Retail investors are fueling the largest arbitrage opportunity in Crypto

Grayscale LLC Inc. is the largest cryptocurrency asset manager globally, with $ 12 billion in assets under management (AUM). Bitcoin-backed GBTC is its main product with $ 9 billion in AUM.

However, there is a high premium on these stocks. The average premium per GBTC inception of the asset was 38.7%. Other crypto-based stocks like that of Ethereum temperature and Litecoin’s LTCN stocks are seeing higher premiums at 5,900%.

The reason for these high premiums?

A common misconception among retail investors.

High Premiums and Institutional Grayscale Arbitrage

Institutional investors block their Bitcoin or other cryptocurrencies for GBTC equivalent shares or for spot purchases at net asset value (NAV). After a six-month lock-up period, these investors can sell their shares on the market (there is no redemption program).

The blocking period for other cryptocurrencies such as Ethereum, Litecoin and XRP is one year. These lockdown periods create an attractive arbitrage opportunity for institutions. And in pursuing this opportunity, companies are creating a steady offering of grayscale stocks for the retail markets.

Unpacking this dynamic is simple.

To initiate premium arbitrage, institutional funds borrow Bitcoin at a certain interest rate, called “r”.

The fund then hedges the exposure via an option contract or short position in the futures market as insurance against negative price movements of Bitcoin.

Additionally, they create units of GBTC at the trust by exchanging the borrowed BTC for an equal number of GBTC shares. Institutions can also buy GBTC at the price of the net asset value (NAV).

The new shares are then sold at market value with a premium after the end of the lock-up period, where the premium is the amount that retail investors pay in addition to the NAV.

The above trade is only profitable if the premium is greater than the “r” rate and other associated costs.

Over-the-counter (OTC) desks, such as OTCQX® Best market, trades in grayscale products, which brokerage firms such as Schwab and Fidelity offer to their clients.

The premium depends on two things: institutional supply and retail demand for the shares. As institutions consistently sell to earn risk-free arbitrage rewards, retail traders are raising GBTC in huge volumes.

GBTC’s monthly trading volume on Fidelity, a proxy for retail volumes, went from $ 100 million in September to nearly $ 250 million in November.

Castle Island Ventures partner and Coinmetrics co-founder, Nic Carterhe said in a podcast with Anthony Pompliano:

“Even though there is constant selling pressure from the fund’s creation, the persistent premium shows me that there is strong demand from retail investors.”

There is also a risk of premiums falling in the future. Nonetheless, institutions continued to create astonishing levels of GBTC stock in 2020. This signals bullish sentiment from institutions despite the 6-month freeze. Kevin Rooke, an independent researcher, shared with Crypto Briefing:

“Equity growth is definitely picking up over the year. In Q1 and Q2, around 70-80K BTC was added to the trust. In the middle of the fourth quarter, the grayscale is already ahead of the 70,000 added. “

Press Altcoin

The premiums on funds like ETHE, LTCN and XRP are much higher than GBTC. Currently, the premium for ETHE is close to 80% and 4,500% for LTCN.

Despite the exorbitant prices, there is considerable retail demand for these shares on Fidelity and Schwab.

The reason for the high premiums is because Grayscale is a closed-end fund. Grayscale has no redemption schedule and there is a long wait for the lockout period to end. This limits the provision of these shares.

Furthermore, these altcoin stocks are relatively new to the market, which means that the active supply of these stocks is considerably lower than GBTC.

The rewards are rampant due to the shortage of these shares in the market and the strong demand. Litecoin’s LTCN premium, for example, rose to highs of 5.874% after it recently started trading on the retail markets.

The monthly volume of ETHE on Fidelity went from under $ 1 million in the first half of 2020 to more than $ 5 billion in November.

Ethereum’s ETHE premium was also high in the beginning, reaching as high as 3,000%. As institutions engaged in arbitrage trading and supply increased, premiums dropped to 78%.

Finally, the retail trade is also fueling this arbitrage trade due to a misunderstanding about what these are the actions actually represent. Investors often think that by buying ETHE and LTCN, they hold an equivalent of 1 Ether or 1 Litecoin.

In fact, 1 ETHE represents 0.09287969 ETH and 1 LTCN share represents 0.09336698 LTC.

It should be noted that retail investors with brokerage accounts belong to an older and much richer demographic than millennial investors.

However, due to their inexperience with buying cryptocurrencies, they prefer to keep their crypto business in their brokerage accounts. GBTC shares also provide tax benefits and regulatory compliance.

They do not know that they are filling the pockets of the many institutional funds that enter the space for these comforts.