ETHE - Why I'm Not A Fan Of The Grayscale Ethereum Trust At A 10.64% Discount (Rating Downgrade)

2023-12-27 04:47:02 ET

Summary

• Grayscale Ethereum Trust trades at a discount to net asset value, but the discount has narrowed in recent months.
• The Grayscale funds are trading at premiums due to technical and regulatory constraints on owning altcoins outside of regulated market vehicles.
• The possibility of SEC delays and the mismatch between staking and ETF liquidity makes the conversion of ETHE to an ETF uncertain.

The Grayscale Ethereum Trust (ETHE) is a closed-end fund that trades at a discount to a net asset value of 10.6%. The discount to net asset value has narrowed considerably over the past few months.

Bitcoin appreciated a lot during 2023, and altcoins didn't take long to follow along. I've been invested in the Ethereum Trust and wrote it up on The Special Situations Report , together with the Grayscale Bitcoin Trust ( GBTC ), back when it traded at $6 and held $10.50 worth of Ethereum. As things stand now, I'm not a huge fan of buying into ETHE. I still like GBTC if hedged .

I don't have a view on Ethereum but just on this Grayscale vehicle that's primarily used to get exposure to Ethereum. The discounts on Grayscale's funds have narrowed substantially from where they were during the latest crypto bear market. Many are now trading at a substantial premia even:

The Bitcoin, Ethereum and Ethereum classic trusts are the remaining funds trading at discounts. I think Ethereum Classic is not a hot crypto and, therefore not in high demand. The premia on various other funds are surprising. It is a very rare sight to see closed-end funds trade at such high premiums to NAV. The default for the universe is to trade at a discount. There is a lot of variability in the discounts but most of them trade at a discount between 1% to 20%.

It is surprising because you could just buy these cryptos through a trusted crypto exchange (if something like that exists) or self-custody these cryptos instead of paying 2.5% fees. The funds are trading at a premium because 1) some crypto traders are technical or quantitatively oriented and follow price signals (predicting surging prices lead to further short-term upside), and 2) there are professional traders that are constrained to U.S. Tradfi assets. They simply don't have the infrastructure or legal right to own altcoins outside of regulated market vehicles. For these investors, these Grayscale funds are one of the few ways to express these altcoin trades. 3) U.S. investors can own the Grayscale vehicles in tax-advantaged accounts.

Ethereum and Bitcoin are easier to access in tradfi markets. There are different ways to own Ethereum and Bitcoin including futures markets that are loved by hedge funds and traders. That's why I never expect these funds to start trading at a premium again.

In the case of the Bitcoin fund, there is an ongoing push to convert it into an ETF. The SEC has been sandbagging this attempt for a long time but the court has ruled this isn't right and now it should happen imminently. The court ruled that the SEC's denial of its application was "arbitrary and capricious" because it did allow Bitcoin futures ETF.

For Ethereum, Grayscale is also applying to get an ETF approved, but I'm not nearly as confident this will result in an imminent conversion. The market seems to believe the probabilities are much closer aligned than I:

There are a few reasons. For starters, Ethereum holders can theoretically benefit from staking their cryptos (resulting in a yield). If you don't stake you're not earning any compensation for the dilution you're experiencing.

Offering products on cryptos you can stake but don't is like offering real estate funds where you don't bother collecting the rent. It doesn't pass the sniff test of a responsible product.

The staking is also a technical difference and complication that wasn't there with Bitcoin. In years past, the SEC has delayed and hindered the crypto-industry on many occasions. Whether justified or not, I don't expect them to change that behavior. Meanwhile, the Ethereum trust is trading at only a 10% discount. If an ETF is approved, that leads to an 11% return. If I were interested in capturing that 11%, I would definitely do so by hedging out the Ethereum exposure.

I believe it's currently quite advantageous to offset the inherent exposure to Ethereum. This strategy allows me to secure approximately an 11% return while essentially committing no significant capital. I can take a long position in ETHE and balance it by shorting between 100%-110% of that position through Ethereum futures or the VanEck Ethereum Strategy ETF (EFUT).

This results in minimal or nearly zero market exposure to Ethereum, depending on the hedging ratio. If Grayscale is allowed to convert ETHE to an ETF this would result in an 11% return as the spread would instantly approximate zero on conversion.

In closed-end fund arbitrage, fully mitigating the risk associated with the underlying asset is often a complex task. At times the asset comprises numerous components, sometimes the full composition is unknown, and frequently, the portfolio data is outdated. However, here it is quite straightforward because there is just one type of cryptocurrency in the fund.

Instead, maintaining an unhedged position could lead to the inherent volatility overshadowing the 10% arbitrage target. Ethereum can surge by 24% or plunge by 22% any day. It wouldn't surprise me. If I believed the fund would convert within the next 6 months (which I don't) I don't want to pollute the predictable "risk free" 11% return with a bet that's much less attractive in terms of risk/reward. That's why I prefer the more stable returns of a hedged strategy both in this case and GBTC.

The final reason I don't like ETHE here is because of the possibility that the SEC finds ways to delay a conversion of ETHE, there is a non-zero chance Grayscale may ultimately not pursue conversion.

ETHE charges 2.5% on assets under management; there is almost $7 billion in the fund that doesn't get staked and can't leave. This is a beautiful fee stream. I can imagine staking could ultimately be realized in a closed-end fund but will be a very difficult feature to package into an ETF. ETF's offer immediate liquidity and staking for yield means you lock-up assets for a period of time. That's a crucial mismatch and that's why I don't think proof-of-stake protocols are well-suited to be held through ETF products. In Europe, they've been put in ETN's and I'm not sure that's wise. If the SEC doesn't allow staking in ETF's that would be a perfect excuse for Grayscale to refrain from converting this fund. If a scenario like that plays out I expect the discount to blow out to 20%+.

I think the market is getting too excited about ETHE because there are also Ethereum futures. It looks like the rationale holds that if the judge says that Bitcoin spot ETFs have to be approved because Bitcoin futures have been approved, the same line of reasoning applies here.

But I don't think that's precisely true. Futures are derivative products that promise a delivery of the underlying at a certain point in time. Because you can hold the promised product to deliver it at some point, the yield and/or cost-of-carry get reflected in the prices of these products. Then there are lots of other forces of demand and supply that can push prices up or down but big picture that's how it works. A futures product may not offer a yield but arbitrageurs could take advantage of that until it is more or less reflected in the futures prices. This isn't the case with an Ethereum ETF.

In conclusion, while the Grayscale Ethereum Trust is an option for investors seeking exposure to Ethereum, there are multiple reasons why I don't like it. The narrowing discount to net asset value means there is little upside compared to outright Ethereum or alternative products. The path towards ETF conversion seems less straightforward than for Bitcoin. The complexities and potential inefficiencies of incorporating staking features into an ETF format raise questions whether proof-of-stake protocols belong in ETFs at all. I don't have a beef with Ethereum. I just don't think ETHE is worth it, at this narrow a discount.

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