What is a bitcoin-ETF? How it works and how it affects the cryptocurrency market

What is a bitcoin-ETF? How it works and how it affects the cryptocurrency market

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Author: Robert Strickland (crypto-journalist)
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What is a bitcoin-ETF? How it works and how it affects the cryptocurrency market

We tell you in simple words what a bitcoin ETF is, how spot ETFs differ from futures ETFs, and how the approval of ETFs by major players can change the way investors look at cryptocurrencies




An ETF (exchange-traded fund) is an exchange-traded fund that collects securities based on an index, sector, commodity, or other asset. A share (unit) of ETF is a registered uncertificated security, which confirms the indirect right of its owner to the corresponding part of the fund's assets. Buying units in ETFs gives an investor the opportunity to invest, for example, in all securities included in the index on the basis of which a particular fund is collected. This is more convenient than assembling an investment portfolio on one's own.



In the context of Bitcoin, ETFs give investors the opportunity to follow the movement of its price without having the cryptocurrency itself. Instead of having to deal with cryptocurrency exchanges and wallets on their own, an investor can buy bitcoin-ETF shares through regular brokerage accounts. It is expected that it is the ease of access that can bridge the gap between the traditional financial and cryptocurrency markets.

The U.S. Securities and Exchange Commission (SEC) has given the go-ahead for the creation of several types of bitcoin ETFs, particularly those based on futures contracts. Futures-based ETFs do not provide direct ownership of bitcoin. Instead, they track futures contracts that forecast the price of the cryptocurrency at a future date. As these contracts expire, they must be sold or replaced.

Despite the progress made, a so-called spot bitcoin ETF that tracks the actual market price of bitcoin still doesn't exist. The first applications for one appeared about 10 years ago during the nascent stage of the massive crypto market but were rejected by the SEC, the regulator citing investor protection and public interest concerns. Two major fiat companies - BlackRock and Fidelity - have applied for their own bitcoin ETFs, and this has been a big development for the crypto market.

  • How a Bitcoin futures ETF works

A futures ETF is a fund that slices off the value of a cryptocurrency, which can be bought or sold depending on the terms of the contract. However, when you buy or sell futures, you don't own the underlying crypto asset, which is directly bitcoin, or any other cryptocurrency for which a futures fund exists. Instead, you own a contract that promises to buy or sell the cryptocurrency at some point in the future.

If you invest in a bitcoin ETF, it means that you agree to buy or sell bitcoin at a set price on a specific date, regardless of market conditions. The contract settlement date or expiration date is an agreed-upon date by which both parties must fulfill their obligations.

A party who agrees to buy bitcoin at the expiration of a futures contract will have to buy it at either a discount or a premium. A futures market is called a "premium" market when the futures price is trading above the actual market (spot) price. A discount occurs when the spot price is higher than the futures price. Normal is when the futures price converges with the current price.

The amount to be paid depends on the spot price and the value of the futures contracts purchased by the buyer. In addition, arbitrage traders can utilize the spread between the ETF share price and the underlying asset price if it becomes too wide; the ETF share price tends to remain highly correlated with the movement of the underlying asset price.

  • Bitcoin trusts and spot ETFs: key differences

While both ETFs and trusts offer bitcoin investments, their structure and regulatory frameworks differ. A Bitcoin trust is a closed-end fund that invests exclusively in Bitcoin. Shares in the trust, like Grayscale Bitcoin Trust (GBTC) shares, are not redeemable for the underlying bitcoin. As a result, the trust's prices can deviate from the value of bitcoin.

Unlike trusts, a spot bitcoin-ETF is an open-end fund with a more dynamic equity issuance system. Its purpose is to track the market (spot) price of bitcoin. ETF shares can be issued or redeemed based on market demand, ensuring that the ETF price matches the real value of bitcoin. In addition, ETFs are under the regulation of the Investment Company Act of 1940 (Investment Company Act of 1940), which gives investors additional.

 

  • Difficulties with bitcoin-ETF approval

Despite Bitcoin's growing acceptance, the SEC remains cautious about approving spot bitcoin ETFs. Dozens of asset managers have applied to launch such a fund. The first of them were the Winklevoss twins, who filed the first application back in 2014 when bitcoin was trading below $1,000. However, the SEC did not accept such applications, explaining the refusals by the fact that the cryptocurrency is traded on unregulated exchanges. The agency claims that it cannot provide investors with guarantees that the market is free from fraud and manipulation.

 

Following the news of BlackRock and Fidelity's participation, companies such as Invesco, WisdomTree, Bitwise, Ark Investment Management, and Valkyrie resubmitted applications to register their own bitcoin-ETFs, making some changes to the documents.

 

Applications from players looking to launch their own fund often lacked a "joint surveillance agreement" with major regulated cryptocurrency exchanges, which the SEC says is crucial to prevent market manipulation. Such agreements would facilitate thorough investigations if suspicious activity is detected.

 

BlackRock has applied for its own ETF in the form of the iShares Bitcoin Trust, and its application includes a provision for such joint surveillance agreements. By doing so, it has likely increased the chances of its ETF being approved. In addition, of the 575 existing ETFs for other assets submitted by BlackRock, the SEC rejected only one.

 

  • Impact of the spot ETF on the bitcoin market

The introduction of a bitcoin spot ETF could be a game changer for both cryptocurrencies and the broader financial market. For example, the SPDR Gold Shares ETF launched in 2004 (the shares trade under the ticker GLD on the NYSE) quickly accumulated assets of more than $1 billion. By 2010, the fund had already reached $50 billion in assets under management.

Despite the fact that gold ETFs account for only a small part of the global gold supply, they have had a significant impact on the dynamics of gold trading, providing an increase in the volume and liquidity of the market. Drawing parallels, a bitcoin spot ETF could also serve to increase bitcoin's acceptance and liquidity.

 

  • Positive aspects of ETFs

Building confidence in the market. An officially authorized ETF can further strengthen Bitcoin's credibility in the traditional financial world, attracting both institutional and retail investors.

Increased market liquidity. Attracting more participants can make the Bitcoin market more stable, curbing sharp price fluctuations.

A regulated and understandable investment path. With a regulatory framework in place, the bitcoin-ETF provides potential investors with a simple, transparent, and safe way to invest.

Affordable entry into investing. The ETF model simplifies the process, which is especially helpful for beginners, or those who are hesitant to buy bitcoins directly.

 

  • Possible problems

Regulatory dependency. The value of bitcoin may become more susceptible to regulatory decisions due to its close association with financial products or sanctioned entities.

Potential for price manipulation. There is a risk that major bitcoin players could adjust the market in favor of their assets in ETFs.

Changing investment patterns. The attractiveness of ETFs may discourage some from buying Bitcoin directly.

Transaction costs. When investing in a bitcoin ETF, you must consider the management fee, which is not present with a direct purchase of bitcoin.

 

A bitcoin spot ETF could be a bridge between traditional investment avenues and the crypto market as it exists, allowing investors to add bitcoin to their portfolios and retirement funds. For an asset in which there is growing interest from institutional investors, the emergence of such an investment vehicle seems well justified, although not without its challenges and potential drawbacks.

 

 

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