What is a Bitcoin ETF

A Bitcoin ETF Guide for Beginners

As a new way of trading and investing in crypto technology, Bitcoin ETFs made headlines in 2018.

What is an Exchange Traded Fund (ETF)?

As a new way of trading and investing in crypto technology, Bitcoin ETFs made headlines in 2018. Proponents of ETFs describe them as tools to promote Bitcoin adoption and as an acronym for unlocking the full potential of cryptos for investors.

However, despite their association with Bitcoin, exchange-traded funds aren't exactly a new technology. As an investment vehicle, ETFs have been present in the financial markets for more than two decades, bundle around $ 1 trillion in assets under management, and hundreds of copies are launched every year. Getting to know Bitcoin ETFs is best started with getting a clear picture of what non-cryptographic ETFs actually are and how they are used:

  • An exchange traded fund is a fund or security that is essentially used to track the prices of the underlying assets on which it is based. These can be "traditional" assets like gold or oil, as well as other commodities, bonds, stocks and even cryptocurrencies like Bitcoin. With an ETF, it is possible to hold the assets to be tracked in custody, followed by the issuance of shares confirming ownership of those assets.
  • Exchange-traded funds behave similarly to traditional stocks, at least in the sense that they can be traded on regular exchanges. Their surge in popularity is largely due to their perceived selling and buying potential, as well as their solid liquidity. For an investor intending to buy the underlying asset of an ETF, they are often a more accessible option than trading the assets themselves. This level of trading convenience extends to Bitcoin, which this cryptocurrency recommended for an ETF model in the first place .

How does a Bitcoin ETF work?

As there is some misunderstanding about the real potential of the ETF, it is generally advisable to learn as much about how it is managed and how it is set up before investing in it.

First of all, one has to understand how the ETFs are created, including those based on Bitcoin:

  1. A potential custodian (a bank, an asset management company, or even a cryptocurrency exchange like Coinbase) picks up the funds from investors and buys stocks associated with the underlying asset. Parties responsible for buying underlying assets for the benefit of the ETF are known as Authorized Participants. In the case of Bitcoin, a custodian buys positions in Bitcoin or its futures contracts by spending the investor's funds.
  2. Authorized participants distribute the assets to the ETF providers in exchange for the shares in the fund. The value of these shares is proportional to the value of the assets received by the ETF providers. On this basis, the investors take on the role of the fund's shareholders without becoming the actual owners of the underlying asset to be tracked, be it gold or bitcoin.
  3. ETFs should be approved by the securities market regulator before they are made available on exchanges. But despite the push to approve Bitcoin-based ETFs in the US and Europe, regulators have now abolished more than a dozen attempts to approve them. The reasons given have to do with concerns about price manipulation and the security of the underlying cryptocurrency value. The first rejection came back in 2013 when the Winklevoss brothers tried to set up their Bitcoin Trust. Still, the optimists hope that the first Bitcoin ETFs will be approved either in 2019 or 2020.
  4. Once the ETFs are on the exchanges, they can be bought and sold and the decisions made about them can result in either a profit or a loss for the investor. The ETFs also include the management fees, which are covered by a reduction in the net asset value (NAV) of the ETF. Because ETFs behave like traded stocks, their price can fluctuate during the trading day depending on supply and demand.

What could be the benefits of Bitcoin ETFs?

Institutions and private investors can use the ETFs as an opportunity to use Bitcoin as an asset class that is publicly traded for the first time. Proponents of ETFs present the Bitcoin ETF as an investment model that is said to offer some important advantages:

  • Bitcoin and other cryptocurrencies would receive much-needed exposure and validation from global financial markets. Bitcoin ETFs are believed to be an easier way to raise awareness of the growth of blockchain technology without forcing investors to get involved in potentially risky token sales or complex blockchain-based projects.
  • Because ETFs have long been traded as stocks on the stock exchanges, they have already gained significant popularity with both institutional and retail investors. ETFs are an established type of security and are often viewed as stable, liquid and easy to buy, sell, or sell short.
  • The hopes of the advocates of Bitcoin ETFs aren't limited to just professional investors: the way the ETFs travel should mean being able to distract the exchanges, which makes buying and selling bitcoins a little easier, even for the average user. Investors would not have to deal with cryptocurrency exchanges as they can easily buy and sell the ETF using "traditional" exchanges.
  • Bitcoin ETFs arguably represent a more flexible option for short, medium, or long-term investments, as opposed to Bitcoin futures, which are often described as better suited for short-term endeavors.
  • Better regulated status of Bitcoin ETFs should help legalize the status of Bitcoin as an asset as well. Combined with potential tax benefits, less room for market manipulation and less volatile trading, the ETFs are seen as potential stabilizers of Bitcoin as a project.
  • The more optimistic among Bitcoin ETF supporters see them as an opportunity to bring Bitcoin's price and reputation back to pre-its ongoing crisis levels. Investors' hopes are centered on the potential of Bitcoin ETFs to divert the flow of money into the global Bitcoin market. This is especially important for the funds that come from institutional investors such as banks or hedge funds. Once your money is fed into the ETFs, the price of Bitcoin should follow and become more stable.
  • Finally, Bitcoin ETFs can also benefit institutional investors such as mutual funds and pension funds as they can expand their portfolios with cryptocurrency exposure in a more regulated manner.

Bitcoin ETFs vs. direct investments in Bitcoin

In addition to the proposed benefits, Bitcoin ETF supporters must also convince potential investors that investing in the ETFs is as attractive an option as investing in Bitcoin itself. In other words, they must find a realistic justification for using the investment intermediaries when investors know that the Bitcoin ETFs actually only reflect the price of the currency itself. Still, Bitcoin ETF supporters claim that working with ETFs has some advantages that direct investing in Bitcoin cannot:

  • ETFs would make it easier for investors to invest in cryptos and speculate on their prices without dealing with the technical issues like storing coins, creating wallets, security procedures, etc.
  • Bitcoin ETFs should give investors access to the services of regular brokers. In addition to feeling secure when investing in this way, investors would not have to deal with security-related issues such as hacking, theft and others. The ETFs would be insured against these risks, and the custodians can be required to only adhere to transparent data sources in connection with transactions in Bitcoin. All of these efforts should increase the confidence of both investors and crypto market participants.
  • The ETFs are considered the tools to attract money from investors who are familiar with the ETF format but know much less about Bitcoin technology and are unwilling to learn from it.
  • Since Bitcoin ETFs act like investment vehicles, investors could short sell their ETF stocks if they decide that Bitcoin prices will suffer another slump. This is not an option in the standard cryptocurrency markets.

What are the potential weaknesses of the Bitcoin ETF model?

While Bitcoin ETFs attracted a lot of attention from their followers over the course of 2018, their opponents highlighted some of the potential weaknesses of this model:

  • The issue of ETF custody and regulatory oversight is a critical obstacle to wider application of the Bitcoin ETF model. Regulators like the SEC are reluctant to approve ETFs because they want them to be backed by physical bitcoins stored by authorized institutions or third parties. This is hardly possible because bitcoins are not a physical commodity (like gold or oil). Financial institutions that want to become active in the crypto sector have to decide whether they want to develop and implement their own storage and custody solutions or use those of the established players in the crypto world.
  • Another problem is the fact that Bitcoin futures trading still lags behind that of mature assets like oil or gold. Lower trading volumes make it difficult for the ETF to obtain official regulatory approval.
  • ETFs' use of the custodial system can discourage users who want more control over their bitcoins rather than handing it over to a custodian.
  • Since bitcoins are controlled by a third party, no matter how "trustworthy" they are, investors would have little or no say in deciding the future development of governance and consensus mechanisms in the Bitcoin protocol itself.
  • For example, the SEC also cited the potential risk of fraud and tampering as one of the main reasons for denying approval of multiple Bitcoin ETF applications. This body also referred to the inability of the applicants to stop or prevent fraudulent practices to which investors may be exposed. With this in mind, ETFs can also be seen as an incentive to introduce Bitcoin for the purpose of speculation rather than being used as real currency.
  • There are even some fears that instead of ETFs pushing the price of Bitcoin down, this model would actually cause Bitcoin price spikes. Removing a large amount of Bitcoin from circulation can make the first global cryptocurrency even more scarce and destabilize as an asset.

Differences between Bitcoin ETFs, Blockchain ETFs, ETNs, and ETPs

Bitcoin ETFs shouldn't be confused with blockchain ETFs, despite their superficial similarity. For one, the difference between the two reflects that between Bitcoin as a cryptocurrency and blockchain as the underlying technology.

Blockchain ETFs are used to track the prices of companies that invest in blockchain as a technology, especially in the case of companies that use it as a transformative technology. In this case, the blockchain is treated as a technical solution and therefore cannot be used with a specific product or industry.

A Bitcoin ETF can also be confused with Bitcoin-based Exchange Traded Notes (ETNs), which are similar to ETFs but have some important differences:

  • ETNs are structured products that are issued as senior debt notes. In contrast to them, ETFs represent a participation in an underlying asset.
  • ETNs behave in a way that is more similar to bonds in the sense that they are unsecured. In contrast to them, ETFs offer investments in a fund that holds the assets it tracks, such as stocks, bonds, or gold.
  • ETNs have a less rocky reputation with regulators for their legal status - Bitcoin ETN, for example, has been traded on the Swedish stock exchange since 2015 and is offered in euros and kroner as the Swedish national currency.

Exchange traded products (ETPs) related to cryptocurrencies have also been confused with ETFs, despite their differences:

  • ETPs are a type of securities that are derivative-priced and traded on a national stock exchange within a day.
  • ETPs are passive investments, which is what sets them apart from ETFs. However, investment instruments such as commodities, currencies, share prices or interest rates can be part of an ETP. These funds can function like actively managed funds, including ETFs.
  • Crypto ETPs are already available on the market (e.g. the Bitcoin Investment Trust from Grayscale Investment).