETF that has been approved yet, which is what GBTC would have to be converted to considering it physically owns its BTC. The SEC has reliably shot down approval for spot bitcoin ETFs due to concerns with the lack of transparency and the susceptibility to manipulation of the market. Which brings us to this brief filed by Grayscale (the proprietor of GBTC) against the SEC. The SEC denied Grayscale’s application to convert GBTC into an ETF, and now Grayscale is suing. I won’t devolve into legalese (for now) — all I’ll say is that the catalyst for the GBTC spread trade revolves around the probability of Grayscale successfully winning its lawsuit. The discount continuing to widen implies the probability is, well, pretty low that Grayscale is successful, and the legal drama will probably take about a year to play out. In the meantime, it is theoretically possible (though extremely unlikely) that another spot ETF gets approved. But if your thirst for legal catalysts wasn’t quenched from Twitter and Musk, this is certainly a juicy one to bet on.

A Wrench gets Thrown in

Let’s talk a bit about corporate structure. Grayscale and a trading outfit called Genesis are both subsidiaries of a parent company called Digital Currency Group (DCG). Up until October, Genesis Trading assisted Grayscale in distribution and marketing of GBTC shares and was the “Authorized Participant” for Grayscale, which is responsible for the issuances of shares and transactions on their digital wallets, among other responsibilities. Why does this matter? Well, this morning, Genesis’s lending arm froze withdrawals, citing market turmoil leading to a massive spike in withdrawals that exceeds the liquidity they currently have to service them. (Whether this is a crunch in liquidity or insolvency remains to be seen.) While Genesis is no longer the AP for Grayscale, it does provide them liquidity. But this prompted Grayscale to clarify that

1) Grayscale products continue to operate business as usual, and recent events have had no impact on product operations.

2) The assets underlying [GBTC] and all Grayscale products remain safe and secure, held in segregated wallets in deep cold storage by our custodian [Coinbase]

FTX contagion doesn’t have to be directly due to funds lost on FTX’s exchange — it has created a rush of withdrawals and a lack of trust throughout the ecosystem. Though, in this case, it seems like that’s an issue as well:

As part of our goal in providing transparency around this week’s market events, the Genesis derivatives business currently has ~$175M in locked funds in our FTX trading account. This does not impact our market-making activities.

It’s not exactly clear what Grayscale and Genesis Trading’s current relationship is, but short of verification beyond just tweets, given the current uncertainty, I’m a little wary over the stability of GBTC’s holdings and ability to liquidate. This is certainly more of an inhibitor of demand for GBTC shares.