Bitcoin in an ETF

Introduction

Australian Bitcoin ETFs have been long demanded, and for good reason. They offer a regulated investment vehicle for wholesale and retail investors alike to invest their capital into bitcoin, while bypassing many challenges encountered with unregulated pathways.

Here, we will discuss various factors regarding Bitcoin ETFs including:

• What is a Bitcoin ETF?
• ETF costs
• Price discovery
• Asset proximity
• The importance of benchmarking
• Comparison between futures-backed and spot Bitcoin ETFs.
• What sort of Bitcoin ETF is best for me

What is a Bitcoin ETF?

An Exchange Traded Fund (ETF) is an investment product that allows investors to purchase a basket of assets.

Generally, an ETF provides a more diversified and less risky option for investors who seek exposure through a passively managed fund. This differs slightly when one looks at what are commonly labelled “Bitcoin ETFs”.

A Bitcoin ETF is an investment product that has either direct or indirect exposure to bitcoin’s price. Rather than using a basket of equities (for example, a mixture of crypto industry shares), a Bitcoin ETF will seek to gain exposure to the underlying price action of bitcoin as a singular asset. Bitcoin ETFs are becoming more widely offered throughout the world in a variety of forms to suit differing investment theses.

Costs

For ETFs in general, costs that an entity will typically face come in the form of fees and the bid-ask spread.

There are generally two types of fees associated with ETFs; transaction fees and management fees.

A transaction fee is a fee charged by an exchange for allowing you to transact units of an ETF on their platform. Transaction fees are incurred for buying or selling any type of financial instrument, be this Australian or international equities, or futures or options contracts. As such, they are not exclusively incurred by entities transacting units of an ETF. Transaction fees vary from platform-to-platform, and the larger the total investment, the smaller the percentage they represent of the total investment.

A management fee is a fee charged by an ETF for managing investors’ funds. Management fees compensate the ETF provider for all the costs associated with managing the ETF, such as custodial fees, accounting and auditing fees, and index licensing fees, and are generally included in the unit price of the ETF. In Australia, crypto ETFs (both direct and indirect) typically have a management fee premium over other ETFs due to a heightened perceived risk profile, overhead cost (including crypto custody) and volatility.

ETFs, being exchange-traded, also face a bid-ask spread. At any given time, an ETF will have a bid price, which is the highest price one will buy a unit of the ETF, and an ask price, which is the lowest price someone will sell a unit of the ETF. The smaller the bid-ask spread of the ETF, the less it will cost to trade. Typically, the greater the volume of units traded of the ETF, the smaller the bid-ask spread will be.

Price Discovery

The price discovery of an asset is the process followed by the interaction of buyers and sellers, which allow for the fair price of an asset to be determined. As such, the process of price discovery is solely driven by the channels through which buyers and sellers can interact and transact the asset in question.

Asset Proximity

Typically, the price of the ETF is tied to, and is therefore in close proximity to, the ETF’s Net Asset Value (NAV). Therefore, the level of demand for a particular ETF should not directly impact the price of the ETF. Instead, the price will be primarily determined by the underlying assets being traded.

Benchmarking

In the context of a fund's performance, a benchmark is a target against which the performance of the financial asset is compared against.

Benchmarks are important as they allow the investor to accurately gauge the performance of a financial asset.

For Bitcoin ETFs, the relevant benchmark would be a reference rate such as the CME CF Bitcoin Reference Rate. When a fund lacks a benchmark, the investor is unaware of the relative performance of the fund versus the underlying basket of assets it purports to represent.

Types of ETFs

There are two primary types of Bitcoin ETFs; futures-backed, and spot. Though both types of ETF may present viable use cases, spot Bitcoin ETFs are considered to be superior to futures-backed Bitcoin ETFs for investors seeking “direct” exposure to the price movements of bitcoin.

Bitcoin Futures ETFs

Futures-backed Bitcoin ETFs are based on bitcoin futures contracts. These ETFs gain exposure to bitcoin futures by entering into long positions on bitcoin futures contracts with relatively short expiry dates, and rolling these over into a new futures contract when the contract is about to expire.

There are three key disadvantages of a futures-backed Bitcoin ETF compared to a spot Bitcoin ETF.

Firstly, futures-backed Bitcoin ETFs are prone to what is known as contango. Contango occurs when the price of the bitcoin futures contract is higher than the price of bitcoin in the spot market. This is a disadvantage as it causes the price of bitcoin futures contracts to be more speculative, and for long-term holders of physical bitcoin to lose value in their position, as they can instead hold the bitcoin futures contract.

Secondly, and very similarly, a bitcoin futures contract can experience divergence from the underlying asset price. This occurs when the price of the bitcoin futures contract is below the spot price of the physical bitcoin.

Lastly, futures-backed Bitcoin ETFs are not backed by physical Bitcoin. Some investors (with strategies built around pure asset price appreciation, for example) may consider this a disadvantage as futures-backed Bitcoin ETFs do not contribute as much to the price discovery of bitcoin as opposed to a spot Bitcoin ETF.

Bitcoin Spot ETFs

On the other hand, spot Bitcoin ETFs are a physically settled Bitcoin ETF. A properly benchmarked spot Bitcoin ETF trades with close proximity to the price of bitcoin in the spot market, rather than a futures contract offering what investors would consider closer exposure to bitcoin as a direct asset.

There are two key advantages of a spot Bitcoin ETF over a futures-backed Bitcoin ETF.

Firstly, it is much easier to determine the net asset value of a spot Bitcoin ETF rather than a futures-backed Bitcoin ETF. This is because every share of the ETF represents a portion of bitcoin held by the fund.

Secondly, investing in a spot Bitcoin ETF contributes to the price discovery of bitcoin. As mentioned prior, price discovery of bitcoin as an asset may be crucial to some investor strategies when considering exposure. As a spot Bitcoin ETF trades on the price of bitcoin in the spot market, there is more potential for price discovery.

What sort of Bitcoin ETF is best for me?

As with most investment considerations, there is no one-size solution for all investors. Many factors will influence both the suitability of Bitcoin in an investment portfolio, as well as the product which best suits exposure. Some of these factors include risk appetite, investment time-frame, custody considerations and structure of investment.

Investors who wish to learn more about integrating a Bitcoin ETF into their portfolio can discuss such with their professional financial advisor.

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