Roads to an Australian Bitcoin ETF - Part 1

BRISBANE, February 16, 2022 – In the first of a multi-part series on Bitcoin’s investment market evolution, Monochrome examines the journey taken in US markets to launch a Bitcoin ETF.

As Bitcoin matures and is recognised as a potential institutional investment asset and local investors anticipate the launch of an Australian Bitcoin ETF, Australian investors may find value in the journeys undertaken by other markets across the globe.

Beginning this series, Monochrome will offer insight on the development of US markets, culminating in the second largest ETF launch in history.

Why Bitcoin, Why an ETF?

A Bitcoin ETF provides an accessible regulated onramp for considerable capital to flow into bitcoin from both institutional and retail investors alike. Regulatory requirements also need to be considered by institutional investment firms if they want to buy and store bitcoin for themselves. An ETF would bypass many of the technical and legislative hurdles currently faced by institutional and retail investors.

The Securities and Exchange Commission (SEC) stands central to the story of US Bitcoin ETFs, having rejected or delayed a number of ETF applications from companies like Fidelity, Gemini, Grayscale, VanEck, Valkyrie, Kryptoin, SkyBridge, and others. The current majority of bitcoin trading occurs on unregulated exchanges across the globe that are not, and cannot, be monitored by the SEC.

A long and layered history

In 2013, Tyler and Cameron Winklevoss filed for the first Bitcoin ETF as a way for investors to gain exposure to the nascent asset class. Following a March 2017 rejection, the twins applied again in July of 2018 but were rejected by the SEC a second time due to the unregulated nature of dominant markets and perceived potential for fraud and price manipulation.

It would take three years for concrete progress to be made in the US. In October 2021, new Chairman of the SEC Gary Gensler began to provide direction on the pathway to a US Bitcoin ETF. This direction identified a futures-based ETF, rather than the long proposed spot-based offerings.

The SEC indicated that the perceived potential for fraud and price manipulation, lack of market flow transparency, and insufficient benchmarking, was behind their reasoning. This stands in contrast to European and Canadian markets which have shown greater engagement with the notion of a spot ETF, highlighted by the Toronto Stock Exchange-hosted, and spot-based, Purpose Bitcoin ETF (BTCC).

In lieu of regulated investment vehicles, investors migrated to alternate means of exposure, often in the form of digital currency exchanges (DCEs) and proxy investments in companies such as Coinbase (NASDAQ:COIN).

The US Bitcoin ETF race is won

Following SEC guidance, a US market breakthrough was made on October 19th 2021, as the ProShares Bitcoin Strategy ETF (BITO) received approval and entered NASDAQ trading.

The BITO ETF attracted more than US$1.1 billion in trading volume within its first two days of trading. This placed BITO as the second largest launch in ETF history.

BITO is based on futures contracts that are traded on the Chicago Mercantile Exchange (CME). In order to gain bitcoin exposure through futures contracts, the BITO fund enters into long positions that are near-term (one month). As expiration dates get closer, the fund will gradually sell their expiring positions and then buy longer dated contracts.

Second place and consolation prizes

Three days after the BITO launch, Valkyrie Fund’s Bitcoin Strategy ETF (BTF) was approved and began trading on the NASDAQ on October 22nd, 2021. In contrast to BITO, the demand for BTF was not nearly as high with $78 million worth of BTF shares traded on debut.

While both ETFs have an expense ratio of 0.95%, the main difference between the two is the average spread and assets under management. BITO has an average spread of 0.05% and $950 million under management while BTF has a slightly higher 0.09% spread but a much lower $12.39 million under management.

An alternate variant of the futures ETF recipe

Following the release of BITO and BTF, market hype around futures-based Bitcoin ETFs seemed to subside in relation to trading volume and inflows. Long-standing fund provider VanEck would look to test this via the launch of the VanEck Bitcoin Strategy ETF (XBTF).

While the first two US Bitcoin ETFs are very similar and were released within a few days of each other, VanEck’s XBTF ETF trailing offering provided a point of differentiation. XBTF began trading at Cboe Global Markets on November 16th, 2021 while providing investors with an expense ratio of 0.65% (32% lower than BITO’s and BTF’s expense ratio). XBTF saw $9.5 million in assets under management with a trading volume of $4.6 million for the first day.

US Futures-Based Bitcoin ETF Fee Comparison

US Futures-Based Bitcoin ETF Follow-up Figures

*As at February 4th, 2022

Futures-based ETF Limitations

While a futures-based ETF provides a convenient and regulated onramp for investors to gain bitcoin price exposure, investors should be aware of the limitations imposed by a futures structure.

Contango - Contango occurs when futures prices (in this case bitcoin futures) are higher than the underlying spot prices. By the time the futures contracts are meant to expire, the price of the futures contracts will gradually converge to the same price as the spot price. The further away the expiration date of a futures contract, the more speculative the futures price can be. Whenever contango occurs, this causes long term holders of bitcoin to lose value in their position.

Divergence from underlying asset price - With a contango scenario where the prices of futures contracts can be speculatively increased, the opposite may also happen where backwardation occurs. This is when the futures price is below the spot price of a product.

Bitcoin futures ETFs are not backed by bitcoin - An ETF backed by futures will tend to be higher or lower than the actual bitcoin price. Without having bitcoin to back the ETF, shares for a bitcoin futures ETF may then be diluted if more shares are created to be sold on the open market. This increase in shares will decrease shareholder value. In the opposite scenario where an ETF is backed by bitcoin, the fund would be obligated to disclose how much bitcoin they hold which makes it easier to determine the underlying value of the ETF fund.

What’s next in understanding the journey to a Bitcoin ETF in Australia?

Topics such as the global adoption of Bitcoin, development of regulation and financial products are complex enough to warrant more than a cursory glance - even more so when one intends to engage with the nascent asset in question.

It is for this reason that Monochrome is diving deeper into the details, with the intent to provide a comprehensive and accessible reference point that touches on the details otherwise left astray.

As we progress through this series, Monochrome will examine topics including:

• The important roles of Canada and Europe
• Some of the novel but ultimately unsuccessful Bitcoin ETF proposals
• The importance of product structure
• Why crypto industry asset baskets may not be the answer investors are looking for

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