These days, Bitcoin ETFs are the talk of the town. The market is in dire need of a rally, and investors believe institutional money flowing in from ETFs will do just that.
Many speculators blame the most recent rout in the market on the SEC once again postponing Bitcoin ETFs.
Needless to say, there is a lot of uncertainty and buzz surrounding Bitcoin ETFs right now.
To unpack what’s going on, I’m going to first explain how ETFs work. Then we’re going to examine the two main types of Bitcoin ETFs being proposed and look at why the SEC has chosen to reject all proposals thus far. Finally we’ll look at the implications of how ETFs will affect the market.
An exchange traded fund (ETF) is simply a security that tracks some underlying assets, whether that be equities, bonds, commodities, or cryptocurrency.
An ETF takes custody of the underlying assets it tracks. Then it issues a large number of shares that represent the ownership of those assets.
An ETF’s shares are as easy to trade as a stock and therefore can knock down a lot of barriers an investor would face if they tried to purchase the underlying assets themselves. In the case of Bitcoin, barriers like verification, high transaction fees, and delays come to mind.
How are ETFs created?
What I imagine APs look like
When an ETF wants to create new shares of its fund, it turns to someone called an authorized participant (AP) for help. An AP is just a fancy name for someone who is responsible for purchasing the underlying assets an ETF wants to hold. APs require a license from the ETF provider and are typically financial institutions with a lot of purchasing power.
Here are the basic steps:
An AP starts the process by buying up the underlying assets. For example, if an ETF wants to track the S&P500, an AP will buy an appropriate amount of each security based on the index weighting.
The AP sends the assets over to the ETF provider.
In return, the ETF provider sends back shares of the fund back to the AP. The value of these shares are equal to the assets the ETF provider just received.
How are ETFs redeemed?
The redemption process works in the reverse direction.
The AP sends over ETF shares it wants to redeem to the ETF provider.
The ETF provider returns the underlying assets back to the AP.
How does an ETF Keep its Price the Same as its Underlying Assets?
Because an ETF trades like a stock, its price will fluctuate during the trading day due to changes in supply and demand.
Sometimes the price can become higher than its underlying assets, or net asset value (NAV). When this happens, an ETF is said to be trading at a premium. The opposite is called trading at a discount.
The AP arbitrages premiums and discounts to keep the market price tightly coupled to the NAV.
Let’s explore how this works.
If the price of an ETF goes above NAV
An AP will go out and buy up a bunch of the underlying assets and send it over to the ETF provider. The ETF provider will issue new shares of the fund to the AP. The AP will then sell these new ETF shares on the market.
Assuming demand stays the same, a higher supply will lower the price of the ETF and bring it back towards NAV.
If the price of an ETF goes below NAV
An AP will buy up a bunch of ETF shares and redeem them for the underlying assets. The AP then sells the underlying assets at the NAV price in order to make a profit. Profits can be used to buy and redeem even more overpriced ETF shares.
An decrease in supply, assuming demand stays constant, will increase the price of the ETF and push it towards NAV.
How do Bitcoin ETFs Work?
Now that we understand how normal ETFs work, we can turn our attention to Bitcoin ETFs.
ETFs that Physically Hold Bitcoin
This type of ETF is almost identical compared to the ETF model we’ve described.
The only difference is that APs have the option of sending over baskets of cash instead of Bitcoin. This is simply for convenience as many APs don’t want to purchase Bitcoin and hold on to it themselves.
So when the AP sends over a basket of cash, the ETF provider trades the cash for Bitcoin. Then the provider returns ETF shares that are of equal value, less transaction fees, to the AP.
Low transaction costs — It’s generally very cheap to trade ETFs on the market especially when compared to the high fees exchanges charge to trade between fiat and Bitcoin.
Tracks Performance of Bitcoin — Since the ETFholds Bitcoin, it should track the performance of Bitcoin well. APs can arbitrage price differences between the ETF price and NAV for a profit and this should remove large discounts and premiums.
Liquid markets — The daily trading volume for Bitcoin is in the billions. The risk of illiquid markets having an impact on redemption is not too high.
Risks & Concerns:
Counterparty risk — The ETF provider remains in custody of the Bitcoin and has to take security precautions to avoid theft.
High cost per share — It’s highly likely that the first wave of ETFs will be unavailable to retail investors. In order to placate the SEC’s concerns about protecting retail investors, a minimum purchase of VanEck’s proposed Bitcoin ETF is valued at 25 BTC.
Higher expense ratio — Bitcoin ETF will likely have higher fees than traditional ETFs due to the high transaction costs APs have to pay in the creation and redemption of ETF shares when they choose to submit, or redeem, baskets of cash. So far VanEck is planning to charge $1,000 for every creation & redemption transaction, plus some TBD variable transaction fee on top.
Inaccurate NAV — Redemptions are made based on NAV so an inaccurate NAV will break the arbitrage mechanism. Most ETF NAVs are calculated once per day. But since the Bitcoin market is so volatile, intra-day NAV measures are required. For instance, the VanEck ETF plans to use the MVIS Bitcoin Index which is updated every 15 seconds. Still, determining NAV can be difficult since prices can be different across multiple exchanges.
Markets closed for ETF but open for Bitcoin — The market for trading ETFs can be closed while cryptocurrency exchanges are open. Prices may fall significantly in the meantime and investors will not be able to mitigate losses in a closed market. Non-concurrent trading hours also may increase the gap between the ETF price and NAV.
ETFs that Purchase Bitcoin Derivatives
The second kind of ETF does not actually hold any Bitcoin. Instead the ETF tries to mimic the performance of Bitcoin by trading Bitcoin futures, options, swaps, money market instruments, and investing in other pooled vehicles.
The fund doesn’t have to worry about the security risks of holding Bitcoin since it does not take custody of any Bitcoin.
Risks & Concerns:
Approximating the performance of Bitcoin — Since the fund only approximates the performance of Bitcoin, there could be scenarios where the returns of the fund are significantly divorced from the performance of Bitcoin.
Active management risk — The holdings of an actively managed fund are completely under the discretion of the money manager. In an attempt to track the performance of Bitcoin, an active manager may significantly underperform Bitcoin.
Active management cost — Actively managed funds charge higher fees than their passive counterparts. This is often known as the management expense ratio (MER).
Margin call risk —Futures contracts require some amount of capital on hand called a maintenance margin. If the deposit margin does not meet the requirements of the maintenance margin, the exchange will attempt a margin call. If there are not sufficient cash or cash equivalents, the futures contract will be liquidated and result in immediate and substantial losses to the fund. Both market volatility and leveraged trading makes this more likely to happen. Even a relatively small price movement under leveraged conditions can cause massive liquidations to happen. Given the volatility of Bitcoin, this can be a big risk if not handled correctly. To make matters worse, prominent futures exchanges like Bitmex have been accused for manipulating Bitcoin prices in order to trigger margin calls.
Leveraged Trading Risk — The significant use of leveraged financial instruments means that even short-term price movements can adversely impact the performance of the fund.
Rollover Risk — Many futures contracts are switched for ones that expire further into the future in a process called rollover. This is done so the contracts do not expire and go to settlement. If the contract’s future price is higher than the spot price, the investor loses money by rolling the same quantity of the asset at a higher price.This is usually referred as contango.
The letter is quite long, so we’ll be summarizing the main points below.
Pricing NAV correctly is important because it determines the amount an AP sends or receives during the creation and redemption process. The SEC is concerned that because cryptocurrency is volatile and exchange prices can be disjoint, NAV measures will be inaccurate.
Arbitrage (for ETFs)
Since NAV measures can be imprecise and the markets are very volatile, the SEC is concerned that arbitrage mechanisms, that are essential for keeping the price of ETFs aligned with NAV, may be disrupted.
The SEC is concerned that unusually large daily redemptions will be the norm in such a volatile market, and that there may not be enough market liquidity to honour redemptions without a massive amount of slippage.
The SEC is also concerned that a futures based ETF could grow to represent too much of the entire Bitcoin futures market, such that it affects fund performance and liquidity.
The SEC is concerned that an ETF may not be able to protect against cybersecurity threats when taking custody of Bitcoin.
The SEC is also concerned with ETFs taking custody of any physically-settled Bitcoin derivatives.
Potential Manipulation and Other Risks
The SEC is concerned that the cryptocurrency market is unregulated and rife with market manipulation.
Looking Forward into the Future
ETFs that Hold Physical Bitcoin > ETFs Trading Bitcoin Derivatives
After reading SEC filings for most of the proposed Bitcoin ETFs, I quite prefer ETFs that physically hold Bitcoin.
Obviously the biggest worry surrounding ETFs that hold Bitcoin is custody risk. But I am inclined to believe that mitigating custody risk is easier than mitigating the risks of improperly tracking Bitcoin by trading derivatives.
Like we mentioned before, investors need to place a great amount of trust in the active manager to approximate the performance of Bitcoin using derivatives. It will be less transparent, cost more, and a small price change can have a big impact on performance because of leveraged trading.
Bitcoin ETFs Need to Stabilize around NAV before They Can Attract Institutional Investors
We are greatly overestimating the amount of fiat inflow that will come in from Bitcoin ETFs. Articles like this one, use some incredibly suspicious math to estimate how ETFs will add 24 million investors and $420 billion in fiat inflow, as if seemingly overnight.
In reality, a lot of institutional investors are still dipping their toes when it comes to investing into cryptocurrency. They will not recklessly invest into a Bitcoin ETF if its trading at a massive premium.
Grayscale’s Bitcoin Investment Trust traded at about a 50% premium to its NAV in July. Expect similar challenges in the beginning. It will take some time for APs to stabilize the ETFs price around NAV.
Bitcoin ETFs will Likely Have High Expense Ratios
Someone has the shoulder the cost of trading from fiat into Bitcoin. Someone also has to pay for the cost of secure custody.
The SPDR S&P 500 charges 0.09% per year. Expect Bitcoin ETFs to charge in the range of 1–3%. High expense ratios may also turn institutional investors away.
A Cryptocurrency ETF Index is Far, Far Away
The SEC is already worried about the liquidity, valuation, custody of just Bitcoin. Imagine how difficult it would be to build an ETF around the top 20 cryptocurrencies by market cap.
This actually renders one of the main benefits of ETFs useless: the ability to take fractional ownership of a large and diverse base of underlying assets.
If you want to diversify your cryptocurrency portfolio across the top 20 coins, you’ll have to hold on to the underlying assets yourself. I’m working on a project that enables you to do just that. I think there are a lot of benefits to holding onto the underlying assets yourself. I will describe this in a future article.