Grayscale GBTC and ETHE Arbitrage Risks
The GBTC and ETHE premium arbitrage trade has recently become very topical. Both products, issued by Grayscale, have traded at a consistent premium over NAV (TradeBlock XBX and ETX Index) since inception. Currently, GBTC trades at a 30% premium to NAV, and ETHE trades at a 850% premium to NAV.
Whilst the secondary market trades at a premium to NAV, there are ways to subscribe to shares struck at NAV:
- In cash, using USD to buy shares struck at NAV
- In-kind, by sending BTC or ETHE to the trust and receiving shares struck at NAV
After a lockup period, investors may pull their shares into a brokerage account as an equal number of ETHE or GBTC shares, which they can then sell at market prices. Grayscale charges a 2% annual management fee on GBTC and a 2.5% annual fee on ETHE which the investor pays during the holding period. The lockup period for GBTC is 6 months, and 12 months for ETHE. If the premium is still positive after shares unlock, investors can pocket the difference in the spread. Below we outline the trade setup for 3 broad types of market participants.
For USD-denominated investors:
- Investor sends USD to the trust and subscribes to shares struck at NAV
- Shares are locked for 6m in GBTC / 12m in ETHE, and upon unlock, investor sell the shares at the prevailing market price
- If the premium persists upon unlock, investor is able to realize the spread
- This is ideal for investors who wish to gain BTC or ETH exposure and monetize their view on a sustained premium (as a way to enhance yield)
For BTC and ETH-denominated investors:
- Investor sends coins to the trust and subscribes to shares struck at NAV
- Shares are locked for 6m in GBTC / 12m in ETHE, and upon unlock, investor sell the shares at the prevailing market price
- As there exists no in-kind redemption, the investor needs to use proceeds from the share sales to buy back physical coins in order to return to his/her base portfolio
- This is ideal for investors who wish to earn more coins and monetize their view on a sustained premium
For market neutral investors
- Investor borrows coins from a lender, and subscribes to shares struck at NAV (potentially using the shares as collateral)
- Shares are locked for 6m in GBTC / 12m in ETHE, and upon unlock, investor sell the shares at the prevailing market price
- Investor needs to then use the USD proceeds to buy back the physical coins (BTC or ETH)
- Investor pays back the coin principal to the lender, and the interest
- This is ideal for market neutral investors who wish to express a view on a sustained premium, and are able to borrow coins at a funding cost within their expected premium (less accrued management fees)
None of these trades would constitute an arbitrage. In each of the above cases, investors need to sell the shares in the secondary market, and are subject to market fluctuations in the spread/premium, with no direct way to hedge. Whilst historically the shares have traded at steep premiums to NAV, premiums could compress, or trade at discounts in the future. Below we outlined few examples of various headwinds against a sustained premium.
First to the finish
As subscriptions have grown tremendously over the past few quarters, a large amount of this likely relates to market participants looking to monetize the sustained premium. Given the growth in popularity of this trade, there will be increasingly more sell pressure on GBTC and ETHE as shares from subscriptions unlock. This makes the market more conducive to spread compression.
No redemption program
Currently, BTC and ETH that are sent to the trust never leave the trust. So whilst investors can subscribe in-kind, they can not redeem in-kind (exchange shares for underlying coins). Hence, there is nothing stopping the shares from potentially trading at a discount to NAV should spot significantly outperform / shares underperform on a swift market move.
Reduced lockup periods
The lockup period could be subject to further changes for private placement investors. Earlier this year, following approval from the SEC, the previous 12 month holding period was reduced to the current 6 month period in GBTC. Should the lockup period reduce again in the future, this could translate into further sell pressure on the shares from existing subscriptions.
More stock borrow availability
Historically, trust shares have been scarce in supply, making securities borrow difficult and expensive. Investors have therefore been unable to short GBTC against the underlying. With the GBTC trust AUM now at $3.7bn and growing (ETHE @ $360mio and growing), shares are likely to become easier to borrow with higher availability as the public float grows.
Competing products
As high entry-barriers and difficulty of crypto-access continue to subside (Robinhood, Coinbase), premiums should naturally compress over time as investors find alternative ways to buy underlying assets directly. An ETF approval (e.g. Bitwise, VanEck; albeit chances may be slim in the near term) would serve as a key catalyst for institutional buyers to switch over from GBTC as the preferred instrument to hold.
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