wNews: Unwinding the Grayscale Bitcoin Trade

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This week’s edition of wNews digs into the Grayscale arbitrage trade. Understanding how this particular trade works is key to identifying its effects on the greater crypto economy. 

In short, institutional investors are making bank on high premiums from retail investors buying up Grayscale “shares.” This week, however, this premium has plummeted. 

Today’s dispatch unpacks what this means and why it’s important. 

Markets continued their upward trend after hitting a snag last month. Bitcoin is up 17.6%, and Ethereum is up 14.3% at the time of press. For reference, the leading cryptocurrency is 74% of the market cap of Google and 11% of gold’s market cap. 

Likely much of the bullish action this week came from the latest $1.9 trillion stimulus package getting the green light. Who knows where Americans will put their incoming round of stimmy checks. 

But with death knells of the 60/40 portfolio ringing, some are likely to turn to Bitcoin. Last month, JP Morgan even backed a 1% allocation, saying: 

“In a multi-asset portfolio, investors can likely add up to 1% of their allocation to cryptocurrencies in order to achieve any efficiency gain in the overall risk-adjusted returns of the portfolio.”

Finally, this week’s crypto to-do list is all things Layer 2 on Ethereum.

All that and more, below.

The Great Grayscale Trade

Before this week, the great Grayscale trade was free money for investors. Here’s how it worked. 

Grayscale created an onramp for wealthy investors to lock up their Bitcoin. In exchange for this lock-up, they receive equivalent amounts in Grayscale Bitcoin Trust (GBTC) “shares.” These shares are meant to track the price of Bitcoin. 

These shares are then sold on platforms like Fidelity, Charles Schwab, and other brokerages. 

Investors on these platforms are typically retail too. Moreover, this demographic likely prefers the GBTC product over actual Bitcoin because it removes self-custody and tax concerns. In exchange, however, they have often had to pay a premium. 

GBTC is still subject to supply and demand, which means it often leaves its peg to Bitcoin. There are only so many GBTC shares on the market at any given time. 

This has created a massive premium on the asset. The average premium since the birth of GBTC has been nearly 40%. For the altcoin equivalents, the premium has been as high as 5,900%. 

Investors in the Bitcoin Cash Trust are paying $37.90 for underlying assets worth $3.19. 1008% Premium to NAV. pic.twitter.com/t8inyn2djT

— Charlie Bilello (@charliebilello) November 25, 2020

For the original investors who helped create the GBTC shares, capturing this premium has been one of crypto’s easiest, most profitable trades. 

One strategy revolves around taking out Bitcoin on loan, creating GBTC shares, selling those shares on the open market, repaying the loan, and pocketing the difference. As long as the premium is higher than the interest on that loan, the trade remains profitable. 

Despite this constant sell pressure, demand has also been rampant, hence the premium.

This week, however, the premium has finally dropped. 

At the time of press, GBTC is sold at a 1.72% discount. On Mar. 4, this discount fell as low as 11.59%. This means it is cheaper to buy GBTC than actual Bitcoin.

There are a handful of conclusions one can draw from this. Based on the above outline, this drop in premium indicates that GBTC supply has finally outpaced demand. 

And, as such, Grayscale has also halted inflows from investors looking to join in on the GBTC trade. On the same day, Digital Currency Group (DCG), the owner of Grayscale, announced that it would purchase $250 million in GBTC shares. 

It was unstated, but both actions are likely meant to help retrieve the peg. 

What This Means for Investors

Due to the structure of Grayscale’s crypto products, the arbitrage opportunity only works in one direction. This is because GBTC cannot be redeemed for Bitcoin. 

Investors cannot buy shares on the market and swap them for BTC to capture that difference. It is a one-way revolving door. The only way shares can refind their peg, or enjoy the same premiums, is by renewed buying demand. 

It’s not impossible, and many investors can now buy discounted GBTC shares hoping that a soaring premium does eventually return. Unfortunately, revitalizing one of crypto’s most popular, mediatized trades will be difficult.

Plus, this isn’t the only force at work here. Before the tumbling premium, several other products have entered the market. The most important entrant was Canada’s redeemable Bitcoin ETF. 

Candian firm 3iQ Corp, the creator of The Bitcoin Fund, wrote on Mar. 8: 

“The Bitcoin Fund (the ‘Fund’) is pleased to announce an in-kind redemption feature on annual redemptions of Class A Units and Class F Units (the ‘Units’) of the Fund.” 

With this move, 3iQ has created a product that allows investors to profit from both premiums and discounts should they arrive. Naturally, these arbitrage opportunities will be far less lucrative compared to the Grayscale trade.

As this particular trade dwindles, it would also appear that Grayscale will soon offer an ETF of sorts. This week, the firm posted nine different positions, all related to such a product. 

The success of this application would also mean the end of the Grayscale GBTC trust. But, as many crypto veterans know, getting approval from the SEC for such a product has been far from easy. 

And until then, a few industry analysts believe the premium is likely to return. Ben Lilly, a partner at Jarvis Labs, told Crypto Briefing:

“Our team at Jarvis Labs fully expects the premium to return in several months assuming a Grayscale ETF doesn’t change the structure of the Trust.”

As for a timeline, Jarvis said that this summer might offer another sizeable premium. He said:

“With massive sums of capital due to unlock in June, I wouldn’t be surprised if we saw a gamma squeeze in the options market as we saw in December. Only this time it’ll be around the $100K to $120K market by the end of June.”

Crypto To-Do List: Use Layer 2

Ethereum is suffering from overload. Network utilization hasn’t dropped below 94% since mid-2020, according to Etherscan, and demand for block space is showing no sign of slowing down. DeFi has become its own burgeoning ecosystem, with over $37 billion locked across protocols like Aave and Uniswap today. Meanwhile, the NFT trend has taken many by surprise, thanks to growing interest among a “mainstream” audience. 

While the demand to use the network may be long-term bullish for Ethereum, it’s caused some serious problems. Ethereum currently processes only 15 transactions per second. Gas fees are a source of complaint for almost anyone who uses the network on a regular basis, with prices increasing alongside utility over the last couple of years. 

Last month, fees briefly surpassed 1,000 gwei—that’s the equivalent of a few hundred dollars for a Uniswap trade. Ethereum hopes to find a solution in the form of Serenity, which will ultimately bring sharding to the network. 

Still, Ethereum 2.0 is potentially a few years away, but the chain needs a more immediate solution to keep processing 1 million transactions daily. The recent growth of Binance Smart Chain has shown that users are prepared to flock elsewhere to interact on-chain, regardless of centralization. Other projects like Solana are hoping to have similar success in the smart contract wars. 

Until Serenity is complete, Ethereum’s best answer to its problems is Layer 2. To understand what Layer 2 means, it’s worth explaining Layer 1 first. Ethereum is a Layer 1 blockchain. It’s the settlement layer for every transaction on Ethereum Virtual Machine. Other Layer 1 chains include Bitcoin, Solana, and Mina. Layer 2, meanwhile, is a framework that runs on top of Layer 1. 

It can help the blockchain achieve scalability by handling some of the network’s load. 

In Ethereum’s case, various Layer 2 solutions are being developed or already available to users. There are different types: channels allow for multiple transactions to be processed off-chain, Plasma leverages Merkle trees to add a new chain, sidechains connect to Ethereum through a bridge, rollups bundle transactions as cryptographic proofs called SNARKs, and Validium uses zero-knowledge proofs while storing data off-chain. 

Several projects are in use and already helping Ethereum regulars use the network at a higher speed and lower cost. 

Polygon, recently rebranded from Matic, uses Plasma and a proof-of-stake mechanism to achieve up to 65,000 transactions per block. Matic is connected to Ethereum via a bridge, which can send assets like ETH to Matic Mainnet.

By changing your MetaMask wallet to the Matic network, you can then interact with the network at practically zero fees using MATIC tokens. Polygon has attracted several on-chain games, including Aavegotchi and Decentraland. Atari also announced it would launch on Polygon, and SushiSwap just deployed its contracts onto the network. 

Another of the most prominent projects is Loopring, a ZK (zero-knowledge) rollup that groups transactions into one transaction. By creating a wallet on Loopring, you can use it to make fast transfers at a fraction of the cost of Ethereum itself. Loopring also has its own decentralized exchange. Gas is required to set up a wallet, but it’s very easy to use without spending a fortune on transactions once you do. 

Arguably the most anticipated Layer 2 solution is Optimism. An optimistic rollup solution, it’s slated to launch this month and will provide composability for DeFi by running on a side chain alongside Ethereum. 

Synthetix went live on Optimism during the team’s soft launch, and other prominent projects have announced their plans to move over in the imminent future. Once Optimism launches in earnest, Ethereum could end up surprising its doubters. 

Ethereum can be slow and expensive to use, not unlike the Internet was in the Windows 95 era. But with promising solutions here today, there’s an opportunity to improve the experience of using the network without compromising on security. When Ethereum 2.0 comes into play, it’s hard to see the “ETH killers” completely destroying the project. We’re heading for a multi-chain world, and Ethereum’s Layer 2 will be a crucial part of it. 

That’s all for this week’s edition of wNews, readers. Stay tuned for next week’s dispatch.

Disclosure: At the time of writing, some of the authors of this feature had exposure to ETH, AAVE, BTC, UNI, SNX, LRC, MATIC, and POLS. 

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