Last month, the U.S. Commodity Futures Trading Commission (CFTC) ordered Coinbase to pay a $6.5 million penalty for delivering false, misleading or inaccurate reports concerning digital asset transactions taking place on its GDAX trading platform. Specifically, the CFTC found that Coinbase was placing matching orders in certain asset pairs, essentially trading with itself. Coinbase would include these transactions in their required reporting, giving a false impression of the volume and liquidity on the GDAX platform.
The order also finds that a Coinbase employee used GDAX to place matching buy and sell orders in the Litecoin/BTC trading pair in order to give a false impression of the liquidity and interest in Litecoin.
While significant in and of itself, the implications of the CFTC’s finding and fine reach beyond Coinbase. In fact, it may prove disastrous for the development of a much-anticipated area of digital assets: the fabled Bitcoin ETF.
The Grayscale Bitcoin Trust
To understand why, one must start with Grayscale Investments LLC, one of the earliest movers in offering vehicles for digital asset exposure without needing to own the underlying asset itself.
One of these vehicles, and undoubtedly the best known, is the Grayscale Bitcoin Trust. The Trust is a digital asset investment product which allows investors to gain exposure to digital assets through the form of a security (GBTC) without the need to hold the underlying asset.
This kind of vehicle is distinct from an ETF. A trust has a fixed number of shares available and new shares can’t be issued simply, meaning that price is largely driven by supply and demand. Shares in the Trust also can’t be traded before six months. As the only assets in GBTC’s portfolio are supposedly BTC, the net asset value (NAV) of the Trust should be more or less exactly equivalent to the value of all Bitcoin in their possession.
An ETF, on the other hand, allows the market maker to create and redeem shares at will, more in line with a regular stock.
Due to these features of GBTC as a trust, the actual price of GBTC has almost always been somewhat disconnected from the NAV value of each share. This disconnect might not be a problem when GBTC is trading at a premium to NAV, but negative sentiment can have an outsized impact on the price, pushing it well below NAV.
Grayscale is in an even more precarious position with regard to its share value, because investors in GBTC have no mechanism by which they can redeem their shares for Bitcoin, further severing the link between the value of GBTC shares and the value of the Bitcoin portion they represent. This is due to an SEC ruling from back when Grayscale Bitcoin Trust was called Bitcoin Investment Trust which determined that the redemption program being proposed at the time was in violation of SEC rules because it was redeeming shares before the shares themselves had been created. According to Grayscale financial statements, “The Trust currently has no intention of seeking regulatory approval to operate an ongoing redemption program.”
This wouldn’t have been a problem and the GBTC premium (meaning the price of GBTC shares above the NAV) stayed high for a long time merely because there has been no other ways for investors to gain exposure to BTC without owning the underlying asset itself. The lack of competition kept GBTC prices high, meaning the inability to redeem them for BTC wasn’t an issue since the value of the stock was higher than the value of the corresponding portion of BTC.
However, since GBTC’s inception, competition has heated up. Not only have efforts by third parties to get a Bitcoin ETF approved continued, but competing trusts which work similar to GBTC have been established, meaning that where Grayscale once enjoyed a premium well above the value of the underlying Bitcoin, it is now stuck below NAV.
Grayscale uses digital asset lender Genesis (Grayscale and Genesis share a parent company, Digital Currency Group) in order to fulfil GBTC creation requests. As the only Authorized Participant of the Trust, the only way new GBTC shares are issued is via Genesis, who provide the BTC required to create each order on behalf of investors. It isn’t clear how Genesis’ decision to suspend its credit extension last year impacted the ability to create shares in the Trust, but Grayscale has been force to suspend new investments into the Trust as recently as this year after spending weeks trading below NAV.
An ETF is Grayscale’s solution
All of this should make it no surprise, then, that Grayscale recently announced that they were “100% committed to converting GBTC into an ETF (exchange traded fund).”
The reason the Coinbase ruling affects Grayscale is because Grayscale has been using Coinbase (among others) to determine its NAV. This is important (and unfortunate) for Grayscale, because the SEC has made clear that the reason they have yet to approve Bitcoin ETFs is because it fears the accounting of exchanges are unreliable in determining NAV.
In fact, in denying the ETF application of another company last year (NYSE Arca), the SEC cited its fears over the very thing Coinbase was just penalized by the CFTC for doing:
“The Commission concludes that NYSE Arca has not met its burden… to demonstrate that its proposal is consistent with the… requirement that the rules of a national securities exchange be ‘designed to prevent fraudulent and manipulative acts and practices’.”
This puts Grayscale in an impossible spot, because Coinbase is not merely one of a number of sources in determining its NAV – it also acts as the Trust’s custodian, according to SEC filings. Grayscale’s parent company Digital Currency Group was also reported to be one of Coinbase’s early-stage seed investors. It therefore seems unlikely that Grayscale can push the Coinbase ruling under the rug by omitting it as a NAV source.
Even if that did happen, it seems more likely that the CFTC’s Coinbase investigation confirmed what the SEC already feared about the prospect of Bitcoin ETFs and the role played by exchanges in determining the value of Bitcoin, and with exchanges continually appearing in the news for the wrong reasons, it’s hard to see the SEC’s stance changing.