Amid the collapse of FTX, there are growing fears of a domino effect in the form of the fall of many other industry players, including the largest cryptocurrency funds. Is there a risk of bankruptcy for GBTC holding over 600,000 BTC?
The consequences of the FTX collapse were felt for the cryptocurrency industry, but expectations of a string of bankruptcies were exaggerated. Even despite the lawsuit against the founder of the bankrupt exchange, Sam Bankman-Fried, and his closest associates, Bitcoin has been trading steadily in the range between $16,000 and $18,000 since November 10. It has not been thrown off balance by the ongoing attacks from regulators and large banks, or by a serious drop in volumes bidding However, exiting any range happens sooner or later. Where will Bitcoin go?
If even the whole mass of negative news could not break through the support levels, then Bitcoin still has high growth potential. The absence of serious negativity will encourage the bravest traders to move on to purchases. To return to sustainable growth, most investor sentiment needs to improve. But what other dangers could lie in wait for Bitcoin, besides those already realized?
One of the most stable instruments in the cryptocurrency market is regulated trust and exchange-traded funds. Their total value is only a few percent of the capitalization of the cryptocurrency market. However, these are SEC-regulated players in the traditional financial market, so they are more trustworthy than most cryptocurrency exchanges.
The largest operator of cryptocurrency funds is the American company Grayscale. This is not a public company, and only a few thousand large investors hold shares of its funds. Moreover, the capitalization of Grayscale funds is an order of magnitude higher than all other funds combined. Last year, Grayscale tried to convert GBTC into a publicly traded ETF, but the SEC refused, citing Bitcoin's volatility and Tether's influence. After this, Grayscale even sued the regulator.
Grayscale, like the largest exchanges, can be considered a systemically important player in the cryptocurrency industry. Barry Silbert's company has been around since 2013 and is well-deservedly trusted as one of the most stable. Consequently, its bankruptcy would be even more devastating than FTX's. And given the company’s reserves in major cryptocurrencies, the closure of its funds in terms of effect on stock prices could surpass even the collapse of Binance.
How GBTC and other cryptocurrency funds work
First, let's look at the financial basis of the oldest of the cryptocurrency trusts. How are its profits or losses generated? What are the risks for the fund operator and shareholders, and how can they realize gains, if any?
GBTC and trust funds for other cryptocurrencies are managed by Grayscale Investments, registered in the US state of Delaware. This is one of the most favorable jurisdictions for cryptocurrency companies in terms of taxation. The fund was launched in September 2013.
The total amount of assets under Grayscale management is more than $15 billion, placed in sixteen funds, both for one cryptocurrency and for portfolios of crypto assets. Of these, the largest are GBTC (Bitcoin) and ETHE (Ethereum). The asset value of GBTC at the close of Friday, December 30 is $10.49 billion, ETHE is $3.633 billion. The accounting price of Bitcoin in fund shares is calculated using the Coindesk index.
GBTC (or its investors) owns 635,235.84 BTC, and at the beginning of 2022 owned 644,809.97 BTC. Thus, in nine months, Grayscale sold about 9,574 BTC on the market. These are not direct sales, but withdrawals in favor of the fund operator to pay the commission.
At the end of 2022, GBTC remains the world's largest active Bitcoin holder, second only to Satoshi Nakamoto, whose coins have not moved since 2009. The fund owns more than 3% of the maximum possible amount of BTC, even on a global scale this is a serious figure.
Grayscale does not store cryptocurrencies itself, outsourcing this function to the largest platform in the United States, Coinbase. Of course, they are not stored on the exchange, but in a special custodial service, that is, in cold storage. However, after the collapse of FTX in November, Grayscale refused to publish information about its reserves, citing the reliability of Coinbase services and regulatory oversight. To a certain extent, this is justified, since reserves in cold wallets cannot be controlled online, and Grayscale reports publish the amount of bitcoins in storage. Yet the outright refusal did not inspire investors.
Regardless of the fund's performance, 2% of asset value goes annually to parent company Grayscale Investments as a service fee. In the ETHE fund, the cost of maintenance is even higher—2.5% per annum, although its capitalization is three times lower than that of GBTC. By comparison, traditional stock and commodity ETFs typically have annual maintenance fees in the range of 0.1%–0.5%, and even riskier “pooled products” rarely exceed 1% per annum.
It is on this 2% that Barry Silbert lives. Even after the underlying asset fell five times from its highs, 2% of $10 billion is not such a bad amount, right? The annual profit from servicing ETHE is more modest and amounts to about $100 million. And for the record year 2021, Grayscale’s guaranteed income from GBTC alone exceeded $400 million.
Profit and loss
Now let's take a look at who bears the risks and benefits from trading Grayscale fund shares. In general, everything is standard. The fund operator receives the profit (minimum guaranteed 2%), and the exchange collects its commission. Investors bear all risks. Just like with any other stock market instruments.
After purchasing shares, the investor's future profit or loss depends entirely on their market price. The position can only be closed by selling shares on the secondary market. The fund operator has no obligation to redeem shares or compensate for losses.
When Bitcoin rises, and it has risen more than 100-fold since the fund launched, investors are doing well. They can sell the shares on the open market and walk away with a profit. But in a prolonged bear market weighed down by political instability, the liquidity of such risky instruments falls, and the price may fall faster than the price of the underlying asset. The investor has little choice: sell shares at the current price or wait. It is even more difficult for large holders to exit without increasing the drawdown.
What’s interesting is that even if Bitcoin falls to $1, Grayscale itself will only lose potential profits, because bitcoins are nominally owned not by the operator, but by investors. And they will bear all the losses. Moreover, in the current market, which is teetering on the brink of panic, it will be more profitable for investors to close the fund than to sell at the current price, since GBTC shares are denominated in bitcoins, not dollars.
Buy bitcoins at half price
No, this is not an advertisement. This is indeed possible if you have the status of an accredited investor in the USA and are willing to invest $50,000 or more. But there is one caveat. Grayscale's bitcoins are real, but only derivatives backed by them are traded on the market. The closest analogue is impersonal accounts for precious metals instead of physical bullion. It is possible to receive the underlying asset only if certain conditions are met.
The strangest and even alarming circumstance is the maximum discount to the price of shares in relation to their collateral for the entire existence of Grayscale funds. According to Grayscale itself, the current price of one share of GBTC on the day of publication is $7.9, and the market price of the bitcoins backing it is $15.15. Thus, Bitcoins backed by GBTC can be purchased for just 53% of their market value!
With ether the situation is even worse. One share of ETHE costs $4.73 on the over-the-counter market, and the corresponding coins in the vault cost $11.71. That is, you can buy ETH in Grayscale shares for only 40% of the market price!
In a conventionally normal market such discounts do not exist. A similar situation was observed, for example, before the collapse of the BTC-e exchange. Cryptocurrencies, the withdrawal of which was closed, were initially traded two to three times cheaper than the market price, and just before the collapse they were already five to ten times cheaper.
There may be two reasons for such a low valuation of Grayscale shares, and they can work together:
Expectation of a further fall in cryptocurrencies. When buying GBTC shares, you are not buying bitcoins, but a derivative instrument equivalent to them. In a stable market, the share price is close to the collateral price, but during periods of turbulence, deviations both up and down are possible. You can sell shares on the secondary market at the current price, but you cannot get “live BTC” for them. This is only possible in the event of liquidation of the fund or by individual agreement with Grayscale. Therefore, investors expecting a fall in cryptocurrencies factor this decline into the future value of GBTC shares.
Suspicions of Grayscale instability. If Grayscale goes bankrupt or otherwise closes the funds, bitcoins from the fund will be transferred to unit holders "as is" or sold on the market. But since this event will in any case cause a strong drawdown of Bitcoin, and the process may drag on, investors also include risks in the market value of shares.
It is obvious that there are now more pessimists than optimists. And ETH is believed less than BTC. The discount in the price of Grayscale shares is, albeit an indirect, but quite reliable indicator of the sentiment of American investors. And not “retail herring”, since the minimum entry threshold of $50,000 for BTC and $25,000 for ETH cuts off small players.
You also need to understand that when the fund is liquidated due to the bankruptcy of the company, there is a risk of not receiving all the bitcoins due. During the bankruptcy process, unit holders join the ranks of other creditors of the operating company. In the case of a high credit load, the remaining assets, primarily the collateral for funds, will be diluted by other liabilities of the company. Only the court will determine who will have priority.
Other crypto funds
For comparison, here are a few more relatively popular Bitcoin funds. But, as mentioned above, all of them combined are worth much less than one GBTC.
ProShares Bitcoin Strategy ETF. Traded in the United States under the ticker BITO, it is based on CME futures denominated in Bitcoin. Simply put, it is a derivative of a derivative. For now, freely traded Bitcoin ETFs can only exist in the American market in this form. The ProShares fund is the second largest by capitalization after GBTC, it is $1.3 billion.
Bitwise 10 Crypto Index Fund. Another fund from a company that has been fighting for several years to launch a direct Bitcoin ETF. But for now, she has to make do with virtual index funds without direct collateral. BITW is based on price indices of the top ten cryptocurrencies, with Bitcoin accounting for over 60%. The current capitalization of the fund is about $810 million.
Valkyrie Bitcoin Strategy ETF. A fund from a large investment company, little known in the cryptocurrency market. Through it, only $47.9 million was invested in Bitcoin. The fund is also based on CME futures. Interestingly, this week Valkyrie announced its interest in becoming the managing sponsor of GBTC, but there has yet to be a response from Barry Silbert. At the same time, the company promises to reduce the fund management fee from 2% to a more market-leading 0.75%.
Of course, there are many more different funds in the cryptocurrency industry, but they are mainly located in offshore jurisdictions. And most regulated funds are not based on cryptocurrencies themselves, but on shares of companies operating in the blockchain industry.
Consequences of Grayscale fund closures
If Grayscale closes its two main funds, over 3 million ETH and over 630,000 BTC will enter the market. Given the current low liquidity and negative expectations, the appearance of such a huge amount on free sale could trigger a real collapse. There are hardly many optimists with money ready to buy more than 600,000 BTC. And if they are pragmatic, they will prefer to buy more bitcoins at a low price.
If a potential Binance collapse hits the wider community, affecting millions of traders, then the shutdown of GBTC and ETHE will be more targeted, but more powerful. There will be no mass lamentations on all social networks, rallies of bankrupt traders and hundreds of lawsuits around the world. However, the collapse of the largest and most trusted of the regulated funds will accelerate the flight from cryptocurrencies by the remaining large corporate and institutional investors.
The “perfect storm” of excess supply can create a powerful red candle, collapsing Bitcoin and Ethereum by tens of percent, and if large buyers do not come, then several times. You will have to look for a new balance of about $10,000 or even lower.
But if you look at it without emotion, then even with a long bearish trend, Grayscale has no reason to voluntarily close its funds. Investors bear the brunt of the losses and risks, while Grayscale continues to reap multimillion-dollar profits. GBTC has been around for almost ten years, and ETHE for over five years. They have already survived several crises, multiplying the assets of early buyers and bringing billions of dollars to the operator.
Of course, the company may face difficulties. For example, with a class action lawsuit from investors or a regulatory investigation, because its ten-year history is hardly flawless. There may also be new changes in legislation that are unfavorable for cryptocurrency funds. Markets have entered a period of unpredictability, and the best-informed forecasts can be destroyed in a single day.
