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Grayscale Could Find Itself in Suit as it Sues SEC Over Bitcoin ETF


In the animal kingdom, the hunter rarely (if ever) becomes the hunted, but these same rules don’t apply in the blood sport that is litigation.

Which is why a recent suit by Grayscale against the US Securities and Exchange Commission, creator of the eponymous Grayscale Bitcoin Trust risks doing just that — causing the hunter to become the hunted.

Grayscale alleges that the SEC’s logic for denying its application to convert its US$8 billion Grayscale Bitcoin Trust (GBTC) into an ETF is “arbitrary, capricious and discriminatory” and to be fair, the suit has merits and puts forward some decent legal arguments.

But that’s not the point here.

Consider that Grayscale had every opportunity over the past almost a decade since its inception, to convert GBTC into an ETF, but never attempted with any sincerity to do so.

Even when competitors like the Winklevoss twins applied to the SEC in 2018 to list the first ever Bitcoin ETF, Grayscale sat idly by.

It wasn’t until late 2021, when it looked like ProShares Bitcoin Strategy ETF, an ETF which attempts to track the price of Bitcoin by holding CME Group’s Bitcoin futures look set to be listed that the heat on Grayscale finally got real and they threw their hat in the ring.

But why?

To understand why the most obvious candidate for a spot-backed Bitcoin ETF was also one of the last applications to make it to the SEC, it’s important to go back in time to what the Grayscale Bitcoin Trust is to begin with.

Michael Sonnenshein, CEO of Grayscale.

In the fall of 2013, with Bitcoin barely four years old, Grayscale debuted the Bitcoin Investment Trust with the ticker name GBTC. Available to accredited investors, GBTC was publicly traded on OTCQX, an over-the-counter market, under the Alternative Reporting Standard for companies not required to register with the SEC and quickly became the preferred way for institutional investors to gain Bitcoin exposure despite having an annual fee of 2 per cent.

Buying GBTC shares was a way for investors, including pension and mutual funds to gain exposure to Bitcoin without necessarily fussing with things like private keys and hardware wallets.

Many institutional investors are particularly ill-suited to handle Bitcoin anyway, never mind that their investment mandates and compliance departments would not allow for it. Given that for most of its lifetime, GBTC was the only way to buy Bitcoin as if it was virtually any other US security, for instance GBTC could be traded through a brokerage firm, including tax-advantaged accounts like IRAs or 401(k)s, many investors were able to look past its lock-up.

As a grantor trust (similar to a closed-end fund), GBTC was initially offered with a one-year lock-up, which was later reduced to six months in 2020, meaning that it could not easily add or remove shares to deal with inflows and outflows into the fund, but which also fed well into something that Grayscale was keen to foster — the “Grayscale Premium.”

Because GBTC shares are locked up and can’t be sold within the first six months of their creation, GBTC’s share price could either trade at a premium or a discount to the underlying price of Bitcoin itself.

Historically, given that GBTC was the only way for investors to gain institutional-grade exposure to Bitcoin, GBTC traded at a reliable premium to the actual price of Bitcoin, especially during times of strong price rallies.

But it wasn’t all superyachts and Lambos at Grayscale in the early days.

Launched with barely US$3 million in assets in 2013, interest in GBTC was slow to start and it didn’t break US$100 million until 2016, around three years after launch.

GBTC really entered hyperdrive in mid-2020, alongside a significant uptick in the price of Bitcoin and soared to US$40 billion to become the largest Bitcoin investment product, but that may have been more than just market conditions.

In a perfect world, the number of shares outstanding for GBTC would perfectly match the demand for those shares and the share price of the trust would be in line with its total NAV, which is exactly how ETFs trade, with market makers able to create and redeem shares to keep the NAV in line with price.

But GBTC (as is the case for grantor funds and other similarly structured closed-ended type funds) lacked this flexibility, with the only entity able to create and remove shares from the market, Grayscale itself, which is an important point to note.

While it may look as if demand for GBTC shares is driven by the market, in reality, shares in the trust are created and redeemed through private placements, available only to accredited investors on a periodic basis and at Grayscale’s sole discretion and that’s a big deal.

Between December 15 and December 28, 2020, with the price of Bitcoin soaring, GBTC shares commanded a premium of as much as 40 per cent to the NAV that underpinned its shares.

Those stuck buying GBTC shares on the open market were having to pay a significant premium for Bitcoin exposure, compared with those who had access to Grayscale’s private placement.

But who were these chosen individuals you might ask?

Cryptocurrency in the future

Fortunately the information is public, just that nobody bothered to review it, except perhaps the good people at DataFinnovation.

To understand how everything works, it’s important to start with who owns what.

Digital Currency Group owns Grayscale (of GBTC fame) and Genesis.

Genesis is a US-registered broker-dealer providing borrowing and lending services, including among other things, Bitcoin-denominated loans, and dollar-denominated loans against GBTC shares.

So far so good.

There are two ways to obtain GBTC shares, one way is to purchase the shares over-the- counter, paying a premium (if any) and the other way is to use Bitcoin to create GBTC shares.

When GBTC trades at a premium to Bitcoin’s price, using Bitcoin to create GBTC shares allows whoever does so the opportunity to literally make “free money” as long as the premium exists for more than six months (or whatever lock-up was in place).

But who are these “chosen ones”?

Three Arrows Capital apparently.

Because GBTC is a US-registered security and Genesis is a U.S.-licensed broker dealer, both of them submit plenty of documents to the SEC which are available as a matter of public record.

And what the public record reveals is disconcerting to say the least.

One of the things that Genesis does is to lend Bitcoin for the creation of GBTC shares — Genesis themselves reveal this in their Q1 2021 report at page 6-25:

“There are several reasons why, on a relative basis, there was less BTC lent out to the market in Q1 than over previous quarters. First, the level of demand to borrow BTC to arbitrage products like the Grayscale Bitcoin Trust (GBTC) declined as the premium to Net Asset Value (NAV) shifted and became a discount towards the end of the first quarter.”

“Traders who previously borrowed BTC to contribute in-kind to the private placement or similar securities, with the intent to sell at a premium in the public market after the vesting period, lost the ability to arbitrage this spread. As a result, less BTC borrow was needed to enable this trade.”

Genesis is also an “Authorized Participant” that can create GBTC shares, as evidenced by this agreement.

Barry Silbert, Founder and CEO, Digital Currency Group.

So Genesis lends certain chosen parties Bitcoin to create GBTC, interesting, but nothing controversial so far.

But Genesis does more than just lend Bitcoin to create GBTC, it also lends dollars on the back of the value of GBTC shares and here’s where things get altogether a lot more interesting.

How much should the security of a GBTC share be valued? At the value of its NAV or at the price (premium included) when making a loan on the back of GBTC shares?

The answer is “it depends.”

In the Notes to Financial Statements for Genesis for the financial year ended December 31, 2020, the company considered investments in digital currency trusts (of which GBTC is one) carried at the net asset value on the Statement of Financial Condition.

Carrying GBTC shares at their NAV is more conservative of course because you can’t assume that the “Grayscale Premium” will always exist, yet by 2021, in the Notes to Financial Statements, Genesis adopted this policy on page 4,

“Investments in digital currency trusts with readily available pricing are carried at their fair value using quoted market prices.”

But why?

To use the “Grayscale Premium” to generate more GBTC shares and increase the size of the trust.

Three Arrows Capital or 3AC for short, borrowed Bitcoin from Genesis.

3AC then passed back this Bitcoin to Genesis (as the Authorized Participant) to create shares in GBTC.

Genesis locked the Bitcoin (that it had lent initially to 3AC) in GBTC and handed the GBTC shares back to 3AC.

Because these GBTC shares are at a premium to the NAV of Bitcoin, the value of the GBTC shares is greater than the value of the Bitcoin that 3AC had borrowed from Genesis to begin with.

3AC then pledges these GBTC shares (at that premium) to take out dollar-denominated loans from Genesis.

Voila, “free money.”

But more importantly, so long as the “Grayscale Premium” existed, this “free money” machine could go on indefinitely, except that it didn’t.

Because by March 2021, the “Grayscale Premium” had turned into a discount and that was a problem.

Digital Currency Group (remember them who owns both Grayscale and Genesis?) started to step in and buy GBTC shares to prevent the discount from becoming a self-perpetuating race to the bottom.

And who did they buy those GBTC shares from?

Between March 2021 and January 2022, Digital Currency Group bought 15 million shares of GBTC, something that was revealed in their disclosures.

Which uncannily coincides with a period of time when 3AC sold 15 million shares of GBTC.

But why?

Well because if the GBTC premium disappeared, it wasn’t just a problem for 3AC anymore, it was a problem for Genesis and by extension Digital Currency Group because Genesis was funding the entire thing to begin with.

And why is that a problem?

Because it would have given the impression that an active market for GBTC shares existed when in fact, there was none, which in industry parlance is known as “wash trading.”

Genesis lends Bitcoin to 3AC, which swaps it to GBTC shares through Genesis and because of the trick of accounting of Genesis, the value of these shares recognizes the “Grayscale Premium” allowing the GBTC shares (which they had just created) to be used as collateral for 3AC to borrow more dollars.

With those borrowed dollars, 3AC could technically borrow more Bitcoin from Genesis to start the cycle all over again and if that sounds absurd, that’s because it is.

But dig a little bit deeper and it becomes apparent that this isn’t Grayscale’s first rodeo.

Not so long ago in a galaxy not so far away, Grayscale used to be called SecondMarket and back when it was, it already had some problems with the SEC for violating Rule 101 and 102 of Regulation M of the Exchange Act.

Rule 101 of Regulation M prohibits any “distribution participant” and its “affiliated purchasers” from directly or indirectly bidding for, purchasing, or attempting to induce any person to bid for or purchase any covered security during the applicable restricted period.

While Rule 102 of Regulation M similarly prohibits issuers, selling security holders, or any affiliated purchaser of such person from directly or indirectly bidding for, purchasing, or attempting to induce any person to bid for or purchase a covered security during applicable restricted period.

Back when Grayscale was SecondMarket, it was found by the SEC to have been in violation of both Rule 101 and 102 of Regulation M and issued a cease-and-desist order for creating the impression of a liquid market for BIT shares where none otherwise existed.

Fast forward to our current epoch and it does look as if Digital Currency Group, Genesis and Grayscale are doing precisely that because there are an awful lot of coincidences as identified by DataFinnovation.

But why?

Besides the 2 per cent fees charged for GBTC shares, it’s not clear if Digital Currency Group, Genesis, or Grayscale enjoyed a cut of any “Grayscale Premium” it helped to create and maintain.

But if Grayscale could restrict GBTC shares such that they traded at a premium to the NAV of Bitcoin itself, then whoever Genesis selected to create shares with Bitcoin got free money as long as the “Grayscale Premium” was maintained for six months.

Digital Currency Group couldn’t run this by itself, or through its subsidiaries as that would ultimately lure in enforcement by the SEC so it needed an external party, which is where 3AC came in, but before 3AC there were likely others.

Because GBTC shares must be issued 100 Bitcoin at a time and given that Genesis had about 30,000 Bitcoin on its lending books over the years, the amount of churn would have been significant, making GBTC larger and more exciting than it otherwise would have been.

But “free money” doesn’t last forever and with the launch of competing products like ProShares Bitcoin Strategy ETF, investors were able to gain exposure to Bitcoin, with the liquidity of an ETF, never mind that the ETF was based off CME Group’s Bitcoin futures.

Which is why the “Grayscale Premium” has become a “Grayscale Discount” ever since and the only way out is to convert GBTC into an ETF, which will at least try to get GBTC shares at parity with its NAV.

And that’s why Grayscale is pursuing the conversion of GBTC into an ETF, with such urgency when for years, it was quite content to maintain the status quo — because of the “Grayscale Premium” and the ability to make “free money.”

So much urgency that Grayscale is now suing the SEC, when if the SEC were to dig a little bit deeper, some inconvenient “coincidences” could very rapidly come to the surface.


By Patrick Tan, CEO & General Counsel of Novum Alpha

Novum Alpha is the quantitative digital asset trading arm of the Novum Group, a vertically integrated group of blockchain development and digital asset companies. For more information about Novum Alpha and its products, please go to https://novumalpha.com/ or email: ask@novum.global

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