Traders Piling Into Overvalued Crypto Funds Risk a Painful Exit

(Bloomberg Businessweek) -- Many investors racing to get in on Bitcoin's big rally have bet on the cryptocurrency through investment trusts rather than buying the coins themselves. These fund-like trusts have some advantages: Their shares can be bought and sold through ordinary brokerages, without the need to set up digital wallets or move money to a crypto exchange. And some institutional investors, barred by the rules of their funds from holding Bitcoin directly, have also turned to trusts. Cathie Wood, for example, has made the Grayscale Bitcoin Trust the fourth-largest holding in her Ark Next Generation Internet ETF.

But the market value of the trusts can swing way above or below the value of the Bitcoin they hold, adding a new element of risk for an already volatile investment. Take the $25 billion Grayscale trust. Demand was so relentless in December that the trust's price soared 40% above its net asset value—that is, the market value of all the Bitcoin it holds. Essentially, at the top, investors were indirectly paying $14,000 for the equivalent of $10,000 in Bitcoin. That's bad enough. But when Bitcoin falls, the value of trusts like Grayscale could sink below that of their holdings, further amplifying investor losses.

If Grayscale were an exchange-traded fund, it would have specialized traders known as authorized participants who work behind the scenes to make sure this dislocation doesn't exist. When prices for an ETF's shares get out of whack with the underlying holdings, these arbitragers push them back in line through a process that relies on the ETF's ability to issue and redeem its own shares to balance supply and demand. But while it's possible for a crypto trust to issue new shares, it has no ability to redeem them—a key reason the trust's prices stray from the value of Bitcoin. “There is no arbitrage mechanism to keep the price of the shares closely linked to the value of the underlying cryptocurrency assets,” says Teddy Fusaro, president of Bitwise Asset Management, which also runs cryptocurrency trusts.

When investors want to get out of a Bitcoin fund, they have to find someone else in the market willing to buy their shares. That's not a problem when Bitcoin is hot, and in fact traders have mostly been willing to overpay. But the dislocation can go both ways. “What might be a premium—and a pretty significant premium at one point—can quickly reverse and become a sizable discount when people begin selling, and it doesn't take a whole lot of selling pressure given that you don't have that pressure release valve,” says Ben Johnson, Morningstar Inc.'s global director of ETF research.

Grayscale's price-to-NAV gap has narrowed recently, as Bitcoin pulled back from a record above $40,000 per coin to around $35,000. It never turned negative. But if it did, an investor who wanted out of the trust would be selling a share for less than the cost of the Bitcoin it represents. And of course the fund doesn't have to fall into a discount to potentially exacerbate losses—a narrowing of the premium could have a similar effect.

Demand for crypto exposure sent $3 billion to Grayscale Investments' products in the fourth quarter, the bulk of which was absorbed by Grayscale Bitcoin Trust, the company said last month. Meanwhile, the Bitwise 10 Crypto Index Fund has already gathered more than $700 million in assets after its mid-December debut, according to data compiled by Bloomberg.

As Bitcoin has boomed, Grayscale has tried to keep pace with demand by issuing more shares. Yet even as it sold shares to push the total to 684 million, from 278 million a year ago and just 174 million at the height of 2017's mania, it wasn't enough to keep the price from swelling above its underlying value. And now the massive issuance has the potential to exacerbate a supply-demand imbalance in the event of a selloff.

Grayscale Chief Executive Officer Michael Sonnenshein says he doesn't anticipate that the Bitcoin trust's price would sink meaningfully below that of its holdings in such a scenario. Grayscale Bitcoin Trust's lone instance of a discount occurred in March 2017, but it continued to trade at a premium even as Bitcoin soared to a then-record of nearly $20,000, before plunging as low as $3,100 the following year.

“In the five-plus years that this product has been trading in the public market, Bitcoin has gone through no shortages of bubbles and bursts, and popularity and lack of popularity,” says Sonnenshein. “The demand for access for Bitcoin through a titled security has remained a very, very popular means.”

Bloomberg Intelligence's James Seyffart says a meaningful discount would likely attract traders looking for a bargain. While the traditional create-and-redeem arbitrage doesn't exist for such products, that natural demand for shares would eventually realign the vehicles' prices with their underlying assets, he says. Before that happened, though, traders who bought in when Bitcoin was high and fund share prices were even higher could go through a lot of pain.
 
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