Bitcoin ETF - the holy grail?

In this article, we will give an overview and explain what an ETF is in detail, we discuss the pros and contras of a BTC ETF and we will give a detailed view of the most promising proposal.

What is an ETF? 

ETF stands for exchange traded fund, which is basically a security that tracks some underlying assets (for example equities, bonds or commodities). The issuer of the ETF takes custody of the underlying assets it tracks and then issues a number of shares that represent ownership. These shares can be easily traded (like stocks) and therefore remove a lot of barriers for investors who are willing to invest in this particular asset. 

If an ETF-issuer wants to create new shares, they turn to an authorized participant (AP). An AP is someone who is responsible for purchasing the underlying assets an ETF wants to hold. APs require a license from the ETF provider and then buys the underlying asset on behalf of the ETF-issuer. Subsequently, the AP sends these freshly purchased assets to the ETF-issuer and then ETF provider sends shares of the fund back to the AP. The value of these shares is equal to the assets the ETF provider just received.

The redeeming process works in the opposite direction: AP sends ETF shares it wants to redeem to the ETF provider, which then returns the underlying assets back to the AP.

There are times when the price of the ETC can become higher than the price of its underlying assets, or net asset value (NAV). Then the ETF is said to be trading at a premium. If the ETF is trading below NAV it is called trading at a discount. The AP arbitrages premiums and discounts to keep the market price tightly coupled to the NAV. 

What is the benefit of a BTC ETF?

The shares of an ETF can easily be obtained and traded and lowers the barrier of entry for investors. With Bitcoin, these barriers are buying the asset and, most of all, safe storage of the asset. A BTC ETF enables technologically inexperienced investors to profit from BTC price movement without going through the hassle of securing their private keys. Hedge funds, pension funds, and 401ks can easily invest in this ETF, so we expect a lot of new capital to flow in Bitcoin. Increased capital inflow decreases volatility and therefore making BTC more stable.

What types of Bitcoin ETFs are proposed?

There are two types of Bitcoin ETF proposals:

  1. ETFs that Physically Hold Bitcoin (VanEck & SolidX ETF)
  2. ETFs that Purchase Bitcoin Derivatives (ProShares, GraniteShares, Direxion)
ETFs that physically hold Bitcoin

This type of ETF owns the underlying asset it tracks. Every share is backed by the real deal.
  • low transaction costs
  • tracks the performance of the underlying asset directly
  • high liquidity
  • counterparty risk (custody of the asset)
  • ETFs can only be traded through specific daytimes where the BTC market is open 24 hours

ETFs that purchase Bitcoin derivatives
The second kind of ETF does not actually hold any Bitcoin. Instead, the ETF tries to mimic the performance of Bitcoin by trading Bitcoin futures, options, swaps, money market instruments.
  • no worrying of custody of BTC, since these types of ETF don't hold BTC directly
  • approximating the performance of Bitcoin
  • active management risk
  • active management cost
  • margin call risk
  • leveraged trading risk
  • rollover risk
ETFs that are holding physically Bitcoin are far superior to the derivatives-based one. And I expect the first type to havesignificant higher chances of approval. BTC-futures are only a few months old and I cannot imagine that the SEC will approve an
ETF that tracks these highly speculative and brand new derivatives as underlying.

Requirements of the SEC 

The U.S.- Securities and Exchange Commission (SEC) has certain requirements for an ETF to be approved:
  • Custody solutions
  • immune to manipulation
  • sufficient liquidity
  • correct valuation of the NAV

Current situation

All derivatives-backed ETFs were rejected by the SEC on August 23. These ETFs were filed by ProShares and Direxion.
The decision came down to the risk of market manipulation & fraud. The SEC can only approve an ETF that is designed to prevent fraudulent and manipulative acts and practices. The Winklevoss ETF (backed by the underlying asset) was rejected earlier this month. The main argument for rejection was the fact that the price determination of the NAV would only happen on the Gemini exchange (which is owned by the Winklevoss twins). The only remaining big proposal is the ETF from VanEck & SolidX which backed by the CBOE (Chicago Board of Options).

The VanEck & SolidEck ETF proposal backed by the CBOE

This proposal is vastly superior to prior ETF proposals and addresses most of the concerns the SEC has expressed when rejecting prior ETF applications. Reasons are:
  • holds physical BTC
  • backed by the CBOE, which is a very serious institution
  • shares are big (25 BTC = 1 share), this excludes retail investors 

Involved parties:
Fund: SolidX Bitcoin Shares.
Filer/Exchange: CBOE BZX Exchange.
Trust/Fund Issuer/BTC Custodian: VanEck SolidX Bitcoin Trust.
Trust’s Sponsor/Manager: SolidX Management.
Trust’s Administrator & Cash Custodian: BNY Mellon.
Marketing Agent: Foreside Fund Services.
Marketing: Van Eck Securities Corp.

The whole proposal can be viewed here:
VanEck & SolidX Bitcoin ETF proposal

Comparison with a Gold ETF

The SEC approved the streetTRACKS Gold Shares ETP even though the spot gold market were largely unregulated.  
On March 28, 2003, the first gold-backed ETF, developed by ETF Securities, was launched. It trades on the Australian stock exchange as the ETFS Physical GoldGOLD, +0.06% with assets under management at about $602 million.
“We can certainly track the growth of gold ETFs since their invention, and see how investor interest in gold has grown significantly,” said Will Rhind, managing director of U.S. operations for ETF Securities. Globally, there are now 143 gold ETFs available, with the latest data showing assets under management at roughly $132 billion, he said.

In the first few years after the first Gold ETF was introduced, the Gold price rose by over 600%. The ETF lowered the barrier of entry for many investors.

Final deadline

The Sec can postpone the final decision until 21. February 2019 and we expect them to do so. The developement of Bitcoin markets made big leaps forward since the filing for the Winklevoss ETF, for example we have now very advanced custody solutions (from Coinbase for example) and with increasing lliquidity volatility decreases. So we can finish this article with a positive outlook.

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