Investing in the Future: An Introduction to Crypto ETFs

Introduction to Crypto ETFs

Crypto Exchange-Traded Funds (ETFs) are relatively new and emerging investment vehicles. Over three decades ago, the first ETFs made their debut in North America with ProShares, launched in October 2021 to offer investors exposure to Bitcoin futures. Since that time, these financial innovations have proven to be highly successful and have transformed the landscape of investments.   

As gaining direct exposure to digital assets demands a certain level of technical expertise in navigating the virtual asset market and entails heightened risks within a regulatory framework that is still evolving, investors looking to access the crypto-asset markets within their familiar environment can use derivatives, funds, and exchange-traded products (ETPs) such as virtual asset-related ETFs.

These products don't necessitate learning new skills or setting up new infrastructures (such as trading on crypto-asset platforms or securing storage for those assets) and serves as an entry point for both institutional and retail investors to venture into this emerging asset class, offering a cost-effective, transparent, and regulated environment and enhancing accessibility.

In conclusion, using regulated investment products, like regulated derivatives or funds, offered by intermediaries, can help mitigate some of the risks associated with crypto-assets. In this realm, crypto-based ETP have the potential to increase investor confidence in the stability of bitcoin markets, thereby encouraging market growth.

Direct and Indirect Access in the Virtual Asset Market

There are two options for entering the virtual asset market: direct and indirect.

• Direct access involves purchasing or selling cryptocurrencies through platforms like crypto brokers, crypto exchanges, or ICOs.
• Indirect access consists of investing in products related to blockchain or cryptocurrencies, such as stocks, futures, ETFs, or funds.

Although direct access to virtual assets offers potential benefits, it also carries significant risks. Certain platforms may lack regulation or security measures. Investors may need to oversee their personal wallets or rely on third-party custodians. Cryptocurrency liquidity and fees can fluctuate based on the platform and transaction type. For instance, centralized crypto exchanges enable transactions between fiat and cryptocurrencies and potentially provide custody services; decentralized crypto exchanges utilize smart contracts on a blockchain to facilitate transactions solely between cryptocurrencies, necessitating that investors possess their own digital wallets. The fees on decentralized platforms are contingent on the expenditure of the blockchain network.

Compared to direct methods, indirect access of virtual assets rely on traditional financial products with innovative underlying assets. These can be cash or derivative products, and they depend on services provided by the well-regulated traditional financial system. Such financial products include ETFs and other investment funds issued by financial institutions. These funds may invest directly in virtual assets or related products, including derivatives based on virtual assets.

Moreover, investing in shares of listed blockchain companies, which are engaged in virtual asset businesses, also provides investors with exposure to virtual assets. ETFs on blockchain equities serve as another indirect means of gaining exposure to virtual assets. Both ETFs on virtual assets and ETFs on blockchain equities are collectively known as "virtual asset-related ETFs".

These traditional products are subject to disclosure requirements and other regulatory mandates under the conventional regulatory regime. There may also be special requirements to accommodate the product design, such as position limits and large position reporting for futures, to manage overall market risk.

What are ETFs?

A crypto ETF, or exchange-traded fund, is a financial product designed to track the performance of cryptocurrencies, a single cryptocurrency, or crypto-related businesses and technologies.

These ETFs enable investors to participate in the crypto market without the need to purchase, safeguard, or manage the actual assets. Exchange Traded Notes (ETNs) are often used in crypto ETFs to follow a mix of different cryptocurrencies, simplifying investment in multiple digital assets with a single product.

Crypto ETFs share similarities with traditional ETFs that monitor indices, sectors, commodities, or currencies but offer distinct advantages. Unlike mutual funds that are traded and priced once daily, ETFs can be bought and sold on stock exchanges throughout the day, providing retail investors with greater flexibility and accessibility to a range of assets and indices at lower costs. Crypto ETFs also offer diversification, liquidity, and potential tax benefits compared to direct cryptocurrency holdings.

In the case of a Bitcoin ETF, it would replicate the value of Bitcoin itself, making it a regulated and easily tradable investment option on standard exchanges. This eliminates the need for secure Bitcoin storage, which can be risky, illiquid, and slow.

Supporters believe that this will attract more institutional investors to the crypto market, increasing available capital for the cryptocurrency industry and encouraging the creation of innovative crypto products. These advantages have contributed to the popularity of ETFs.

How Crypto ETFs work?

ETFs function in a similar manner to mutual funds. However, while mutual funds are typically designed for collective investments, ETFs are tailored to individual investors, providing them a bundle of assets, effectively reducing risk and diversifying their portfolio and offering accessibility to a broader audience.

Both ETFs and mutual funds consist of a blend of assets, allowing investors to achieve portfolio diversification and gain exposure to a wide array of asset classes and niche markets. ETFs can include various types of investments, such as stocks, bonds, and commodities.

ETFs are based on a mechanism called creation and redemption, which allows the continuous creation and destruction of Etf shares. To create new ETF shares, authorized financial institutions buy index-related securities and exchange them with the ETF management company. These shares can be traded on the secondary market. Conversely, to redeem existing ETF shares, authorized participants buy ETF shares on the secondary market and exchange them for index-related securities.

Nevertheless, several key distinctions set the two apart. One significant difference is that ETFs can be traded intraday, similar to stocks, offering investors substantial flexibility, unlike mutual funds, which can only be bought at the close of each trading day based on the Net Asset Value (NAV) and sometimes with minimum investment requirements. This intraday tradability of ETFs grants investors a more flexible and dynamic approach compared to the fixed trading window of mutual funds.

Unlike mutual funds, ETFs can be bought on margin and sold short. Buying an ETF share allows for real-time investment in an entire market index that closely tracks the performance of its benchmark, particularly in the case of passively managed ETFs that mimic the composition and weights of the index.

ETFs typically have a modest annual fee that is automatically adjusted based on the holding period, and they don't charge entry, exit or performance fees. Investors only pay their broker's fees for buying and selling.  

A Bitcoin ETF's returns depend on several factors: how the Bitcoin price changes in the spot market, how the cash left after buying futures with leverage is invested (or the basis risk), and how the roll yield affects the futures price over time. These factors can cause the ETF to deviate from the Bitcoin price. Another cost to consider is the expense ratio, which is the fee that the ETF charges for its management.

In conclusion, ETFs offer flexibility for a variety of strategies, from long-term investing to intraday trading and even short selling. However, they do carry the risk of the underlying instruments losing value.

Types of ETFs

Cryptocurrency Exchange-Traded Funds (ETFs) exist in different variants, characterized by their underlying assets and investment approaches. Certain ETFs follow the cost of specific cryptocurrencies, such as bitcoin, by utilizing futures contracts or derivatives to mirror crypto market performance, while taking fees into account. BITO and DEFI, like ProShares Bitcoin Strategy ETF and Hashdex Bitcoin Futures ETF, are prominent examples.

Some investors diversify their portfolio by including a range of cryptocurrencies and related assets, as well as equity positions in crypto-related companies. This approach seeks to benefit from the industry's growth and innovation while mitigating the volatility of individual cryptocurrencies. Notable examples of exchange-traded funds (ETFs) that employ this strategy are Bitwise Crypto Industry Innovators (BITQ) and Invesco Alerian Galaxy Crypto Economy (SATO).

When it comes to Bitcoin ETFs specifically, there are two fundamental types:

• those that physically hold BTC such as VanEck/SolidX;
• and those that employ Bitcoin derivatives, trading futures, options, swaps, and other similar instruments without keeping any actual BTC. ETFs that deal with Bitcoin derivatives are exemplified by ProShares ETF and Direxion ETF.

Both physical and derivative forms of ETFs have requested approval from SEC but are yet to receive it.

Risks and Opportunities of Crypto ETFs

ETFs offer six advantages that appeal to both retail and institutional investors:

• liquidity and easy access to various asset classes because ETF shares are tradable throughout the day;
• price transparency because the trading price of an ETF closely reflects the market value of its underlying securities;
• tax efficiency because they rarely distribute capital gains and often use in-kind transactions to acquire and dispose of their underlying investments;
• exposure to specific markets that otherwise may be hard or impossible to reach;
• high demand from investors for index-linked investments;
• use by financial advisors in third-party asset allocation models to manage their clients’ assets.

A key benefit of this investment vehicle is that it enables indirect investment in cryptocurrencies like bitcoin on a regulated securities market. However, crypto ETFs also have some drawbacks and challenges:

• regulatory uncertainty, as many jurisdictions have not yet approved or defined the legal status of crypto ETFs. For instance, in the US, the Securities and Exchange Commission (SEC) has repeatedly rejected or delayed the approval of several crypto ETF proposals, citing concerns over market manipulation, fraud, custody, valuation, and liquidity;
• tracking error, which is the difference between the performance of the crypto ETF and its underlying assets. Tracking error can arise due to fees, rebalancing, market inefficiencies, or technical issues;
• custody risk, or essentially the risk that an ETF custodian might go bankrupt and no longer support the ETF.

ETFs Regulation

ETFs have experienced significant growth, offering an expanding selection of options tailored to meet investors' diverse needs. Nevertheless, the regulatory atmosphere encircling ETFs is a crucial aspect of their operation, with regulations and oversight playing a pivotal role in ensuring the products' integrity and stability.

Approvals in the U.S.

The U.S. Securities and Exchange Commission (SEC) has yet to authorize a U.S. Bitcoin exchange-traded fund (ETF). The SEC rejected Bitcoin ETP proposals because of insufficient surveillance-sharing agreements and worries about safeguarding investors from market manipulation.

BlackRock's recent filing for a spot Bitcoin ETF, the iShares Bitcoin Trust, and Nasdaq's proposal to list it, are perceived as game-changers for U.S. crypto ETFs. BlackRock's impressive performance prompted other contenders such as WisdomTree and Ark Invest to resubmit their applications.

Multiple submissions, including from major U.S. asset managers, are still awaiting approval. Notable ETF applications come from major firms like BlackRock, Invesco, VanEck, and WisdomTree. These applications face inquiries regarding the prevention of market manipulation and determining asset pricing.

Approvals in other countries

Spot Bitcoin ETFs have obtained regulatory approval in various international locations, such as Europe, Canada, and Brazil.

On August 15, 2023, Euronext Amsterdam accomplished a landmark achievement by launching Europe's first-ever Bitcoin exchange-traded fund (ETF). This event is a major turning point for the digital asset industry. Jacobi Asset Management oversees the ETF which uses the FT Wilshire Bitcoin Blended Price Index as its benchmark.

In December 2021, Fidelity, the world's third-largest asset manager, introduced a Bitcoin spot ETF on the Toronto Stock Exchange. Following suit, Australia rolled out its maiden Bitcoin spot ETFs in May 2022.

Conclusion

The emergence of Crypto Exchange-Traded Funds (ETFs) marks a significant evolution in the world of investment. Over the past three decades, these innovative financial instruments have reshaped the investment landscape, offering a unique avenue for investors to gain exposure to the dynamic and rapidly evolving realm of digital assets.

The appeal of crypto ETFs lies in their ability to bridge the gap between traditional finance and the virtual asset market, providing a user-friendly entry point for both institutional and retail investors. By obviating the need for extensive technical expertise and infrastructure setup, they offer a seamless and accessible way to participate in this emerging asset class.

Furthermore, the regulatory framework that surrounds crypto ETFs adds an essential layer of security and transparency, which can help mitigate some of the inherent risks associated with crypto-assets. Investors are provided with a regulated environment in which to trade and invest, increasing their confidence in the stability and integrity of the digital asset markets.

As the crypto landscape continues to evolve, crypto-based ETPs, including ETFs, hold the potential to foster market growth and provide a secure and cost-effective means for investors to explore the exciting possibilities of the digital asset space. In an ever-changing financial world, these innovative instruments stand as a testament to the adaptability of the investment industry and the opportunities it offers to those seeking to diversify their portfolios and participate in the future of finance.

References

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• Duke University. (n.d.). Bitcoin ETFs: Measuring the performance of this new market niche. Available here.
• Hacker Noon. (2018). What Are Bitcoin ETFs and Why Are They Controversial? Available here.
• University of North Carolina School of Law. (2019). Cryptocurrency and Financial Regulation: The SEC’s Rejection of Bitcoin-Based ETPs. North Carolina Banking Institute Journal. Available here.
• Financial Times. (2023). Crypto vs SEC: What Grayscale’s court victory means for bitcoin ETFs. Available here.
• Regulation Asia. (2023). Euronext Amsterdam Lists Europe's First Spot Bitcoin ETF. Available here.