Grayscale Bitcoin Trust: A Cryptographic Roach Motel

November 29, 2020 Update: Guggenheim’s $4.87 billion Macro Opportunities Fund has filed with the SEC to allow it to invest up to 10% of AUM into GBTC. Count that as $500m more Bitcoin soon to be locked in the roach motel.


Today’s post is ostensibly about the Grayscale Bitcoin Trust, but before we talk about that we need to talk about Other People’s Money again.

We talk a lot about leverage and other types of OPM a lot on this Substack. That’s no surprise given that great businesses are good at hoovering up OPM and the readership around here is interested in both the former and the latter.

John Malone: An OPM Grandmaster

I read a book some years back about John Malone, the prominent technology, media and telecom executive best known for leading TCI and later founding Liberty Media. He happens to be a Grandmaster when it comes to using OPM.

That book was called Cable Cowboy and was meant to be a biography about Malone. For me, it was a blueprint for how public company executives could optimally utilize OPM for their own benefit.

In the investment community, Malone is best known for some of the more creative corporate structures known to man. His corporate structures are so complicated that I don’t even want to open that can of worms.

The point I want to make is that he uses every available means to attract other people’s money into his Liberty Media complex, including Uncle Sam’s. Malone has made himself fabulously wealthy sitting atop a corporate complex of OPM (this is an important point we will come back to) contributed through equity, debt, preferred equity, tracking stocks, tax assets, you name it.

He then uses this capital to shrink the public floats (this is an important point we will come back to) of his various holdings and help his assets achieve adequate levels of scale, which bolsters the flywheel of cash flow and continued share repurchases. It is a cycle that amazes many in the investment community.

Malone pushes around his media assets like chess pieces. However, instead of taking pieces off the board, Malone expands the board and adds more pieces. Once a dollar makes its way into the Liberty Complex, it rarely leaves… and has an oddly high likelihood of ending up in Malone’s pocket.

Grayscale Bitcoin Trust

When I came across the Grayscale Bitcoin Trust, I saw shades of Malone in what they are doing. There is a lot of leveraging of other people’s money going on here.

First of all, what is Grayscale Bitcoin Trust? From the 10-K:

Grayscale Bitcoin Trust (GBTC) is a Delaware Statutory Trust that was formed on September 13, 2013.

The Trust’s purpose is to hold Bitcoins, which are digital assets that are created and transmitted through the operations of the peer-to-peer Bitcoin Network, a decentralized network of computers that operates on cryptographic protocols. The Trust issues common shares, which represent ownership in the Trust, on a periodic basis to certain “accredited investors” in exchange for deposits of Bitcoin.

Grayscale Investments, LLC is the sponsor of the Trust, Delaware Trust Company is the trustee of the Trust, Continental Stock Transfer & Trust Company is the transfer agent of the Trust and the administrator of the Trust and Coinbase Custody Trust Company, LLC is the custodian of the Trust.

The Trust issues Shares only in one or more blocks of 100 Shares (Baskets) to certain authorized participants from time to time. Baskets are offered in exchange for Bitcoins. At this time, the Sponsor is not operating a redemption program for the Shares and therefore Shares are not redeemable by the Trust

GBTC is fairly simple. It is an open-end Trust that holds one asset, Bitcoin. Each GBTC share represents ownership in the Trust and therefore indirect ownership in some amount of Bitcoin.

Why might someone elect to invest in GBTC rather than directly purchasing Bitcoin for themselves? The major advantages of the Trust are largely related to security, public market liquidity and retirement account eligibility (yes, you can put GBTC in your IRA).

How does it work? An investor approaches GBTC, forks over some Bitcoin for safe keeping and Grayscale issues that investor a Basket, or block of 100 shares.

Note: There is no mention in filings of investors showing up with piles of regular dollars to be invested in GBTC. However, I suspect the sponsor of the trust, Grayscale Investments, would be more than happy to accommodate the conversion of fiat money into Bitcoin prior to the issuance of new Baskets should an accredited investor approach them with such an idea.

Notice also that GBTC does not operate a redemption program for its shares. In some company filings it even says that “the redemption of Shares is not currently contemplated.” This means that once your Bitcoin go into GBTC, they don’t come out.

I call it a cryptographic roach motel for effect and because it is funny. It is also true!

Sponsor’s Fee

What does all of this cost? Grayscale Investments, the sponsor, is paid to keep the Bitcoin assets safe and sound. In doing so, the sponsor employs a number of service providers - auditors, lawyers, custodians, transfer agents, middle men of all kind - to act as a proverbial goal line defense against any impropriety or adverse regulatory oversight. To public market investors, that cost is covered in one simple line item called the Sponsor’s fee.

The Trust’s only ordinary recurring expense is the Sponsor’s Fee. The Sponsor’s Fee accrues daily in U.S. dollars at an annual rate of 2.0% of the Bitcoin Holdings Fee Basis Amount of the Trust as of 4:00 p.m., New York time, on each day… The Sponsor’s Fee is payable in Bitcoins to the Sponsor monthly in arrears.

The Trust pays the sponsor, again Grayscale Investments, 2% of all Bitcoin under management, or BUM if you work on Wall St, at an annual rate.

Think about this again. First, investors show up and deposit their Bitcoin into GBTC in exchange for shares. Then, because there is no redemption mechanism, those Bitcoin sit idle inside the Trust and leak to the sponsor at 2% per year.

Note: There is almost no scenario in which Grayscale Investments can make less income (in Bitcoin) from the Trust in each subsequent year (absent the case in which Grayscale Investments makes 2% less than last year because of their own fee).

You should be thinking two things right now: 1) “Wow, it is a roach motel” and 2) “John Malone would love this.”

If Malone is an OPM Grandmaster, whoever thought up this Grayscale structure is at least an OPM National Champion.

The reason Malone would love this structure is that it utilizes two of his favorite things: OPM and a shrinking float. Let’s look at that second one closer.

Bitcoin’s Shrinking Float

Every couple of weeks Grayscale updates investors via 8-K filings with regard to their purchasing activity and capital inflow. I went ahead and plotted all of the disclosed purchase activity by GBTC in the chart below.

I estimate that GBTC as of November 25, 2020 is holding in excess of 530,000 BTC in Trust. This is some 100,000 BTC higher than what it held in September 2020. Moreover, GBTC is locking up Bitcoin at the rate of almost 2,500 per day, substantially faster than historical rates.

One notable thing about Bitcoin is that it has a supply cap built into its protocol. There will never be more than 21,000,000 Bitcoin and that is by design. So the free float of Bitcoin is already capped at an upper bound of 21,000,000 BTC.

This free float cap comes down with every Bitcoin that finds its way into the roach motel.

At this point GBTC has locked up 2.55% of all Bitcoin that will ever be mined. When you account for lost or dormant Bitcoin, estimates of which vary significantly, it could be the case that GBTC has already hoovered up more than 5% of the entire free float. The importance of that cannot be understated.

Conclusion

In my opinion, Grayscale has become probably the most important player in Bitcoin at the moment and Grayscale’s recent success is extremely bullish for Bitcoin.

What makes them so important is - and I will say it again - that Bitcoin go into GBTC and do not leave. They only come out via the Sponsor’s fee. And even that fee is not being completely liquidated. This is de facto supply shrink.

What is really noteworthy is the pace of supply shrinkage. Since September 1, 2020, GBTC has seen inflow of 106,530 BTC. That is 0.5% of all BTC that will ever be mined... In 10 weeks. Take note at this acceleration in inflows!

My take is that GBTC is perhaps the greatest advantage vehicle for direct Bitcoin holders (aka Hodlers) ever created. It has engineered a cryptographically perfect short squeeze using other people's money to lock up free float. Until such time that GBTC institutes a redemption mechanism, there is no reason to think this squeeze will stop.

Until then, get in while supplies last!