The Bitcoin ETF season is upon us.
After a wait of eight years and multiple rejections from the Securities and Exchange Commission (SEC), a Bitcoin ETF finally made a record-setting debut in public markets. With a trading volume of slightly more than a billion dollars, the ProShares Bitcoin Strategy ETF (BITO) had the second-highest trading volume for any ETF ever. Only BlackRock’s U.S. Carbon Transition Readiness ETF (LCTU), which began trading in April this year, has generated more trading volume. ProShares’s ETF also mopped up the fifth-largest figure for assets under management (AUM) of $550 million at the end of its first day of trading, according to data from research firm Morningstar.
Bloomberg reports that interest in BITO is such that the fund is already poised to surpass its 2000 futures contracts limit set by for this month and has mopped up 1,400 contracts for November. (The fund needs to buy futures contracts in order to keep up with demand). BITO’s success has spilled onto its underlying asset’s price. Bitcoin price throttled into top gear, pushing past $66,000 on Thursday in wake of the fund’s success.
More ETFs are following ProShares. Valkyrie Investment’s Bitcoin Strategy ETF launched Friday and immediately fell 6% to $24 before recovering. As of this writing, it has inched up slightly to $25.24. Investment manager VanEck’s Bitcoin Strategy Fund is expected to begin trading on Monday.
The funds making their debut in public markets are futures-based, meaning their price is based on the trading price for futures contracts at the Chicago Mercantile Exchange (CME). Disappointed Bitcoin purists are still clamoring for an ETF based on the cryptocurrency’s spot prices. That scenario is unlikely to happen anytime soon (at, at least, this year), given SEC Chair Gary Gensler’s recent pronouncements.
Predictably enough, the Bitcoin cheerleading squad is out in full force discussing the “ravenous appetite” of investors for exposure to the cryptocurrency. According to reports, Grayscale Bitcoin Trust (GBTC), the other Bitcoin-linked product in trading markets is also considering changing its product to an ETF “to force the SEC’s hand”.
Not Quite a Main Street Offering
The argument for Bitcoin ETF was that it would ‘democratize crypto investing’ for retail investors. For all the celebrations and fist-pumping, however, a futures-based Bitcoin ETF is hardly the financial product to signal cryptocurrency’s entry into mainstream finance. It simply reiterates the speculative nature of Bitcoin trades and targets investors willing to take large risks with their money. It also does not solve the cryptocurrency ecosystem’s underlying problems. Most of those problems were laid out by the SEC in Jan 2018 letter, while explaining its rationale for rejecting multiple Bitcoin ETF applications.
Price manipulation in the underlying cryptocurrency markets or exchanges was a key concern. Cryptocurrency exchanges that set prices for Bitcoin are not regulated and have been accused of illegal practices to pump up their figures for volume. The CME’s Bitcoin Reference Rate (BRR) is calculated based on data collected from four exchanges – Coinbase, itBit, Kraken, and Gemini.
One of these exchanges is publicly-traded and none of them is registered with the SEC. Self-regulation, of the sort that is a feature of most commodity markets, is still struggling to find acceptance in the crypto ecosystem. In recent months, SEC chief Gary Gensler has tightened the argument for regulating cryptocurrency exchanges. An adverse regulatory action by the SEC against any one of these exchanges could throw BRR calculations into disarray and have a domino effect on futures prices.
A futures-based ETF is also hamstrung by the same volatility problem that has beset investment firm Grayscale’s products in the OTC market. GBTC trades at significant premiums and discounts to Bitcoin’s actual price. The double-wrapping of an ETF and futures places ProShares’s product at a similar risk. Front-running by traders, in which they purposely buy front-month contracts only to resell them to ETF providers at higher prices, could further inflate prices of these contracts and widen the price difference between Bitcoin and its futures contracts. They could also make the overall ETF more expensive for retail investors.
A variant of the situation described above are the costs associated with a contango – when front-month futures contracts are more expensive than an expiring contract. Prices for the new contracts can roll up to add to make BITO’s overall costs more expensive.
Portfolio turnovers and margin requirements for Bitcoin’s futures contracts are another problem. Bitcoin’s price volatility, a source of profits for those who can handle greater risk, could result in greater portfolio churn than average as the ETF readjusts its holdings to ensure returns for investors. Each portfolio turnover has tax implications that are passed onto ETF investors, who might be on the hook for more government liabilities due to the churn.
Margin requirements for Bitcoin futures contracts are also steep. When CME futures debuted back in 2017, the agency demanded 100 percent of the invested amount as margin money. In recent times, that figure has fallen to 50 percent but it is still higher than margins for other commodities. All of this means that ETF providers will need to dip into their investments in other assets – cash and securities – to make up for the shortfall as Bitcoin price rises and margins for the trade increase. Again, it could inflate fees and risk profile for these assets.
In the end, the argument for Bitcoin ETFs was based on providing access to the asset class minus risks to retail investors. But the current crop of ETFs is a risk-laden bet on Bitcoin prices.
An indication is the strategy adopted by brokerages offering these ETFs to consumers. When I invested in the ProShares Bitcoin Strategy ETF through my Fidelity self-directed retirement account, I was asked to change my risk profile to “Aggressive Growth” to safeguard the firm’s fiduciary obligations. Not surprisingly, research firm Vanda Research found that the only $7.68 million of the nearly $570 million mopped by the ProShares’s Bitcoin Strategy Fund on its first day of trading came from retail investors.