The Bitcoin Investment Trust (OTCMKTS:GBTC) is the first publicly traded security designed to track the performance of Bitcoin, and it does so for a 2% annual fee. The trust holds a little over $230 in Bitcoin per share while trading for $450-550 per share. Shares of GBTC trade for a significant premium over the value of the Bitcoin they represent, annoying many observers.
However, the negativity surrounding GBTC’s premium is based on a misunderstanding of market efficiency and should not deter investors from this excellent opportunity. Often, analysts and investors mistakenly assume a large premium is a sign of market inefficiency or irrationality when it is actually a normal and healthy part of an investment’s value. This article will explain why GBTC’s premium over the spot price of Bitcoin is actually a good thing.
Like most rule of thumb beliefs, the idea that a premium over NAV is bad feels intuitive. After all, you wouldn’t want to buy an apple for double the price of an apple. But this surface-level example doesn’t fully capture why premiums over NAV became such an anathema to the investment community.
Most investment trusts hold bonds and other income generating securities that pay a fixed amount based on their face value. If an investor buys $100 worth of 10% coupon bonds for $200 – not only is his income reduced to 5% but when the bonds mature or get called, the investor will only receive $100 when he paid $200 to buy the bond. Most of the bond’s yield was just return of capital. And that 5% was in practice only 1% or 2% if not negative when considering inflation. That sounds awful – but only in perception, not reality.
Investments can only be evaluated on a risk-adjusted basis. And if abond trades for such a high premium that its yield becomes minuscule, that simply means the bond was incorrectly priced at face value and the market compensated for this through a premium that reduced its yield. Premiums and discounts to NAV are the market’s way of ensuring an equilibrium between risk and reward.
The Risk Premium
GBTC’s premium exists because of the significant risks averted by investing in GBTC instead of the traditional methods of transacting in Bitcoin. To be clear, GBTC’s premium is not about convenience, it is about actual value. Cryptocurrency exchanges are generally not secure. Digital currencies lack central accountability or authority and there is little recourse for theft. Many of the largest exchanges have been hacked. In 2014, a Bitcoin exchange called Mt. Gox handled around 70% of global transactions before being hacked for what was worth $450 million at the time. Last year, Bitfinex was hacked for $71 million, causing users to lose 36% of their deposits.
Because of the threat of hacking, cryptocurrency users generally recommend holding Bitcoin in what is called “cold storage” – a secure offline environment where it cannot be hacked. But there is a problem here. And whenever there is a problem there is an opportunity for value to be created through a security that solves the problem. By holding Bitcoin in cold storage, an investor sacrifices liquidity – the ability to quickly buy and sell his Bitcoin. However, if the investor holds the asset online, he increases the risk of total loss from hacking. GBTC solves this dilemma.
The Bitcoin Investment Trust stores its Bitcoin in “Xapo, Inc., in deep cold storage vaults. Bitcoin stored in the Xapo Vaults reside on multi signature-addresses, the private keys for which are protected by intense cryptographic, physical and process security.” By storing its Bitcoin in offline cold storage, GBTC solves the problem of security without sacrificing the liquidity. By solving this problem, GBTC has created value and it is literally worth more than the liquidation price of its assets.
But it doesn’t end there, GBTC provides many more advantages. For example, Coinbase, the most popular Bitcoin exchange, imposes limits on the amount of Bitcoin that can be bought at a time. On top of this, bank transfers take 3-5 days to process. Bitcoin purchases transacted through a bank account are locked-in and cannot be sold until up to a week after purchase. The price of Bitcoin can change significantly over this period, but the investor will be unable to sell or cancel the order. On the other hand, GBTC allows investors to buy and sell freely.
The Bitcoin Investment Trust creates value by providing a solution to the tradeoff between security and liquidity in traditional Bitcoin investments. The trust’s premium over the value of its assets is a reflection of the risks investors avoid by investing in GBTC instead of actual Bitcoin. This is not simply a premium for convince, but rather a premium for safety. And as investor awareness and interest in cryptocurrency grows, GBTC’s premium is likely to increase, making the security a good way to invest in Bitcoin. With all that said, Investors must also consider the possibility of a new Bitcoin-based fund or ETF reducing demand for GBTC and removing its premium.