There’s been a lot of discussion in recent months about the Bitcoin ETF.
When will it get approved? Who will win the tortoise race through the SEC’s glacial approval process? Will it even matter?
But what often gets glossed over is that there are already not one, but two “sidedoor ETFs” trading on OTC Markets in the U.S. - Bitcoin’s GBTC and Ethereum Classic’s ETCG - both from DCG’s Grayscale Investments subsidiary.
These aren’t exchange-traded (so they aren’t really * E* TFs), and they haven’t gone through the full-blown public listing process, but they are structurally similar to large commodity ETFs, and investors can purchase them today as titled securities in their retirement accounts.
Grayscale relies on something called a “Rule 144 exemption” that allows them (and their investors) to resell investment trust shares to the public. But only after an initial restricted “Reg D” accredited-only offering and a one year holding period.
There are a few other criteria to rely on rule 144 (you need adequate public reporting information, insiders can’t sell more than 1% of weekly volumes, and you need to file a notice period with the SEC), but it’s much less restrictive than the S-1 rigmarole many other teams are dealing with right now.
That does cause a number of unique issues for Grayscale’s products, though. In particular, it’s hard (impossible?) to short, which means its public share prices usually trade at a massive premium to the underlying “NAV" (net asset value). To understand why, you need to know about how this particular type of ETF works.
- ETFs like the gold trust $GLD are usually structured in such a way that the trust company custodies the underlying commodity in exchange for issuing shares in the underlying. The GLD custodies gold, then issues an equivalent amount of shares to parties who deliver them the goods. This structure improves liquidity and accessibility of commodities markets, so GLD’s sponsors earn fees.
- The average Joe can’t simply deposit physical gold into the GLD. Instead, this work is done by “authorized participants”, usually a broker dealer or bank, that “creates” or “redeems” new baskets of shares in the trust. The AP can send gold to the trust, and the trust will send back shares at an agreed-upon exchange rate at a fixed time and reference rate each day, usually a 24-hour volume weighted average price (VWAP) based on regulated exchange rates.
- An ETF that makes it onto a major exchange has a healthy ecosystem of regulated authorized participants that effectively ensure prices of the ETF’s shares don’t fluctuate wildly from the commodity’s fair market value (same thing as the NAV). Every day the ETF trades, the APs trade around the NAV to provide better price stability; if the share price moves higher than the NAV, the AP can buy the underlying commodity, short the public shares, and create a new basket of shares at the end of the day at the lower NAV, covering their shorts and earning a spread.
- The process works in reverse as well. If an ETF share price falls below the NAV, an AP can buy the shares on the open market, short the physical commodity, and redeem a basket of shares at the end of the trading day to cover the commodity short (and profit) from the share sale.
If that’s confusing as shit, I understand.
And it took me a while to grok it, too. But here’s the most salient point, one that’s maybe the best way to convince the SEC to get its shit together and approve an ETF:
Those separate lines show the spread between market exchange rates and NAV. Everything about the green line is a market inefficiency. And that’s all because GBTC and ETCG aren’t bona fide ETFs.
Grayscale’s Bitcoin investment Trust currently trades at a 17% premium to NAV (actually relatively modest by historical standards), but the ETC trust trades at a whopping 85% (!!) of NAV.
That’s objectively bad for the retail buyers on the other end of this trade, but there’s nothing Grayscale (or anyone) can do about it until the actual ETF is approved.
On the other hand, the fact that the only path to liquidity for investors is through rule 144 sales is great for private, wealthy investors with a bit of patience.
After a 12 month holding period, they’re rewarded for modest interim illiquidity with a pretty much guaranteed 12 month “exit” at a premium to spot prices. That means savvy investors can “recycle” trades for as long as a SEC-approved ETFs are held in limbo: hold for a year, sell shares at the premium, and then enter a new position via a Grayscale private placement (or direct investment in the underlying).
It’s like a 17% free bitcoin dividend if you’re recycling GBTC private placements!
Old news. Why bring this up now?
Grayscale has a LOT of new products that will soon be eligible for OTC quotation (i.e. the same playbook the company has followed with the BTC and ETC products historically. Only a few have raised any meaningful capital to date, but the ones that have raised more than meager amounts are all eligible for OTC quotation under a Rule 144 re-sale process.
Eligible later this year:
Mar 2: BCH trust: $2.4mm AUM | LTC trust: $200k AUM | XRP trust: $4.7 AUM
Aug 7: ZEN trust: $1.8mm AUM
Dec 12: XLM trust: $400k AUM
Eligible Now (and could already be in the works):
ETH trust: $6.4mm
ZEC trust: $7.8mm
Digital Cap Large Fund: $8.4mm (eligible Feb 2)
TBD on whether Grayscale actually pushes these puppies to market given the current crypto bloodbath, or if they hold off until some semblance of a sector rebound is in hand (or their restricted products have enough AUM to justify the legal fees).
Either way, three more sidedoor ETFs could hit the market soon.
I should note (and this should really go without saying) this is not investment advice.
If you are being really clever you might think you can game this system, BUT remember that a) your “risk-free” spread could evaporate overnight if any ETFs are actually approved, b) these premiums have occasionally turned negative historically (it happened during the nadir of the 2015 bear market), and c) at least with the digital large cap fund, we think it’s probably overweight XRP.