Welcome to Structure Corner, a series of Spotlights where we use StructureFlow to help explain the complexity behind current and engaging commercial issues, harnessing the power of visualisation to do so.  In this Spotlight, we’re taking a look at Bitcoin Exchange-Traded Funds (ETFs). What exactly is an ETF and what has led us to cryptocurrency-linked ETFs?

Bitcoin ETF hits the NYSE

In 2021, major world markets have seen the launch of several new exchange-traded funds (ETFs) linked to cryptocurrencies.

Of particular significance, in October the US Securities and Exchange Commission (SEC) approved a crypto-linked ETF for listing on the New York Stock Exchange (NYSE) for the first time. Listed as ‘BITO’, the Proshares ETF will track futures contracts for Bitcoin, enabling investors to speculate on the value of Bitcoin without needing to buy any directly.

These developments represent a big step forward towards the cryptocurrencies becoming institutional-grade investments and have contributed to Bitcoin’s continued rise in value through the year.

But what exactly is an ETF and what has led us to cryptocurrency-linked ETFs?

What is an ETF?

ETFs are a type of investment fund.

Investment funds collect capital from investors and use it to invest in a range of stocks, bonds, or other financial assets. Different types of investment fund provide for variances in terms of the type of stocks or assets held, how those assets are managed, and how interests in the fund itself can be bought and sold.

They key attribute of an ETF is that interests in the fund are traded on a public market, in the same way as shares in public companies. This means they can be bought and sold easily and offer great liquidity, making ETFs attractive to traders.

By contrast, interests in mutual funds and hedge funds can’t be traded in that way. Interests in some mutual funds can be bought and sold daily, but in many examples of these types of fund capital is locked up for longer periods.

ETFs themselves typically fall into one of the following categories:

Stock ETFs, tracking a particular stock index. For example, the SPDR S&P 500 Trust, the world’s largest ETF, which tracks 500 of the most valuable companies in the US.

Sector ETFs, tracking the performance of a particular sector, through the holding of shares in companies within that sector. For example, the iShares U.S. Technology ETF tracks major US technology companies including Apple, Microsoft and Alphabet.

Commodity ETFs, that either physically hold the asset they are tracking, such as the Goldman Sachs Physical Gold ETF, or track the performance of a commodity by holding futures – contracts to buy or sell a specific commodity at a fixed price at a specified time in the future. The largest oil futures ETF is the United States Oil Fund, which has over $2.7bn in assets.

For more information about investment funds and examples of ETFs, please check out the charts below.

Why are we seeing Bitcoin-linked ETFs?

Over recent years, investments in Bitcoin and other cryptocurrencies have continued to gather momentum. Many professional investors predict that their value will continue to grow rapidly, whilst hedge funds expect to hold 7% of assets in cryptocurrency within 5 years.

More and more members of the public are looking to own and invest in cryptocurrencies as well, with a recent survey finding that 26% of US investors (having at least $10,000 in investable assets) own Bitcoin.

It therefore makes sense that ETFs focused on cryptocurrency would become hugely popular with professional and amateur investors alike – and that has proven to be the case. The Proshares ETF attracted more than $1bn in investment within two days of its initial launch, becoming the fastest ETF ever to reach that milestone.

Why Bitcoin futures?

So far, the SEC has only given approval for ETFs linked to Bitcoin futures contracts. It hasn’t yet given approval for an ETF that links directly to the spot price for Bitcoin despite a number of applications this year.

With a futures ETF, the ETF acquires short-term futures contracts, at the Chicago Mercantile Exchange. These contracts are for the acquisition of Bitcoin at a future date, but are always cash-settled, meaning that the Bitcoin is never actually acquired by the ETF. Whilst this enables exposure to the value of Bitcoin, this type of ETF is likely to underperform Bitcoin itself, because these contracts need to be continually ‘rolled over’ when they expire. The transaction costs of buying and selling these contracts must come out of the fund. Also, if the fund is forced to buy longer term futures contracts (perhaps because popular Bitcoin ETFs are all competing for the shorter-term ones), these can be more expensive than shorter ones, again adding to the costs of the fund.

By contrast, in Canada, approval for an ETFs that directly holds Bitcoin has been given, leading to the Purpose Bitcoin ETF launching in February 2021. A series of US-based funds are now looking to launch equivalent ETFs in Canada rather than waiting for the SEC to change its course.

The reason for the SEC’s ongoing caution is concerns about the possibility of “fraudulent and manipulative acts and practices” in the Bitcoin market, and the potential for related price volatility. As an example, it is considered that around 40% of all Bitcoin is held by around 1,000 people, who could theoretically send prices plummeting by selling even a portion of their holdings.

Many commentators are struggling to see how the SEC can approve an ETF based on futures contracts for Bitcoin, but not the asset itself. That is particularly so when considering the additional complexities of trading futures contracts, that some investors may not understand.

What next for cryptocurrency ETFs?

With the advent of crypto-linked ETFs, investors have a new way of investing in the world’s most valuable cryptocurrencies. Whilst having a more traditional route of exposure to the cryptocurrency market will be welcomed by many, some concerns around unpredictability remain. We will have to wait to see if the SEC and other major securities exchanges globally will follow Canada’s lead and approve ETFs linked directly to Bitcoin and the other cryptocurrencies.

Get access to the cryptocurrency & ETFs project in StructureFlow

To view our Cryptocurrency & ETFs project within the StructureFlow application and find out how you can harness the power of visualisation, please submit your details in the form below for access. This is the last in our spotlight series for 2021 but we will be back in 2022 so keep a look out on LinkedIn and our website for the start of a new series!