November 17, 2022 - 6:49pm EST by
2022 2023
Price: 7.06 EPS 0 0
Shares Out. (in M): 310 P/E 0 0
Market Cap (in $M): 2,189 P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV (in $M): 2,189 TEV/EBIT 0 0

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"I don't think people realize just how deep the crypto cess-pool is because crypto is sexy and hard to even comprehend unless you have a hard core CS background. People involved in Crypto are at the intersection of the morally bankrupt and technical savvy. The same Venn diagram as ransomware and malware operators." -NPComplete on the SI board, 15 minutes ago as I type this sentence

I intend this hastily-written entry as a fat finger in the eye of the VIC members who opine so vociferously and negatively about crypto while revealing in their opinions that they are too far out over their skiis.  We all suffer from the Dunning-Kruger Effect, especially when a topic is closely adjacent to another that we in fact know well, such as crypto and tradfi investing.  I have owned crypto for almost a decade and spend large chunks of my investing research & analysis time on crypto, probably never more so than the last 10 days.  I have almost never mentioned crypto on VIC so as to avoid having to deal with the inevitable blowback.  This will be my one shot, with no blowback engaged.  I am writing and posting it in one drafting session, sandwiched around a mid-day meeting. I will never post comments on this board and won't answer questions, no matter how balanced and constructive, because I know the overall experience would be a farce.  Unlike with every other write-up I've ever posted on VIC, I do not care what you think, and I do not owe you either a debate or handholding.  I'll probably go back to not mentioning crypto on VIC.

Contrary to NPComplete's assertion, almost everyone now realizes how deep the crypto cess-pool is, in so many different ways: Vaporware, scams, grifts, frauds, quasi-ponzis, hacks, thefts, etc.  And also, as highlighted last spring/summer, facially and existentially flawed $50 billion algorithmic stablecoin ecosystems -- I had seen plenty of people flag the Luna/Terra problem before it blew up; the tokens operated exactly as designed! -- and outrageous overleverage and counterparty risk because the space remains grossly underregulated.  And now this month, outright criminal theft of $billions in customer assets, paired with some of those other problems.  The entire crypto space is ~90% horrible.

And yet, beneath all that rubble, there are plenty of real developers working to solve real problems with real cryptoassets. A lot of people don't process this duality well.  An example you may know better: I call Elon Musk a "charlatan genius," and people focused solely on one or the other half of that duality lose their minds when someone mentions the other side.  The same thing happens in crypto.  To borrow NPComplete's idiom, the Venn diagram intersection of people who strongly criticize crypto and those who know crypto well enough to do so with sufficient balance or nuance to be useful is depressingly small.  A good place to start for helpful criticisms is, oh, portions of 7 out of every 10 Matt Levine columns or the 40,000-word primer he published three weeks ago:

Part of the problem is that almost nothing in crypto has intrinsic value (fiat-based cash flows).  If you are the type of value investor who will never get past "no intrinsic value" (and there are a lot of you), then of course you hate all crypto, for at least another several years until something starts earning real fiat cash.  In particular you hate Bitcoin, so let's pause there briefly.  Bitcoin is specifically designed not to have intrinsic value.  It is digital gold.  You probably hate gold also.  Fine.  Over 2,000 years of investing history shows that plenty of people disagree with you about whether intrinsic value is an absolute requirement for an investment.  You should also never buy fine art, a rare baseball card, a 1975 Ferrari, etc.  People also make the particularly bad argument that these types of things can't be stores of value because the prices are volatile.  Store-of-value does not mean price-stable store of value; the entire point is to act differently than fiat cash.  My average Bitcoin cost basis is $200.  I am rather fond of its price volatility, which yielded me a 350-bagger at the last price peak, and I am unperturbed that it is currently down to an 85-bagger.  No leverage, no trading, no personal spending based on its expected future value.  This is my third crypto-winter of 70%+ price declines.  I'm chill.

So now to the recommendation.  I did buy some ETHE near last Friday's close.  It is a tiny position, and one of only two tiny crypto purchases I've made this year.  Here are several reasons for the buy, building from the foundation upwards.  I think about my crypto investments the same way I do my stocks, to the extent the analogy can apply: value investing, multi-year time horizon, short-term and technical/market considerations around the margins of the trading decisions.

(1) Ethereum is hands-down the #2 most-legitimate cryptoasset after Bitcoin.  It long ago won the battle to become the dominant level-1 smart contract platform.  An enormous amount of developer person-hours have been and are being put into using Ethereum to build eventually-real-world-useful things.  The sunk costs for developers to gain fluency in its developer tools are also enormous.  They're never going to switch if they can help it.  Other L1s will fill various niches, but it by now it is highly unlikely that any of them will challenge Ethereum for dominance.  The investment case for Ethereum is a weird amalgam of owning a quasi-equity stake in what should remain the dominant platform for an ecosystem that should keep growing exponentially and start adding real-world value, and the #2 crypto store-of-value, and now a bond with yield.  Ethereum could someday overtake Bitcoin as the #1 store of value.  That is the #1 bear case for Bitcoin these days.

(2) Ethereum's investment case has strengthened in several important ways this year:

  • Transition from proof-of-work to proof-of-stake cut its energy usage by 99.9%, which eliminates a widespread, real, but overstated criticism of crypto and particularly Bitcoin
  • The Merge also converted Ethereum from being an inflationary asset (coin count rises over time) to a deflationary asset (coin count falls over time), and one that now earns you yield if you stake it to perform the proof-of-stake function. (Yes, yes, the yield is in the form of more Fake Internet Money)
  • The latest crypto winter has probably destroyed or crippled a number of other L1 competitors that otherwise would have eaten more into Ethereum's L1 market share -- particularly Solana, which was heavily backed and promoted by FTX/Alameda

The latter is of course countered by the destruction or diminishing of many crypto projects already built on Ethereum, which will now not drive as much Ethereum adoption as hoped.  But that negative is baked into the 75% price decline.

(3) Watch how Bitcoin's and Ethereum's prices have been behaving for the past 10 months as more and more bad news came out.  Look in particular at the last month.  The news has been absolutely horrendous, the worst in crypto's 13-year history.  And yet the declines have decelerated sharply, and this week have stopped even with more geniunely bad news.  You have all seen this movie in value stock investing: I think the prices are now bombed out. Although some contagion from the recent collapses will continue, the large majority of the excess leverage is already gone, and it looks like we're at the point where other people will step up and buy. The cycle-time factor also matters a bit.  The last two big crypto winters both bottomed 13 months after the prior peaks. We are now 13 months after the prior peak.  I expect that the recent debacle will push out the recovery for a while; six months from now might be a better time yet.  It's impossible to know.  There has never been a day in the life of crypto without a real risk that prices immediately fall another 80% and stay there.  Given the payoff asymmetries, however (risk losing 100% for the chance to gain >1,000%), at some point you have to say "this is a good time to buy," in an appropriately sized amount.  Now seems like a good time to buy.  The medium-term downside risk from here seems lower than it has been in a while, not higher.

To my surprise, I have seen statements from a decent number of people in crypto with roughly my profile -- not the crazies or zealots, but the more balanced people who have been around the space for a relatively long time -- that they are substantially more bullish now than they were in late 2018 (the same point in the last crypto winter).  Everyone is giving the same stated reason: Institutional adoption has become an established fact rather than a hope, and it has acheived critical mass.  Obviously the last two weeks' events put a large-institution generalist back in the "think about the career risk" category for a while, but I don't think that will last.  When the smoke clears, the rubble of scams and vaporware gets pushed away, and institutions look at the smoking ruins of counterparty risk and realize "BofNY Mellon solves this," Bitcoin and Ethereum look better rather than worse.  FOMO on the crazy stupid cryptoassets that used to moon 100x is now gone.

(4) Now on to ETHE in particular, the Grayscale Ethereum Trust.  The very short version of its story: ETHE and its big brother GBTC, the Grayscale Bitcoin Trust, are trust vehicles that own a stated amount of Ethereum or Bitcoin per unit.  All they do is buy the crypto and throw it into cold storage.  You can hand Grayscale crypto and they will hand you units, but you cannot hand Grayscale units and get your crypto back. This asymmetry means there is no way to arbitrage the two and keep the unit price near NAV.  During the 2019-2020 crypto run-up, a number of institutions and individuals wanted crypto exposure but in an exchange-traded product with normal custody arrangements, and not via owning spot crypto at some non-traditional custodian, or via CME crypto futures that sometimes have terrible roll decay. The Grayscale trusts were the only way US investors could do that, because the SEC resolutely refuses to approve any spot-crypto ETFs.  So the trusts routinely traded at very large premiums to their NAVs.  "Aha!," said a bunch of smart-guy hedge-fund types. "I can go buy the crypto, better yet borrow money to buy the crypto, hand it to Grayscale, get the units, market them to market for an instant 20-50-70% paper profit, then just wait 6 months to sell and realize the gains.  (The trust's terms prohibit selling for 6 months.)  You can guess what happened.  So many people piled into this arb that they not only closed the arb opportunity; the 6-month delay caused them to throw the entire thing into reverse without knowing they had done it, until some large holders' 6 months were up and they tried to sell.  The selling sent the spread-to-NAV negative, then more negative, then more negative yet.  The spread went negative already in early/mid-2021, when underlying crypto prices still had another +100% to go to reach their October peak.  Fun fact: This one bad trade was a material contributing factor in the blow-ups of 3AC and Blockfi, and I believe Alameda got caught as well, to a lesser extent.

Anyway, the spread has been negative ever since, and it kept getting worse as the crypto winter got colder and colder.  As of last week, ETHE was at a 30% discount to NAV and GBTC was at -35%.  The optics and current fundamentals for these trusts are terrible.  Grayscale charges 2.5% of assets annually to run them, which is ~4% of market value.  There is no hope that the spread closes to zero any time soon.  Why in the world would you want to own that when you can own spot crypto for free and, if you're an institution, store it at BofNY Mellon with the rest of your assets, or if you're an individual or smaller institution, throw it in a cold storage vault at Coinbase?

Well, because, as a value investor, I think there's a decent chance the discount will close in the medium-term, and if it does, I earn 67% on the spread close.  (Yes, 67%, because as discussed below, the discount just grew to 40%.  100/60-1 = 67%)  If, say, Ethereum's spot price has doubled by that point, I earn 200/60-1 = 233% profit instead of 100% on Ethereum spot.  It's a highly asymmetric payoff tree on top of spot Ethereum's own highly asymmetric payoff tree.  This discount-closing leverage pays for a lot of potential years' worth of 2.5% trust fees.  Several ways the discount could close:

  • Grayscale has sued the SEC, claiming that the SEC's rejection of its petition for spot-based ETFS is "arbitrary and capricious" given the SEC's approval of ETFs for bitcoin futures. On one hand, "arbitrary and capricious" is an extraordinarily high legal burden to meet.  On the other hand, the distinction the SEC has drawn actually is ridiculous from the perspective of the investors whom the SEC is supposed to be protecting.  The SEC claims the futures ETF offers more protection than spot ETFs would because the SEC itself has more regulatory authority over and visibility into the futures, thus they are less susceptible to price manipulation. But wait; the futures prices are driven by the spot prices, not the other way around. If you manipulate the spot, you indirectly manipulate the futures.  Plus futures have that terrible roll decay issue.  Plus no one who talks publicly out in the real world of crypto is particularly concerned about bitcoin price manipulation, even the cautious and careful people.  Gensler just wants as much regulatory control as possible.  If Grayscale gets the right appellate court panel of judges, it has a real shot here.
  • The SEC could finally give in and approve spot ETFs.  Political pressure has been building.  The political world has been evolving into Democrats-hate-crypto, therefore (I hypothesize) Republicans-must-like-crypto.  There is also a growing "sensible center" in Congress working for actual good crypto regulation.  Chief crypto-hater Elizabeth Warren is also Gensler's chief political sponsor; that is not a good thing for him at this point.  When you look at what Senate seats are up in 2024, the Republicans are likely to gain 7-8 seats; they need only 2 to retake the Senate.  The winds are changing.  Gensler is, above all else, a political animal.  If the SEC ever does approve spot ETFs, Grayscale has pinky-sworn it will convert its trusts into ETFs.
  • Congress could force the SEC to approve spot ETFs through legislation.  See above.
  • Grayscale could give up, liquidate the trusts, and return the NAV.  This is a super-high bar given that they are currently clipping 2.5% of assets every year from trapped money.  But you never know, stuff happens.  Mild pressure in this direction has already started.

(5) Why I bought a bit now: Partly because I think spot Ethereum's price is bombed out, but partly because I am guessing the discount to NAV just got bombed out also.  Last Friday afternoon saw straight-down panic-selling of ETHE into the close that pushed the discount from ~30% to ~40% in a few hours.  When we (in crypto) saw the first spreadsheet last week documenting a best guess as to FTX's assets, one of the few liquid assets on it was $53 million of ETHE.  $53 million isn't a lot on a $2 billion market cap, but whatever, people were panic-selling every market-traded thing on that spreadsheet.  There may have been other forced ETHE sellers, but none that I could dream up that wouldn't be merely temporary selling pressure.  I thought I would have a decent shot to earn 11% in the short term if the discount rebounded to 30%, which provides an extra margin of safety on the main thesis.

Guess what, the premium closed by 10% on Tuesday.  Then it dropped by 10% again on Wednesday when more bad industry news hit.  Today it didn't move, so it remains right around -40%.

Again: This is a tiny position for me, on top of a large spot crypto position. If you don't have a large spot crypto position, you could potentially have much more fun and profit than I can trading around this premium.


RISKS:  You know. This is crypto. At this point in its history, it will not literally go to zero.  It can always do another -80% from any trough no matter how low.  It can also do 10x.  Size accordingly.


I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.


Crypto institutions stop blowing up.

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