Grayscale is on the cusp of winning Bitcoin’s biggest prize—but Wall Street’s big dogs could snatch it away

It hasn’t worked out that way. Two-and-a-half years after Sonnenshein’s ascension, Grayscale still doesn’t have an ETF, and the company’s name is mud among many investors. Meanwhile, its parent company is mired in legal trouble with customers, rivals, and the Securities and Exchange Commission. Sonnenshein desperately needs to catch a break—and is poised to get one in the coming days if a federal court sides with Grayscale in a closely watched case.

But a new obstacle stands in the way of Grayscale’s dream: competition. Financial giants like BlackRock are swooping in to snatch up the Bitcoin ETF market, which one analyst says will gradually open the door to a $30 trillion capital pool that could funnel hundreds of billions of dollars into crypto.

Sonnenshein is putting on a brave face about these headwinds, telling Fortune: “I remain focused on Grayscale, and not getting distracted.” But with or without a court victory, there is a real risk the company could lose out—and become a footnote in the industry it helped create.

Grayscale’s golden goose

Crypto still carries some of the outlaw reputation from its early days, when the industry’s leading figures were radicals, weirdos, or outright criminals. Sonnenshein is none of those things. He is tall, likes to wear suits, and has the air of a banker from JPMorgan, where he worked before joining Grayscale as one of its first employees.

The crypto world is famously tribal, but if Sonnenshein has a tribe, it’s the world of Manhattan’s affluent Upper East Side, where he was raised and still lives, and where working on Wall Street is a proud tradition. This background made him a natural choice to lead Grayscale, a well-established crypto brand that needed an ambassador to regulators and the old guards of finance. At the same time, the fact that Sonnenshein has been part of Grayscale since it launched in 2014 gives him credibility with longtime crypto figures.

“Being employee No. 1 prepared me for the role [of CEO] by doing a bit of what everyone here does,” he told Fortune in a recent interview.

Sonnenshein’s job was made easier by the fact Grayscale was milking a cash cow. The company has long produced a gusher of easy revenue thanks to the prescience of its founder, Barry Silbert, who had been the first to spot a lucrative trade that involved wrapping Bitcoin in the garb of traditional finance.

In 2013, Silbert ran Second Market, a company that offered rich investors access to rare items like fine wine or pre-IPO shares of Twitter and Facebook. In order to tap into the growing interest in crypto, Second Market created a novel product in the form of BIT, a trust built to hold Bitcoin, and then sold shares in that trust to accredited investors.

Buying shares in what would become known as the Grayscale Bitcoin Trust (ticker: GBTC) has never made much sense for everyday crypto aficionados. If you want to own Bitcoin, the best way is to buy it directly through Coinbase, Kraken, or another broker. Doing so lets you use the Bitcoin for purchases or gifts, and, more important, it doesn’t cost anything after the initial transaction; holding GBTC, on the other hand, involves tying up funds while paying Grayscale a 2% annual management fee.

For Grayscale and accredited investors, though, the GBTC arrangement made plenty of sense. As the value of the assets in the trust swelled to billions of dollars, the company raked in fat fees, and the upscale investors who purchased GBTC shares from the company could unload them on the retail market 12 months later, typically for a handsome profit. It was a grand arbitrage opportunity—especially after Grayscale obtained a legal status in 2020 that shortened the period to flip shares to six months—and it went on for years.

Between 2014 and 2021, the Grayscale shares traded at a premium to the underlying Bitcoin that backed them. This premium was explained in part by millennial investors who liked the ease of buying crypto in stock form—in 2020, a survey found that GBTC was a top-five choice among those under age 30, along with big-name firms like Apple and Tesla—and by institutions that wanted exposure to Bitcoin but that, for legal or operational reasons, couldn’t hold it directly. And if the price of Bitcoin went up—which it has for the most part—GBTC’s share price followed. In this context, no one really minded paying a 2% cut.

Dreaming of a Bitcoin ETF

Grayscale’s jerry-rigged system to sell Bitcoin in a trust was always supposed to be a temporary arrangement. Silbert, Grayscale’s founder, has said so himself. The long-term plan has been to wait for the U.S regulatory landscape to evolve, and then package Bitcoin as shares in an exchange-traded fund.

Since the first one launched more than 30 years ago, ETFs have become hugely popular with investors of all stripes, offering a safe and convenient way to get exposure to everything from gold to stock indexes for fees as low as two basis points (0.02%), or two cents for every $100 invested. Many in finance, both inside and outside the crypto industry, believe the time is right for a Bitcoin ETF.

The first company to offer a Bitcoin ETF is poised to reap a handsome reward—most analysts believe deep-pocketed pension funds and other institutional investors will welcome the familiar legal structure of an ETF and jump into the crypto market for the first time. According to Bloomberg ETF analyst Eric Balchunas, these investors control $30 trillion of wealth, and could deploy 1% to 2% into crypto.

Grayscale has been eyeing this opportunity for years, but the company was hardly the only one. Back in 2013, when Bitcoin opened the year trading around $900, the Winklevoss twins’ crypto firm Gemini applied to create the first one, only to be rejected by the Securities and Exchange Commission four years later. According to the SEC, the Bitcoin market was too small and thinly traded, which could open the door for someone to manipulate the price of the ETF shares. During this time, in 2017, Grayscale approached the SEC to convert GBTC shares into an ETF but voluntarily withdrew the application.

More than a year later, in 2018, the agency rejected a second Gemini bid. Even though the size of the Bitcoin market had expanded significantly—the currency was coming off a bull market that saw the price brush $20,000—officials remained concerned about price manipulation. Shortly after this second refusal, the SEC turned down nine other companies’ applications to create a Bitcoin ETF, always on the same grounds.

These rejections came as no surprise to Grayscale or anyone else. The 2017 bull market had vaulted crypto into the mainstream, but also given rise to outrageous scams and exposed many of the industry’s leading figures as two-bit hucksters—or worse. In response, Grayscale stuck to its plan to play the long game and wait for the right regulatory infrastructure to emerge.

It didn’t hurt, of course, that Grayscale could rake in even more cash while waiting for the SEC logjam to break. By 2018, in addition to the Grayscale Bitcoin Trust, which currently holds over 3% of the world’s Bitcoin, the company had created identical trusts to offer shares in other cryptocurrencies, such as Ethereum and Litecoin, for which it charged even higher fees—as much as 2.5% per year. At its peak, Grayscale would have more than $60 billion in assets under management, which generated $20 million a month in revenue.

The upshot was that, in early 2021, Grayscale was in a win-win situation—it was poised to be at the vanguard of a new Bitcoin ETF market when the SEC finally came around, and it could keep raking in fees from its trust products. But then everything changed, and Grayscale’s once-loved product became toxic in the eyes of many investors.

The grand plan fizzles

Grayscale’s biggest trust had for years provided a handsome arbitrage opportunity. Then one day the easy money dried up.

Ever since a precursor to the Grayscale Bitcoin Trust launched in late 2013, shares had always traded at a premium to the so-called NAV—the net asset value of Bitcoins held in the trust. The GBTC premium was typically more than 10%, and sometimes as high as 40%. The shares couldn’t be exchanged for Bitcoin, but they remained hughely popular with institutional and retail investors all the same.

In March 2021, however, GBTC shares began trading at a slight discount to NAV, a gap that would soon widen significantly:

The discount occurred owing to a series of factors, including the approval of Bitcoin ETFs in Canada and Europe, and the fact that mainstream companies like PayPal and Robinhood had made it easier to buy Bitcoin directly.

The emergence of the discount didn’t sting much at first, since for much of 2021 the crypto market went on a spectacular bull run that saw the price of Bitcoin peak near $70,000. In this context, GBTC shares soared alongside Bitcoin, so everyone was in the green. It was during this time, in October 2021, that Grayscale finally pursued a full-blown effort to ask the SEC to let it convert GBTC into an ETF.

The mood among Grayscale investors turned sour, however, toward the end of that year as crypto’s latest bubble burst, and as the GBTC discount to NAV widened.

GBTC owners stewed over the fact their money was tied up in a stock that now had little appeal to other buyers—and worse, that came with management fees of 2% a year or more. Institutional investors were caught flat-footed when the long-time arbitrage opportunity abruptly vanished.

“It was a great carry trade that everyone suddenly got stuck in,” said a crypto executive who asked not to be named. The executive added that several crypto funds, including the since-failed Three Arrows Capital hedge fund (known as 3AC), got wiped out through holding large blocks of suddenly illiquid GBTC.

The implosion of 3AC in March 2022 accelerated a full-blown bear market. Then in June of that year, the SEC rejected Grayscale’s ETF. The company had expected such an outcome, and, in a sign of how urgent its business predicament had become, filed a lawsuit that same day asking a court to reject the SEC’s ruling.

GBTC customers get restless

The lawsuit would prove to be a symbolic milestone for Grayscale and the crypto industry. But it did little to help GBTC owners, who could only grit their teeth as they paid 2% a year and watched the NAV gap turn into a chasm as the crypto market imploded in the wake of the massive FTX scandal. In response, disgruntled investors organized abusive Twitter campaigns against Silbert and Sonnenshein, and the hedge fund Fir Tree Partners sued Grayscale over alleged mismanagement.

Some demanded Grayscale conduct a so-called Reg M redemption—an esoteric process that would entail getting permission from the SEC to let customers exchange their shares for the underlying Bitcoin. Such relief would both placate Grayscale’s noisiest critics, by letting them redeem their Bitcoin at market value, and help close the GBTC discount.

Grayscale, however, has refused to offer such a redemption—a process that would shrink its asset base and its commissions—and at times has invoked legal pretexts, including a 2015 consent decree with the SEC, to declare that it can’t even do such a thing.

In interviews with Fortune, however, several lawyers said there is no serious legal barrier to conducting a redemption, and suggested Grayscale’s hesitancy is driven by business concerns. “Redemption opens the door for less AUM, therefore less fees,” said Fred Rispoli of Hodl Law.

In an attempt to pacify frustrated investors, Grayscale’s parent company bought up hundreds of millions of dollars’ worth of trust shares to defend the price of GBTC and its sister stocks. The effort did little to boost the share price or narrow the discount, and investors’ howls grew louder.

As for Sonnenshein, he’s declined to cut Grayscale’s fees or offer a redemption. Instead, one of his primary roles as CEO has been to undertake frequent media appearances, making the case over and over again that the best option for investors is to wait for the company to prevail in court and obtain its ETF—an event that would close the discount to NAV, and likely cause the price of Bitcoin to soar.

Grayscale’s strategy to brush off investor frustration and stay the course could be vindicated when the U.S. Court of Appeals for the District of Columbia rules on the question of whether the SEC was “arbitrary and capricious” in denying the company’s ETF bid. A decision is expected any day, and analysts say Grayscale has a 70% chance to win—but even a victory may not be enough to rescue the firm.

BlackRock and Fidelity wait in the wings

By the time Grayscale sued the SEC in June 2022, the agency’s chairman, Gary Gensler, had repeatedly taken a hard line against the crypto industry—to the point where even impartial observers began to question if he had stepped beyond the limits of his authority.

The SEC suffered a legal setback in July when a federal judge rejected its interpretation of securities law in a case involving the crypto company Ripple, and the D.C. appeals court has sent signals that it may deliver another one with Grayscale. During oral arguments in March, the three-judge panel repeatedly poked holes in the agency’s argument that spot market ETFs—like the one Grayscale seeks to offer—are different than ETFs for Bitcoin futures, which the SEC approved in 2021.

The situation means Grayscale could demolish a major legal obstacle blocking its path to a Bitcoin ETF. But this may not be enough. Since it first filed for the ETF, two major developments now threaten Sonnenshein’s dream of leading the crypto industry into a new era.

The first is trouble at Grayscale’s parent company. In January, another one of DCG’s main subsidiaries, Genesis, declared its lending unit insolvent, and froze the assets of hundreds of thousands of customers. The legal mess, which is ongoing, has also led to allegations of questionable accounting practices at DCG and its subsidiaries—notably a promissory note with a 1% interest rate that Genesis obtained from DCG in what critics say was a slippery attempt to plug a hole in the now-bankrupt subsidiary’s balance sheet.

The controversy led the SEC to sue Genesis in January, and, according to an unconfirmed Bloomberg report, has given rise to investigations by the agency and the Justice Department into intracompany loans at DCG. In interviews with Fortune, lawyers said it was hard to characterize the loans as arm’s-length transactions.

For now, no agency has publicly accused DCG of wrongdoing. The company insists its subsidiaries operate as stand-alone units, and that Genesis executives are responsible for the company’s problems. A DCG spokesperson told Fortune that it arranged the promissory note on the advice of reputable lawyers, and that there was nothing wrong or misleading about the transaction.

It’s not clear where the chips will land with Genesis and DCG, but, according to lawyers and industry watchers, the debacle may provide the SEC with a new reason to deny or slow-walk Grayscale’s Bitcoin ETF application.

“After last year, there’s mistrust in crypto industry heads, including Barry Silbert, for acting in self-interested ways,” says Damien Scott, a crypto lawyer at Scoolidge, Peters, Russotti & Fox. “That could be weighing on the SEC—‘Do we really want to give it to these guys? A BlackRock or Fidelity is a safer bet.’”

Scott’s comment about the SEC awarding the first Bitcoin ETF to BlackRock is not hypothetical—and points to the other major development that could thwart Sonnenshein’s plans.

In June, the giant asset manager filed an ETF application of its own, a move that goosed crypto prices as analysts took the application as a signal BlackRock believed it would succeed with the SEC where others had failed. “They are about as good as it gets at reading the regulatory tea leaves,” said one. Soon after, Fidelity and other big names filed for Bitcoin ETFs of their own.

The upshot is that the SEC, whether it wins or loses the Grayscale case, is in a position to award the first Bitcoin ETF to BlackRock or to another familiar name from traditional finance, a move likely to have more political appeal both inside and outside the agency.

“BlackRock is the Apple of the financial industry,” the ETF analyst Balchunas told Fortune. “The key thing people don’t know is advisors love them. It’s like in the ’80s with IBM stock—you can’t get fired buying it.”

All of this raises the very real question of whether Grayscale would be late to the party, or stuck on the sidelines entirely, as BlackRock and others reap the first fruits of Bitcoin ETFs. And what happens then to Grayscale and all of its customers paying 2% a year?

‘A few big winners—and then you’ll have to be creative or lucky’

It’s hard to believe Grayscale isn’t worried about Wall Street behemoths muscling in to snatch its long-sought prize. But for now, Sonnenshein is taking the position that his company is the only one that has the operational chops to offer a Bitcoin ETF.

“The filings you’re seeing now are ideas on paper, while Grayscale is a fund with billions of assets and 10 years of operational success,” Sonnenshein told Fortune, adding that the company has always envisioned a landscape with multiple Bitcoin ETFs.

The problem, however, is that new ETF categories have proved to be a winner-take-all market. That was the case with the first ETF for Bitcoin futures, operated by a firm called ProShares, which now controls over $1 billion in assets and 97% of trading volume. A similar ETF from rival Valkyrie, which launched only a few days after ProShares, controls only around $30 million, according to Balchunas.

The analyst added that the Bitcoin ETF market is likely to resemble the one for gold. That market featured a dominant early player, but in time grew to include a handful of other firms, which grabbed a slice of the market by offering niche variations or, in the case of BlackRock’s gold ETF, a big discount on price.

In the current jump-ball environment for a Bitcoin ETF, large and well-known firms have an advantage thanks to their huge marketing budgets and long-standing relationships with brokerages and financial advisors.

“There is potential for a few big winners—and then you’ll have to be creative or lucky,” Balchunas said of the likely trajectory of Bitcoin ETFs.

There is also the question of how much the ETF issuers will be able to collect. Justin Young, CEO of Volatility Shares, which has created other types of exotic ETFs, told Fortune that the first Bitcoin products to market likely will be able to command a fee of over 1%, but that this will drop rapidly as competitors emerge.

It‘s unclear where Grayscale will fit into this world. If the company isn’t first to market, it’s likely BlackRock or another rival will vacuum up the vast majority of customers. And while Grayscale has the advantage of possessing millions of GBTC investors—who will automatically be converted to ETF owners under the company’s plan—many of them are resentful over the firm’s refusal to cut fees or issue redemptions. Many will likely bolt.

Sonnenshein says Grayscale customers are unlikely to flee to a rival, because doing so would trigger a taxable event if they sell their shares instead of keeping their money in the ETF it plans to create. He also made the case that customers will be well-served by sticking with a company with years of expertise in running crypto funds. And, on a more personal level, Sonnenshein said he believes Grayscale will achieve its destiny as leader of the crypto ETF market.

“I’m very proud of coming through a time after the pandemic that saw different businesses shutting, during Crypto Winter,” he said. “We are built to survive all cycles.”