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Bitcoin ETFs: How They Work Compared to Crypto

November 22, 2021

6 min

Bitcoin ETFs: How They Work Compared to Crypto

In October 2021, the SEC approved the first Bitcoin ETF after 8 years of stalling. ProShares’ fund kicked off and other firms followed.

What is an ETF?

The term ETF is an acronym for Exchange Traded Funds, i.e. funds that replicate an index exactly.

They are usually traded in a very similar way to equities, but they also provide the typical advantage of managed funds, namely diversification. They allow, in fact, to invest in the entire market through a single instrument, as if you were buying a basket of securities of a given market.

The performance of the ETF is determined by the performance of each individual security that makes up the fund; in the case of index-replicating ETFs, performance is linked to the index.

For Bitcoin, there is no real basket of securities and therefore the ETFs will replicate exactly the price performance of the cryptocurrency.

More precisely, there are Bitcoin ETFs based on:

  • Futures

Contracts that allocate a certain quantity of the underlying to two parties on the basis of a predetermined delivery price and maturity. One of the two parties bets on the price going up and one bets on it going down.

  • Spot market

Where financial instruments are traded for immediate delivery, i.e. the order to buy or sell is immediately followed by the actual exchange of the instrument for liquidity (mostly in fiat currency).

Pros and cons of ETFs

ETFs are financial instruments that are very often used by institutional or retail investors with experience in finance, for whom they have some advantages:

  • Liquidity – being listed on an exchange and traded like shares, liquidity is very high;
  • Regulatory – ETFs are regulated and easily monitored financial instruments, which generally instils trust in institutional investors.
  • Ease of use – for those who already trade with traditional financial intermediaries (banks or trading desks) and have never bought cryptocurrencies before.

Let’s now see a few cons

  • Costs – compared to the Spot Exchange markets, ETFs generally have higher transaction and management costs;
  • Indirect ownership – for all those users who share the cryptocurrency philosophy, not having control over their own currencies is a downside;
  • Latency – it is possible that due to large price fluctuations, the ETF may not be able to match the price of the underlying in a timely manner, exposing investors to additional risks;

The current situation

Several ETFs have recently been approved by the SEC, the US financial markets regulator. The launch has been quite successful, both for retail and institutional investors. Institutional investors have entered the market in the past either by buying Bitcoin directly or by diversifying their portfolios and buying shares in companies that are active in the mining industry or that have a business in the cryptocurrency sector (MicroStrategy is one of the most famous companies).

To date, all approved ETFs are based on Futures, i.e. contracts that allow holders to sell or buy Bitcoin at a future date at an agreed price.

As is also the case in the financial markets, Futures are excellent instruments that allow a variety of investment strategies to be used, but they should be used with caution and by experienced traders. At present, there are also critical issues, such as limits to the size of positions and high costs associated with renewing the underlying futures contracts.

Spot market Bitcoin ETFs are very different from Futures-based ETFs in that they allow you to physically buy Bitcoin. Any firm issuing a Spot Market ETF will need to own Bitcoins directly and hold them securely. Initial purchases by ETF managers however means that if investor demand is high then a large amount of BTC will be bought on the market with major consequences for scarcity and price.

The current problem is that in order to launch such an ETF, one has to meet several technical and regulatory requirements, especially with regard to the underlying, which in this case is the entire Bitcoin spot market. For example, it must be demonstrated to regulators that there is no price manipulation in the market.

A future perspective

With the gradual growth of interest from institutional investors and the creation of new and innovative financial instruments (including ETFs), Bitcoin may be increasingly able to stimulate trust in investors and financial intermediaries.

At the same time, regulators and policymakers around the world will be able to work more effectively to ensure greater regulation and protection for investors and businesses. The more confidence there is in Bitcoin, the greater the likelihood that it will spread and be used on a daily basis as a means of payment and not just speculation.

On the other hand, many people, often early adopters, believe in the original philosophy of Bitcoin and consequently don’t like all these developments, regulations and intertwining with finance; they perceive them as one of the many methods used by central banks and the world of classical finance to try to somehow influence the evolution and development of a currency designed and created to be totally decentralised.

ETFs play a very important role in traditional economics and finance. They are financial instruments used mainly by institutional investors but also by private investors familiar with the financial markets. The approval of a Spot ETF will be a very important step for the sector because it would open up totally new and most likely positive scenarios.