Introduction

Exchange-traded funds (ETFs) have become an increasingly popular way for investors to gain exposure to the cryptocurrency market without directly holding crypto assets. ETFs track an underlying index or basket of assets but trade on exchanges like stocks. This provides the advantages of diversification and liquidity compared to owning the assets directly.

In recent years, interest in crypto-based ETFs has surged as the market has matured. Major financial institutions like ProShares and Valkyrie have launched Bitcoin futures ETFs that have quickly attracted billions in assets. Investors are eager to gain exposure to the crypto market through regulated investment vehicles like ETFs.

Spot Bitcoin ETF Volumes. Source: The Block.

While crypto ETFs are still relatively new, they have quickly become one of the most popular vehicles for investing in digital assets. Over 40 crypto ETFs are trading globally, with over $6 billion in assets under management. According to this report, global ETF assets under management could reach $18 trillion by 2026, representing huge potential for growth in crypto ETFs.

This guide aims to explore a new generation of ETFs tied to cryptocurrency assets, focusing on Bitcoin ETFs. The approval of Bitcoin ETFs has been a significant milestone, opening the crypto market to broader mainstream investment. Therefore, it is valuable to understand their underlying mechanics, regulatory landscape, and future outlook.

Understanding ETFs

Exchange-traded funds (ETFs) are investment funds that track an underlying index or basket of assets like stocks, bonds, or cryptocurrencies. ETFs combine elements of mutual funds and stocks - they offer the diversification of funds but trade intraday on exchanges like stocks.

They allow investors to gain exposure to many assets through a single tradable security. The ETF provider selects the underlying assets and weights them according to the fund's objective. For example, an S&P 500 ETF aims to replicate the performance of the S&P 500 index by holding shares of all 500 companies.

The key difference between ETFs and traditional investments like stocks and mutual funds is that ETFs can be traded throughout the day like stocks, while mutual funds trade only once per day after market close. ETFs offer diversification by holding many assets, while stocks represent just one company.

ETFs first emerged in the 1990s, giving investors an easy way to track stock market indexes like the S&P 500. The ETF industry exploded in the 2000s with the introduction of more diverse funds tracking various assets. With the rise of digital assets, creating crypto ETFs was a natural next step to opening the crypto markets to mainstream investors.

Image: Different Types of ETFs. Source: Changelly.

Background on Crypto ETFs

Crypto ETFs are financial instruments that track the price of underlying cryptocurrencies like Bitcoin and Ethereum. They allow investors to gain exposure to the cryptocurrency market without purchasing and holding digital assets directly.

Crypto ETFs function similarly to traditional ETFs. The issuer purchases and holds the underlying crypto assets and issues shares representing a portion of those assets. The shares trade on exchanges like stocks, allowing investors to buy and sell exposure to crypto prices quickly.

There are several key benefits to investing in crypto via ETFs rather than owning the cryptocurrencies directly:

• Regulatory Oversight: Crypto ETFs must comply with regulations governing traditional ETFs, providing investors with protections around transparency, custody, auditing, etc.

• Simplicity and Convenience: Investing in a crypto ETF is as easy as trading any publicly listed stock or ETF through a brokerage account. This type of trade helps to avoid the complexity of setting up a crypto wallet, managing private keys, etc.

• Diversification: A single crypto ETF provides exposure to a basket of cryptocurrencies rather than a single asset. This results in diversification across the crypto market.

• Security: The crypto assets are held by a regulated custodian, which avoids the risks associated with personally securing crypto wallets and private keys.

• Reduced volatility: Crypto ETFs may see lower volatility than directly owning cryptocurrencies.

Differences Between Crypto and Traditional ETFs

Below is a comparative table highlighting the differences between Crypto ETFs and traditional ETFs.

The first Bitcoin ETFs launched in 2021 after much anticipation and regulatory discussion. Ethereum ETFs soon followed as the second-largest cryptocurrency matured. Approving these crypto ETFs was a significant milestone for mainstream adoption in the finance industry.

Genesis of Bitcoin ETFs

The concept of a Bitcoin exchange-traded fund has been discussed for over a decade, with several firms proposing Bitcoin ETFs to the Securities and Exchange Commission (SEC). These proposals were, however, repeatedly rejected or delayed by the SEC, citing various concerns around volatility, liquidity, custody, and the potential for manipulation in the underlying Bitcoin market.

The first attempt to launch a Bitcoin ETF dates back to 2013 when Cameron and Tyler Winklevoss filed with the Securities and Exchange Commission (SEC) to create the Winklevoss Bitcoin Trust ETF (COIN). However, their application was rejected due to concerns over regulation and volatility in the nascent crypto market.

Since then, numerous proposals for Bitcoin ETFs have been submitted to the SEC but rejected or withdrawn. Some of the notable attempts include:

• SolidX Bitcoin Trust ETF by VanEck in 2016 - Withdrawn in 2017.

• Winklevoss Bitcoin Trust ETF by Bats BZX Exchange in 2017 - Rejected by SEC.

• Bitcoin ETF by ProShares in 2017 - Withdrawn.

• GraniteShares Bitcoin ETF in 2018 - Withdrawn.

In mid-2021, hopes were high when VanEck submitted a new application for a Bitcoin ETF. However, the SEC delayed its decision multiple times and eventually rejected it in November 2021.

Some key milestones in the regulatory journey include:

1. First Bitcoin ETF Proposal (2013): The Winklevoss twins submitted the first Bitcoin ETF proposal in 2013, the Winklevoss Bitcoin Trust ETF (COIN), which the SEC rejected in 2017.

2. SEC Rejects Nine Bitcoin ETF Proposals in One Day (2018): The SEC rejected several proposals from firms like ProShares, Direxion, and GraniteShares, citing similar concerns about Bitcoin markets.

3. The First Spot Bitcoin ETF is Approved (Feb 2021): The first Bitcoin ETF is approved outside the US, with the launch of the Purpose Bitcoin ETF in Canada, adding pressure on the SEC to approve a Bitcoin ETF.

4. The First US Bitcoin Futures ETF Approved (Oct 2021): The SEC approves the ProShares Bitcoin Strategy ETF (BITO), the first US Bitcoin futures ETF. Other futures-based ETFs from Valkyrie, VanEck, and others soon followed this approval.

Some major players in the Bitcoin ETF space have been Grayscale Investments, VanEck, ProShares, Valkyrie, and others. While an actual Bitcoin/spot Bitcoin ETF is yet to be approved, launching futures-based ETFs has been an important milestone.

Milestones Since January 2024

Here are some of the latest developments in the Bitcoin ETF scene since January 2024:

1. SEC Approval: On January 10, 2024, the U.S. Securities and Exchange Commission (SEC) approved the launch of several Bitcoin Exchange-Traded Funds (ETFs). This approval resolved critical legal and regulatory issues in launching a Bitcoin ETF.

2. Spot Bitcoin ETFs: U.S. regulators allowed exchange-traded products tied directly to the day-to-day movement of bitcoin prices—known as the asset’s spot prices. Some of the most notable spot Bitcoin ETFs that investors can buy today include Grayscale Bitcoin Trust (GBTC), iShares Bitcoin Trust ETF (IBIT), Invesco Galaxy Bitcoin ETF (BTCO), Bitwise Bitcoin ETF (BITB), ProShares Bitcoin Strategy ETF (BITO), Volatility Shares 2x Bitcoin ETF (BITX), and ProShares Short Bitcoin ETF (BITI).

3. Record-Breaking Inflows: Spot Bitcoin ETFs recorded $107.91 million in inflows in May 2024 for a 9th straight day, the longest run since mid-March, as demand for the successful new products continues.

Types of Crypto ETFs

Let’s further explore the different types of crypto ETFs:

Single Asset Crypto ETFs (Spot ETFs)

These ETFs focus on one type of cryptocurrency, such as Bitcoin or Ethereum. They provide direct and concentrated exposure to the price movements of a specific digital asset, making them suitable for investors with a firm belief in the future performance of that particular cryptocurrency.

For instance, the Grayscale Bitcoin Trust (GBTC) and the iShares Bitcoin Trust ETF (IBIT) are examples of single-asset crypto ETFs focusing on Bitcoin. These ETFs allow investors to gain exposure to Bitcoin without the need to manage the storage and security challenges of holding Bitcoin directly.

Multi-Asset Cryptocurrency ETFs

These ETFs track the price of multiple cryptocurrencies. They provide exposure to a diversified portfolio of digital assets, which can help spread the risk associated with investing in cryptocurrencies. For instance, the Bitwise 10 Crypto Index Fund (BITW) is a multi-asset cryptocurrency ETF that invests in the top 10 largest cryptocurrencies.

These ETFs can be an attractive option for investors who want exposure to the broader cryptocurrency market rather than betting on a single cryptocurrency, but they also have inherent risks.

Crypto Industry ETFs

These ETFs focus on companies operating in the crypto industry rather than cryptocurrencies. They offer exposure to companies that own or operate in the cryptocurrency industry.

These ETFs are linked to the crypto world, but they do not own crypto. Instead, they hold shares in companies that have invested in crypto or whose business involves cryptocurrency trading, mining, or other services.

Examples of such ETFs include the Amplify Transformational Data Sharing ETF (BLOK) and the First Trust Indxx Innovative Transaction & Process ETF (LEGR), which invest in companies involved in blockchain technology.

Spot ETFs

Spot ETFs directly hold the underlying cryptocurrency, such as Bitcoin or Ethereum. They securely hold cryptocurrencies in a secure digital vault, which registered custodians manage. The purpose of this kind of ETF is to mirror the price of cryptocurrencies in the crypto market.

Some examples of spot ETFs include the ARK 21Shares Bitcoin ETF (ARKB), the Invesco Galaxy Bitcoin ETF (BTCO), and the VanEck Bitcoin Trust (HODL). Note that a Single Asset Crypto ETF can be a Spot ETF if it directly holds the cryptocurrency it focuses on.

Futures ETFs

Future ETFs invest in future contracts for the underlying cryptocurrency. They offer exposure to the cryptocurrency's price without owning the actual cryptocurrency10. This type of ETF can benefit investors who want to speculate on the cryptocurrency’s price without the risk of owning it. This category can be further divided into:

• Standard Futures ETFs: These ETFs aim to track the underlying asset's performance. An example of this type is the ProShares Bitcoin Strategy ETF (BITO).

• Inverse (Short-Selling) ETFs: These ETFs are designed to profit from a decline in the value of an underlying asset by shorting futures contracts or using derivatives. An example of this type is the ProShares Short Bitcoin Strategy ETF (BITI).

• Leveraged ETFs: These ETFs aim to amplify the underlying asset's returns using leverage, such as derivatives. An example of this type is the Volatility Shares 2X Bitcoin Strategy ETF (BITX).

Image: Types of Cryptocurrency ETFs.

Leading Bitcoin ETFs By AUM

Spot Bitcoin ETFs

1. Grayscale Bitcoin Trust (GBTC)

   1. Launch: September 2013.

   2. AUM: $23.7 billion.

   3. Performance: As of April 30, 2024, the 1-month return was -16.88%, the 3-month return was 38.22%, and the 6-month return was 29.05%.

   4. Fees: 2.0%.

2. iShares Bitcoin Trust ETF (IBIT)

   1. Launch: January 11, 2024.

   2. AUM: $17.7 billion.

   3. Performance: As of May 23, 2024, the 1-month return was -15.30%, and the 3-month return was 39.84%.

   4. Fees: 0.25%.

3. Bitwise Bitcoin ETF (BITB)

   1. Launch: January 11, 2024.

   2. AUM: $2.2 billion.

   3. Performance: As of May 16, 2024, the 1-month return was -15.29%, and the 3-month return was 39.88%.

   4. Fees: 0.20%.

Futures-Based Bitcoin ETFs

1. ProShares Bitcoin Strategy ETF (BITO)

   1. Launch: October 19, 2021.

   2. AUM: $1.9 billion.

   3. Performance: As of April 30, 2024, the 1-month return was -17.75%, the 3-month return was 35.02%, and the 6-month return was 60.93%.

   4. Fees: 0.95%.

2. ProShares Short Bitcoin Strategy ETF (BITI)

   1. Launch: June 21, 2022.

   2. AUM: $107.2 million.

   3. Performance: As of April 30, 2024, the 1-month return was 18.78%, the 3-month return was -31.34%, and the 6-month return was -45.22%.

   4. Fees: 0.95%.

3. Valkyrie Bitcoin and Ether Strategy ETF (BTF)

   1. Launch: October 21, 2021.

   2. AUM: $46.3 million.

   3. Performance: As of May 21, 2024, the 3-month return was 29.78%, the YTD return was 59.07%, and the 1-year return was 138.38%.

   4. Fees: 1.24%.

Structure and Mechanics of Bitcoin ETFs

Understanding the mechanics of Bitcoin ETFs is critical, as they allow you to gain exposure to Bitcoin without buying or storing the cryptocurrency directly. Here, we delve into the granular details of how Bitcoin ETFs are structured and how they operate.

Custody and Security

In physical Bitcoin ETFs, custodians hold the actual Bitcoin. These custodians are often specialized firms with robust security protocols. Secure custody is paramount for Spot Bitcoin ETFs. Let’s examine the different types of custody solutions:

• Cold Storage: Most of the Bitcoin is kept in cold storage (offline), significantly reducing the risk of hacking and theft.

• Hot Wallets: A small portion may be kept in hot wallets (online) for liquidity purposes, but this is minimized to reduce risk.

• Custodians: Managed by specialized and reputable firms with robust security protocols and insurance coverage.

• Bitcoin Futures Contracts: These ETFs invest in Bitcoin futures contracts rather than holding Bitcoin directly.

• Insurance: Custodians typically have insurance policies to protect against theft or loss.

NAV Calculation

• Net Asset Value (NAV): The NAV of a Bitcoin ETF is the total value of its Bitcoin holdings divided by the number of outstanding shares.

  • Daily Calculation: NAV is usually calculated at the end of each trading day based on the current market price of Bitcoin.

  • Market Price: The ETF's market price can fluctuate throughout the day based on supply and demand, sometimes trading at a premium or discount to the NAV.

Creation and Redemption Mechanism

• Authorized Participants (APs): These are financial institutions authorized to create and redeem shares of the ETF.

  • Creation: APs create new ETF shares by delivering Bitcoin (for physical ETFs) or cash (for futures-based ETFs) to the ETF issuer.

  • Redemption: APs can redeem ETF shares for Bitcoin or cash. This process helps keep the ETF's market price close to its NAV.

  • In-Kind Transactions: Creations and redemptions for physical ETFs are typically in-kind, meaning they involve the actual transfer of Bitcoin rather than cash.

Price Tracking and Arbitrage

• Price Tracking: The ETF aims to track the price of Bitcoin closely.

  • Index Tracking: Many ETFs track a Bitcoin index, which represents the aggregated price of Bitcoin across multiple exchanges.

  • Futures Contracts: Futures-based ETFs track the price of Bitcoin through regulated futures contracts traded on exchanges like the CME.

• Arbitrage Mechanism: APs perform arbitrage by exploiting price discrepancies between the ETF shares and the NAV.

  • Premiums and Discounts: If the ETF trades at a premium (above NAV), APs can create new shares and sell them on the market, driving the price down. If it trades at a discount (below NAV), APs can buy shares and redeem them for Bitcoin, increasing the price.

Futures-Based ETF Specifics

• Futures Contracts: These ETFs invest in Bitcoin futures contracts, which are agreements to buy or sell Bitcoin at a predetermined price at a future date.

  • Contract Rolling: ETFs must roll over contracts as they approach expiration, which involves selling the expiring contracts and buying new ones.

  • Contango and Backwardation: Futures markets can be in contango (future prices higher than spot prices) or backwardation (future prices lower than spot prices), impacting the cost and performance of the ETF.

  • Leverage: Some futures-based ETFs may use leverage, increasing exposure and risk.

Image: Pricing differences can lead to an inherent premium for fixed-income ETFs. Source: Vanguard.

Functioning of Bitcoin ETFs: An Example of How They Work

Bitcoin ETFs function similarly to traditional ETFs but with crypto assets as the underlying holdings. Here's how they work:

1. The ETF manager obtains a large quantity of Bitcoin to back the ETF shares, which are held securely by a custodian.

2. ETF shares are created and issued based on the amount of bitcoin holdings. Shares track the bitcoin price.

3. ETF shares are listed and traded on stock exchanges. Investors can buy/sell shares through brokerages.

4. To redeem, authorized participants exchange ETF shares for the equivalent value in bitcoin from reserves.

5. Custodians handle safekeeping, transactions, and proof of reserves auditing for the ETF's bitcoin.

6. ETF manager handles administrative operations like accounting, regulatory compliance, marketing, and risk management.

Risks and Challenges

Investing in crypto ETFs has inherent risks that investors should know before allocating funds. One of the key risks is the tracking error. Since crypto ETFs don’t directly hold the underlying crypto assets, there is a risk of tracking error between the ETF’s performance and the price of the actual cryptocurrency. Factors like fees and expenses can cause the ETF’s returns to diverge from its benchmark index.

Another risk is the occurrence of premiums or discounts. The volatility of the underlying cryptocurrencies poses a risk. For instance, Bitcoin is still prone to significant price swings over short periods, increasing the chance of premiums or discounts occurring. ETF shares may trade their net asset value above (premium) or below (discount). This price discrepancy can impact returns, especially during times of high volatility. Traders can exploit these premiums/discounts, adding to pricing inefficiency.

Regulatory uncertainty is another significant risk. Crypto regulation is still evolving globally. In certain jurisdictions, sudden regulatory changes like trading halts or crypto bans can adversely impact crypto ETFs. Investors may have limited legal recourse in case of issues.

Lastly, there are also risks around fraud and mismanagement. While the crypto ETFs themselves may be operated correctly, the underlying cryptocurrencies could be subject to hacks, theft, or fraud. These events can impact the price and stability of the cryptocurrency held by the ETF.

How to Evaluate and Select Crypto ETFs

• Examine the fund's holdings: Make sure you understand precisely which cryptocurrencies and in what proportions the ETF invests in. This knowledge will determine the risk profile and expected returns.

• Assess the index methodology: Passively managed crypto ETFs track an underlying index, so review the index construction methodology. Is it market cap weighted? Does it include emerging coins? These factors impact performance.

• Compare fees: Management fees and other expenses vary widely between crypto ETFs, so compare these costs. Higher fees can eat away at long-term returns.

• Review the provider: Look at the ETF provider's reputation, experience, assets under management, and other available funds. More established firms may offer greater security.

• Consider liquidity: Crypto ETFs can have wide bid-ask spreads. Ensure sufficient trading volume and assets under management to allow easy trading.

• Evaluate performance: While past performance does not guarantee future returns, a crypto ETF's historical returns can give an indication of its strategy.

• Assess risk factors: In addition to market risk, evaluate counterparty risks, cyber risks, regulation, and other hazards that could impact the ETF's performance.

Strategies for Allocating Your Investment Portfolio

• Start small: Limit crypto ETF exposure to 2-5% of your total portfolio when adding this asset class. Monitor performance before increasing allocation.

• Diversify: To mitigate volatility, consider investing in a basket of crypto ETFs that track different digital assets beyond just Bitcoin or Ethereum. Diversification can help spread risk and reduce the impact of any asset’s price fluctuations.

• Rebalance Periodically: Review and adjust your portfolio regularly to maintain your desired allocation to crypto ETFs. Rebalancing quarterly or annually ensures that your exposure remains consistent with your overall investment strategy.

• Long-Term Holdings: Treat crypto ETFs as long-term investments rather than short-term speculative trades. Given the inherent volatility in the crypto market, a patient approach can yield better results over time.

• Maintain an investing plan: Develop an investing plan that outlines how you’ll gradually build up your exposure to crypto ETFs. Avoid impulsive decisions based on short-term.

An Ethereum ETF?

Ethereum ETFs have recently become a hot topic in crypto. They represent a significant milestone in the mainstream adoption of cryptocurrencies, and their approval could pave the way for other digital assets to follow suit.

The hype around ETH ETFs is mainly due to their potential to enhance the credibility of the cryptocurrency industry. The approval of spot Ethereum ETFs in the US has been one of the most critical developments in Ethereum’s history. This decision followed months of anticipation and is expected to have a broad positive effect on investor sentiment.

The Impact of an Ethereum ETF

The impact of Ethereum ETFs on ETH and the market in general can be significant. Introducing Ethereum into the ETF market might lead to institutional investors reallocating funds. These investors may prefer the diversity and potential growth Ethereum promises over more established funds. This move could influence Ethereum’s price dynamics and increase demand for Ethereum, potentially driving its price upward.

Furthermore, the approval of Ether ETFs could enhance liquidity in the Ethereum market by attracting more participants. Increased liquidity may lead to more stable prices and reduced volatility, making Ethereum a more appealing investment for a wider audience.

In recent news, the U.S. Securities and Exchange Commission (SEC) has approved spot Ethereum ETFs. This decision is significant as it confirms Ethereum’s status as a non-security. The approval of these ETFs is expected to impact the Ethereum market substantially.

However, it’s important to note that while the approval of Ethereum ETFs is a positive development, their future and impact on the Ethereum market will still be subject to various factors, including regulatory developments and market dynamics.

Conclusion

Crypto ETFs are a significant advancement in the cryptocurrency ecosystem, offering a regulated, mainstream method for investors to gain exposure to digital assets like Bitcoin and Ethereum.

The introduction of Bitcoin and Ethereum ETFs marks a key milestone in crypto adoption. They provide a convenient way for institutional and retail investors to add cryptocurrencies to their portfolios without managing digital wallets.

Key Takeaways

• Crypto ETFs function like traditional ETFs but focus on cryptocurrency assets, providing regulated exposure to crypto prices.

• Bitcoin ETFs are popular due to Bitcoin's prominence, with top ETFs like BITO offering futures-based exposure.

• Ethereum ETFs are newer but promising for balanced crypto exposure.

• Regulatory concerns have slowed new crypto ETF approvals in the US, but the outlook remains positive as authorities recognize their benefits.

As crypto adoption grows, further innovation in crypto ETF products is expected, driving mainstream cryptocurrency investing forward. Their future growth will depend on evolving regulatory frameworks and meeting investor demand for crypto assets.