Since many of you are sick of hearing about Bitcoin, I promise this is my last post on the topic for a while. That said, I’d be remiss if I didn’t point out the unusually lucrative arbitrage trade that is largely responsible for sending Bitcoin parabolic. I glossed over it in my last post and given the questions that I’ve received, a full post on the topic was more than necessary—especially as the mechanism is really quite fascinating.
To start with, I believe that Grayscale Bitcoin Trust (GBTC – USA) is unique in the world of finance in that it facilitates an oddly reflexive Ponzi Scheme. Since we all know what a Ponzi Scheme is, I’m going to gloss over the terminology and instead focus on the concept of reflexivity. Before George Soros focused on destroying American society, he was a remarkably successful investor. His theory of reflexivity asserts that prices do in fact influence the fundamentals and that this newly influenced set of fundamentals then proceeds to change expectations, thus influencing prices; the process continues in a self-reinforcing pattern. In the case of Bitcoin, GBTC is the transmission mechanism for this reflexivity and once you understand how this game works, you’ll realize that Bitcoin is going much higher before it collapses.
What is GBTC? It is a vehicle that issues new shares daily in exchange for cash or Bitcoins. The shares are issued at the Net Asset Value (NAV), but with the unique wrinkle that they cannot be sold for 6 months. GBTC does not sell Bitcoin except to pay management fees and there is no mechanism in place for it to ever sell Bitcoin like a typical ETF. Think of GBTC as Pac-Man. The coins go in, but do not go out.
Now, here’s what makes GBTC special; GBTC currently trades at a 26% premium to NAV and has traded at a 18.7% average premium for the past year. Why does it trade at such a wide premium? That’s easy to understand; a lot of people are lazy and they want Bitcoin exposure but don’t want to open a new account and figure out how a wallet works. Others want exposure to Bitcoin, but are restricted from opening new accounts to own it directly—remember, as an institutional investor, you deal with compliance, custodians and auditors. As a result, for a whole bunch of investors there are only two choices; Bitcoin futures or GBTC. Given the roll cost in futures, the only real option is GBTC. As a result, investors keep bidding up GBTC. While you may laugh at people paying a 26% spread to NAV, in a bull market, such spread could easily increase dramatically beyond that, as it has in the past.
However, that spread to NAV is what makes this all reflexive. I’ve already shown why people continue to plow into GBTC despite it trading at a wide premium to NAV. Now let’s talk about why this is reflexive and how funds are making a fortune off of this. Any time there’s a spread, someone in finance will try and monetize it. When the spread is 26% wide and liquid to the tune of hundreds of millions per week, you can bet the biggest guys in finance are all over it. What’s the trade? You buy GBTC in the daily offering and short free-trading GBTC. Six months later, it all nets out and you are left with your profits. Of course, you take on a multitude of operational risks like securing term borrow and balance sheet risk if the spread blows out, but the pros know how to handle that. You can recycle your capital twice a year and on an unlevered basis, even after paying borrow fees, you’re making north of 40% a year (FYI—I left out a few other steps and a bunch of legal wrinkles to overcome).
That’s great for guys with real Prime Brokers offering term borrowing, but if you don’t have a real Prime Broker, you can still go the poor man’s route and sell your GBTC at today’s price and buy it back at NAV through the daily offering (which gets you long about 26% more shares for a bit of paperwork). You can even use futures in a dirty hedge. I don’t want to go too deeply into execution on this arbitrage trade as there’s lots of ways to make sausage and everyone has their own recipe, many of which go OTC or through swaps. If you don’t understand what I just said over the past few paragraphs, please don’t try this at home.
As you can imagine, everyone big is putting on some version of this trade. Hell, I’m making serious money simply lending out my GBTC to arbs who are neck deep in this trade (I’m not doing the arb as I don’t want to pay taxes on some pretty hefty unrealized GBTC gains).
Why have I just spent a few paragraphs explaining all of this? That’s because every version of this almost risk-free arbitrage trade involves a leg that buys GBTC directly at NAV. This results in GBTC purchasing more Bitcoin. Every day, it seems that GBTC and the other CUSIPS are buying a few basis points of the Bitcoin “free-float.” As they buy Bitcoin at a rate that is a few percent of the global Bitcoin trading volume, it is forcing Bitcoin higher, which is in turn bringing marginal investors into the Bitcoin ecosystem, often through GBTC as no one wants to deal with the brain damage of opening a Bitcoin custody account, which is then forcing the spread further out, which is bringing in more arbitrage players who buy more GBTC and the process accelerates. It is stunning that despite hundreds of millions deployed into this arbitrage trade lately, the spread keeps blowing out. The FOMO is just so powerful that the arbs cannot close it (yet).
By the time this bubble pops, even the doubters will have to own Bitcoin or get redeemed for lagging their benchmarks—which ironically completes the circle as these funds will either buy GBTC in the market or buy in a placement. Seriously, if you’re running a Global Macro fund and don’t at least have a few percent allocation to something this obvious, you should be ashamed. With GBTC now owning almost 10% of the “free-float” of Bitcoins, it has become the central enabler of this Ponzi Scheme. I have never seen a security act in this fashion and as soon as I realized that the risk-free arbitrage mechanism imbedded in GBTC was driving Bitcoin higher, I bought a whole lot of GBTC.
All Ponzi Schemes collapse under their own weight and this one will too, but first Bitcoin is going to have a supernova squeeze higher as the free float continues to be restricted as GBTC corners the market, driving the price higher. As long as the demand for free-trading GBTC exceeds the supply and this spread exists, there will be arbs who help accelerate the process of GBTC cornering the market. That doesn’t mean that Bitcoin cannot swoon tomorrow or that the spread cannot go negative for periods of time (this is Bitcoin after-all and it’s all sort of made up). However, the multi-year trend says that the spread will remain wide and force Bitcoin higher.
This arbitrage spread drives everything else in Bitcoin.
Disclosure: Funds that I control are long shares of GBTC
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