Bitcoin ETFs Explained

Let’s start with the basics, what is Bitcoin and cryptocurrency?

Bitcoin (BTC) was the first example of a new class of digital asset. It combines cryptography, distributed ledger technology (blockchain) and network consensus to represent programmable value (and a cornerstone of Web 3.0).

Digital assets such as BTC can be regarded as a store of value (“digital gold”), a currency (in some countries such as El Salvador, BTC is regarded as legal tender), or as a utility coin (such as a software license or membership token). Cryptocurrencies like BTC can also be seen as a commodity, because of their finite supply and fungibility.

What is a Bitcoin ETF?

A Bitcoin ETF is one form of exchange-traded product (ETP), which uses a particular investment structure that follows the legal and compliance requirements as set down by the U.S. Securities and Exchange Commission (SEC) and other similar regulatory bodies worldwide. At present, the SEC has only approved BTC ETFs that are backed by Bitcoin futures. There have been several applications (and rejections) for BTC ETFs backed by “physical” or spot BTC, and there is no firm ETA on when the SEC will approve the latter. Meanwhile, Canada has approved several ETFs backed by spot BTC, and a number of other jurisdictions (e.g., Australia, New Zealand) are expected to approve BTC ETFs in the near future.

Why not just buy Bitcoin?

Bitcoin ETFs are a natural evolution in the growth and development of digital assets. They are attractive to institutional investors (e.g., pension funds, money managers) who may not have the infrastructure to directly hold digital assets, and to retail investors who may not want to set up their own digital wallets or manage their own private keys.

Providing secure custody for Bitcoin is something many institutional and retail investors are not comfortable attempting.

The US has only allowed futures backed ETFs so far – so what are Bitcoin futures?

BTC futures are simply a form of derivative contract (similar to FX, commodity and Index futures), which enable investors to hedge their positions in physical or spot BTC. In essence, futures contracts act as a form of insurance policy to protect against (or take advantage of) market conditions.

However, investors may simply prefer to trade futures contracts, rather than buy and sell BTC in the spot markets, as they may not want to bother managing digital wallets and private keys.

There are a few variations of BTC futures contracts:

1. Most are “synthetic” contracts. This means that they settle in cash (usually USD), rather than having to deliver physical BTC to close out their futures position.

2. A few BTC futures are settled physically – these products are typically aimed at institutional investors and prime brokers.

3. BTC futures can be time-based – i.e., their duration may be 1 week, 1 month or 3 months. This means that at the contract expiry, the investor must either settle (close out) their position, or roll the contract over into the next period.

4. Some futures contracts are open-ended, known as perpetual contracts (or “perps”). They are particularly suited to investors who may want to “go long” or “short” the market, without needing to hold physical BTC.

Are there other ETFs tied to cryptocurrencies?

Yes, there are ETFs linked to Ethereum (ETH). There are also equity-based ETFs that invest in companies active in the Blockchain, BTC and crypto industry.

How does a Bitcoin ETF work? Does it track the Bitcoin price?

Depending on the actual structure used, a Bitcoin ETF will either hold “physical” BTC or BTC futures in a trust entity on behalf of its investors (or unit holders). Units in the ETF then trade on an exchange (similar to shares or other ETFs), and investors will typically access the market via a registered broker or approved participant.

The ETF does not directly track the BTC price. Instead, the market price of the ETF units will be based on the exchange where it is traded. The NAV (net asset value) of the ETF will be based on the number of BTC held in the fund, multiplied by the prevailing market price of BTC. At times, the NAV (and therefore the unit price) of the fund may be higher or lower than the spot price of BTC.

Some BTC ETFs use an index to calculate the NAV of the fund (preferably an independent benchmark) that represents a “fair value” of the assets in the fund. Typically, the ETF units will have a real-time or intraday exchange price, and the fund manager will publish a daily, weekly or monthly NAV.

Why have ETF providers had trouble getting regulatory approval for funds tracking spot Bitcoin?

There appears to be three main issues:

1. Custody: Institutional-grade custody solutions for BTC and digital assets are not yet widely available, or not at a cost comparable to custody services provided for other ETFs, equities and fixed income instruments. Since ETF providers/managers usually need to have an external trustee and/or custodian, the limited availability of suitable digital asset solutions may be a barrier if the ETF provider cannot satisfy the regulator that they have appropriate arrangements in place.

2. Nature and oversight of the underlying assets: The reason the SEC has so far only approved ETFs backed by BTC futures is that these derivatives are already recognised and regulated by the CFTC (Commodities & Futures Trade Commission). So the SEC is probably more comfortable approving an ETF that represents a “known quantity”. Whereas BTC itself does not yet have the same level of universal recognition or regulatory oversight, which introduces a level of uncertainty for the SEC.

3. Price discovery: Notwithstanding the number of market data vendors that now offer BTC pricing services, there has been some regulatory concern with the data sources that ETF managers are using to price and value the underlying assets. Traditionally, ETF providers need to demonstrate that they are using appropriate, accurate, consistent, reliable, robust and objective pricing sources that meet industry standards and criteria.

Brave New Coin’s Bitcoin Liquid Index draws pricing data from a minimum of six trusted exchanges to ensure effective data redundancy and uncompromised Bitcoin price index quality.

What specific advantages does an investment in Bitcoin through an ETF bring?

Apart from ease of access, a BTC ETF is just another type of a known (and well-established) regulated product, and as such comes with the associated investor protections, safeguards, insurances and disclosure requirements. A BTC ETF may be more secure, less technically complicated, and easier to manage for tax and accounting purposes.

What are the arguments against investing in Bitcoin through an ETF?

The main argument against investing in a BTC ETF is the cost. All ETFs typically attract management and other product fees that may be higher than the costs of holding the underlying assets directly (or the fees end up eroding the asset appreciation).

On the other hand, holding the physical assets directly comes with trading and brokerage fees, and possibly custody costs. And retail investors are not able to access the same level of market liquidity or prices that an institutional manager can take advantage of, which should help to offset the managers’ fees that get passed on to ETF unit holders.

Depending on the ETF structure or strategy, the manager may be able to mitigate price volatility and liquidity – for example, tapping into more efficient liquidity pools, deeper order books and OTC markets than the spot retail exchanges, or using derivatives and other techniques (e.g., staking) to generate additional yield. But this is straying away from the discussion of a ‘plain vanilla’ BTC ETF that holds physical crypto.

A single asset ETF comprising only BTC is not that difficult to structure, whether it holds physical BTC or BTC futures. In some ways, it is very similar to a gold ETF that is either backed by physical gold deposited in a vault or trades gold futures. So although an equity ETF is often used to provide diversification without having to ‘stock pick’ individual shares, it is not unreasonable to use single asset ETFs. In fact, for many institutional investors who want to diversify into crypto as part of their alternative assets, a BTC ETF may actually be the easiest and most efficient way to gain exposure to this new asset class.

What other ways are there to get investment exposure to Bitcoin?

Direct BTC holdings, shares in crypto-related companies, and ETFs that hold crypto-related stocks are all possible ways to get exposure to Bitcoin, and each comes with its own pros and cons. In addition, as mentioned above, investors can trade BTC derivatives if they are comfortable with managing this type of exposure.

Publically traded companies like chip makers Nvidia provide crypto ‘adjacent’ opportunities for investors.

Although DeFi, crypto staking and lending are dominated by the Ethereum blockchain and ERC 20 assets, it is possible to get exposure via wrapped BTC or other stablecoins. This requires some understanding of DeFi and the associated protocols, but is yet another avenue to access BTC investing.

Finally, a small but growing number of BTC and crypto products are being launched by traditional brokers, payment providers and mobile banking apps. These solutions offer opportunities ideally suited to retail investors due to lower minimum investment thresholds compared to some ETFs – from trading crypto through your existing equity brokerage account (e.g., Robinhood), to maintaining BTC balances in an existing digital wallet (e.g., PayPal), or allocating part of your savings to BTC funds (e.g., round-up apps like Raiz).

About the Author Rory Manchee is Head Of Business Development for Brave New Coin’s Market Data business.