The ‘Bitcoin (Crypto) ETF’ Primer Series: PART I

By Rodrigo Zepeda, CEO, Storm-7 Consulting

INTRODUCTION

In recent years, terms such as ‘Crypto ETF’, ‘Bitcoin ETF’, ‘Bitcoin futures ETF’, and ‘Bitcoin spot ETF’, seem to have been widely featured in crypto news articles. Yet, many of these cursory articles seem to skip crucial underlying financial market fundamentals.
At the same time, many writers seem not to have taken the time to analyse relevant decisions from regulatory authorities, in order to provide more in-depth and definitive assessments of regulatory policies adopted vis-à-vis these new types of crypto investments.
Consequently, this Bitcoin (Crypto) ETF Primer Series spread across four blogs aims to do just that.

It seeks to provide readers with an in-depth understanding of new types of crypto ETF investments such as crypto ETFs generally, and more specifically Bitcoin futures ETFs and Bitcoin spot ETFs.
The Series will also seek to translate relevant legal regulatory decisions into understandable market commentary and analysis for crypto investors and readers. Readers will ultimately be equipped with a more sophisticated understanding of the nature
and future direction of crypto ETFs and Bitcoin ETFs. In this first blog, I will set out the relevant underlying financial market fundamentals that are to be discussed in the next blogs. 

AN OVERVIEW OF GLOBAL ETF MARKETS

An ‘exchange-traded fund’ (ETF) refers to an investment fund whose shares are listed and traded on a stock exchange, and which can be bought and sold by investors at the prevailing current market price during trading hours (The
Investment Association 2018, p. 4
). The growth of the global ETF market has accelerated at an unprecedented rate, with assets under management (AuM) ranging from $500 billion in 2006, $1 trillion in 2009, $2 trillion in 2013, and $3 trillion
in 2015 (Deutsche Asset Management (DAM) 2017, p.
4
).

According to PricewaterhouseCoopers (PwC), the widespread popularity of ETFs has resulted in phenomenal momentum notwithstanding times of high market uncertainty and volatility – in
November 2021 global ETF AuM now totalled more than $10 trillion (PwC 2022). As will be
seen, there exist a range of ETF benefits, characteristics, and strategies behind the surging global popularity of ETFs. In terms of global market distribution, in
2016 the two top regional markets for ETFs in order of ranking were the United States (US) (ETFs=1,655; ETF AuM=$2,158 billion) followed by Europe (ETFs=1,559; ETF AuM=$502 billion) (DAM
2017, p. 5
).

Historically, ETFs were originally created to track the performance of a specific index, e.g., US equity indexes such as the NASDAQ Composite index (.IXIC) or the S&P 500 index (.INX). In fact, equity ETFs still remain the most popular form
to this day, and they represented approximately 73.6% of global AuM in 2016 (DAM
2017, p. 5
). However, ETFs now cover a very broad range of additional market segments such as commodity, fixed income, currency, speciality (e.g., inverse, leveraged), and sustainable ETFs.

ETF METHODOLOGIES

There are two main investment methodologies that are applied and used in ETFs, and these are ‘passive’ and ‘active’ ETF investing. The majority of ETFs utilise a passive investment strategy in which the ETF passively tracks one or more specified
indexes. However, a small minority of ETFs incorporate an active investment strategy in which a portfolio manager exercises discretion over fund investments with a view to securing higher returns (Kosev
and Williams 2011, p. 54
). It should be noted that it is generally the case that the index underlying an ETF includes hundreds, if not thousands, of bonds or shares, and regulations typically require regulated ETFs to be subject to minimum diversification
requirements (DAM 2017, p. 12).

Within each of these types of investment strategy, ETFs can also employ a range of securities lending methods to generate additional income streams for the fund. Securities lending enables an ETF to temporarily lend securities owned by the fund to an approved
borrower in return for a fee (J.P. Morgan 2022, p. 1). The
additional income that is generated through securities lending can then be used to offset index replication costs, thereby increasing the overall accuracy of benchmark index tracking (The
Investment Association 2018, p. 7
).

Additionally, in practice, the replication of an index by an ETF is typically carried out in one of three ways, namely:

(1) full physical replication (i.e., all referenced securities are bought to ensure minimal tracking error);

(2) optimised physical replication (i.e., a limited sample of securities is purchased to broadly reflect an index with optimisation methodologies applied to reduce tracking deviations); and

(3) synthetic replication (i.e., derivatives such as forwards, futures, options, and swaps are used to synthesise investment returns) (The
Investment Association 2018, pp. 6-7
).

This range of index replication methodologies means that a wide range of ETFs can be offered to investors to cater to diverse investment portfolio needs. There are also a range of key ETF benefits, characteristics, and investment strategies that bolster
the investor attractiveness of ETFs even further.

KEY ETF BENEFITS, CHARACTERISTICS, INVESTMENT STRATEGIES, AND RISKS

The original appeal of ETFs included that they provided investors with: (1) a simple, low-cost means of obtaining a diversified portfolio; (2) exposure to intraday trading; and (3) a way to invest in a range of asset classes that might otherwise have been
inaccessible or too costly (Kosev and Williams 2011, p. 51). The lower costs resulted from the lower management fees and brokerage
costs charged, as ETFs do not generally need to buy or sell underlying assets to create shares (Kosev and Williams 2011, p. 52).

This is because of the ETF creation and distribution mechanism. In practice, this works by an ETF issuer issuing ETF shares to ‘Authorised Participants’ (APs), which are dealers that are authorised to transact directly with the ETF issuer, i.e., this
forms the ETF ‘Primary Market’ (DAM 2017,
p. 12
). The APs then provide the ETF issuer with a specified basket of securities (creation basket), and the APs are then free to interact and trade with other market participants on stock exchanges, regulated trading venues, and bilateral over-the-counter
(OTC) markets, i.e., this forms the ETF ‘Secondary Market’ (DAM
2017, p. 10
).

This process can occur in reverse, which results in an ETF redemption. Together, these processes can be referred to as the ETF creation/redemption mechanism (DAM
2017, p. 11
). Overall, the key ETF characteristics for investors are:

(1) transparency (clear investment objectives, transparency of unit pricing);

(2) cost-effectiveness (cost-effective investment benefitting from scale management and lower transaction costs);

(3) diversification (exposure to a securities basket via a single trade);

(4) flexibility (intraday trading via stock exchanges); and

(5) liquidity (supplied via secondary markets, block trades, and unit creation using ETF creation/redemption mechanisms) (The
Investment Association 2018, pp. 8-9
).

Taking into account the range of benefits and characteristics associated with ETFs, along with the different ETF investment and replication methodologies available, ETFs can now be used to pursue a broad range of investment strategies. In reality, these
have massively increased the global popularity of ETFs. For example, the London Stock Exchange Group plc (LSE) states that ETFs can be used to implement cash equitisation, core-satellite, hedging, pairs trading, shorting, and tactical asset allocation
investment strategies (LSE 2013, p. 3).

Investors can deploy tactical asset allocation by obtaining instant access to a whole index with a single trade, or they can extend asset manager investment capabilities, e.g., ETFs can provide access to corporate bonds, emerging markets, or high yield stocks
(LSE 2013, p. 3). ETFs can also be used to hedge long or short exposures in an effective and efficient manner
(i.e., hedging administrative burden and cost is reduced as they do not require quarterly rolls or margin maintenance), especially where the future is relatively illiquid (LSE
2013, p. 3
).

Nevertheless, there are a range of ETF investment risks that can be identified, including concentration risk, counterparty risk, and liquidity risk, along with complexity and a lack of transparency that may arise for certain speciality or newer types of
ETFs (Kosev and Williams 2011, p. 55). Concentration risk may arise where an ETF portfolio is built on only a select limited
number of securities, or if securities used within an ETF are based on certain sectors, markets, or countries. Counterparty risk may arise because of the use of derivatives to create synthetic ETFs, and it may also arise where ETFs actively participate in
securities lending markets, i.e., risk that a counterparty may default and not return the borrowed securities from the ETF portfolio (Kosev
and Williams 2011, p. 56
).

An ETF’s liquidity on the Primary Market is directly linked to the liquidity of the underlying assets, and market volatility can inhibit ETF liquidity if large ETF traders withdraw from a market (or there are difficulties in creating new ETF shares) (Kosev
and Williams 2011, p. 55
). Where markets for assets are highly evolved, heightened market volatility may be less impactful owing to deep liquidity pools that may exist; however, the opposite is also true, so that nascent markets for new and emerging
assets (e.g., crypto assets) may be significantly more affected by heightened market volatility (Kosev and Williams 2011, p. 56).

TYPES OF CRYPTO ETFs

In theory, any type of crypto asset may be used for ETF investment purposes – there are literally thousands of cryptocurrencies to choose from in circulation today. However, in reality, certain characteristics such as historical trading volumes, market volatility,
and listing venue, may currently inhibit the overall ETF investment suitability of many new and emerging cryptocurrencies. For instance, such cryptocurrencies may not have been established for a sufficient length of time, or they may feature unacceptably high
levels of market volatility (which investors may simply not be willing to accept, and/or APs may not be willing to sponsor an ETF issuer).

They may be established but feature only comparatively low levels of growth in value. Alternatively, they may only trade on a few, select markets, thereby significantly limiting their market liquidity. Indeed, it is the global distribution of cryptocurrencies
across multiple markets that may be less heavily regulated and supervised, that may also expose them to significantly higher risks of market abuse and market manipulation.

At the same time, the comparatively more established nature of other cryptocurrencies such as Ethereum (ETH), Litecoin (LTC), and Ripple (XRP), means that in theory these might be used within ETFs. Indeed, such usage will be explored
further in the next parts of this blog. Given the long-established and leading nature of Bitcoin (BTC), it is little wonder that it has been used in initial attempts to develop new types of crypto ETFs. I will first briefly explain what ‘Bitcoin futures
ETFs’ and ‘Bitcoin spot ETFs’ are, and how they operate, in order to set out the existing crypto ETF landscape that exists.

BITCOIN (CRYPTO) FUTURES ETFs

The US Commodity Futures Trading Commission (CFTC) explains that a Bitcoin futures ETF, issues securities that are publicly traded and that offer exposure to the price movements
of Bitcoin futures contracts (CFTC 2022). Such Bitcoin futures contracts are standardised, time-limited contracts,
which do not involve ownership in the underlying asset (i.e., Bitcoin), but instead convey the right to buy/sell Bitcoin at some point in the future, and they are required to trade on exchanges regulated by the CFTC (CFTC
2022
).

Bitcoin futures ETFs are predominantly based on Bitcoin futures contracts that are traded on recognised, regulated, and supervised exchanges. With such Bitcoin futures contracts, investors are not immediately purchasing Bitcoin as an asset, but are instead
committing themselves to buying or selling Bitcoin at a predetermined rate on a specified date in the future for hedging or speculation purposes (Blockchain
Council 2022
).

For example, CME Bitcoin futures are based on the ‘CME CF Bitcoin Reference Rate’ (BRR), which is calculated based on the relevant Bitcoin transactions on all ‘Constituent Exchanges’ between 3:00 p.m. and 4:00 p.m. London time (CME
Group 2020
). As of 14 November 2016, there were six Constituent Exchanges listed by the CME Group, these were: (1)
Bitfinex; (2) Bitstamp; (3) GDAX; (4) itBit; (5) Kraken; and (6) OKCoin.com (HK) (CME Group 2016, p. 3). However,
only four of these are participating in the BRR, i.e., Bitstamp (Luxembourg), GDAX (San Francisco), Kraken (San Francisco), itBit (New York) (CME
Group 2020
).

BITCOIN (CRYPTO) SPOT ETFs

Where Bitcoins are sold for cash they are said to trade on the ‘spot’ market, which reflects the
current price of Bitcoin (as opposed to future potential value); however, in the US, the CFTC notes that, with limited exceptions, the Bitcoin spot market is not regulated by either the CFTC or the US Securities and Exchange Commission (SEC) (CFTC
2022
). The main difference between a spot-based Bitcoin ETF and a futures-based Bitcoin ETF, is that the former would track the price of real physical Bitcoins (i.e., direct price tracking), whereas the latter tracks the price of Bitcoin futures (i.e.,
indirect price tracking) (Georgiev 2021).

So, by creating and issuing a Bitcoin spot ETF, investors would be allowed to receive exposure to Bitcoin via a regulated financial product, without them having to actually own the Bitcoin asset (Georgiev
2021
). A Bitcoin spot ETF would provide crypto investors with exposure to Bitcoin price movements (e.g., long-term price gains); they would be able to access the Bitcoin spot ETF via traditional existing investment firm portals; they would not be required
to store multiple private cryptographic keys to access multiple crypto digital wallets (e.g., cold storage wallets); and they would not be exposed to the costs of purchasing Bitcoin via exchanges (Georgiev
2021
).

Crypto commentators such as Moeller (2022) have made statements such as:

“Enthusiasts view a spot ETF as a more legitimate method of investment because a spot ETF involves holding Bitcoin” and

“Crypto industry pundits often fight for a firm to establish a Bitcoin spot ETF as they believe that markets will take Bitcoin seriously after a spot ETF has been established.”

Such observations are elementary and misinformed, and as such they have the potential to distort the views and understandings of crypto investors, which is problematic. In this
Bitcoin (Crypto) ETF Primer Series, I will endeavour to clarify why this is the case. At present, whereas Bitcoin futures ETFs are now available on US markets, Bitcoin spot ETFs are not. In this next part of the Blog Series, I will seek to analyse why
this is still the situation in the US based on previous SEC decisions and commentary.

TO BE CONTINUED 

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