ETHE - Bitwise 10 Crypto Index Fund: Another U.S. Listed Crypto Arbitrage Building Block

2023-12-11 11:36:29 ET

Summary

• Bitwise 10 Crypto Index Fund is an OTC-traded closed-end fund with $614 million in assets under management.
• The fund currently holds Bitcoin (67%), Ethereum (22.5%), and other cryptocurrencies like XRP, Solana, Cardano, and Litecoin.
• The fund trades at a deep discount to its net asset value, presenting an arbitrage opportunity for investors.

Because of the unusual arbitrage situations that are appearing in the crypto-related closed-end funds driven by rapid price changes and uncommon limits to arbitrage due to different geographic regulations or accessibility of markets, I'm swamped looking at a lot of these types of funds.

Another one I've come across is the Bitwise 10 Crypto Index Fund ( BITW ). This OTC-traded closed-end fund charges 2.5% on assets under management. It has gathered $614 million in assets under management and tracks the Bitwise 10 Crypto Index (rebalanced monthly). The fund currently contains Bitcoin 67% and Ethereum 22.5% but also holds XRP, Solana, Cardano, Chainlink, Avalanche, Polygon, Polkadot, and Litecoin. The table below shows the weightings:

I understand the fund is a pass-through partnership and ownership results in K-1s being filled out. But I'm not a tax expert, so please consult your tax advisor if you're considering investing here.

Interestingly, the fund trades at a deep discount to a net asset value of around ~30.45%. The intraday net asset value on December 8 stands at $35.73. The market price is only $24.85.

Meanwhile, within the Grayscale suite of closed-end crypto funds, the same assets trade at much smaller discounts and sometimes at enormous premia.

I'm leaving tax considerations out of this discussion because I don't have the expertise to offer a helpful perspective there. I suspect they can complicate this trade, so be mindful of that.

The BITW fund is attractive for a few different reasons. First of all, because if we hedge out the cryptocurrencies through a combination of the Bitcoin futures fund ProShares Bitcoin Strategy ETF ( BITO ) and the right amalgam of Grayscale funds, we get free crypto exposure alongside. If you have access to European markets, this trade can be improved by shorting a European crypto ETN (because it trades much closer to NAV) instead of the Grayscale product, for example.

For example, if we take 10k worth of BITW, and then we short against it: 8.7k BITO, 2.9k ETHE, 0.3k GSOL, 0.98k LINK, and 0.611k LTCN.

Then, we've hedged out ~93.5% of the assets included in BITW. But we did so by shorting 13.5k worth of assets against it. That 3.5k can be re-invested wherever you want. It could be put back into BITW or a favorite Grayscale fund, but it could just as well go into the SPDR Bloomberg 1-3 Month T-Bill ETF ( BIL ).

If the discount narrows, we get a return, and it won't matter whether any of these cryptos is up or down. In addition, we're effectively long the cryptos we aren't able to hedge out. We also get to put 3.5k of created capital wherever we want. However, that capital would be at risk. Another way we can generate a return is if the Grayscale funds that trade at a premium lose it. Historically, this has happened over time.

I just noticed that Grayscale closed many of its funds to private placement. The private placement historically likely helped to erode the premia. On the other hand, the European market is much more mature with alternative products this way around, and the community of traders with crypto expertise and the ability to trade global TradFi markets has also grown.

Per 10k of investment in BITW, we are effectively long for "free" the following cryptocurrencies:

$294 Ripple ( XRP-USD ), $121 Cardano ( ADA-USD ), $68 Avalanche ( AVAX-USD ), $66 MATIC ( MATIC-USD ), $63 DOT ( DOT-USD )

I don't think it is inconceivable that any of these underlying crypto end up zeroing out at some point. Theoretically, this should widen the discount to NAV, and you are somewhat negatively affected despite shortening out most of the BITW exposure.

To finish this up, I want to talk through some of the risks that come with what, when simplified, looks a lot like long X (at a discount) vs. short X (at a premium).

If Grayscale funds are used as the alt-coin short side of this trade, there is a risk with the Ethereum fund that it is converted to an ETF and starts trading at NAV. Because it currently trades at a discount to net asset value, that means you incur a loss there that isn't offset, as long as BITW doesn't convert to an ETF as well. As far as I know, Bitwise doesn't plan to convert this fund. Most of the other altcoins, on the short side, trade at a premium. If these Grayscale funds were to convert, it would result in extra returns.

Another risk with this position is that the discount to NAV widens. The good news is that the discount to NAV is already 30%, and I've never seen a discount to net asset value in the U.S. markets beyond 50%. That doesn't mean it can't happen, or it has never happened. In practice, it is pretty rare.

A risk worth mentioning is that the borrowing costs to get shares to short can be expensive. It can also become more expensive, making it difficult to maintain the position profitably.

These crypto arbitrage trades that I've been writing about publicly here and here , as well as for members, theoretically have relatively little risk. The net position sizes are quite small. In practice, brokers don't always recognize this. The trade will also eat up a lot of margin relative to the theoretical risk. If the discount increases or the premia on certain Grayscale funds widen, you can be faced with quickly increasing margin demands.

The most realistic risk is probably that the fund just keeps trading at a massive discount and doesn't narrow or widen a bit, while you keep paying 2.5% fees on assets under management. If the enthusiasm for crypto were to wane again, a scenario like that could unfold.

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