The U.S. Securities and Exchange Commission (SEC) will decide on two proposed bitcoin exchange-traded funds (ETFs) this week – but what are they weighing exactly?
ProShares, the tenth largest provider of ETFs according to CNBC, has two proposals in the running, both based upon bitcoin futures contracts approved by the Commodity Futures Trading Commission in 2017.
What’s more, this impending decision comes at the heels of a more recent ruling by the SEC to delay (until September, if not longer) their determination on a physical-backed bitcoin ETF put forth by VanEck and SolidX.
The distinction between the two, a physical and futures-backed ETF, is worth unpacking to understand the ProShares proposal – aside from whether bitcoin ETFs should or shouldn’t be approved in the U.S. – centers on which among the two actually has a better shot at SEC approval.
What’s a bitcoin ETF?
To recap, all ETFs trade like stocks, on stock exchanges, but without the same degree of risk.
Due to their design, they’re often a favored instrument for those who want to diversify their investments, offering exposure that’s closer to what you would see in an index fund.
This is because, when you’re buying a share of an ETF, you don’t actually own the underlying shares of the asset (in this case bitcoin). Instead, you own a piece of the fund and how the fund is structured and where the money goes.
“Part of the money when you buy a fund goes to pay for the company that set up the fund and manages the fund. It’s the fund’s money, and the fund owns these assets and, by definition, the fund,” Eric Ross, chief strategist at Cascend Securities, explained.
With a physical-backed bitcoin ETF, investors can effectively participate in the crypto market without being in direct possession of any coins, thereby avoiding some of the risks associated with handling bitcoin private keys (the pieces of information required to actually transfer bitcoins).
Futures-backed bitcoin ETFs take this level of separation one step further by basing the shares in the fund on bitcoin futures contracts as opposed to actual bitcoins themselves.
A futures contract sets a fixed price and date to trade an asset. As such, depending on an investor’s outlook on how the markets will move over time, he or she can buy contracts at varying prices to reflect that outlook and, if correct, make returns on their investment.
In this way, certain futures-backed bitcoin ETFs can indeed prove profitable for investors even if the bitcoin markets are looking bearish. Additionally, holding futures contracts with set prices and expiration dates hold lower degrees of risk given that the company issuing bitcoin ETFs wouldn’t have to make efforts to safeguard any bitcoin assets from theft or hack.
‘Physical’ vs futures
As a result then, it doesn’t come as much of a surprise that among the 10 bitcoin-related funds that are concurrently undergoing review by SEC officials in the next two months, only one is a physical-backed bitcoin ETF, suggesting most companies are placing their bets on approval of a futures-backed trading option as opposed to physical.
Daniel Masters, executive chairman for CoinShares, explained to CoinDesk in early August:
“Until such time major institutions put their name to cryptocurrency custody, I don’t believe a physical ETF can exist in the U.S…I think any futures backed ETF in the United States now has a far better chance of being approved.”
Although, from a strictly operational standpoint, Eric Balchunas, senior ETF analyst for Bloomberg Intelligence, points out that it is widely understood “where the investors have a choice of buying the ETF that hold the futures versus the ones that physically holds it…95% of the people go to the physical one, the only time they hold the one that holds futures are if they have to.”
“I take the one that actually holds the bitcoin will be more successful and you don’t have to deal with rolling futures. There could be some costs associated with that people don’t like,” he added.
These costs mentioned by Balchunas go back to how the fund issuing ETFs will make a sustainable profit. By holding bitcoin ETF futures contracts, the fund will often have to maintain a “rolling position,” buying contracts at high early prices and later selling these contracts closer to expiry at comparatively low prices. Otherwise known as the “cost of carry,” Balchunas notes that in Bloomberg’s “traffic lights system” anything that rolls futures is given a red light to denote high risk.
For Balchunas, on top of other potential concerns by critics who attack cryptocurrencies for having no intrinsic value, futures-backed bitcoin ETFs add “another laying of complication and risk that you don’t need when you already have all these other issues.”
Still, one thing is for certain: the market impact of a bitcoin ETF – if and when approved by the SEC – will be a significant one.
Masters, whose firm offers exchange-traded notes for crypto assets including bitcoin and ether, explained how ETFs could effectively enable a new class of participants to invest in the technology.
“Our customers are individuals, family offices, hedge funds that acquire our products through regulated marketplaces and often that might be insurance-based or pension-based. [Our notes] appeal to a very traditional set of investors,” he remarked.
And that’s appealing also to the many crypto enthusiasts in the U.S. who want to see cryptocurrencies move beyond the fringes of the finance industry and into the mainstream.
For his part, Balchunas sees the entry of a bitcoin ETF as a potentially market-boosting one, explaining:
“If a coin-based bitcoin ETF comes out, I would see it getting to probably $5 billion within a year and then ultimately would be a pretty big product probably maybe $10 to $15 billion over the next couple years and that would put it in the top 10 percent biggest ETFs.”
However, Masters isn’t exactly bullish that the U.S. will move quickly on approving cryptocurrency-based ETFs, adding that “the ruleset in America is meaningfully more complex. In the U.S. things tend to be a lot more structured from day one.”
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