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What are Bitcoin ETFs?

8 min read

  • ETFs are investment vehicles designed to track the price of an underlying asset

  • More than six Bitcoin ETFs have been approved by the SEC so far

  • They are all futures ETFs, while a Bitcoin spot ETF is yet to be approved in the US

  • In 2021, global ETF assets soared past the $10 trillion mark, demonstrating the huge popularity of this investment vehicle

  • Bitcoin spot ETFs could drive institutional adoption given the familiar regulatory framework and ease of tax reporting

Bitcoin exchange traded funds (ETFs) have been in the news lately, as the community awaits the approval of the first Bitcoin spot ETF in the US with great anticipation. Some have gone so far as to label the launch of Bitcoin ETFs as one of the biggest catalysts for the widespread adoption of digital assets. So what exactly are Bitcoin ETFs and why should you care?

Many years have passed since the Winklevoss brothers first filed an application with the US Securities and Exchange Commission (SEC) for a Bitcoin ETF in 2013. The first Bitcoin ETF began trading in the US some nine years later, on 19 October 2021. Since then, more than six have been approved for trading by the SEC. However, they have all been Bitcoin futures ETFs. The holy grail of Bitcoin ETFs – a Bitcoin spot ETF – is yet to be approved in the US.

On 18 March 2022, the SEC once again postponed its decision regarding the applications of WisdomTree Investments (WETF) and One River Asset Management for Bitcoin spot ETFs. Could this be the beginning of a long battle to launch an ETF tracking the Bitcoin spot price? Let’s delve deeper into this topic.

What is an ETF?

ETF stands for exchange traded fund and is primarily a type of security. It determines the regulatory framework that governs this type of investment vehicles. Bitcoin, on the other hand, is not treated or regulated as a security by the SEC.

ETFs are designed to track the price of an underlying asset. This can be a single commodity or a basket of securities, such as stocks, currencies or bonds. The first ETF was introduced in the US in 1993 tracking the S&P 500 index – the index of the 500 largest companies in the US market.

ETFs come in two shapes: physical and synthetic. The physical ETFs buy the underlying assets, such as stocks, for example, while synthetic ETFs invest the money in derivatives and swaps instead of real assets. An ETF will typically regularly rebalance in order to remain close to the underlying index it is tracking.

All this often comes at a relatively low management fee (depending on the ETF), since ETFs don’t tend to involve as much active management as mutual funds. In fact, most ETFs are managed passively, which means they are only rebalanced from time to time, without the need for a manager to watch the market on a daily basis.

As such, ETFs have been an extremely popular type of investment with both retail and institutional investors. The total net assets under management (AUM) of ETFs in the United States increased by 449% between 2010 and 2020, while global ETF assets have long soared past the $10 trillion mark. Since their launch, ETFs have been the single biggest driver of asset price growth, which explains why the listing of a Bitcoin spot ETF is expected to drive up the price of BTC.

SOURCE: https://www.statista.com

How do Bitcoin ETFs work?

Currently, all the available Bitcoin ETFs in the US are Bitcoin futures ETFs. However, Bitcoin spot ETFs have been trading in Canada since 18 February 2021. So what’s the difference?

Futures ETFs are synthetic, aiming to track the price of the underlying asset through futures contracts. As such, they don’t buy the actual Bitcoin on the spot market. Futures contracts are a legal agreement to buy or sell a specific commodity or security at a predetermined price at a specific time in the future. This means that instead of buying the underlying Bitcoin, today's futures ETFs in the US tracks Bitcoin prices via futures contracts traded on the Chicago Mercantile Exchange (CME).

Bitcoin futures contracts were first introduced on 18 December 2017, a move that was welcomed for the increased liquidity it would provide. However, despite the great enthusiasm of retail investors, the introduction of these futures contracts did not have a major impact on the price of Bitcoin at the time, since it had already reached a peak in its cycle.

Spot vs futures ETFs

Unlike a futures ETF, a Bitcoin spot ETF is backed by physical Bitcoin held in custody by the ETF issuer. A Bitcoin spot ETF purchases its asset in the Bitcoin spot market, which would have a direct impact on the Bitcoin supply and consequently on the spot price.

The simplicity of a spot ETF structure allows for efficient and cost-effective operation. Since the ETF is directly backed by the underlying asset, it is able to track the price closely. Furthermore, the operational activities of a Bitcoin spot ETF would only involve the purchase and storage of Bitcoin and issuing the ETF.

Bitcoin futures ETFs, on the other hand, incur higher operating costs, meaning higher management fees. In addition, they may not track the price of Bitcoin as accurately as a spot ETF, since the futures they trade are also subject to market speculation and volatility. This results in tracking errors – the deviation in the value of the ETF from the price of the underlying asset.

There are two types of tracking errors: contango, when the futures price is higher than the spot price, and backwardation, when the futures price is lower than the spot price. If the futures market is in contango, the price of the futures usually falls as the expiration date of the futures contract approaches. Before the sell date, the ETF issuer must sell the contract and buy a new futures contract, which trades above the spot price again, resulting in a loss for investors.

When an ETF transfers its positions in futures contracts from one expiration date to the next, this process is referred to as rollover. If the market is constantly trading in contango, this means that the ETF must keep buying BTC above the spot price. Taking into account the compound effect, this can result in a financial instrument that consistently underperforms Bitcoin’s spot price. All this makes a Bitcoin spot ETF potentially more attractive than a futures-based product.

Regulatory concerns

This raises the question of why, to date, no Bitcoin spot ETF has been approved by the US regulator. One of the key concerns, according to Gary Gensler, chairman of the SEC, is that “the markets for actual Bitcoin itself today are largely unregulated”. Speaking in front of the Committee on Banking on 14 September 2021, he explained that “this lack of regulatory oversight and surveillance leads to concerns about the potential for fraud and manipulation”.

Bitcoin futures, on the other hand, are regulated by the CME Group, and are therefore preferable from the SEC’s point of view. However, this line of reasoning has met with strong public criticism from the crypto industry, with pundits arguing the futures contracts are inherently connected with the underlying asset.

Why Bitcoin ETFs?

According to Jan van Eck, CEO at Van Eck Securities Corporation, the advantages of owning Bitcoin in the form of an ETF are ease of tax reporting in the US and a more secure trading infrastructure. This, as well as the regulatory framework for ETFs, could make them the preferred option for some institutional investors. Greater adoption by institutions could, in turn, promote the wider adoption of Bitcoin and digital assets in general.

However, CME futures markets are less liquid than the spot market. Moreover, futures are only traded during market hours, while Bitcoin trades 24/7, 365 days a year. In addition, if trading is highly volatile, there is a risk that the CME will stop trading while Bitcoin itself continues to trade. As such, owning Bitcoin directly has many advantages over a futures ETF.

What does the future hold?

To date, it is not clear when the SEC will approve the first Bitcoin spot ETF. Some speculate that with the help of a professional custodian, most likely a traditional financial institution, the approval of a Bitcoin spot ETF could be around the corner.

Due to the efficient structure that a Bitcoin spot ETF would provide, experts forecast greater demand for a spot ETF than a futures one. Coupled with the continued popularity of exchange-traded investment vehicles, the introduction of a Bitcoin spot ETF could have a more dramatic impact on the market than Bitcoin futures ETFs have had so far.

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DISCLAIMER: The content of this article does not constitute financial advice and is for informational purposes only. The price of digital assets can go down as well as up, and you may lose all of your capital. Investors should consult a professional advisor before making any investment decisions.


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