A Bitcoin ETF has been a topic that has kept the crypto world in suspense for a long time. This year, the topic has gained a lot of momentum as BlackRock has filed an application with the SEC for its own spot ETF. What are Bitcoin ETFs and why are they important to Bitcoin prices?
What is an ETF?
ETF stands for “Exchange Traded Fund” in German for exchange-traded funds. This is a financial instrument that replicates the performance of any index and can be traded on the stock exchange at the same time. With an ETF, the investor can invest in a shopping basket, just as is possible with classic funds, with the advantage of being easy to use. The ETF combines the advantages of conventional funds, such as: B. risk diversification with the advantages of stocks. ETFs track all possible asset classes such as stocks, commodities, bonds, indices, etc. If companies in an index ETF pay out dividends, these are passed on to the ETF holders. The theoretical history of ETFs began at the beginning of the 20th century. The effective introduction then began in the early 1990s.
How do ETFs work?
There are two methods to replicate an index. On the one hand, the issuer (publisher) of the ETF deposits the securities physically and on the other hand, the price is reproduced synthetically.
Physically replicating ETFs
Among physical ETFs, there are two models of how the value is represented. With full replication, the securities are held in exactly the proportion required by the index. For example, SAP’s share in the DAX is weighted at 10.49% at the time of writing this article. Siemens’ share is 8.76%. For a fully replicating ETF on the DAX, the ETF issuer would hold 10.49% SAP and 8.76% Siemens shares among the other companies listed in the DAX.
With partial replication, only parts of the index are reproduced, but these are weighted accordingly in order to accurately reflect the index. The resulting loss in risk diversification is offset by the lower costs of replication. Finally, there are indices with thousands of stocks such as an MSCI All Country World (MSCI ACWI), which make it difficult to manage all stocks cost-effectively. It is important to remember that the stocks in the index are constantly changing, so which ones are removed while others are added. The liquidity or availability of securities can be weak, which means that the acquisition costs are high.
Synthetic replicating ETFs
With synthetically replicating ETFs, the issuer does not have to hold the corresponding securities in the index itself. He concludes an agreement on a swap transaction with a third party, such as an investment bank. If the performance of the issuer’s arbitrary portfolio differs from that of the index to be tracked by the ETF, an exchange is made. If the performance of the portfolio is better than that of the index, the issuer pays the difference to the exchange partner (counterparty). If the performance is worse, the counterparty pays the difference to the issuer. In many cases, synthetic ETFs can be cheaper than physical ones. In addition, certain niche markets can hardly be represented with physical ETFs. Since synthetic ETFs are exposed to the risk of default by the counterparty, the counterparty can minimize this with additional collateral. The principle is also known from the crypto world. There, synthetic tokens such as stablecoins are often secured using over-collateralization, usually in a smart contract.
The history of Bitcoin ETFs
ETFs are very popular. The global trading volume (the major markets of the USA, Europe and Asia) amounted to over 12 trillion US dollars in the third quarter of 2023. Over 80% comes from the US market (source: Ishares ). Global cryptocurrency trading volume was around $1.2 trillion in Q3 2023, which is only a fraction of the ETF trading volume in the US. This shows how important the US market is and what potential it has. The trading infrastructure for assets is particularly well developed.
The USA is by far the country with the most advanced financial markets. It is therefore not surprising that there are efforts to issue a Bitcoin ETF there in order to benefit from this liquidity. In addition, ETFs are regulated, which provides the investor with a certain level of security in many things (tax handling, risk, etc.). ETFs are examined by regulatory authorities before approval in most countries. In the USA, the institution that takes care of this is called the SEC (Security and Exchange Commission).
The first steps began 10 years ago
The Winklevoss twins (founders of the Gemini crypto exchange) submitted the first draft of a Bitcoin ETF in 2013 ( Winklevoss Bitcoin Trust ). At that time, the price of a Bitcoin was around 90 US dollars. After years of adjusting the ETF with the ticker “COIN” (now occupied by Coinbase stock) due to influential events such as the Mt. Gox collapse or the Bitfinex hack, it was finally rejected by the SEC in 2017. The reason was that the risks were too high due to high volatility, market manipulation, potential attack vectors such as 51% attacks and a lack of market regulation. A second attempt by the Winklevoss brothers with some changes also failed in 2018.
Since 2013, more than a dozen Bitcoin ETFs have been rejected citing problems or a lack of investor protection. These were physically replicating spot ETFs as well as synthetically replicating future ETFs in all possible forms and designs. None could withstand the demands of the SEC.
The Chairman of the SEC in the 2017-2020 legislative session, Jay Clayton, made it clear what he thinks about Bitcoin ETFs. A low point was reached in August 2018. In a single day, the SEC rejected 9 Bitcoin ETFs.
Not all exchanges where digital currencies are traded have rules and monitoring to prevent manipulative techniques.
This was a bitter blow for the applicants and applications fell sharply in the near future due to the increasing hopelessness. However, the dream for a Bitcoin ETF in the USA remained intact and after 2 quieter years, the number of applications rose rapidly again under the new chairman Gary Gensler (since 2021). Gensler appeared more open to cryptocurrency ETFs, particularly Bitcoin.
The first Bitcoin Futures ETF
A handful of mutual funds have focused on pushing for a futures ETF since Gensler’s takeover, believing it has a higher chance of passing. The requirements for a futures ETF that does not display the price in real time, but allows you to bet on the price at a specific date in the future, are lower. In October 2021 the time had finally come. The first Bitcoin Futures ETF with the ticker BITO was launched on the New York Stock Exchange. Other futures ETFs followed soon after. The holy grail, the spot Bitcoin ETFs, still seemed out of reach.
Is there a Future for Bitcoin ETF?
A key event then occurred in the summer of 2022. Crypto investment company Grayscale has filed an application with the SEC to convert its Grayscale Bitcoin Trust (GBTC) into an ETF (more on that later). The regulatory authority also rejected this application. Grayscale didn’t let this go and took the SEC to court.
Then it was quiet again in the spot Bitcoin ETF world for around a year. On June 15, 2023, BlackRock, the largest asset manager, finally set a milestone. He submitted a well-crafted application, which many other providers followed days and weeks later. Including some who adapted previously rejected ETFs based on the BlackRock model and resubmitted them. At the time of writing, the following 12 providers have ETF applications pending with the SEC: Grayscale, 21Shares & Ark, BlackRock, Bitwise, VanEck, Wisdomtree, Invesco & Galaxy, Fidelity, Valkyrie, Global X, Hashdex and Franklin. The ticker of the ETF will be IBTC. The “I” at the beginning stands for BlackRock’s iShares ETF product group.
At the end of August, it was announced that Grayscale had won its case against the SEC. That is, a court found the SEC’s rejection of the ETF unlawful. This event did not immediately automatically approve the ETF, but the pressure on the SEC is increasing. In mid-October, news emerged that the SEC did not intend to appeal. Since then, the Bitcoin price has increased by around 30%. The probability that the spot ETF will come sooner or later has increased significantly. Observers assume that the SEC could confirm all ETF applications at once.
Why does Grayscale want to convert its trust into a spot Bitcoin ETF?
The Grayscale Bitcoin Trust is a Bitcoin investment fund and currently manages the largest Bitcoin assets with around 640,000 BTC. Public trading of the shares (1025 GBTC = 1 BTC) began in 2015. The goal of the trust, similar to an ETF, is to make investing in Bitcoin as easy as possible. However, the trust is a closed-end, passive investment fund. This means that the shareholders cannot easily redeem their share certificates for the deposited Bitcoin. However, Grayscale sometimes issues new notes to accredited investors. New Bitcoin is purchased and deposited to cover the notes. The amount of Bitcoin under management has increased over the years. This inflexibility leads to sometimes significant deviations (called premium) in the GBTC price from the Bitcoin price. It is not possible to adjust the prices through arbitration. GBTC is traded on OTCQX.
In addition, there is a 2% annual management fee for the trust, which is deducted from the amount of Bitcoin managed. The amount of Bitcoin is slowly shrinking in relation to the amount of shares, which devalues them in relation to Bitcoin. The chart image shows that GBTC trades higher than Bitcoin in bullish times and lower in bearish times.
An ETF does not have these disadvantages. The amount in circulation can be adjusted dynamically, which makes the depiction of the Bitcoin price much more accurate. In technical jargon, the deviation of the price of an ETF from the underlying asset to be represented is referred to as tracking error.
Because of these disadvantages of the trust compared to an ETF and the increasing likelihood that other ETFs will be approved as competing products, Grayscale is seeking to convert its Bitcoin Trust into an ETF. Investors will choose an ETF over a trust because they don’t have to deal with the premium.
Is Spot Bitcoin ETF Good?
Investors and especially large investors do not have to deal with the complicated handling of Bitcoin. Operating a wallet, protecting yourself from hackers, etc. are no longer necessary. They can simply bet on the real-time price (as opposed to futures) by purchasing the ETF in the regulated environment they know. A spot ETF would reflect the price of Bitcoin with a level of accuracy not achieved by other classic financial instruments such as GBTC. So there is still a gap here that a spot ETF could finally close.
In return, the properties for which Bitcoin was originally designed are lost, such as decentralization, self-custody, etc. Overall, however, the Bitcoin Spot ETF will be an advantage for the Bitcoin world. Investors can ultimately decide whether they want to hold Bitcoin physically or buy an ETF. The bottom line is that a Bitcoin ETF is likely to significantly boost the trading volume and thus the adoption of Bitcoin.
Gold ETF and Gold Prices
Bitcoin is often compared to the asset gold. Even SEC boss Gary Gensler has made this comparison several times. The first Gold Spot ETF was released for trading in Australia in 2003. The first spot ETF on the New York Stock Exchange, GLD, followed towards the end of 2004.
It is clearly visible on the chart that there was a strong bull market in the gold market from around 2004 to 2011. Institutional investors have exposed their portfolios to the gold price through gold spot ETFs. The price has increased approximately sixfold to a high in around 7 years. Optimistic investors expect similar developments for Bitcoin and tend to set their forecasts higher because Bitcoin is generally more volatile.
