Detailed Explanation of the Operation Model of Gray Trust

This article was first published on December 2, 2020, in Xu Kun's Think Tank, authored by Xu Kun.

1. Introduction to Grayscale Trust Background

Barry Silbert, the founder of Grayscale, began personal investments in Bitcoin in 2012, and in 2013 invested in now-crypto giants like Coinbase, Bitpay, and Ripple. In the same year, he directly promoted the establishment of Grayscale, a Bitcoin trust company, and the precursor department of Genesis Trading, through his private equity trading platform SecondMarket, founded in 2004. In 2015, SecondMarket was acquired by Nasdaq but retained its crypto asset-related business.

In 2015, Barry Silbert integrated these two major businesses with his personal investment business to establish DCG (Digital Currency Group). Currently, DCG has five subsidiaries and has directly invested in over 160 cryptocurrency and blockchain-related companies.

(Source: dcg official website)

Grayscale Investments was established in 2013 and can be roughly divided into three stages:

From 2013 to 2016, the exploration period, where the Bitcoin trust was its only product. In 2014, the non-redeemable clause was established, and in 2015, GBTC was listed on the OTC market, connecting the primary and secondary markets. During this period, the asset scale was relatively small, increasing by only $700 million.

From 2017 to 2019, the product diversification period, where nine new varieties were added, and the asset scale increased by $2.6 billion.

In 2020, the rapid growth period, where compliance improved significantly. The Bitcoin trust and Ethereum trust became SEC reporting companies, and the lock-up period for primary market subscriptions was reduced from 12 months to 6 months. Meanwhile, both capital inflow and asset scale doubled.

(Source: grayscale)

From the perspective of capital inflow, since its establishment in 2013, as of the third quarter of this year, cumulative capital inflow reached $3.63 billion, with 68% of this amount occurring in the first three quarters of this year. There has been a significant increase in ETH trust, BCH trust, LTC trust, and large-cap funds this year.

According to information disclosed by Grayscale to the SEC, in October and November, the capital inflow for the Bitcoin trust alone was $1.223 billion (corresponding to approximately 81,000 BTC). Based on this estimate, by the end of this year, cumulative capital inflow is expected to reach $5 billion.

(Data Source: sec.gov)

Grayscale currently offers 9 single-asset investment products, providing exposure to BTC, BCH, ETH, ETC, ZEN, LTC, XLM, XRP, and ZEC, as well as 1 diversified asset product, which is invested in the highest market cap assets. Currently, it holds BTC, ETH, XRP, LTC, and BCH, weighted by the market cap of each asset, with rebalancing occurring on the first business day of January, April, July, and October.

The Bitcoin trust (GBTC), Bitcoin Cash trust (BCHG), Ethereum trust (ETHE), Ethereum Classic trust (ETCG), Litecoin trust (LTCN), and Digital Large Cap Fund (GDLC) have been listed on the OTC market.

The Grayscale Bitcoin Trust became an SEC reporting company on January 21, 2020, and the Grayscale Ethereum Trust became an SEC reporting company on October 12, 2020, with the lock-up period reduced from 12 months to 6 months.

As of November 30, Grayscale's total assets under management reached $12.2 billion, with the Bitcoin trust accounting for approximately $10.2 billion (83%), the Ethereum trust approximately $1.6 billion (13%), and the Digital Large Cap Fund $170 million, with the remaining assets being smaller in scale.

(Data Source: Grayscale, 2020/11/30)

2. Grayscale Trust Operation Model - Taking Bitcoin Trust as an Example

1. Subscription Model

Grayscale's Bitcoin Trust accepts two forms of funding: cash contributions and in-kind contributions (BTC).

In the cash contribution model, investors submit subscription funds to Grayscale, which then hands the funds over to authorized brokers. Genesis buys BTC on the spot market and stores it in the custody of Coinbase for cold storage, while issuing equivalent Bitcoin trust shares (GBTC) to investors.

In the in-kind contribution model, investors hand over BTC to Grayscale, which stores the BTC in Coinbase for custody and issues equivalent Bitcoin trust shares (GBTC) to investors.

The cash contribution portion flows into the spot market at the time of subscription, while the in-kind contribution portion may bring funds back to the spot market after the 6-month lock-up period. According to the Q3 2019 report, in-kind contributions accounted for 79%, while cash contributions accounted for 21%. (This data is no longer disclosed thereafter.)

2. Open Period

Grayscale periodically opens private placements to qualified investors and institutional users in the primary market. During the open period, on each trading day, contributions can be made to the trust in cash or BTC. The open period is determined by Grayscale itself; for example, on July 1 of this year, Grayscale suspended subscriptions for the Bitcoin trust and resumed at the end of July.

3. Redemption Mechanism

Since October 28, 2014, Grayscale's Bitcoin Trust has suspended its redemption mechanism, and currently, redemption of shares is not allowed. In the future, the trust sponsor may decide to set up a redemption mechanism after obtaining regulatory approval from the SEC, but currently, Grayscale has no intention of submitting a redemption plan to the SEC.

4. Asset Custody

The Bitcoin assets of Grayscale's Bitcoin Trust are stored in offline or "cold" storage, with Coinbase Custody serving as the custodian.

5. Management Fees

The management fee for the Bitcoin Trust is accumulated daily in USD, with the accounting time set at 4 PM New York time. The accounting basis is the amount of Bitcoin held in the trust, with an annualized fee rate of 2%. If the accounting day is a non-working day, the accounting basis is the amount of Bitcoin held on the most recent working day minus accrued but unpaid interest. The daily accrued amount in USD will be converted to Bitcoin based on the corresponding Bitcoin index price. Fees are paid to the sponsor in Bitcoin on a monthly basis.

6. Lock-up Period

In January 2020, the Bitcoin Trust officially became an SEC reporting company, with the lock-up period reduced from 12 months to 6 months. Shares subscribed in the primary market can be freely transferred after 6 months.

3. Grayscale Trust Holdings

Grayscale currently holds 9 digital assets, including BTC and ETH, through single-asset trust products and large-cap funds. The BTC holding is approximately 540,000, accounting for 2.93% of the total circulating supply of BTC, while the ETH holding is approximately 2.7 million, accounting for 2.38% of the total circulating supply of ETH, and the ETC holding accounts for 10.54% of the total circulating supply.

Note: Total holdings = Single asset trust holdings + Large-cap fund holdings

(Data Source: Grayscale, CoinGecko, 2020/11/30)

It is important to note that Grayscale does not directly disclose the number of held coins but periodically updates the total number of trust shares and how much each share corresponds to in terms of digital assets. The current market-disclosed Grayscale holdings are calculated using the formula "Holdings = Number of Issued Shares * Unit Share Holdings."

Currently, the six varieties listed on the OTC market update the "Number of Issued Shares" and "Unit Share Holdings" on their official product introduction page every trading day, allowing for daily calculation of holdings changes. However, for the four varieties ZEN, XRP, XLM, and ZEC, Grayscale updates the total scale and unit value daily on its official Twitter, but the issuance shares and unit holdings update frequency is about once a month, so tracking the changes in holdings using the above formula has a certain delay.

From 2020 to now, Grayscale's Bitcoin Trust (excluding large-cap funds) has added approximately 250,000 holdings, while the new circulating supply of Bitcoin this year is about 420,000. Calculating based on the post-halving period, Grayscale's new holdings are roughly on par with the newly mined Bitcoin.

(Data Source: the block, grayscale, 2020/11/30)

The growth rate of the Ethereum trust has exceeded that of the Bitcoin trust, with ETH holdings increasing by 2.1 million this year, which is five times the amount at the beginning of the year.

(Data Source: the block, grayscale, 2020/11/30)

Additionally, both BCH and LTC have seen significant increases in holdings this year. In the second half of the year, Grayscale increased its BCH holdings by about 150,000, mainly concentrated in August; and increased its LTC holdings by about 800,000, mainly concentrated in August, September, and November.

It is also important to note that Grayscale does not have a reduction issue, but the number of coins corresponding to each share may decrease due to daily management fees being accrued. If there are no new issued shares, the actual holdings will decrease. For example, in the case of ETC, without new issuances from September to October, the annualized 3% management fee accrued daily led to a decrease in holdings.

(Data Source: QKL123, 2020/11/30)

4. Grayscale Trust Secondary Market

1. Secondary Market Trading Volume

GBTC was listed on the highest-level OTC market OTCQX in March 2015 and was rated as one of the 50 best-performing securities on OTCQX for three consecutive years from 2017 to 2019. Currently, the daily trading volume is around $300 million, making it the most active security in the OTC market. ETHE (Ethereum Trust) also has a daily trading volume in the tens of millions of dollars, ranking among the top ten. Other products have relatively low secondary market activity.

(Data Source: otcmarkets, 2020/11/30)

2. Secondary Market Premium

The secondary market price of GBTC generally follows the price trend of BTC, with higher volatility in the secondary market, but it has consistently maintained a positive premium, peaking at over 100%, and has remained around 20% over the past year.

The US OTC market and the Bitcoin spot market are two isolated markets. Non-redeemable shares, a 6-month lock-up period, and limited circulation create certain barriers for arbitrage, leading to a long-term positive premium for trust shares in the secondary market. Moreover, the lower the circulation rate, the higher the premium. For instance, the Litecoin Trust (LTCN) once had a premium as high as 57 times, but the actual circulation was less than 100,000 shares, with a circulation rate of only 1%. The premium for the Bitcoin Trust has narrowed with the activity in the secondary market, currently around 20%.

(Data Source: grayscale, 2020/11/30)

For coin-based investors, GBTC can enhance coin-based returns. By contributing BTC in-kind to subscribe for GBTC shares from Grayscale, investors can choose to sell GBTC in the secondary market after the 6-month lock-up period, with returns being the secondary market premium minus the annualized 2% management fee.

Additionally, on one hand, investors can amplify leverage through borrowing coins, while on the other hand, they can lock in profits by short-selling, but they need to consider whether the overall returns can cover the additional borrowing costs.

For USD-based investors, holding GBTC shares means that if the coin price drops significantly, the price of GBTC will also decline accordingly. The premium in the secondary market does not necessarily guarantee returns, so Grayscale's biggest advantage for these investors lies in providing a compliant channel to conveniently track exposure to Bitcoin.

5. Grayscale Bitcoin Trust Investors

The Grayscale Bitcoin Trust is established under the U.S. Securities Act Regulation D, Rule 506 (c), which allows issuers to raise funds from investors without registering with the SEC, known as private placement regulations. Under Rule 506 (c), issuers can only accept investments from accredited investors.

(Source: grayscale official website)

According to data from the Q3 2020 report, institutional investors account for 81%, which is consistent with data from the past 12 months, with hedge funds likely contributing significantly to Grayscale's products. Accredited individual investors account for 8%, a relative decrease; family offices account for 8%, showing some growth; while retirement account funds account for 2%, remaining stable.

In terms of geographic distribution of investors, in Q3 2020, 43% of capital inflow came from U.S. investors, while 57% of capital inflow came from offshore investors.

As of November 30, 2020, according to Fintel statistics, a total of 26 companies held GBTC shares, totaling approximately 59.72 million shares, accounting for 10.6% of the issued shares of GBTC. Among them, the crypto asset lending company BlockFi held about 24.24 million shares, accounting for 4.3%, ranking first; Three Arrows Capital held 21.06 million shares, accounting for 3.7%, ranking second, with only 5 institutions holding over 1 million shares.

(Data Source: fintel, 2020/11/30)

According to the information submitted by Grayscale to the SEC, its affiliates DCG, Genesis, and Grayscale Asset Management collectively hold shares that do not exceed 5% of the total issued shares during the reporting period, and this proportion is showing a downward trend. There is currently no information on the holdings of other trust products by affiliated companies.

(Data Source: sec.gov)

From the publicly disclosed data, GBTC does not have significant large holders. According to SEC requirements, any single institution holding more than 5% must submit an explanation to the SEC.

6. Competitors

1. Wilshire Phoenix

On June 12, asset management company Wilshire Phoenix Funds LLC submitted a registration statement for a Bitcoin commodity trust to the SEC. If approved, the trust could be publicly traded on the OTC Markets' OTCQX Best Marketplace.

Key differences from Grayscale include: 1) Only USD cash can be used for subscriptions, 2) Investors can redeem all or part of their shares (above the specified minimum redemption scale) on the last business day of each month (redemption date), 3) Lower management fees, at 0.9%.

2. 3iQ

Canadian digital asset management company 3iQ Corp has completed the issuance of its Bitcoin fund (QBTC.U) Class A shares (available to all investors) and Class F shares (for institutions), which are traded on the Toronto Stock Exchange. The structure of its Bitcoin fund is a closed-end fund that issues a fixed number of units. Units were publicly offered during the IPO in April 2020, regularly sold overnight, and privately placed to accredited investors. The current scale is approximately 10,000 BTC.

3. 21Shares

Switzerland-based cryptocurrency exchange-traded product (ETP) issuer 21Shares has launched 11 cryptocurrency ETP products, including BTC, ETH, BCH, XRP, XTZ, etc. It has also launched a short Bitcoin (SBTC) exchange-traded product (ETP) aimed at allowing investors to gain "short" exposure to total return investments by tracking Bitcoin's performance. Its BTC ETP has issued a total of 340,000 shares, each corresponding to 0.005 BTC, totaling 1,700 BTC.

Currently, competitors do not pose a threat to Grayscale in terms of management scale or secondary market liquidity, but if Bitcoin ETFs are approved in the future, the attractiveness of the Grayscale model will undoubtedly be diminished.

In summary, the Grayscale model has several core characteristics: first, it connects the primary and secondary markets through compliant means, linking qualified institutional investors; second, it allows in-kind contributions for subscriptions, connecting to coin-based investors; third, the long-term positive premium in the secondary market attracts arbitrageurs.

At present, Grayscale's "only in, not out" model does not require complex strategies, and management fees will continue to grow with the scale of funds, which is indeed very attractive. However, its sustainability also requires maintaining a delicate balance between secondary market liquidity and high premiums, ensuring that primary market subscribers can exit flexibly while continuously attracting funds. If the positive premium continues to narrow or even turn negative, this cyclical positive loop will be broken.