Depth | Deconstructing the Grayscale Bitcoin Trust

This article was published on November 18, 2020, in the Mars Finance Enterprise Column, authored by Ann Hsu, Chief Analyst at Qianfeng Capital.

Grayscale Bitcoin Trust is the largest cryptocurrency asset trust product under Grayscale. Based on the trust's non-redeemable mechanism, dual funding structure, and cleverly separating issuance from circulation across markets, the GBTC shares in the U.S. secondary market have a high premium, providing space for cross-market arbitrage. Arbitrage funds participate smoothly in achieving a perfect closed loop of "selling pressure transferred to the U.S. stock market, funds brought back to the crypto circle." This makes Grayscale Bitcoin Trust a bullish force in the market that is "buying only." This article will use the Bitcoin Trust as an example to deconstruct the design principles of Grayscale's trust products.

1. Bitcoin Trust Monthly Capital Inflow of 1.5 Billion

Grayscale's products are divided into two types: single-asset trusts and multi-asset portfolio funds.

Among them, there are a total of 9 single-asset trusts, including Bitcoin Trust, Ethereum Trust, etc. The multi-asset portfolio fund is a product called Grayscale Digital Large Cap Fund, which includes Bitcoin, Ethereum, and other top-ranking cryptocurrencies by market capitalization.

Figure 1: Grayscale Product Establishment Timeline

Source: "Grayscale Investor Deck October 2020"

This asset management institution is siphoning external funds into the cryptocurrency market at an unprecedented speed. In the third quarter of 2020, the inflow of funds reached $1.05 billion, of which the inflow for Bitcoin Trust in the third quarter was $719 million, equivalent to an average monthly inflow of about 1.5 billion RMB. As of October 22, 2020, the total assets under management (AUM) of all Grayscale products were $7.257 billion, with Bitcoin Trust's AUM at $6.032 billion, accounting for 83% of the total AUM, making it the largest product under Grayscale.

Figure 2: Grayscale Asset Management Scale Source: Grayscale Official Twitter

2. Hedge Funds Contribute the Most

Currently, Grayscale Bitcoin Trust opens private placements in the primary market irregularly, mainly targeting qualified investors as defined by the U.S. Securities Act, with a minimum investment threshold of $50,000. According to the financial report for the third quarter of 2020, the investor structure for Grayscale's products mainly consists of institutional investors, qualified investors, family offices, retirement account funds, etc., with institutional investors accounting for over 80%, and more than half of the investors (57%) coming from countries and regions outside the United States.

Figure 3: Grayscale Investor Structure by Type

Source: "Grayscale Digital Asset Investment Report Q3 2020"

Figure 4: Grayscale Investor Structure by Region

Source: "Grayscale Digital Asset Investment Report Q3 2020"

Among all investor compositions, institutional investors undoubtedly account for the largest share. In the third quarter of 2020, the inflow of funds into all Grayscale trusts and funds was $1.05 billion, of which 81% ($850 million) came from institutional investors. Over the past 12 months, 80% of the total inflow of $2.7 billion into Grayscale came from institutional investors. According to information disclosed by Grayscale, the inflow of funds from institutional investors into Grayscale products is primarily dominated by hedge funds. Although specific data on the inflow of hedge funds into Grayscale products has not been disclosed, considering that hedge funds occupy a significant portion of institutional investors and that the inflow from institutional investors exceeds 80%, the contribution of hedge funds to Grayscale products should not be small.

Figure 5: Overview of Fund Inflows into Grayscale Products

Source: "Grayscale Digital Asset Investment Report Q3 2020"

3. Grayscale's Profitable Model

In the investment terms of Grayscale Bitcoin Trust, there are two particularly notable pieces of information. One is the provision regarding the redemption mechanism of the Bitcoin Trust; currently, Grayscale Bitcoin Trust does not support the redemption of shares, meaning that once investors subscribe to the trust shares, they cannot exchange them back for Bitcoin, and investors can only sell the Bitcoin Trust shares (GBTC) in the U.S. secondary market. The other is the provision regarding the fee collection mechanism, where Grayscale charges a 2% management fee annually from the Bitcoin Trust as its source of income, with the management fee deducted from the number of Bitcoin held, meaning it is charged in a coin-based manner.

Figure 6: Grayscale Bitcoin Trust Terms

Source: "Grayscale Investor Deck October 2020"

These two seemingly unrelated provisions actually contain clever design. According to Grayscale's disclosed announcements, regulators currently do not require trust shares to support redemption, and Grayscale has chosen a mechanism where shares cannot be redeemed, meaning that investors can only realize profits by transferring trust shares in the U.S. stock market. Grayscale chooses to charge management fees in a coin-based manner, and after deducting operational expenses and taxes paid externally, the remaining Bitcoin from the management fees charged to investors becomes Grayscale's profit retention. Furthermore, Grayscale's Bitcoin Trust does not specify a duration for the trust, meaning it is a trust without an expiration date (perpetual existence). By overlaying this information, we can conclude that the non-redeemable mechanism of Grayscale Bitcoin Trust will lead to an increasing amount of assets under management, and the management fee is not a fixed proportion in fiat currency but a fixed proportion in coin-based terms. This structural design will ultimately cause the amount of Bitcoin corresponding to each share held by trust holders to gradually decrease, and in the long term, the Bitcoin held by the trust will slowly transfer to Grayscale, making Grayscale one of the largest Bitcoin holders in the market. As Bitcoin's value continues to appreciate in the long term, Grayscale will reap substantial profits.

Figure 7: The Number of Bitcoins Corresponding to Each Share Gradually Decreases

Source: "Grayscale Investor Deck October 2020"

"The Trust will not generate any income and regularly uses Bitcoin to pay for its ongoing expenses. Therefore, the amount of Bitcoin represented by each share will gradually decline over time." ------ "Grayscale Investor Deck October 2020"

"该信托不会产生任何收入，并定期使用比特币支付其日常开支。因此，随着时间的推移，每份份额所对应的比特币数量将逐渐下降。"------"Grayscale Investor Deck October 2020"

Figure 8: Grayscale Bitcoin Trust Fees and Taxes are Charged in Coin-Based Terms and then Sold for USD Payment

Source: "Grayscale Bitcoin Trust BTC 2019 Tax Information Final"

4. Dual Funding Leaves Room for Capital Reflow

Grayscale's Bitcoin Trust accepts two forms of funding: cash contributions and in-kind contributions (BTC).

In the cash contribution model, investors submit subscription funds to Grayscale, which then hands over the subscription funds to an authorized broker, also Grayscale's sibling company, Genesis Global Trading, Inc. (hereinafter referred to as "Genesis"), which buys BTC spot on the spot market and delivers it to Grayscale. After Grayscale receives the spot, it stores it in the custody institution Coinbase Custody for cold storage and issues equivalent Bitcoin Trust shares (GBTC) to investors.

Figure 9: Grayscale Bitcoin Trust Cash Contribution Model Source: Chain Hill Capital

The other way is through in-kind contribution of Bitcoin. Investors hand over Bitcoin to Grayscale, which stores the Bitcoin in Coinbase Custody and issues equivalent Bitcoin Trust shares (GBTC) to investors.

Figure 10: Grayscale Bitcoin Trust In-Kind Contribution Model Source: Chain Hill Capital

In these two funding models, the cash contribution model will have a certain impact on the spot market price when investors buy Bitcoin with cash during subscription (depending on the scale of funds). The in-kind contribution model directly pays the Bitcoin held by investors to Grayscale in exchange for trust shares, so the impact on the spot price is unpredictable. However, if the Bitcoin held by investors is borrowed from external sources, once the lock-up period for the trust shares issued to investors by Grayscale (currently reduced from 12 months to 6 months) expires, investors will face pressure to return the Bitcoin. Therefore, when the in-kind contribution model involves borrowed contributions, it leaves significant room for subsequent capital reflow across markets and will form a perfect closed loop of "selling pressure transfer and capital reflow."

5. Ingenious Design: Selling Pressure Transferred to U.S. Stocks, Funds Brought Back to the Crypto Circle

As mentioned above, the Bitcoin held by Grayscale Bitcoin Trust cannot be redeemed, and investors need to sell the Bitcoin Trust shares (GBTC) issued by Grayscale in the U.S. stock market (OTCQX) to realize profits. GBTC is currently one of the legal and compliant channels for investing in Bitcoin, and due to the enormous market demand, GBTC often trades at a premium over its net asset value in the secondary market.

Figure 11: GBTC Premium/Discount Situation Source: yCharts.com

Where there is a premium, there are arbitrage opportunities. Common arbitrage models include cash lending arbitrage, in-kind lending arbitrage, and share lending arbitrage. In the cash lending arbitrage model, as long as the market's arbitrage profit exceeds the cash lending cost, there is theoretically arbitrage space. Investors can borrow funds from companies like Genesis or other lending platforms and subscribe to Grayscale's Bitcoin Trust shares. After the 6-month lock-up period for the trust shares expires, investors can sell GBTC in the U.S. stock market (OTCQX), and if there is a positive premium space, the remaining amount after repaying the principal and interest to the lender will be the arbitrage profit. The short-term price of GBTC is determined by investors in the U.S. stock market, but in the long term, it tracks Bitcoin prices. To mitigate the risk of Bitcoin price declines, investors can hedge arbitrage risks in the Bitcoin futures market.

Figure 12: GBTC Cash Lending Arbitrage Model Source: Chain Hill Capital

The in-kind lending arbitrage model is fundamentally similar to the above in-kind contribution model, except that the Bitcoin contributed by investors is borrowed from external sources. Investors use the borrowed Bitcoin as funding to subscribe to Grayscale's GBTC trust shares, and after the 6-month period, they can sell GBTC shares in the U.S. secondary market to obtain cash, and then use that cash to buy Bitcoin in the spot market to return to the lending institution. If there is an arbitrage space, the remaining cash after deducting the returned Bitcoin quantity and corresponding interest will be the profit obtained by the arbitrageur.

Figure 13: GBTC Cash In-Kind Arbitrage Model Source: Chain Hill Capital

In the in-kind lending arbitrage model, the physical asset initially borrowed by investors may not necessarily be Bitcoin; it could also be other digital currencies. For example, Grayscale's sibling company Genesis can provide Bitcoin for lending and also stablecoins like USDC. If investors borrow stablecoins, they need to convert them to BTC before subscribing to Grayscale's trust shares, and the stablecoins returned to the lending institution will also be stablecoins. The share lending arbitrage model is relatively unique compared to the previous two; its principle is that investors first borrow GBTC trust shares from the lending party (the party lending the trust shares). When the premium rate corresponding to the GBTC secondary market price exceeds the lending cost, there is positive arbitrage space. After selling GBTC shares, investors can participate in arbitrage in two ways. One is to use cash to buy Bitcoin in the market and use Bitcoin to subscribe to Grayscale's trust shares. After obtaining the shares, investors return an equal number of GBTC shares and the agreed interest to the lending party after the lock-up period, and the remaining cash will be the investor's arbitrage profit.

Figure 14: GBTC Share Lending Arbitrage Model (In-Kind Contribution) Source: Chain Hill Capital

After borrowing GBTC shares and selling them, investors can also choose to subscribe to Grayscale's Bitcoin Trust shares using cash contributions, and after the lock-up period, return an equal number of shares and the agreed interest, with the remaining cash being the investor's profit.

Figure 15: GBTC Share Lending Arbitrage Model (Cash Contribution) Source: Chain Hill Capital

Due to Grayscale's clever design of a non-redeemable mechanism and the isolation of the GBTC shares' listing and circulation market, a separation between the primary market issuance and the secondary market circulation has occurred, with the U.S. stock market assuming the function of transferring trust shares, while the issuance market remains in the crypto circle. Therefore, investors cannot sell trust shares in the crypto circle and can only choose to sell in the U.S. secondary market, which effectively transfers the massive selling pressure of the trust's holdings to the U.S. stock market. At the same time, since GBTC has long-term premium arbitrage space, in-kind lending arbitrage and share lending arbitrage cause investors to sell trust shares in the U.S. market and then return to the crypto circle to buy Bitcoin in the spot market to repay the lending institutions, thus creating a perfect closed loop of "selling pressure transferred to the U.S. stock market, funds brought back to the crypto circle."

6. Potential Arbitrage Capital Reflow, Bitcoin's Uptrend Expected to Continue

Grayscale has previously disclosed the forms of contributions made by investors subscribing to trust shares. In the third quarter of 2019, 79% of the funds flowing into all Grayscale trust products were in the form of in-kind contributions. During the period from Q3 2018 to Q3 2019, this proportion was also 71%, and Grayscale has not released corresponding data in subsequent quarterly reports.

Figure 16: Contribution Forms for Grayscale Family Products in Q3 2019 and from Q3 2018 to Q3 2019

Source: "Grayscale Digital Asset Investment Report Q3 2019 October 2019"

Although Grayscale no longer publishes recent investor contribution forms, the growth rate of the lending scale of its sibling company Genesis shows a high correlation with the growth of Grayscale Bitcoin Trust's holdings, especially since the second half of 2020, where both have seen a significant acceleration in growth compared to the past. Additionally, as mentioned earlier, the main institutional investors are from hedge funds, and arbitrage is the most common way for hedge funds to profit. We can roughly conclude that there should have been many institutions entering the market for arbitrage.

Figure 17: Rapid Growth of Grayscale Bitcoin Trust Holdings After June 2020 Source: Aicoin

Figure 18: Growth of Lending Scale of Grayscale's Sibling Company Genesis Source: Genesis

Investors enter the market to conduct arbitrage through lending, and most of the contribution methods may be in the form of in-kind contributions to subscribe to trust shares. Once the arbitrage capital flows back, there will be pressure to buy physical assets to return to the lending institutions. According to Grayscale's disclosed Q3 2020 report, there were two waves of subscription peaks after April 2020, one from the end of April to the end of June, corresponding to a share unlock period from the end of October to the end of December. The other wave of subscription peaks occurred from the end of July to the end of September, corresponding to a share unlock period from January 2021 to March 2021. Currently, entering the fourth quarter of 2020, Grayscale Bitcoin Trust's holdings have increased by 17,000 in October, and in fact, the subscription peaks have been ongoing, meaning that there will be a large number of trust shares unlocking before April next year. As the supply-demand pattern continues to change and the existing Bitcoin in the market gradually decreases, coupled with the reflow of arbitrage capital, we maintain a bullish outlook on Bitcoin for the fourth quarter of this year and throughout next year.

Figure 19: Weekly Inflows into Grayscale Family Products Over the Past Year (Deep Green Represents Bitcoin Trust Fund Inflows) Source: Grayscale

Conclusion

Based on the non-redeemable mechanism of Grayscale Bitcoin Trust, the dual funding structure, and the clever separation of issuance and circulation across markets, the GBTC shares in the U.S. secondary market have a high premium, providing space for cross-market arbitrage. Arbitrage funds participate smoothly in achieving a perfect closed loop of "selling pressure transferred to the U.S. stock market, funds brought back to the crypto circle," making Grayscale Bitcoin Trust a bullish force in the market that is "buying only." In the future, Bitcoin is expected to maintain an upward trend.