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Bitcoin ETFs - A Long Time Coming

Editor, TRANSFIN
Oct 22, 2021 5:18 PM 5 min read
Editorial

Two red-hot investment areas - cryptocurrency and Exchange Traded Fund (ETF) - came together in stellar convergence when the US Securities and Exchange Commission (SEC) approved the launch of the first US Bitcoin futures-based ETF

On October 19th 2021, the ETF ProShares Bitcoin Strategy, a first-of-its-kind fund made its debut on the NYSE under the ticker BITO. A second ETF Valkyrie Bitcoin Strategy Fund is slated to launch later today. Bloomberg reports there could be two more by the end of October.

What this means is that anyone with a brokerage account can now buy and sell a Bitcoin-backed financial product on the stock market

Meanwhile, Bitcoin, the world's most valuable cryptocurrency, hit a high of $66.974.



Apart from setting the stage for "direct investment" into Bitcoin's movement, this also enables a large pool of asset management companies that had been beelining for years to tap into the market. 

However, the humongous market response over the launch of the Bitcoin ETF has, in a way, become too hot to handle, with BITO approaching the risk of breaching a limit on the number of futures contracts it owns. Meanwhile, some are also weighing down the appeal of Bitcoin ETFs as investments calling them a "bad idea whose time has come". 

Allow us to explain, clarify and update.

Small Steps To the Moon

Given the fairly nascent, volatile and user anonymous nature of cryptocurrencies, regulatory agencies have long resisted easing up to them despite their incredible run and growth in market capitalisation. Some, like in China, have even gone as far as banning them outright

Even then, crypto enthusiasts in the US have been trying to get Bitcoin-linked investment products approved in the country for quite some time. The SEC had maintained a hardline on cryptocurrency by dismissing every Bitcoin ETF application with unflattering disdain. 

So, what changed now?

One, the new SEC Chairman, Gary Gensler and his pivot towards a crypto-prohibition-to-regulation approach. He believes that trading in cryptocurrencies would benefit from clearer regulation in the long run with "set referees and rules". 

Two, massive fear-of-missing-out occasioned by launch of cryptocurrency ETFs in other parts of the world (Canada, Brazil, Sweden, Germany etc.). The Purpose Bitcoin ETF launched in Toronto this February crossed the billion-dollar mark in assets under management, a figure too hard to ignore for US capitalists.

Three, careful regulatory disclaimer. The "approval" for Bitcoin ETFs granted by the SEC is a tacit one. Instead of rejecting applications like it did in the past, the agency can choose not to formally approve one (for 75 days) but allow it to become effective (no response for 75 days = approval). 

The SEC's concerns involving Bitcoin usually surround issues like limited investor education and disproportionate risks that come with it. But of late, the agency has come around the idea that availability of a Bitcoin ETF will bring more investors under the crypto net which will in turn facilitate greater education on the subject. 

And finally, the fact remains that this approval comes with significant riders. These ETFs are linked to Bitcoin futures and not Bitcoin itself which means they have no direct impact on the spot price. 

Here's what that means.

 

Bitcoin vs Bitcoin Futures

Futures are essentially derivatives. They are contracts to buy or sell an underlying asset at a specified price on a later date. BITO does NOT invest directly in Bitcoin so it is not a "physical" ETF per se. Physical ETFs directly invest in the underlying asset (e.g. Gold, oil) which offer closer price tracking and therefore a closer exposure.

But a closer exposure to crypto assets is frowned upon by agencies like the SEC which wish to protect investor interests. So, instead, the Bitcoin ETFs approved as of now invest in futures contracts of Bitcoin which keep exposure from the asset at a distance. 

When Bitcoin price rises, Bitcoin futures track its spot price indirectly on an exchange - a market exchange (like the NYSE) not a cryptocurrency exchange (like Coinbase).

Bottom line is that BITO tracks Bitcoin futures. Futures which are created and traded on the highly-regulated Chicago Mercantile Exchange. So, essentially, these ETFs are a bridge between the crypto-assets and market-assets. Their very existence means that investing in cryptocurrencies has now been made easier.

But there are variations to this format employed all over the world. For instance, the Bitcoin Tracker EUR Fund listed in the Stockholm Stock Exchange invests in swap contracts (instead of futures). The Toronto-based Purpose Bitcoin ETF, on the other hand, is a "physical" ETF, meaning that if you buy this ETF, you buy real Bitcoin. 

SEC is playing its cards pretty close to the vest by keeping the physical ETFs at bay for now which come with more investor exposure and more proximity with the underlying asset, i.e. Bitcoin. Instead, it is letting investors bet on the price of the underlying asset. 

 

The ETF Swell

The market response has been largely favourable owing to the slow but balanced growth in regulatory momentum. ETFs, in many ways, have been favoured by the investing community because they are: 

  • simplified investment vehicles
  • easily accessible and can be traded directly from brokerage accounts (no crypto wallets necessary!)
  • available through conventional avenues like stock exchanges
  • without the complications one needs to understand to invest in Bitcoin directly 
  • at arms-length to the notorious exposures borne by cryptocurrencies. 

On its opening day, BITO rose to very strong demands with more than $900m worth of shares traded on the first day. Led by this huge swell, Bitcoin's total market cap has risen from $2.4trn to $2.7trn in just the last two weeks.

 

The Bit-Caps!

But that has some very plausible downsides as well. First, the market is beginning to saturate. An explosive debut has meant that BITO is closing in on the cap for the maximum number of futures contracts it can own. To avoid hitting the limit, the fund is spreading out some contracts to later dates but that means risking the fund with more distance from the real-time performance of Bitcoin (aka imperfect tracking). That may create a drag on investor returns.

Then, there are potential fees (0.95% p.a.) that come with owning Bitcoin ETFs. That's quite high as per ETF standards but it may reduce as other funds emerge.

There is also concern that adding an ETF layer complicates an already-complicated asset like Bitcoin. Agreed, it's a middle ground as far as combating volatility risks and fund exposure from cryptocurrency are concerned. But futures are still a derivative asset class, much to the chagrin of crypto enthusiasts who long for purist investment vehicles like spot Bitcoin ETFs.

But there's some good news for Indian investors who, despite having one of the largest Bitcoin stashes in the world, found it difficult to invest directly in US-based cryptocurrencies, on account of the Liberalised Remittance Scheme or LRS. With ETFs, crypto investments are now treated at par with stock investments under the LRS. 

Although better governance doesn't ensure lesser volatility in the crypto markets, it will be interesting to see how the Bitcoin ETFs fare overall. A lot depends on their performance as far as the future of crypto-regulation is concerned. 

FIN.
 

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