Grayscale Digital Large Cap Fund (GDLC) – Discount to NAV Elimination – 24% Upside

Current Price: $33.75

Target Price: $41.87

Upside: 24%

Expiration Date: Nov'21

 

This is a crypto-related idea. The setup is interesting and there is an easy way to hedge crypto volatility risk. Over the last few days, the discount has started to narrow, so the idea might be timely.

Grayscale Digital Large Cap Fund is a physical (not futures-based) crypto investment fund that trades OTC with a ticker GDLC. 65% of fund assets are in Bitcoin, 25% in Ethereum, and the remaining 5% in other coins. Historically the fund has mostly traded above the NAV, with the premium spiking to 100% at one point (end of Aug). However, over the last couple of weeks the fund started trading at a discount to its NAV. Current spread stands around 25%. The trade here is to buy GDLC and hedge Bitcoin and Ethereum exposure by shorting perpetual futures (available through FTX.com). At the moment hedging does not cost anything - actually arbitrageurs are getting paid on short BTC and ETH positions.

 

GDLC portfolio

Full portfolio documentation can be found here.

Historical chart of GDLC unit market price and NAV (Grey - price. Green - NAV).

As can be seen from the chart over the last couple of weeks, most likely due to the sharp crypto market appreciation, a pretty large discount to NAV has appeared, offering an interesting trade on the discount elimination or even spread reversal to premium in line with historical precedents.

Historical premium pricing is likely explained by investors' willingness to have exposure to crypto and limited possibilities to invest in crypto directly.

 

Hedging

Hedging could be done through crypto or crypto ETFs.

The cheapest and cleanest way to hedge exposure to Bitcoin and Ethereum seems to be through FTX markets offered BTC-PERP and ETH-PERP futures. FTX account setup is quick and painless. The important thing to note here are the funding fees. These are similar to borrow fees, but settled hourly. The charts below depict historical funding fees for the 30-day short position holding period. The funding rate is driven by the difference between the future price and the spot index. If the funding rate is positive (meaning that futures are more expensive than the index), investors are actually getting paid to hold a short position. If the funding rate is negative, shorts are paying longs. So far this year, it seems that the funding rate has been positive almost all the time (currently positive as well), so in fact, arbitrageurs are getting paid to hold the hedged position today.

Another, and probably a simpler way to hedge is through the recently launched Proshares Bitcoin ETF, ticker BITO. The EFT is based on short-term Bitcoin CME futures. Plenty of borrow seems to be available at 4% annually. This would hedge Bitcoin exposure only, but as most of the crypto tends to fluctuate in line with Bitcoin, hedging through BITO might be sufficient to offset most of GDLC NAV volatility.

The launch of BITO might also be the reason why GDLC started trading at the discount - now there is a better alternative to get crypto exposure through traditional equity markets. However, the fund started trading at a discount last week, whereas BITO was launched only two days ago. Also most of the GDLC holders are likely less knowledgeable retail investors, who are unlikely to care that much about the differences between GDLC and BITO. Thus, I doubt that the launch of BITO was the cause for the discount.

 

Risks

  • Discount to NAV might persist for longer or never get eliminated at all. It is not clear why it appeared in the first place or what market forces/events are required to close the gap to NAV or for the fund to start trading at a premium to its NAV.
  • The fund charges 2.5% asset management fees which sounds quite excessive for passive investment vehicles (although not excessive by crypto return standards). Given these fees, a certain discount to NAV is clearly deserved and in the longer term GDLC would be expected to trade at a discount to its portfolio value.
  • There is a risk of hedging cost going up substantially. Over the last year that has not happened, but if crypto enters a sharp bear market and futures start to trade materially below the spot index, hedging costs will spike up.

31 COMMENTS

  1. varunjain

    Given that GBTC and ETHE, the Bitcoin and Ether vehicles of Grayscale have consistently traded at a discount to NAV for many months now, why do you think GDLC will get back to NAV? There are specific reasons for such a premium/ discount to persist:

    1. As you rightly point out, these were the only vehicles available to most investors in buy in their 401K and most of that was retail money that didn’t care about p/d, so the premium ran up quite a bit (for ETHE it was many hundreds of percentage).
    2. There was an “arb” available in these products as accredited investors could directly create with Grayscale at NAV. The only catch was that you had to hold GBTC for 6 mins min after creation and ETHE 12 months after creation. Lot of hedge funds did this trade. But once it became popular, it started working in reverse as they were all stuck with inventory they couldn’t sell (Grayscale doesn’t allow redemptions directly).
    3. The big change from premium to discount happened after the listing of Bitcoin ETFs in Canada. I am assuming most of the US base sold their GBTC and ETHE to get the Canadian equivalent, hence the discount on the former (since you can only sell in market and not directly to the issuer).
    4. In my view, the swiftest way for this discount to disappear is for Grayscale to convert the products into ETFs. They have already filed with SEC to do so. But they’ve filed as a “physical” ETF under ’33 Act which is unlikely to get approved. SEC’s Gensler has been very vocal about investor protection and they think those features are embedded in the ’40 Act (which is what the futures based ETFs are using to launch).
    5. I haven’t looked into GDLC closely, I am surprised the discount only appeared in the last couple of weeks – would have expected it to have persisted the same as GBTC and ETHE where there has been a discount for months (you can literally time it to the Canadian ETF launches).

    Hope this is helpful. This is just my interpretation of the issue, please DYODD.

    3
    1. dt

      Thanks for the additional color. Agree that the discount to NAV can stay permanent and that is one of the possible outcomes here. I am also not sure why exactly this fund was trading a premium to NAV for so long – still thinking this is due to laziness of the retail crowd to find more cost-efficient ways to invest in crypto. Whether the spread will stay volatile or whether we have now shifted permanently to the discount territory, anybody’s guess is as good as mine.

      However, the downside seems to be protected as I do not think the spread can get much wider than the current 25% – discount history on GBTC and ETHE seem to confirm that.

      What risks (aside from the opportunity costs) do you see in holding this hedged trade for a month and betting on potential narrowing of the spread?

      1. greenfrog7

        Saw this play out in Canada – BTCG was a closed end fund which traded up to a 20% premium, then collapsed to double digit discounts on the launch of lower fee ETFs. The discount to NAV was resolved when the issuer converted the CEF to ETF units, but clearly the risk with Grayscale is that the pathway to listing a crypto ETF which doesn’t rely exclusively on futures contracts could become more difficult. In the scenario of a clear rebuke, the discount may widen, especially as there is no incentive at Grayscale to liquidate the fund to resolve the NAV discount, meaning that the eventual closing of that gap could be a long time coming.

      2. mosbaek

        Wasn’t it possible to redeem BTCG at NAV – a few pct. every year in june ? – or am I mixing it up with another canadian BTC-fund ?

        Looked at that trade, but the capital required for your long/short kind of killed the idea. No netting of long/short risk and at least 100 pct. capital required x 2. Other stuff looked more compelling at the time. Also the liquidity in the longer dated BTC futures were really c***

        1
  2. Dokler

    I’d strongly recommend against anyone trying to hedge this trade on FTX. They regularly have large wicks (20% yesterday in ETH, XRP, BNB, FTM, and Matic), forcing you to leave more capital tied up in the trade. It’s already a pain to have the long and short in different accounts, particularly with crypto where there could be a 10x quite easily. Involving FTX also introduces non-negligible counterparty risk.

    I’m skeptical of the trade idea as a whole as well. Like Varunjain I don’t see a strong case to expect the discount to close any time soon, especially with how GBTC and ETHE have traded. Also, there’s still significant risk of the discount increasing and persisting indefinitely. The managers are incentivized to not let people out and (assuming the documents are the same as GBTC) have no obligation to.

    2
    1. dt

      Could you clarify what you mean by ‘wicks’? BTC and ETH perpetual futures on FTX seem to track spot market very closely. Also not sure what you mean by ‘incentivized to not let people out’ – my thesis is in no way predicated on investors being able to redeem underlying portfolio coins in exchange for the GDLC units. I am basing the trade on expected spread volatility.

      Re FTX, the platform seems to be credible enough – at least investors in it think so https://www.wsj.com/articles/crypto-exchange-ftx-reaches-25-billion-valuation-11634817601?mod=rss_markets_main

      In any case, not advocating for FTX – as explained above, hedging by shorting BITO is probably way easier, just wanted to highlight other (cheaper) alternatives.

      1. ilya

        Futures and spot prices on crypto exchanges suffer from flash crashes from time to time, e.g. most recent one: https://www.theblockcrypto.com/post/121657/binance-us-blames-bitcoin-flash-crash-to-8200-on-a-bug-in-a-clients-trading-algorithm

        Also crypto prices are very volatile, so you need to post a collateral with a significant margin of safety on FTX to avoid possible margin calls.

        I don’t see any reason why GDLC discount to NAV should decrease or why it can’t increase a little bit more or just stay flat, there are no catalysts on the horizon. IMO a better risk/reward is long GBTC / short BITO (costs ~3.5% p.a.) – Grayscale applied to convert GBTC into ETF, if the permission will be granted (big if), the discount will be eliminated. But GBTC is the only Grayscale fund with potential catalyst. There is no way GDLC may be converted into ETF any time soon as it has a basket of different cryptocurrencies and tokens.

        1
      2. Dokler

        Ilya covered the other points, but re FTX: I’m not saying it’s a massive risk, but it’s certainly non-negligible when compared to trading equities in a brokerage account. Crypto exchanges have a history of being hacked, DOJ or other government action could occur, or perhaps the underlying business is fraudulent. Those are just a couple scenarios that immediately come to mind. I’m not claiming that any of these are particularly likely, but surely the counterparty risk in the wild-west world of crypto is enough to move the needle.

        1
      3. Fa

        I fully agree with your comment…. Trading outside regulated brokerage account in the wild west world of crypto is an extra risk which is not negligible.
        BTW, when you trade only crypto related assets through brokerage accounts with the correct margin requirements, mispricings in the crypto world are much much smaller….

  3. ddagtrader

    I would have to agree that this is likely to persist. The general pattern of ~20% discounts to NAV have been persistent in the GBTC and ETHE, but I don’t feel that they are stable. With BITO launching and getting $2b of assets in its first week, there is now a viable ETF alternative with a redemption clause, which will keep the Grayscale products trading at or near NAV, IMO. I feel the only reason it hasn’t gone worse than 20% discount is because the hedge funds that varunjain referred to are still in the hoping/wishing/praying phase of their denial. I agree Grayscale will not be approved for a physical ETF, but they are collecting a 2% fee on $70b of assets, so it’s in their best interest to continue stringing along the holders of the stock while collecting the $1.4b annual fee. I don’t see what mechanism exists to bring the discount back in line. A lot of people got hurt when we dipped to 5% then 10% then 15% discount, thinking we couldn’t go further. On the surface, the idea of doing this trade is amazing, but I worry that there is not much hope of the discount going away, but instead getting larger with viable ETF’s now available in the US with massive volume and a redemption mechanism.

    1
  4. patrick

    I’m throwing my vote that this discount is likely to persist and could widen depending on how badly the fund abuses its holders through fees. For a bit of history, there was maybe 1 or 2 funds (SVVC and something else) that had access to Facebook before Facebook went IPO. It traded at a massive premium because it was the only way to get a pre-IPO position. When Facebook went public, it fell apart and the discount only got worse over time.
    https://www.sec.gov/Archives/edgar/data/1495584/000139834417007935/fp0026455_image3.jpg

    As crypto ETFs come out, these funds that gave access to crypto will likely become useless to any new investors and only trap existing holders. If they are greedy, they will abuse the holders for many years to come to line their pockets with excessive fees.

  5. dt

    Thank you for the continued discussion. You all might be correct regarding the persistence of the discount. I intend to keep this trade on for a month and then close it if the spread volatility subsides and the discount does not narrow.

    In terms of crypto (futures based) ETF attractiveness relative to GDLC, I think the cost benefits are overstated.
    – GDLC – 2.5% management fee and seems like no other expenses were charged during the last fiscal year https://grayscale.com/wp-content/uploads/2021/09/GDLC_10-K-2021_As-Filed.pdf
    – BITO – a lower 0.9% management fee, however, the fund incurs costs by rolling bitcoin futures contracts every month. Looking at the current strip pricing these costs (i.e. NAV erosion) can amount up to 1.5% per month.

    Unless I am missing something here, GDLC is a much cheaper way to get exposure to crypto compared to BITO. Canadian ETFs (Purpose Investments) that hold crypto directly seem to charge 1.5% management fee, so somewhat better.

    Having said that, the discounts on other Grayscale funds clearly indicate where GDLC is likely to trade in the longer term.

    2
    1. Fa

      I was actually thinking of holding a long ETF / short future trade…. Is there a liquid ETF which holds bitcoins and not futures?
      the issue being long GDLC / short future is that GLDC discount could widen…

      1. ilya

        Canadian bitcoin ETFs (e.g. BTCC) are the best option, they hold bitcoins

        1
      2. ddagtrader

        US ETF’s have not been approved to use physical assets as their asset, so all US based ETF’s are going to have to use futures. As ilya indicated, you have to look to Canada for physical holding of coins for ETF assets, to avoid roll costs.

      3. Fa

        Thanks a lot ! Is BTCC is most liquid Canadian ETF using physical assets?

    2. snowball

      It looks like a better trade may have emerged:
      Long BTCC and short the future, to earn the roll yield (of 1.5% per month currently?)

      1. Fa

        well this is what I am trying to figure out BUT the 1.5% per month is super variable =>it is now less than 1%

  6. Fa

    thanks but you need to hedge your CAD/USD exposure so it adds extra margining to the trade.
    and BTCC liquidity is <<< than GDLC or BITO

    1. snowball

      If you use BTCC.B (Canadian dollar unhedged version of BTCC) or BTCC.U (USD version of BTCC), you would not need to hedge CAD/USD exposure.

      1. Fa

        So Long BTCC.B or Long BTCC.U or Long BTCC hedged / short futures (regular or mini) would earn BTC calendar spread (currently only 0.7%/month) minus BTCC management fees + lending income if you manage to lend your shares.

  7. Brian

    I also like short BITO and long this or OBTC or GBTC. BITO is an inferior product…having to roll futures is pointless when there is essentially no cost to hold bitcoin. Plus BITO has the risk of what happened to XIV….essentially exiting a crowded theater in a hurry. I think it’s inevitable that these are accepted as ETFs and that the discounts will close.

    1. mosbaek

      Why. They earn a fat fee. There are thousands of CEF’s trading at a discount to NAV, where nothing happens for years. I agree 40 pct. is a lot, but not a guarantee. Take VOW / VOW3 spread. VOW is almost 1,5 x of VOW3 – and no one cares…

  8. ddagtrader

    One other thing to consider with BITO, is that they only have about 50% of their fund exposed to BTC values, so doing the basis trade (ETF vs Futs) doesn’t really work. They currently have $2.29B of NAV and only $1.175B of that is BTC. The rest is in T-Bills, so it won’t trade even close to the underlying BTC moves.

    1
    1. Fa

      BITO and bitcoins are super well correlated……sounds very strange that they would be only 50% exposed

    2. mosbaek

      That sounds unlikely. Are you sure you can see the notional future exposure ? -and not just the mv of futures ?

      1. Fa

        Well, I am using BITO (makes no sense as BITO is future based) and BTCC (with a FX hedge but USD/CAD is not very volatile) versus BTC futures using notional exposure and it looks like my P/L is flat even when BTC goes down or up 5%

  9. dt

    I am waving a white flag on GDLC – all who said that the GDLC discount to NAV is now permanent due to cheaper alternatives were correct.

    I intended to keep this open for a month expecting a reversal. With the month passed the discount has widened a bit and I am closing GDLC arbitrage at 3.5% loss.

    2

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