There is Another $7 Billion of Untapped Value in this Bitcoin Fund

A world record-breaking Bitcoin fund is about to have its day in court due to a legal dispute. Whether anyone will be able to gain access to this $7.2 billion profit, which sits in the fund like sunken treasure, is at stake in the fight.

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The Grayscale Bitcoin TrustGBTC +2.29% (ticker: GBTC) appears to be the best deal on BitcoinBTCUSD +1.06% that you can find on the surface. There are 47% discounts between the price of the fund's shares and its underlying net asset value, or NAV, which is made up of $15.4 billion in Bitcoin holdings. Without Bitcoin's price moving in a positive way, investors would have the opportunity to scoop up an 87% gain if it trades up to its NAV. It is estimated that the discount is worth $7.2 billion at recent prices for the token, which are around $23,700.

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That is considered a bargain by some investors. In Cathie Wood's ARK Next Generation Internet ARKW -0.61% exchange-traded fund (ARKW), GBTC accounts for more than 5% of the total assets. “It's obvious that someone will find a way to make some money by closing the discount if there is money to be made," says Ned Davis Research senior portfolio strategist Pat Tschosik, who sees GBTC potentially doubling by mid-year as Bitcoin rallies.

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The discount that GBTC offers has proved to be impregnable over the years. Grayscale Investments, the company that sponsors the fund, has largely protected itself from proxy campaigns by hedge funds, which could otherwise threaten the credibility of such a wide discount in a closed-end fund. With other Bitcoin funds emerging—notably ETFs like ProShares Bitcoin StrategyBITO +1.01% (BITO), which holds Bitcoin futures, for a much lower annual fee than GBTC, GBTC has only widened its discount as other Bitcoin funds have emerged.

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Grayscale has announced that it will convert GBTC into an ETF, arguing that it is the best way to close the discount on GBTC. Market arbitrage mechanisms are used by ETFs to eliminate discounts to their NAV (net asset value) and, in theory, this could allow GBTC owners to unlock the $7 billion that is locked away.

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But there is one catch: The Securities and Exchange Commission has repeatedly refused applications from fund companies that want to own Bitcoin directly instead of through futures contracts in order to create an ETF. After Grayscale’s application to convert GBTC into an ETF was rejected by the SEC in June, Grayscale filed a lawsuit against the SEC in an attempt to overturn its decision.

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There is scheduled to be an oral argument on March 7 in the U.S. Court of Appeals for the District of Columbia. Grayscale is represented by the former solicitor general of the Obama administration, Donald Verrilli who serves as Grayscale's lead attorney. According to Verrilli, in an interview with Trade Algo, the SEC has no good reason to treat spot Bitcoin ETFs differently than futures-based Bitcoin ETFs, arguing that the agency is breaking the law by applying a double standard.

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"Administrative agencies have an obligation to treat similar cases alike, and the SEC has violated that obligation," says Verrilli, explaining that he does not know of a case specifically comparable to this one. The court could rule by the fall.

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The implications of this issue are far-reaching, going well beyond the scope of the GBTC. Fidelity Investments, VanEck, and WisdomTree (WT) are among the fund companies that have attempted but failed, to persuade the SEC to approve an ETF that will allow investors to buy Bitcoins on a spot basis without the need to open an account with a bank.

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If the SEC rules in favor of GBTC becoming an ETF, it would likely open the floodgates to a much larger number of Bitcoin funds, something that it appears the SEC does not want to happen. Despite the fact that the spot Bitcoin market is not properly monitored, in the long run, there is an argument made by the agency that, unlike futures markets, there are not enough measures in place to prevent fraud and manipulation in this market, and it is not properly monitored at all times. As a result, investors are at risk of losing their money if a spot Bitcoin fund is manipulated, the agency warns.

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According to a brief filed by the SEC in this case, the SEC argued that, in these circumstances, a change in treatment was reasonable in light of all the unregulated markets for spot Bitcoin that are underpinning Grayscale's product. There was no comment from the SEC regarding the brief that was filed.

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Grayscale is trying to force hedge funds and other investors to give up control of the fund or find other avenues whereby the $7 billion can be unlocked while the lawyers wrangle in court.

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Fir Tree Capital Management, one of the largest hedge funds in the country, filed a lawsuit against Grayscale in December, accusing it of mismanaging the fund. Fir Tree said Grayscale had quietly changed the governing documents of GBTC in order to make it harder for shareholders to take over the trust. It is also stated that Fir Tree believes Grayscale's corporate parent, Digital Currency Group, has "substantial conflicts of interest" that are incentivizing it to maintain GBTC's status quo as well.

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Fir Tree and other investors argue that the conflicts arise in part due to the fact that DCG makes so much money on its fees. The ETFs that hold Bitcoin futures charge a fee of about 1% per year, compared to the 2% fee that GBTC charges per year. It is estimated that, at current prices, GBTC's management fees are more than $300 million per year, since they are a percentage of the trust's assets.

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“This is a very lucrative business for them. They are making a lot of money from it. There is a necessity for them to continue pushing capital towards their parent company," says Steven McClurg, a chief investment officer of Valkyrie Investments, which runs a hedge fund that owns GBTC and had its own application to launch a spot Bitcoin ETF rejected by the Securities and Exchange Commission. Despite Grayscale's refusal to close the discount, McClurg said he still intends to keep pressing the company to do so.

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Another company that has challenged GBTC is Osprey Funds, which runs the Osprey Bitcoin Trust (OBTC), which is a much smaller fund with a total of $68 million in assets. Also, Osprey has sued Grayscale in an attempt to gain dominance in the over-the-counter Bitcoin funds market, alleging that Grayscale had lied about its chances of converting GBTC into an ETF, to achieve dominance in the market.

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A Grayscale spokesperson has said that the Osprey lawsuit is frivolous and that the activists' other complaints are unfounded. Michael Sonnenshein, the CEO of GBTC, announced on Monday that as soon as the ETF is launched, GBTC's fees will be cut.

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Activists also promote the idea that Grayscale should return the underlying Bitcoin to shareholders, a strategy that would require regulatory approval similar to what Grayscale is seeking with the ETF conversion, as part of its efforts to win shareholder approval, he says. GBTC's management has confirmed that Grayscale is open to a tender offer if its legal strategy fails, including an appeal to the Supreme Court if the legal strategy fails.

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As Sonnenshein says, "We don’t think that it is in the best interests of our shareholders for us to seek approval for a tender offer at the same time we are suing the SEC," Sonnenshein says.

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Due to all of the legal jockeying, crypto investors are stuck in purgatory. If the case goes to court, it could result in a $7 billion windfall, but if it does, it may take years, if ever. Meanwhile, the price of bitcoin has risen by 43% this year. After a period of widening discounts, GBTC is up 39%, continuing its downward trend after falling behind the crypto that it's supposed to track again.