Bitcoin ETFs: A Comprehensive Exploration

Before diving into Bitcoin ETFs, we must fully comprehend the foundational concept of an ETF. An Exchange-Traded Fund (ETF) is a security that encapsulates a variety of other securities—like stocks—and often mirrors an underlying index. Still, their scope can span across various industry sectors or they can employ numerous strategies.

In comparison to mutual funds, ETFs also list on exchanges and trade throughout the day akin to an ordinary stock. This makes them highly liquid assets, granting investors access to a wide spectrum of markets and sectors. Some ETFs are passively managed and adhere to a specific index, while others are actively managed.

Technically, ETFs utilize a structure that facilitates market participants known as Authorized Participants (APs), typically large broker-dealers. These APs create or redeem 'creation units', which are substantial blocks of ETF shares, often in-kind with the fund manager. This system ensures that the ETF share prices remain harmonized with the net asset value of the underlying assets.

At its core, a Bitcoin ETF is a fund that mirrors the price of Bitcoin, presenting a way for investors to engage with the Bitcoin market, bypassing the intricacies of direct purchase and storage of the digital currency. As these ETFs trade on conventional exchanges, they adhere to the same regulatory requirements as traditional ETFs.

Bitcoin ETFs can adopt various structures. Some may hold Bitcoin directly and trace its spot price (although no spot Bitcoin ETF has been approved yet in the United States — more on this later). Others might invest in Bitcoin futures contracts or form grantor trusts, holding Bitcoin while attempting to mirror a Bitcoin index. Regardless of the structure, each ETF provides investors with exposure to Bitcoin, though the extent of this exposure depends on the ETF's design.

Just like traditional ETFs, there are two main types:

Regular ETFs primarily trace a bundle of securities such as stocks, bonds, or a combination of both. The most prevalent type of ETF is the index ETF, designed to replicate the performance of a specific index. For instance, an ETF that traces the S&P 500 will retain the same 500 stocks that constitute that index, in the same proportions. These ETFs aim to match the performance of the index they trace as closely as possible, not to outperform it.

In a regular ETF, the fund’s assets are traded on the open market throughout the day, similar to individual stocks. The ETF's price can fluctuate based on the value of the underlying assets and market demand for the ETF shares.

Regular ETFs can provide diversification across different sectors, geographic regions, or asset classes, depending on the index they track.

Spot ETFs, conversely, trace the spot price of an underlying commodity or currency. The 'spot price' signifies the current market price at which an asset can be purchased or sold for immediate delivery. For example, a gold spot ETF will trace the current price of gold in the marketplace.

Unlike regular ETFs, spot ETFs invest in physical assets or their cash equivalents. In the case of cryptocurrencies like Bitcoin, the ETF might be backed by the actual holdings of the cryptocurrency.

Spot ETFs enable investors to gain exposure to price movements of commodities or currencies without needing to buy and store the physical asset.

Bitcoin ETFs confer several benefits over owning Bitcoin directly:

• Ease of use: Bitcoin ETFs eliminate the need for investors to manage digital wallets or interact with cryptocurrency exchanges, allowing them to buy and sell ETF shares on traditional exchanges using their regular brokerage accounts.
• Regulation: Bitcoin ETFs come under the same regulatory framework as traditional ETFs, providing an extra layer of protection and standardization.
• Liquidity: Due to their trading on major stock exchanges, Bitcoin ETFs often offer better liquidity and narrower bid-ask spreads than buying Bitcoin directly on a cryptocurrency exchange.
• Diversification: Bitcoin ETFs enable investors to gain exposure to the potential growth of Bitcoin while retaining a diversified portfolio.
• Tax efficiency: The 'in-kind' creation and redemption process associated with ETFs can offer tax efficiency. This mechanism enables investors to postpone paying capital gains taxes until the ETF shares are sold.

Despite the benefits, Bitcoin ETFs also bring certain risks:

• Volatility: Bitcoin's price is known for its extreme fluctuations, which can directly impact Bitcoin ETFs, leading to substantial gains or losses.
• Fees: Expense ratios associated with Bitcoin ETFs can erode potential returns. This factor is particularly relevant for investors accustomed to the low or zero fees on many cryptocurrency exchanges.
• Tracking error: There might be discrepancies between the performance of the ETF and the underlying Bitcoin prices, known as tracking error, caused by factors such as management fees or the influence of contango and backwardation on futures-based Bitcoin ETFs.
• Futures risk: Futures-based Bitcoin ETFs carry additional risks related to futures trading, including margin requirements, rollover costs, and the counterparty risk from the futures contract issuer.
• Regulatory risk: The regulatory landscape for cryptocurrencies is continuously evolving. Regulatory shifts can influence the viability and performance of Bitcoin ETFs.

In the journey of Bitcoin ETFs, several attempts made headlines before one finally saw the light of day.

Winklevoss Bitcoin Trust

Entrepreneurs Cameron and Tyler Winklevoss made the first move in 2013 with the Winklevoss Bitcoin Trust, a proposed ETF that would hold physical Bitcoins. The SEC, however, rejected the proposal in 2017 and again in 2018 due to concerns about fraud and market manipulation, and difficulties in monitoring Bitcoin trading happening mostly outside the U.S.

Bitwise Bitcoin ETF

Bitwise Asset Management was another hopeful with their Bitwise Bitcoin ETF in 2019. By tracking an index from 10 crypto exchanges and excluding exchanges with fake or inflated volumes, Bitwise aimed to address the SEC's concerns about market manipulation. Yet, the proposal was rejected, with the SEC citing insufficient evidence of resistance to manipulation.

The Wilshire Phoenix's United States Bitcoin and Treasury Investment Trust

The Wilshire Phoenix's United States Bitcoin and Treasury Investment Trust came forward in 2019. Their hybrid approach aimed to reduce volatility and risk by investing in both Bitcoin and short-term U.S. Treasury bills. Nevertheless, the SEC rejected the proposal, claiming Wilshire Phoenix didn't adequately address custody issues and couldn't prove its trust's consistency with public interest and investor protection.

ProShares Bitcoin Strategy ETF

After numerous rejections, ProShares finally succeeded in 2021 with the ProShares Bitcoin Strategy ETF. Instead of holding physical Bitcoins, this ETF invests in Bitcoin futures contracts, offering investment results corresponding to the S&P Bitcoin Futures Index. The approval of this futures-based ETF marked a significant milestone, albeit without an explicit endorsement from the SEC.

The success of ProShares prompted other fund sponsors like Valkyrie, VanEck, Invesco, and Galaxy Digital to launch their Bitcoin futures ETFs. However, the anticipation for a spot or physical Bitcoin ETF, which directly owns and tracks Bitcoin price, remains strong among crypto enthusiasts and investors for its perceived efficiency, transparency, and cost-effectiveness.

While the future of Bitcoin ETFs in the U.S. remains uncertain, Europe is forging ahead in this new financial frontier. Europe is set to make history with the launch of its first spot Bitcoin exchange-traded fund (ETF), slated for later this year. This follows a year-long delay in the launch of the Jacobi Bitcoin ETF, managed by London-based Jacobi Asset Management, originally scheduled for a July 2022 premiere on the Euronext Amsterdam exchange.

This fund offers a unique opportunity for investors seeking Bitcoin exposure without owning the cryptocurrency directly. The Jacobi Bitcoin ETF is a milestone for the European financial landscape, characterized by crypto-backed exchange-traded notes (ETNs) until now. It has won approval from the Guernsey Financial Services Commission (GFSC) in October 2021, underlining the growing acceptance of cryptocurrencies in traditional finance.

The product's notable difference lies in its central clearing mechanism and its custody, supported by Fidelity Digital Assets. This divergence from traditional financial instruments adds to the growing acceptance and recognition of digital currencies in the financial industry.

As Europe gears up for this significant shift in its financial landscape, anticipation builds over the SEC's decision on the multiple ETF applications filed in the United States. An affirmative verdict could prove transformative for the digital asset, potentially accelerating its uptake among mainstream investors.

Despite multiple applications from prominent investment companies like BlackRock, WisdomTree, Invesco, and VanEck, the SEC has been hesitant to greenlight a spot Bitcoin exchange-traded fund (ETF). Their hesitations stem from fears of fraud and potential market manipulation. But recent events suggest a potential shift in the regulatory landscape.

Fidelity’s Persistence and the Recent Flurry of Applications

Fidelity, a significant player in asset management, submitted its spot Bitcoin ETF application to the U.S. SEC for the second time in June 2023. Their previous application, filed in January 2022, was turned down. Fidelity is not alone in this pursuit, as several major asset managers, including the aforementioned BlackRock, WisdomTree, Invesco, and VanEck, have followed suit.

Tackling Manipulation Concerns: Collaboration with Coinbase

To tackle the SEC's concerns about potential market manipulation, Nasdaq declared its collaboration with Coinbase, the largest U.S.-based cryptocurrency exchange. Their joint aim is to ensure the integrity of trading in the Bitcoin market. Interestingly, the CBOE (Chicago Board Options Exchange) proposed a similar surveillance plan.

The Potential Impact of a Spot Bitcoin ETF

If approved, a spot Bitcoin ETF would simplify and secure investors' access to Bitcoin, eliminating the need for direct custody and transfer. This could lead to increased institutional adoption of Bitcoin. However, the SEC's reluctance to approve a spot Bitcoin ETF puts the future of these investment vehicles on shaky ground.

As the crypto community watches the approval process for spot Bitcoin ETFs unfold, the question remains: Will these investment vehicles become a reality in the U.S. anytime soon? The answer to this could define the future of institutional investment in cryptocurrencies.