Understanding the Fundamentals of Bitcoin ETFs

Bitcoin Exchange Traded Funds (ETFs) are revolutionising the way investors engage with digital assets, by bridging the gap between bitcoin and traditional financial markets. They provide a regulated pathway for investors to gain bitcoin exposure.

In this article, we explore the fundamentals of spot bitcoin ETFs including:

• What is a spot bitcoin ETF?
• Why invest in a spot bitcoin ETF?
• How does a spot bitcoin ETF work?
• Advantages of a bitcoin ETF
• Disadvantages of a bitcoin ETF
• What about spot bitcoin ETFs in Australia?
• The regulatory environment for spot bitcoin ETFs

What is a spot bitcoin ETF?

A spot bitcoin ETF is a managed fund that is traded on public stock exchanges, similarly to a share, and aims to passively track the price of bitcoin.

Why invest in a spot bitcoin ETF?

The core rationale of a spot bitcoin ETF is it provides investors with exposure to bitcoin price movements without having to own the digital currency directly. Investors who wish to purchase their own bitcoin, need to manage certain key risks including those around purchasing and storing their bitcoin. Investors who purchase and store bitcoin on an exchange, may lose all of their bitcoin if the exchange becomes insolvent. Investors who store their bitcoin in hard wallets may, for any number of reasons, lose their wallet seed phrase and lose access to their bitcoin forever.

A spot bitcoin ETF solves many of these concerns by being a low cost option to outsource many of the risks of direct bitcoin ownership to professional managers and custodians, allowing investors access to this asset class in a familiar investment vehicle traded on public stock exchanges.

How does a spot bitcoin ETF work?

Spot bitcoin ETFs operate on primary and secondary markets. To create new ETF units, primary market participants, usually large financial institutions, give the ETF a basket of bitcoin or cash payment - the ‘creation basket’ - and in exchange they receive a block of new ETF units with the same value as the creation basket. The primary market participant then sells those new ETF units to retail investors in the secondary (or ‘lit’ market). To redeem ETF shares, this process happens in reverse.

The Net Asset Value (NAV) of the ETF is calculated at the end of each trading day by taking the assets of the fund, subtracting its liabilities and dividing this by the number of ETF units on issue. The NAV is published daily and primary market participants create and redeem ETF units based on the NAV price. ETF issuers are also required to publish an indicative NAV (iNAV) throughout the trading day which changes based on real time changes to the bitcoin price and allows investors to track the fair price of units in the ETF and compare it to realtime bitcoin market prices.

Although the price of ETF units on the lit market rarely deviates much from the NAV, it can do so due to supply and demand. When it does deviate from the NAV, primary market participants step in to profit from this arbitrage opportunity and in doing so to bring the ETF unit price back close to the NAV.

For example, assume the price of an ETF unit drops below the NAV, because demand has dropped relative to current supply. A primary market participant can buy ETFs on market and deliver them to the ETF issuer in exchange for the underlying bitcoin, and then sell the bitcoin on market. The difference between the paid for ETF unit price and the amount received by the primary market participant for selling the bitcoin on market is their profit. The purchase of ETF units pushes up their price in the lit market until it is again in line with the NAV. The same occurs in reverse.

Advantages of spot bitcoin ETFs

Spot bitcoin ETFs offer investors several benefits. They allow investors to gain exposure to bitcoin without dealing with the complexities of buying and storing the cryptocurrency themselves. They are a familiar regulated investment vehicle making them easy to integrate into existing portfolios as an alternative asset. Spot bitcoin ETFs are retail products and as such have those additional layers of investor protections that retail products offer, that is, compared to crypto exchanges which are largely unregulated and offer investors minimal protections and can be vulnerable to hacks and loss of assets.

Disadvantages of spot bitcoin ETFs

However, unlike crypto exchanges that normally operate 24 hours of the day, 7 days of the week, spot bitcoin ETFs can only be traded during stock exchange trading hours. Bitcoin ETFs also charge a management fee, which is a factor investors need to consider when analysing their investment options.

What about spot bitcoin ETFs in Australia?

Globally, there are a number of spot bitcoin ETF applications being considered in various jurisdictions. In Australia, Monochrome Asset Management has lodged an updated application with the ASX to have the Monochrome Bitcoin ETF (IBTC) quoted on that exchange. IBTC will be a spot bitcoin ETF that will have direct and physical exposure to bitcoin but with the added feature that investors can either sell their units on the ASX, or redeem units in the ETF in exchange for physical delivery of the underlying bitcoin to a digital wallet of their choosing.

Regulatory environment for bitcoin ETFs

Regulators play a key role in bringing these ETFs safely to market, particularly given they hold a financial asset which has existed for only 15 years. In January 2024, the US Securities and Exchange Commission approved a number of spot bitcoin ETFs. In Australia, ASIC, Treasury and industry are doing a lot of work to ensure product issuers comply with certain key requirements around custody, licensing, benchmarking and market integrity to ensure appropriate protections are in place for investors who wish to invest in these products.

Conclusion

Spot bitcoin ETFs present an exciting bridge between traditional markets and digital assets, offering investors a regulated and simplified pathway to Bitcoin exposure. It is anticipated they will lead the mass market adoption of bitcoin but with the protections that traditional financial markets provide.

Additional Resources

In the evolving world of digital assets, continuous learning is essential. For more in depth information on this asset class and how it can fit into your investment strategy, consider subscribing to related updates from Monochrome Asset Management and visit Monochrome Research for more news and articles.

Subject to regulatory approvals, the Monochrome Bitcoin ETF will be a registered managed investment scheme. The Monochrome Bitcoin ETF is proposed for launch in Q2, 2024. Monochrome Asset Management Pty Ltd ABN 80 647 701 246 will be the Investment Manager for the Monochrome Bitcoin ETF and is a Corporate Authorised Representative of Vasco Trustees Ltd ABN 71 138 715 009 | AFSL 344486. Vasco Trustees Limited will be the Responsible Entity for the Monochrome Bitcoin ETF and the issuer of its Product Disclosure Statement (PDS) and Target Market Determination (TMD). Interests in the Monochrome Bitcoin ETF are not currently available for subscription and the PDS and TMD will be made available at https://monochrome.au prior to the commencement of trading. Investors should consider the PDS and TMD in deciding whether to invest in the Monochrome Bitcoin ETF. This information is general in nature and is not financial advice. It does not take into account any person’s individual objectives, financial situation or needs. Before making an investment decision investors should read the PDS and TMD, and with the assistance of a financial adviser, consider if the investment is appropriate for their circumstances.

The content, presentations and discussion topics covered in this material are intended for licensed financial advisers and institutional clients only and are not intended for use by retail clients. No representation, warranty or undertaking is given or made in relation to the accuracy or completeness of the information presented. Except for any liability which cannot be excluded, Monochrome, its directors, officers, employees and agents disclaim all liability for any error or inaccuracy in this material or any loss or damage suffered by any person as a consequence of relying upon it. Monochrome advises that the views expressed in this material are not necessarily those of Monochrome or of any organisation Monochrome is associated with. Monochrome does not purport to provide legal or other expert advice in this material and if any such advice is required, you should obtain the services of a suitably qualified professional.