Bitcoin ETFs 101: A Comprehensive Guide

A crypto ETF - the next step towards a decentrailzed future - bitcoin ETF

Want to learn more about Bitcoin ETFs? We’ll walk you through how traditional ETFs work and the changes that occur when Bitcoin is involved.

Bitcoin ETFs have been a popular topic of discussion for some time now, permeating the entirety of the crypto space and even seeping into the homepages of mainstream media outlets worldwide.

Crypto investors believe that a Bitcoin ETFs would spark a much-needed rally in the markets, while traditional investors see it as a way to invest in cryptocurrency while still using conventional money.

It may have seemed inevitable to some, but when talks of Bitcoin ETFs turned from discussions of ideas about the future to making them a reality, they were met with resistance. Most notably, the U.S. Securities and Exchange Commission (SEC) has rejected numerous Bitcoin ETF proposals in the past and continues to postpone their decisions on others. They have cited concerns about possible price manipulation and fraud that may occur with Bitcoin ETFs, as well as the fact that so many Bitcoin transactions occur overseas.

These decisions, along with the inherent intricacies of cryptocurrencies and ETFs, have led to confusion for many of those wishing to follow the news.

To unravel the complexities of what is going on, we’ve developed a Bitcoin ETF guide. If anything mentioned above seemed unclear, read on to gain a better understanding of what is happening in the world of Bitcoin ETFs.

What Is an ETF?

An exchange-traded fund, or ETF, is a collection of various investment types traded on a stock exchange. Typically the investment types held in ETFs are assets such as commodities, stocks or bonds. Generally, these can be traded individually, but an ETF combines them together, reducing complexity and allowing investors to take advantage of the built-in diversification.

Every ETF has custody of the tracked underlying assets. They distribute the ownership of these assets across thousands or millions of shares which are available for purchase by investors.

These shares are traded exactly like shares of a stock, giving investors the convenience of trading using the same mechanisms they use for buying and selling stocks.

As mentioned before, ETFs allow investors to diversify their portfolios without the complexity of individually trading multiple stocks in multiple sectors of the market. With regard to ETFs based on physical commodities, known as commodity ETFs, an investor could trade the commodities on their own if they’d like. For example, an investor could physically buy and sell gold instead of investing in a gold-based ETF, but this would present higher risk to the investor and may require additional investment in order to protect and store the gold. These barriers to entry are not present when investing in ETFs.

When it comes to Bitcoin, similar barriers are found in the form of high transaction fees, delays and verification processes. These along with the lower transaction costs, reduced management fees and tax efficiencies associated with ETFs are why the desire for Bitcoin ETFs continues to grow.

Bitcoin ETF. Exchange traded fund and cryptocurrency concept on virtual screen.

ETFs that hold Bitcoin and ETFs that purchase Bitcoin derivatives. Both of these types of ETFs have their own pros and cons.

How Would a Bitcoin ETF Work?

When it comes to understanding how a Bitcoin ETF would work, the discussion needs to be divided into two parts—ETFs that hold Bitcoin and ETFs that purchase Bitcoin derivatives. Both of these types of ETFs have their own pros and cons.

ETFs That Hold Bitcoin

This type of Bitcoin ETF functions exactly like a regular ETF, except the asset being traded is Bitcoin instead of other assets like commodities, stocks or bonds.

Just as in a regular ETF, an entity known as an authorized participant or AP, typically a large bank, buys the underlying assets that the ETF desires to hold.

In the case of a Bitcoin ETF, the AP purchases Bitcoins. Once the purchase has been made, the AP transfers the Bitcoins to the ETF sponsor. In return, the sponsor gives the AP a creation unit, which is a quantity of shares of the ETF that is equal in value to the Bitcoin purchased by the AP.

In some cases, the AP will give the ETF sponsor cash in the amount equal to the amount of Bitcoin that is to be purchased for the ETF. In this case, the ETF sponsor purchases the Bitcoin themselves once the cash is received, but the overall process remains the same.

Advantages:

  1. Moves Along with Bitcoin – Since this kind of ETF holds Bitcoin, its value should closely follow the value of Bitcoin.
  2. Low Transaction Costs – Compared to the high fees charged by cryptocurrency exchanges, it is inexpensive to trade ETFs.
  3. Fluid Markets – In the Bitcoin market, the daily trading volume regularly reaches billions of dollars. But since the supply of ETFs is flexible, average daily trading volume is not a sole measure of liquidity. Because of this, there is a fairly low risk of the liquid markets actually having an impact on trades.

Disadvantages:

  1. High Cost Per Share – Although it is fairly cheap to trade ETFs, the cost per share is likely to be somewhat high. This means that the first wave of Bitcoin ETFs may not be accessible to the average investor.
  2. Inaccurate Net Asset Value – ETF net asset values are calculated on a daily basis. This fact, coupled with the high volatility of the Bitcoin market, may lead to inaccurate net asset values, which means that the value of the ETF shares may not reflect the true value of the Bitcoin owned by the ETF.
  3. Trading Hours – Bitcoin markets are constantly active since they are affected by trades occurring around the world. Stock exchanges are only open for a period of time each day, excluding holidays and weekends. If the price of Bitcoin happens to rapidly increase at a time when the stock exchange is not available, those wishing to sell their Bitcoin ETF shares will be unable to do so until the exchange becomes active again. The same is true if Bitcoin’s value plummets. ETF investors would only be able to watch as the value of their shares dropped, unable to pull their money out before even more is lost. ,

ETFs That Hold Bitcoin Derivatives

This type of ETF does not hold any Bitcoin. Instead, it tries to mimic Bitcoin’s performance by exchanging Bitcoin futures, swaps and options. This kind of ETF makes investments in other assets as well.

Advantages:

  1. No Security Risks – Since this kind of fund does not hold any Bitcoin, the ETF does not have to worry about hackers attempting to steal their Bitcoin.

Disadvantages:

  1. Active Management Risk & Cost – Actively managed funds such as these allow their managers to have complete discretion over their holdings. This means that an active manager can potentially underperform Bitcoin in their efforts to follow its performance. Additionally, actively managed funds typically charge higher fees than their passive counterparts.
  2. Approximating Bitcoin’s Performance – ETFs that are based on Bitcoin derivatives only approximate Bitcoin’s performance. This scenario can initiate a situation where the actual performance of Bitcoin is significantly disconnected from that of the ETF.

Why Bitcoin ETFs Have Not Been Approved

Security Exchange Committee (SEC) controls future of crypto currency such as Bitcoin. Investor use finger to touch on mobile tablet device to display status of their decision.

In a letter written in 2018 by the director of the SEC’s Division of Investment Management, several concerns were outlined on the reasoning behind the commission apprehension toward Bitcoin ETFs.

As mentioned before, the U.S. SEC has either delayed the approval of Bitcoin ETFs or rejected their proposals outright.

In a letter written in 2018 by the director of the SEC’s Division of Investment Management, several concerns were outlined on the reasoning behind the commission apprehension toward Bitcoin ETFs.

These included:

  1. Concerns about the accuracy of the net asset value of the ETFs, given the volatility of Bitcoin.
  2. The possible lack of liquidity given the delays associated with trading cryptocurrencies.
  3. The ability of the ETF sponsors to prove their custody of the Bitcoins represented by the shares of their funds.

Even though the SEC has yet to approve ETFs related to digital currencies, crypto investors remain optimistic.

Once the SEC finally establishes a regulatory structure governing Bitcoin ETFs, the market will be green.

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