NEW YORK/LONDON - A handful of hedge funds made a winning bet on approval of a spot bitcoin exchange-traded fund (ETF) by investing in the Grayscale Bitcoin Trust (GBTC) well ahead of regulatory sign off, according to sources familiar with the matter.

Hedge funds bought shares in the Grayscale Bitcoin Trust (GBTC) between 2021 and 2023 betting its price would skyrocket once the Securities and Exchange Commission (SEC) gave the spot bitcoin ETF its green light, the sources said.

Grayscale had been unsuccessfully trying to convert its trust into an ETF since 2016 and filed a lawsuit against the SEC in 2022 after the regulator rejected its new application.

Grayscale Bitcoin Trust was converted from a trust to an ETF on Jan. 11 after the SEC approved U.S.-listed ETFs tracking bitcoin.

Awaiting regulator approval, Grayscale's trust was trading at a discount to its underlying assets that reached almost 50% in December 2022, according to data platform YCharts, following the collapse of crypto exchange FTX.

For some hedge funds, the potential gains that the ETF approval could generate turned into a trade. As soon as a court decided in favor of Grayscale in August 2023, the price gap began to close, the data show.

A market maker said roughly 20 hedge funds, from small to big firms, did this trade. This source spoke on condition of anonymity because this person is not allowed to discuss clients' positions publicly.

Grayscale and the SEC did not respond to a Reuters request for comments on the matter.

Hedge fund Fir Tree Partners, with $3 billion in assets under management, first saw an opportunity in the last quarter of 2022, when Grayscale's trust was trading at a 42% discount to its assets, a person familiar with the matter said. Its bet on the price dislocation narrowing totaled $60 million.

The firm, which declined to comment, started to exit the position in September last year, after the court decision. Fir Tree fully sold it in January, following the regulatory approval of the product, according to the source.

Hedge fund Hunting Hill also invested in GBTC when it was trading at a 42% discount and closed it when it narrowed to 7% last year, a source familiar with the matter said.

The founder of a U.S.-based macro hedge fund told Reuters his conviction on the approval increased after a court ruling said in August last year the SEC was wrong to reject Grayscale's application. He described it as "the trade of a century."

Not all the money in the GBTC bet, however, is returning to the bitcoin space. Many hedge funds are among the investors driving outflows in GBTC after its conversion into ETF. Outflows total $4.77 billion since its launch earlier this month, bringing the ETF's assets to $20.4 billion.

For many portfolio managers, the price arbitrage was opportunistic.

"It worked out to be a very good trade," said Christopher Brown, founder of the multi-strategy hedge fund Aristides Capital, based in Louisville, Kentucky. The $240 million firm invested roughly $20 million in GBTC with an average discount of 30% to its assets.

The fund has sold most of its positions and plans to fully exit in the coming months, as Brown is not interested in investing in the spot bitcoin ETF. "We're not inherently super excited about bitcoin."

(Reporting by Carolina Mandl, in New York, and Nell Mackenzie, in London, additional reporting by Suzanne McGee, in New York; editing by Megan Davies and Marguerita Choy)