Why can Grayscale "only buy and not sell"? Deconstructing the design principles of Bitcoin trusts

This article was first published on November 18, 2020, on the public account Qianfeng Capital, authored by Chief Analyst Ann Hsu.

1. Bitcoin Trust Attracts 1.5 Billion Monthly

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 called Grayscale Digital Large Cap Fund, which includes Bitcoin, Ethereum, and other top-ranking cryptocurrency assets 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 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 of all products, 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 occasionally opens private placements in the primary market, mainly targeting qualified investors as defined by U.S. Securities Law, 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 is primarily composed 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 fund products 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 also came from institutional investors. According to the information disclosed by Grayscale, the funds flowing into Grayscale products from institutional investors are primarily from hedge funds. Although specific data on hedge fund inflows into Grayscale products has not been disclosed, considering that hedge funds occupy a large portion of institutional investors and that the inflow of funds 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 Design

In the investment terms of Grayscale Bitcoin Trust, there are two particularly noteworthy 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; investors can only sell their Bitcoin Trust shares (GBTC) on the U.S. secondary market. The other is the fee collection mechanism, where Grayscale charges a 2% management fee annually from the Bitcoin Trust as its source of income, and the management fee is deducted from the number of Bitcoins held, meaning it is collected 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 the announcement disclosed by Grayscale, current regulations 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's choice to collect management fees in a coin-based manner means that after deducting operating expenses and taxes paid externally, the remaining Bitcoin from the management fees collected from investors becomes Grayscale's profit retention. Moreover, since Grayscale's Bitcoin Trust does not specify a duration for the trust, this means it is a trust without an expiration date (perpetual existence). By interpreting all this information together, we can conclude: the non-redeemable mechanism of Grayscale Bitcoin Trust will lead to an increasing amount of assets under management, and the collection of management fees is not in a fixed fiat currency form but in a fixed proportion of coin-based form. 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, while in the long run, the value of Bitcoin will continue to appreciate, allowing Grayscale to 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 Collected in Coin-Based and then Sold for USD 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 physical contributions (BTC).

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

Figure 9: Grayscale Bitcoin Trust Cash Contribution Model Source: Chain Hill Capital The other method is physical contribution in Bitcoin. Investors hand over Bitcoin to Grayscale, which stores the Bitcoin in Coinbase Custody and issues equivalent Bitcoin Trust shares (GBTC) to the investors.

Figure 10: Grayscale Bitcoin Trust Physical Contribution Model Source: Chain Hill Capital Among these two funding models, the cash contribution model involves investors buying Bitcoin with cash at the time of subscription, which may have a certain impact on the price in the spot market (depending on the scale of funds). The physical contribution model directly pays the Bitcoin held by investors to Grayscale in exchange for trust shares, so Grayscale does not buy on the spot market, making the impact on the spot price 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 physical contribution model involves borrowed funding, it creates significant potential for subsequent capital reflow in the market, forming a perfect closed loop of "pressure transfer and capital reflow."

5. Ingenious Design: Pressure Transfer to U.S. Stocks, Capital Back to Crypto

As mentioned above, the Bitcoin held by Grayscale Bitcoin Trust is not redeemable, 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 huge market demand, GBTC often trades at a premium relative to its net asset value in the secondary market.

Figure 11: GBTC Premium and Discount Situation Source: yCharts.com Where there is a premium, there is an arbitrage opportunity. There are three common arbitrage models: cash lending arbitrage, physical 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 an 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 on 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 the price of Bitcoin. To mitigate the risk of Bitcoin price declines, investors can hedge against arbitrage risks in the Bitcoin futures market.

Figure 12: GBTC Cash Lending Arbitrage Model Source: Chain Hill Capital The physical lending arbitrage model is fundamentally similar to the physical contribution model mentioned above, except that the Bitcoin contributed by investors is borrowed from external sources. Investors use the borrowed Bitcoin as capital 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 amount of Bitcoin returned and the corresponding interest will be the profit obtained by the arbitrageur.

Figure 13: GBTC Cash-Physical Arbitrage Model Source: Chain Hill Capital In the physical 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 physical Bitcoin lending as well as stablecoin USDC lending. If investors borrow stablecoins, they need to convert them into BTC before subscribing to the trust shares from Grayscale, 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 shares from the lending party (the party lending the trust shares). When the premium rate corresponding to the price of GBTC in the secondary market exceeds the lending cost, there is a 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 the Bitcoin to subscribe to Grayscale's trust shares. After obtaining the shares, investors return an equivalent number of GBTC shares and the agreed interest to the lending party after the lock-up period expires, and the remaining cash will be the investor's arbitrage profit.

Figure 14: GBTC Share Lending Arbitrage Model (Physical Contribution) Source: Chain Hill Capital After borrowing and selling GBTC shares, investors can also choose to subscribe to Grayscale's Bitcoin Trust shares using cash contributions, and after the lock-up period expires, 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 the non-redeemable mechanism and the isolation of the GBTC shares' listing and circulation market, a separation has occurred between the primary market issuance and the secondary market circulation, with the U.S. stock market assuming the function of transferring trust shares, while the issuance market remains in the crypto space. Therefore, investors cannot sell trust shares in the crypto space and can only choose to sell them in the U.S. secondary market, which effectively transfers the massive pressure of trust holdings to the U.S. stock market. Additionally, since GBTC has long existed with premium arbitrage opportunities, physical lending arbitrage and share lending arbitrage mean that after investors sell trust shares in the U.S. stock market, they must return to the crypto space to buy Bitcoin in the spot market to repay the lending institutions, thus creating a perfect closed loop of "pressure transfer to U.S. stocks, capital back to crypto."

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

Grayscale has previously disclosed the forms of funding for 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 physical contributions. During the period from Q3 2018 to Q3 2019, this proportion was also 71%, but Grayscale has not released corresponding data in subsequent quarterly reports.

Figure 16: Funding 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 forms of investor funding, the growth rate of lending scale from its sibling company Genesis shows a high correlation with the growth of Grayscale Bitcoin Trust's holdings, especially since the second half of 2020, both have seen a significant acceleration in growth compared to the past. Additionally, as mentioned earlier, the main institutional investors come from hedge funds, and arbitrage is the most common way for hedge funds to profit. We can roughly conclude that there should be a considerable number of 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 arbitrage through lending, and most funding methods may be in the form of physical contributions to subscribe for 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, with the corresponding 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, with the corresponding 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 massive amount 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 for Bitcoin in the fourth quarter of this year and throughout next year.

Figure 19: Weekly Inflows of Grayscale Family Products Over the Past Year (Dark Green Represents Bitcoin Trust Inflows) Source: Grayscale

7. Conclusion

Based on the non-redeemable mechanism of Grayscale Bitcoin Trust, the dual funding forms, and the clever separation of issuance and circulation across markets, the high premium of GBTC shares in the U.S. secondary market provides space for cross-market arbitrage. The participation of arbitrage capital successfully realizes the perfect closed loop of "pressure transfer to U.S. stocks, capital back to crypto," making Grayscale Bitcoin Trust a bullish force in the market that "only buys and does not sell." In the future, Bitcoin is expected to maintain an upward trend.