Arbitrage by Grayscale In-kind Contribution?

KEY TAKEAWAYS

  • Messari’s estimation of in-kind contributions constituting 80% of Grayscale subscriptions is misleading.
  • There is no easy arbitrage money out of trading GBTC or ETHE.
  • GBTC and ETHE can be yield-enhancing tools for hodlers.
  • In-kind contribution reduces the supply of Bitcoin and Ethereum in the same manner as cash contribution.

Recent research by Messari, a crypto analytics company, claims that spot purchase of crypto by Grayscale Trust is overstated. It asserts that Grayscale only bought 20,697 Bitcoins and 192,684 Ethereums in 2020, constituting 20% of the total subscriptions of GBTC and ETHE, whereas in-kind contributions account for 80%. However, this estimation was purely based on the ratio as of 3Q19. 

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Source: Messari
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Source: Messari

What are In-Kind Contributions & How Much in 2020?

As the name suggests, a cash contribution is a process in which Genesis Global Trading, a Grayscale affiliate company, receives cash payment from investors, purchases BTC/ETH, and passes these cryptos to Grayscale to create GBTC and ETHE shares. By contrast, an in-kind contribution entails contributing BTC and ETH in-kind in exchange for GBTC and ETHE shares directly. 

According to data disclosed by Grayscale, in-kind contributions constitute 58% of total quarterly contributions in 3Q18, 71% in 2Q19, and 79% in 3Q19. While data on in-kind contributions in 4Q18 and 1Q19 are not disclosed, we can derive an estimate from the rolling 12-month data, i.e. 43% for 4Q18 and 1Q19 combined.

Source: Grayscale, Bybit Insight 

Grayscale has not disclosed any in-kind contribution ratio since 4Q19. The latest number, 79% in 3Q19, is evidently off-the-chart and cannot be extrapolated to give a realistic overview of in-kind contributions in 2020. 

What is the exact cash-to-in-kind ratio in 2020? Only Grayscale knows.

Huge Arbitrage Opportunities for In-Kind Contributors?

As explained in “ETHE Trading at 800% Premium”, the answer is not really, at least it’s not easy money.

The Messari report suggests that risk-neutral investors may borrow BTC or ETH and subscribe to GBTC and ETHE shares in-kind. The trade is deemed profitable as long as the trading premium upon sale is higher than the total cost. The total cost includes the borrowing cost, 6% p.a. for BTC and 10% p.a. for ETH, and the management fee, 2% p.a. for GBTC and 2.5% p.a. for ETHE.

However, regardless of the mode of subscription, the shares can only be sold after a holding period that varies from 6 months to 1 year. 

The premium of ETHE drops drastically from 950% at the beginning of June to 350% as of June 24, which is in line with Messari’s short term forecast. The report also predicts that the ETHE premium will decline sharply by the end of 2020 when more freely tradable shares are released.

Moreover, we need to factor in emerging competitors. Wilshire Phoenix, the New York-based investment firm, has filed to launch a new publicly traded Bitcoin Trust. Anticipating the arrival of new competition, the current premium may further diminish. Grayscales shares may even be traded at a discount in 6 months or 1 year. To make things worse, without a redemption program, discounts may not necessarily converge. 

An ideal arbitrage strategy is to lock in the premium, that is, borrowing Grayscale shares and short selling them right now. 

According to securities brokers, the borrowing cost of GBTC shares is close to 15%. Summing up the borrowing cost and cost of funding, a 10-20% premium of GBTC does not present enough margin to justify the trade.

GBTC’s latest short selling interest (total number of open short positions) is 29,452,958 shares by the end of May, representing only 7.6% of the total shares outstanding, and around 11.8% of total free tradeable shares. 

Source: Fintel

The high premium of ETHE, over 100% since 2020, seems to suggest a much more profitable arbitrage opportunity. 

However, as we explained in “ETHE Trading at 800% Premium”, only 3% for ETHE shares are freely tradable. In other words, it is almost impossible to find shortable shares. 

ETHE’s short selling interest was only 44,814 shares by the end of May, which is 0.3% of the total shares outstanding, and 9% of freely tradeable shares. 

Source: Fintel 

Is Arbitraging the Main Driver behind the Growth of GBTC and ETHE?

If it does, we would expect a substantial growth of GBTC and ETHE subscription when the trading premium is high.  

Interestingly, GBTC’s subscriptions take place primarily in week 2 to week 4 of the first month of each quarter in 2018 and 2019. One possible explanation is that GBTC only opened its subscription program for April in 2Q19, and from July 8 to 22 during 3Q19. We haven’t found any plausible explanations for the other quarters.

Source: Grayscale

We plot the concentrated subscriptions in the GBTC premium chart, along with quarterly average in-kind contribution ratio. There is no clear correlation between trading premium and subscription demand or the in-kind ratio.

Source: Grayscale, Bybit Insight

Neither do ETHE subscriptions display any discernible pattern. As the ETHE premium dropped to 350% from 950% on June 24, we witnessed a record high daily increase of ETHE by 87,993 ETH.

Source: Grayscale, Bybit Insight

Note: Grayscale’s data disclosure is up to 1Q20. Data in 2Q20 are Bybit estimates based on various other disclosures made by Grayscale.  According to our estimate, the quarter-to-date inflow of GBTC in Q2 will exceed USD 700 million, surpassing last quarter’s inflow of USD 389 million. The quarter-to-date inflow of ETH in Q2 is around USD 130 million, slightly more than USD 110 million of the previous quarter. 

Why Do Investors Subscribe via In-kind Contributions?

While it’s not easy to arbitrage on Grayscale products, in-kind contributions still make sense for some investors, such as hodlers, to whom the minimum holding period is not a concern. As long as GBTC and ETHE are trading at premiums after the holding period, these investors can still sell GBTC and ETHE shares at a higher price and buy BTC and ETH back for a lower price. Of course, the premium has to cover the trust expenses and management fee. 

It is a simple yield-enhancing strategy for long term holding of Bitcoin or Ethereum.

Nevertheless, all subscriptions to GBTC and ETHE, cash or in-kind, essentially lock the same amount of BTC or ETH in a Grayscale vault and reduce the hard supply in circulation. The growth of GBTC and ETHE remains a significant factor that is able to sway the market.