The crypto world’s eyes will once again turn to Washington on Tuesday as oral arguments begin in Grayscale Investments’s lawsuit against the US Securities and Exchange Commission. The case is being argued in the D.C. Court of Appeals.
The drama centers on the $14.8 billion Grayscale Bitcoin Trust (ticker GBTC), which has for two years been trading at a steep discount to the cryptocurrency it holds. That dislocation has been a point of pain for a beleaguered industry, and at times sparked a wave of distress among leveraged investors who piled into the trust to exploit a once-widely used trade. Over the past five years, GBTC has lost more than 25% compared with a 126% gain for Bitcoin, according to data compiled by Bloomberg. Since the end of 2015, the year it listed, the trust is up more than 19-fold on a total return basis.
The lawsuit is also key for Grayscale’s parent company, Digital Currency Group, which is contending with bankruptcy in another part of its universe. GBTC holds roughly 3.3% of all the Bitcoin in circulation, according to a recent filing, and took in millions of dollars in fees in 2022.
How We Got Here
Grayscale filed plans with the SEC in October 2021 to convert GBTC, the world’s biggest Bitcoin investment vehicle, into an exchange-traded fund. While the regulator has allowed futures-backed crypto products to exist, it has repeatedly withheld approval for spot products.
The SEC in June rejected Grayscale’s bid to convert the product into an ETF, citing Bitcoin fraud and manipulation concerns. Grayscale sued the regulator within hours of the rejection in the US Court of Appeals for the District of Columbia Circuit, arguing that the agency was “failing to apply consistent treatment to similar investment vehicles” given that futures-backed Bitcoin ETFs exist.
GBTC Discount
If the SEC were to approve ETF conversion for GBTC, it would solve a persistent issue for the manager: the trust’s roughly 46% discount to its underlying Bitcoin. The structure of an ETF allows shares to be created and redeemed to keep pace with shifting demand, meaning that a fund’s price typically stays aligned with its net-asset value.
GBTC, however, isn’t allowed to redeem shares under the current guidelines. That’s effectively turned it into a closed-end fund, which can be prone to such dramatic dislocations.
Grayscale said at the end of last year that it was considering appealing the SEC for permission, via a tender offer, to buy back shares of its Bitcoin trust.
The double-digit discount has been the subject of a spate of recent lawsuits against Grayscale. Digital-asset manager Osprey Funds at the start of the year filed a lawsuit against its rival. Fir Tree Capital Management has also sued Grayscale.
Grayscale has said the Osprey lawsuit is “frivolous” and that approval of a spot-Bitcoin ETF would benefit its peers. In response to Fir Tree’s action, the company has said that it’s always had the intention of converting GBTC into an ETF when permitted to do so by US regulators, and that it believes that is the best long-term product structure for GBTC and its shareholders.
To Samara Alpha Management’s Wilfred Daye, the discount at least partly also reflects investors’ collective thinking around the probability of the lawsuit ending in Grayscale’s favor.
“The market reflects that it’s doubtful that Grayscale could be successful in converting GBTC into a spot-Bitcoin ETF in the near future,” he said.
Grayscale says that as with all its products, “GBTC was structurally designed to achieve the status of an exchange listing as an ETF.”
“Currently, the price at which GBTC trades in the public market is subject to market forces,” a spokeswoman said. “We are confident that converting GBTC into an ETF is the best solution to the current GBTC discount. At that time, we would expect the arbitrage mechanism inherent in the ETF structure to remove any premium or discount on GBTC’s share price.”
Grayscale’s Perspective
Grayscale has long argued that it was looking to convert GBTC into an ETF. In a Bloomberg interview in 2021, Chief Executive Officer Michael Sonnenshein said such a conversion “has been the plan from Day 1.” The company also said in May of last year that a conversion could unlock as much as $8 billion in value for investors.
Grayscale has made its stance known through various media appearances as well, and it last year encouraged investors to submit letters for the GBTC conversion, a push that yielded thousands of comments as of the end of February, according to the SEC website.
“There is appetite for a spot-Bitcoin ETF,” said James Seyffart at Bloomberg Intelligence. “A spot-Bitcoin ETF would be the preferred option for Bitcoin exposure for anyone using the traditional financial rails. It’s the most efficient way to get exposure and it will actually hold the asset.”
Meanwhile, Donald Verrilli, a lawyer representing Grayscale, said last year that in rejecting the application, the SEC was “failing to apply consistent treatment to similar investment vehicles” in violation of federal law. Verrilli has a prestigious legal background, having previously worked in the Obama administration, where he successfully argued the government’s position in landmark Supreme Court cases on same-sex marriage and the Affordable Care Act.
“The conversion of GBTC to an ETF is the best long-term product structure for Grayscale’s investors,” said the Grayscale spokeswoman. “We are confident in our common sense, compelling legal arguments and we look forward to presenting our arguments in front of the D.C. Court of Appeals on March 7, 2023. We expect to have a final decision from the Court by Fall 2023.”
SEC’s Argument
Recent regulatory crackdowns could weigh on the Grayscale’s case “immensely,” in the eyes of Max Schatzow, partner and co-founder at RIA Lawyers.
“The reason the SEC has given for denying the application is, ‘Look, there’s just not a market that we believe is trustworthy enough to approve the spot-ETF product.’ You point to FTX, you point to all these other failed exchanges and I think you can start believing the SEC’s argument,” Schatzow said. “I would say it has less than a one-in-four chance, if you ask me. You never know in courts, but winning any case against the SEC is difficult.”
Grayscale faces an “uphill battle” in its fight with the SEC, according to Elliott Stein, senior litigation analyst with Bloomberg Intelligence. That’s because the SEC has articulated a standard for approving Bitcoin-based ETFs that BI says should pass the “arbitrary and capricious” test, namely “does the exchange have a surveillance agreement with a regulated market of significant size, making fraud less of a concern.”
Bloomberg Intelligence gives the asset-manager a 40% chance of winning, according to Stein. But if Grayscale “defies those odds and wins,” it could unlock billions of dollars in value for GBTC investors, Stein wrote in a February report.
(Updates to add reference to D.C. Court of Appeals in the first paragraph. In second paragraph, removes a reference to long-term holders and adds GBTC five-year returns vs Bitcoin and total return since end of 2015. Adds latest available estimate of comment letters submitted to the SEC in sixteenth paragraph.)
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