(Bloomberg) — Grayscale Investments’ proposal to buy out certain holders of its flagship Bitcoin trust is the money manager’s latest bid to stanch losses in a fund that’s been a linchpin in the dramatic rise and fall of the cryptocurrency universe.

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For years, the Grayscale Bitcoin Trust (ticker GBTC) served as the conduit through which billions of dollars flooded into crypto to exploit a seemingly automatic arbitrage trade. Now, some of those same industry titans are crumbling into bankruptcy while others contend with a wave of distress sparked in part by this very trade. Most famously, the trust attracted Three Arrows Capital, which held more than 5% of GBTC before the hedge fund’s demise over the summer.

Barry Silbert’s Digital Currency Group, the parent of Grayscale, is one of the most important players now left standing — and dealing with a dilemma of its own design.

The setup was relatively straightforward: an investor would borrow Bitcoin (which, in many cases, involved using loans from Grayscale sister-company Genesis) and deposit those tokens with Grayscale in exchange for GBTC shares. The investor would then offload those shares at a markup to retail investors after a six-month lockup.

The trade’s popularity was in part powered by Grayscale’s own messages to and discussions with investors, including at industry events in Miami, communications reviewed by Bloomberg News show. Grayscale representatives encouraged attendees at Context Summits Miami in January 2020 to lock up their money in order to take advantage of the dislocation, according to a person who interacted with company officials at the time.

“Grayscale prioritizes educating our clients about the opportunities and risks of investing in crypto, as well as the unique characteristics of our product structures. For years, we have worked constructively with regulators to create and strengthen full and fair risk disclosures for our suite of digital asset offerings,” said a Grayscale spokeswoman in an emailed statement. “Grayscale has and will continue to provide the information necessary for investors and other market participants to make informed investment decisions. Any characterization otherwise is false.”

The past couple of months have been a painful reminder that the popular arb trade never really had an exit. GBTC shares can be created, but they can’t be destroyed or redeemed for Bitcoin.

That inability to destroy shares represents a key difference from exchange-traded funds. With ETFs, specialized traders known as authorized participants can work with an issuer to create shares when demand is building. When buyers’ appetites cool, participants redeem those shares with the fund’s sponsor to reduce the supply, keeping the ETF’s price in line with its net-asset value. In the case of GBTC, accredited investors brought Bitcoin — either their own, or borrowed from now-bankrupt firms like BlockFi — to Grayscale in exchange for GBTC.

For years, GBTC represented one of the easiest ways for crypto and traditional-finance investors alike to get exposure to the largest virtual currency. US regulators had repeatedly prohibited the launch of spot-backed Bitcoin ETFs, citing the token’s volatility and vulnerability to scams. That limited the investable options for anyone who was either unwilling to or prohibited from setting up their own digital wallet or interacting directly with crypto trading platforms, making GBTC an attractive alternative.

The trade’s ubiquity became apparent during the slow-motion chain of events, dating back to February 2021, that would ultimately result in the implosion of Three Arrows and spark a reckoning among crypto lenders that accepted GBTC shares as collateral.

That month, the massive premium — which at one point reached more than 80% — evaporated and flipped into a discount, meaning GBTC shares were worth less than the Bitcoin it held. Things started going awry with the launch of the first physically backed Bitcoin ETFs in Canada, and the increasing ease of direct access to Bitcoin on exchanges.

Suddenly investors had multiple options to get exposure to Bitcoin. That seemingly endless demand for GBTC evaporated, removing the critical final leg of what was once called the “slam dunk” arbitrage. Exacerbating the pain was the explosion in GBTC shares, which reached a record 692 million in February 2021, just as the premium evaporated.

“In 2021, it turned negative — you can call it a widow-maker trade,” said Wilfred Daye, the former chief executive officer of Securitize Capital, a digital-asset management firm. “It’s been losing money for two years.”

“The liquidity is actually pretty poor, i.e., you have a liquidity disconnect between the trade itself and when you want to get out,” said Daye. “On paper it looked great, but it’s very hard to get out.”

Daye says Genesis, when the trust was trading at a premium, could require something like 25% cash collateral for an investor to borrow Bitcoin, but once it issued the shares, the investor would then be able to re-pledge them as extra collateral. On paper, it made the investor look like their position was collateralized at 125%. But, the liquidity issue came about because the investor was swapping a liquid holding — Bitcoin — for a much less liquid one — GBTC.

“The layering of leverage around assets such as GBTC played a role in making the entire system more fragile,” said Noelle Acheson, author of the “Crypto Is Macro Now” newsletter and former head of market insights at Genesis.

Shares of GBTC fell to $8.08 on Tuesday. They’ve slumped 76% this year.

There were other complications: lenders lent out the Bitcoin originally used for creating GBTC shares, which were then used as collateral to create even more GBTC shares. And once it started to trade at a discount, many holders didn’t want to have to write down their investment, so they kept it going with the hope that the discount would eventually close, said Adil Abdulali, founder at Incrypture in New York, which develops crypto investment strategies.

“As long as there was a premium, there was enough value there that if anyone defaulted on their loan, the GBTC could be sold and the Bitcoin paid back,” said Abdulali. “But if it’s at a discount, there’s no way to do that.”

Grayscale has tried in vain to repair that discount, which is currently languishing around 50%. Chief among those attempts was a plan to turn GBTC into an ETF of its own, which would allow for share redemptions. The firm is suing the Securities and Exchange Commission for denying its repeated petitions on this front. The regulator said Grayscale’s plan to list the ETF didn’t do enough to prevent fraud and manipulation.

Grayscale is now considering a tender offer for as much as 20% of outstanding GBTC shares, an action that requires approval from regulators. Grayscale Chief Executive Officer Michael Sonnenshein wrote in a letter to investors Monday that the tender-offer plan would need the SEC’s blessing, which he said the agency “may not provide.”

Grayscale is also facing challenges from other players in the industry, including over the relatively hefty 2% annual fee, which compares with an average of 0.54% charged across the entire US ETF universe, according to Bloomberg Intelligence data. Hedge fund Fir Tree Capital Management sued Grayscale this month, seeking information to investigate potential mismanagement and conflicts of interest. Fir Tree claimed the trust has roughly 850,000 retail investors who have been “harmed by Grayscale’s shareholder-unfriendly actions.”

–With assistance from William Selway.

(Adds GBTC share price. An earlier updated corrected a reference to the lender in the 15th paragraph.)

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