Risk Free Arbitrage Trade with GBTC, ETHE and CME crypto futures

Since March 2021, GBTC and ETHE has been trading at a discount to their NAV (net asset value). GBTC is a trust by Grayscale, a firm in the cryptocurrency investment space. At time of this post (6th April 2021, 2.20pm GMT), GBTC is trading at 7.35% discount to NAV

GBTC – $51.24
Bitcoin per GBTC – 0.00094519
BTC price – $58,509
GBTC NAV – 0.00094519 * 58509 = $55.302
GBTC discount = (1 – 51.24/55.302)*100 = 7.35%

Reason for the discount
The discount on GBTC cannot be easily arbitraged away by buying GBTC and redeeming for the underlying GBTC, because it is set up as a trust and not an ETF. A trust is one way only, accredited investors can buy into the fund at NAV, get equivalent GBTC, and after a lockup period of 6 months, sell them on the open market if they wish to. However nobody can pull BTC out of the trust by sending Grayscale GBTC. It used to be possible but SEC shut down the redemption.

Profiting from the discount
Buying GBTC directly exposes you to the price movement of Bitcoin. There’s no joy if you’re right on the discount closing to zero, yet losing 50% due to the underlying BTC crashing.

However, there are several ways to hold a net zero position in BTC through futures, GBTC and shorting BTC directly, and you could long the underlying BTC at a discount (through GBTC), while shorting BTC (by borrowing and selling, or shorting futures). You’ll profit if the discount narrows or closes, and hold a paper loss if the discount widens.

First way – CME Bitcoin futures
CME BTC May 28 2021 Futures – $59190
Premium to BTC = (59190/58509 – 1) * 100= 1.16%

May 28 futures is an example, but further out futures have poor liquidity. For instance, the Dec 2021 futures have a bid ask of about 62k/64k, while the May 28 ones have a spread of around $100. In general Bitcoin futures are more expensive the further out they are and in a state of contango. As the GBTC discount fluctuates daily, the trade may only be held for a short period (eg, open position when GBTC discount at 12%, close at 5%), tight spreads are necessary and the illiquidity of further out futures aren’t suitable.

In this trade, you will open a GBTC position with an underlying X amount of Bitcoin, then short the futures controlling the same underlying amount of Bitcoin. With this trade, you should have an immediate net cash position (assuming you put up 100% margin for the short futures). When the discount narrows, close both trades and you will lock in a profit.

Second way – Borrow BTC on Blockfi and sell it.
One way to short BTC is to utilize Blockfi. You can borrow BTC by pledging USD as collateral, for example send them $100k and borrow $50k worth of BTC. You will then take the BTC and sell them on the open market, at the same time going long the same underlying amount of BTC using GBTC. Do this correctly and you will again get a net positive cash position immediately.

Which method is better?
Right now, I’d say the futures method is better due to contango. This allows the price movement of the futures back to spot price over time to work in your favor. If futures go to backwardation (where further out futures are cheaper than spot), then it should be compared to the annual cost of borrowing BTC.

Risks and Black swan
Your primary risk is the discount growing further, in which case you will hold a paper loss. A black swan will be GBTC discount crashing way down, which isn’t impossible if a leveraged hedge fund holding a ton of GBTC blows up, and their brokerages had to liquidate.
A secondary risk is the discount not narrowing for months. As time passes, there’s opportunity costs for the trade (and this is capital intensive), the GBTC annual fee of 2%, though the futures contango of 6+% annualized works in your favor.

If you borrow on Blockfi, there’s the 4-10% annual interest on borrowing, though it can be partially mitigated by using the funds from selling the borrowed BTC effectively.