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Investors buy cryptocurrency funds that are 10 times less valuable than their real price.
“If you want to easily invest in a crypto — just buy the corresponding fund on the exchange!” — This is the ideology that the Investors of…
“If you want to easily invest in a crypto — just buy the corresponding fund on the exchange!” — This is the ideology that the Investors of the Ethereum fund of the Grayscale company initially had. Which resulted in them paying 5–10 times more than the cost of the cryptocurrency from within the fund.
At the peak of the hype in early June, the shares of the ETHE fund were trading at a price of $240, while the real value of the fund’s assets in the crypto at that date was only $23 per share — As a result, new cryptocurrency investors overpaid by approximately 950%!
The absurdity of the situation can be illustrated by the following example: Suppose you buy a bag of potatoes for a $10, and hide it. Then you write a receipt mentioning “The owner of this paper is the owner of a bag of potatoes worth $10, signature, seal,” and sell this receipt to your neighbour for $100.
How is something of this magnitude possible? Why would he pay ten times over for an asset that he can buy much cheaper in the nearest market. In theory, however, some justifications can be seen in the actions of the neighbour in two particular cases:
● For some specific reason, he is unable to buy potatoes on the market
● He hopes to resell the receipt to at a higher price
(In academic finance this is what they call the “big fool theory”).
The second case gives off a slight Ponzi scheme aftertaste. Does this mean the ETHE crypto fund is a pyramid scheme? Actually, no: the situation is explained simply by the combination of the financial laws and human of the market and individual prediction.
But first we need to understand how the scheme of investing in any assets through exchange-traded funds works in the normal case.
ETFs: How a capable fund works
The very idea of investing in an asset through the purchase of an exchange-traded fund is a completely reasonable thing that is used by a huge number of investors. This is often much more convenient, than trying to buy the asset directly.
Let’s say you want to invest in gold. You can, of course, go and try to buy a gold bar directly, but here a lot of related problems arise:
● You need to ensure its authenticity
● You will have to store it in a suitable place, this costs separate money
● If you need to withdraw money, you can only sell the whole bar
● Taxes are associated, such as VAT, etc.
In general, there are a lot of drawbacks , and little profit. You can, of course, purchase gold coins for investment, at a bank, or open an impersonal metal account — But these options also have very significant drawbacks.
Exchange-traded funds enter the arena — for example, the world’s largest ETF for gold with the ticker GLD. The scheme here is simple: you buy a share of the fund on the stock exchange, and it takes over all the operations for buying and storing physical metal. Due to economies of scale, all associated costs are low — the fund retains a commission of 0.4% per year. There are also options for synthetic ETFs that do not keep physical gold in storage, but also reliably track the dynamics of metal prices, like the SPDR Gold Trust that is available on Nasdaq.
The genius of the mechanism of real ETFs lies in the fact that they have a super-efficient arbitrage mechanism built into them, which prevents the exchange price of the fund’s shares from moving far from the value of net assets within the fund. It works as follows: Investors cannot bring money to the fund directly.
Not everyone can buy new shares from the ETF, but only special authorised participants — market makers. Moreover, they are given new shares not for money, but in exchange for a predetermined number of assets that the fund must monitor. Approximately, you can buy a $100 GLD shares from a market maker, who buys (conditionally) 5 grams of gold with this money. Subsequently, it transfers the gold to the fund, and in return receives the desired GLD share valuation.
Why such a complex scheme? This is because it that allows you to ensure a very accurate correspondence of the current stock exchange quotes of the fund to the cost of a real asset (in our case, gold). For example, a market maker sees orders to buy GLD for $110 (at an equivalent gold price of $100) appears on the exchange, he can immediately perform the following operation: Purchase gold for $100, exchange it with the fund for a GLD share, and sell her this buyer for $110 — instant profit of $10, completely risk free.
Thus, any market inefficiency (in the form of a deviation of the ETF price from the market price of the asset it monitors) is very quickly and efficiently eliminated by the market maker. Note: Not because he is so kind and unselfish — but simply because it is beneficial to him! Economic incentives work to ensure that the market maker maintains fair ETF prices.
ETHE: A Bad example of exchange-traded fund
Here you should have already wondered: If ETFs are so effective, then why did the ETHE cryptocurrency fund turn for the worse?
It’s simple: ETHE is not a real ETF
Grayscale Crypto Funds have not passed all the regulatory checks and authorisations required for ETFs. Therefore, they are not listed on the exchange like other ETFs. In fact, only a small group of authorised participants can officially invest in this fund, but not the general public.
But the guys at Grayscale found a clever workaround with a loophole in US securities law (Rule 144 Exemption for more details). This loophole allows authorised members to sell ETHE shares to all other (regular) investors 12 months after they were purchased from the fund. It is precisely this nuance that violates the main advantage of ETFs: The possibility of risk-free arbitrage, which ensures the fairness of the price per share of the fund in the market.
In the case of real ETFs, for any deviation of the fund’s share prices from the asset prices within the fund, is what the market maker could take advantage of: Instantly receive a new fund share and sell it on the market at a higher price, earning an easy profit. For ETHE, this scheme does not work: Each new share received from the fund, an authorised participant can sell to the end investor only after a year. This is no longer risk-free arbitrage, but a rather long-term risky investment: The value of the Ethereum in a year can’t be predicted.
Thus, we are witnessing the following situation: Investors want to make money and invest in a “high-yield crypto”. They do not want to deal with technical features in order to buy the same ether on a crypto-exchange directly. Buying a crypto fund on a regular exchange is more reliable. Moreover, this scheme is already familiar to them and works great with all other assets (stocks, bonds, gold, etc.).
They are simply unaware, and therefore unable to figure out and understand what exactly they are buying, and at what price. They probably believe that since they take the fund, the market has decided so that the price is fair (as is the case for ETFs). But in this case, the mechanism for creating new shares is violated, their deficit arises, and on the waves of the hype, the fund begins to trade at prices many times higher than its real value.
As a result: Investors will regret, when they understand what they have bought (if they do not have time to sell their investments to someone else according to the “even bigger fool” theory), and authorised participants will continue to grow rich selling their assets to ordinary investors with a wrapping of 950%.
What conclusions to draw from the article:
● Similar is applicable to us, at Velvet.Capital — This is because the majority of our clients are new to the crypto space and therefore lack guidance of how to generate a suitable portfolio.
● Remember that cryptocurrency is an extremely risky speculative asset, in which it is worth investing only those amounts that you do not mind losing completely.
Velvet.capital was launched with a vision to build a simple solution for everyone to diversify into crypto. We created the solution for ourselves and we are excited to share it with you.
We’re focused on simplicity for “first-timers”. So the process should be super smooth — you just go to velvet.capital, create an account with your email, deposit $40+ directly with PayNow or other payment systems, and you will be a happy owner of a portfolio of top-30 crypto assets.
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