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Exponential News

Don’t Buy The Grayscale Ethereum Trust (ETHE:US)

Jun 25, 2020 10:43:15 AM / by Steven McClurg

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When the Grayscale Bitcoin Trust (GBTC:US) began trading, many investors made great paper profits from the premium that it carried in the early years. This knowledge enticed the same accredited and institutional investors, as well as others eagerly sitting on the sidelines, to jump into the Grayscale Ethereum Trust (ETHE:US). However, it is not the same because the fundamentals of Bitcoin and Ethereum are not the same. There is no one size fits all investment strategy that encompasses all cryptocurrencies.

Closed-End Funds and Premiums

Many investors do not understand the mechanics and nuances of closed-end mutual funds and trusts. This extends to institutional investors as well. Having launched and managed numerous closed-end mutual funds and trusts, I have learned the granularity of their many pitfalls as well as the opportunities in these instruments.

It is important to examine the premium to the Net Asset Value (NAV) or the price per share compared with the value of the underlying asset. In the case of the ETHE:US, an open-end investment trust, it is Ether (ETH). ETHE:US has recently traded in a range of 6x-10x premium (or 600% — 1,000%) to the NAV. Two weeks ago, on June 11th, grayscale.co reported that the market price per share of ETHE was about $218 and ETH holdings per share were estimated to be $23.03. This means that as a retail investor, you are paying a premium of over 1000% or about $100 for $10 worth of ETH. As a comparison, on Kraken’s cryptocurrency exchange, you can pay $100 for $100 worth of ETH during the same time period. If you were a prudent investor, you would understand that purchasing ETHE:US and disregarding the premium to the underlying spot market is a poor investment decision.

Premiums do not always reflect the future value of an asset. In normal markets, a bond closed-end fund will trade at a premium because the market wants access to the underlying bonds when interest rates go down. It sells at a discount when interest rates go higher. Equity closed-end funds are a little trickier as it is easy to replicate the underlying unless options contracts are involved. However, even with the equity and bond examples, there is a greater premium or discount to future values depending on market volatility.

Premiums often collapse when the market has volatility.

Grayscale funds trade at massive premiums because people just don’t know any better. They buy the trust thinking that it accurately reflects the price of the underlying assets of Bitcoin (BTC), Ether (ETH), and others. We even speculate that recently, retail investors may have been confused with the price of ETH vs ETHE:US, as the price of ETHE:US was as high as $240 on June 11, when ETH was at $220, despite the fact that it was trading at a 1,000% premium to its per share NAV of $23. One thing is certain about these closed-ended instruments: high premiums always collapse, and in this case, investors will be harmed. This has just proven true for any ETHE:US retail buyer on June 11. The ETHE:US premium has collapsed by 60% in the last two weeks to a price of $84.50. This means that you lost 60% of your investment in a two-week period, rather than staying relatively flat if you had owned ETH outright.

Brad Mills explained that “because the price of ETHE rose so high, it started appearing like it was the price of ETH at a discount. Retail investors buying ETHE at $200 aren’t getting a discount at all; rather they are effectively paying $2000 per ETH, when they almost certainly think they are getting a deal on ETH. I think it’s safe to assume the 500–1000% premium is due to a perfect storm: buyers are a combination of FOMO institutional investing, market manipulation by holders of the constrained supply of only 3% liquid ETHE, retail traders getting hosed thinking they are getting a deal on ETH, and maybe a few simple investing for the convenience of not holding keys and tax savings. I think it’s going to end very badly for retail investors and probably a class action lawsuit against Grayscale for allowing this to happen.”

Corporate Structure

The trust structure that Grayscale uses is similar to a closed-end fund but with some annoying nuances. First, closed-end funds are a Regulated Investment Company (RIC), which means that 40% of its underlying assets must be securities. Grayscale Trusts will not work in that structure because none of the underlying crypto assets are securities.

Many people describe trusts working as a casino. I think it is more like a Hotel California. You can put money in to create additional trust shares but you can never redeem them. As Greyscale’s website explains, you can never redeem for the underlying cryptocurrency. You can only sell your shares to the next lucky buyer after your lockup period is over. Closed-end funds do not have these lockups. They also allow you to add structures to enable redemptions.

Finally, trusts are taxed as partnerships, meaning you have to file the Schedule K-1 document, even if you own them in a retirement account. Schedule K-1 forms can lead to more complex and potentially more costly tax preparations each year because some categories of income may be taxed as capital gains, while others are taxed as regular income, and for an investment in an IRA or 401(k), you may also need to pay tax on distributions received. Close-end funds often deliver a more favorable tax treatment to shareholders as well as tax-deferred distributions.

Given the deficiencies in the features of the trust, an investor could be correct about the underlying price action of ETH and yet still lose money.

ETH is a Poor Investment

ETH itself is a poor investment as proposed in our prior paper, Ether And Bitcoin Are Not The Same. The most important part of this paper is explaining the network effect. As the number of users increases and the Ethereum network supporting more dApps grows, then Ethereum becomes more valuable, which improves the network, which decreases gas costs.

Technological advances dictate prices decrease.

It is no different from cell phones. As the network and competition grow, the amount of data transferred increases, while the cost to transfer that data decreases. This is a simple economic theory of supply and demand, examining where the curves intersect. Technology shows greater depreciation of price following demand. Shifts in the supply curve are usually the result of advances in the technology that reduced the input costs of production. This has been true for technologies such as televisions, computers, cell phones, and wired/wireless data. It will also be true for blockchain.

Technological advances that improve production efficiency, such as ETH 2.0, will shift a supply curve to the right. The cost of production decreases and consumers demand more of the product but at lower prices. This has proven true for the price of ETH over the last two and a half years; as the network grew in earnest, prices have dropped significantly despite speculative buying.

An often-heard argument against developers and dApp users demanding lower prices on Ethereum is the fluctuation of gas costs priced in ETH. While the price of ETH is variable, the amount of gas can go up or down as a function of ETH price and network demand. However, this is a failed theory. First, adjustments in gas prices, at best, keep ETH prices stable over the long term, which is an argument against investment and speculation in ETH going higher in USD terms. Secondly, if gas prices can simply adjust to promote users at a lower cost on the network, any true relationship of the price of ETH to the use of the Ethereum network is broken, and the argument that buying ETH is buying the growth of the Ethereum network is void.

Because of this, ETH cannot serve as a means of exchange, unit of account or store of value and therefore cannot be seen as a viable currency. Therefore, ETH is only a speculative asset for speculation’s sake, with no true underlying fundamentals.


ETH Price and Network Growth

As of the date that we are writing this article (June 25, 2020), ETH is trading at $233. If you bought ETH a year ago, you lost 37%. Two years ago, you lost 49% and three years ago, you lost 24%. Of course, many people bought between Oct 2017 and August 2018, losing up to 93%. Retail investors buying ETHE:US a year ago have lost 31%.

During the same time periods, The Ethereum network has grown:

  • 3 years ago: 449 dApps
  • 2 years ago: 1515 dApps
  • 1 year ago: 2854 dApps
  • Today: 3479 dApps

It is important to note that Dapp growth began heavily in January 2017, when ETH was $1419.

Ethereum daily gas usage has increased since mid-2017 and has accelerated in recent months as on-chain transactions grew and became more competitive. Ethereum network use has hit a new all-time high, which is why the Ethereum community has recently been debating raising the block size limit. The network utilization chart, which depicts the average gas used over the gas limit in percentage, has currently surpassed 95%. Ethereum’s growing adoption is proving to be its Achilles’ heel.

The issues inherent in gas costs have created congestion, which is a negative network externality. Congestion on Ethereum has led to poor user experience, especially for traders in this highly volatile environment, as their leveraged positions may be liquidated before they can act. Ethereum has created a Braess’ paradox, which suggests that adding one or more roads to a road network can slow down overall traffic flow through it. Ethereum currently has a congested highway as well as expensive toll booths which have created an unpleasant experience with drivers looking for alternative routes.

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Ether And Bitcoin Are Not The Same

Jun 11, 2020 11:45:57 AM / by ExIM Team posted in Investor Letters

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The inordinate thirst of gain that had afflicted all ranks of society was not to be slaked even in the South Sea. Other schemes, of the most extravagant kind, were started. The share-lists were speedily filled up, and an enormous traffic carried on in shares, while, of course, every means were resorted to to raise them to an artificial value in the market. — Charles Mackay, 1841

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Why Are Stocks Rising Amidst Riots And COVID-19?

Jun 4, 2020 2:23:32 AM / by Steven McClurg posted in Investor Letters

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Why are stocks rising amidst riots and COVID-19?

Because people aren’t spending.

John Maynard Keynes laid out in The General Theory of Employment, Interest and Money a simple equation that sums up the current situation:

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The Bitcoin Halving Is Not A Buy

May 18, 2020 12:21:42 PM / by Steven McClurg posted in Investor Letters

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Bitcoin has rallied to over $10,000 from around $6,000 just a month ago, adding more than $1.4 billion in value. As of the release of this piece, Bitcoin is $8586. Bloomberg, CNBC, along with top technical analysts are covering the price action and attributing the surge to the upcoming halving and excitedly pulling up countdown clocks on their shows. The media is rampant with bull-run hype and moon shooting price targets.

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Human Behavior After COVID-19

May 18, 2020 12:13:55 PM / by Steven McClurg posted in Investor Letters

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There is hope and an expectation that lives will return to normal after the quarantines loosen and “non-essential” businesses are allowed to open in the US and globally. Market participants believe that a $2 trillion dollar aid package is enough to float small and large businesses, as well as the 20%+ who are now unemployed — not to mention freelancers who do not qualify for unemployment and many who are underemployed. In fact, the markets continue to rally on hope and news that the COVID-19 curve is flattening and a vaccine is close.

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Paycheck Protection

May 18, 2020 11:58:20 AM / by ExIM Team posted in Investor Letters

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The Coronavirus Aid, Relief and Economic Security (CARES) act included a $349 billion loan program called the Paycheck Protection Program (PPP) as a lifeline for small businesses desperate for cash during the COVID-19 pandemic lockdown. We believe that a payroll tax holiday is a better solution to ensure that Small Medium Enterprises (SMEs) receive the economic support that they need.

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Hunger: The Socioeconomic Effects of Food Inflation and Disrupted Global Supply Chains

May 18, 2020 11:33:02 AM / by Steven McClurg posted in Investor Letters

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The Fed is pumping $6 trillion dollars into the US economy, but will it trickle down to the recently jobless? The latest addition to Quantitative Easing Infinity (QE8) was the announcement that the bond purchase program has extended to junk bonds and collateralized loan obligations (CLOs) on Thursday. The benefit of this purchase program ultimately extends to the largest holders of CLOs, structured products holding junk bonds.

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Monetary Policy And Inflation: Is This Time Different?

May 18, 2020 11:02:13 AM / by Steven McClurg posted in Investor Letters

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The Federal Reserve just added $4 trillion to its balance sheet, with many market participants and the general population bracing for inflation, including higher asset prices. This fear is from Monetarists’ thought, who believe that inflation was a direct result of the money supply; however, Keynes argued that prices, resulting from economic pressures, are more reflected in inflation.

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3 Ways Digital Assets Will Reshape The World

May 15, 2020 6:22:08 PM / by Sunny Durante

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Digital assets are poised to revolutionize the way people operate and exchange value in the world. Adoption of distributed ledger technology, which is the platform digital assets are built upon, has provided the infrastructure for this new asset-class to bring much-needed innovations to the world of finance and beyond.

In their simplest form, digital assets are units of value or ownership stored on a distributed ledger. Stock shares, equity, property, and nearly any other unit of value imaginable can be stored and represented on these ledgers. They also enable fractionalization, so you can own a small percentage of a larger item.

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Exponential Group Launches Exponential Capital & Markets

Apr 28, 2020 12:39:29 AM / by Exponential Team

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Based in Toronto, Montreal and New York, ExC&M is a global advisory and digital asset platform with broker dealer capabilities. ExC&M provides strategic advisory, capital raising (through our partnership with a FINRA registered broker dealer), research, and M&A as well as digital asset issuance and trading services.

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