Bitcoin ETFs

Bitcoin has been a hot topic of conversation amongst asset allocators, but now the discussion has heated up with the recent SEC approval and subsequent launch of the ProShares Bitcoin Strategy exchange-traded fund (ETF). The launch of this bitcoin ETF marks a defining moment in bitcoin’s future, as it provides retail investors the opportunity to invest in this exotic asset class through the stock market.

Previously, investors could access bitcoin by buying coins through an online trading platform (such as Coinbase) or through a closed-end fund/trust (largest currently being Grayscale Bitcoin Trust: GBTC). Each method comes with its own advantages and disadvantages. The main disadvantage is that these avenues do not trade on a regulated exchange as ETFs do.

In this piece, we aim to answer some questions related to the ProShares Bitcoin Strategy ETF, such as how is this structured, what are the potential benefits, and what are the drawbacks?

Starting this discussion, we’ll discuss the structure of an ETF. An ETF is a publicly-traded fund, which holds a basket of securities. Investors can buy shares of an ETF, which provides them exposure to the basket of securities. ETFs are traded throughout the day on a stock exchange, hence where the name comes from, which provides investors the ability to buy and sell throughout the day. ETFs do carry costs, which are passed through to the investor. The costs are typically associated with building the structure and creating the basket of securities but usually run fairly low at under 1%.

Source: Fidelity, ETFs 101

The new ProShares Bitcoin Strategy ETF launched earlier in October and raised over $1Bn in investor assets in its first week of launching, marking the quickest billion-dollar fundraising on record. This bitcoin ETF attempts to mimic the price of bitcoin, offering investors the opportunity to participate in the asset class without trading bitcoin itself.

To provide investors exposure to bitcoin, the ProShares bitcoin ETF purchases bitcoin futures contracts rather than the cryptocurrency. To date, the SEC has rejected multiple proposals for ETFs seeking to buy the underlying cryptocurrency. The fund purchases the closest month’s futures contract because the nearest month will usually provide the closest correlation to the current bitcoin spot price. Once the contract expires, the fund must roll over its existing contracts into the next month.

The fund handles one of the most important issues of bitcoin, which is storage and security. Given bitcoin remains fairly unregulated and doesn’t have a governing body, there is little recourse if bitcoin is lost or stolen. Furthermore, due to the lack of fraud protection, it is a natural target for cyber-criminals. Once an investor buys bitcoin, their coins are stored on a digital wallet through a specific passcode. Once a bad actor accesses your passcode, which can be done over a public internet connection, your bitcoin can be transferred and stolen.

More importantly, the ProShares ETF sidesteps the custody issue by trading in the futures market rather than the asset class. This further eases investors as the fund grows in assets. For example, a trust that holds massive amounts of bitcoin is more susceptible to being hacked. Of course, this does not mean ETF investors can be completely insulated from cyber security threats, as the price of bitcoin ETFs would likely be impacted if a major bitcoin hack were to occur.

The ETF vehicle also makes it much easier for investors to engage in short selling, which is currently extremely difficult in the traditional cryptocurrency market. Before the Proshares Bitcoin ETF, retail investors were generally only able to buy, known as being long, which establishes a bullish view that the price of bitcoin will increase over time. However, with the advent of the ETF structure, retail investors now have a way to establish a bearish view on bitcoin. Investors can short the shares of the ETF, making a bet that the price of bitcoin will fall.

Source: Investopedia, November 2021, Bitcoin ETFs Explained

While trading bitcoin futures addresses some investor concerns, the performance of bitcoin futures is subject to different performance compared to the underlying asset. The performance dispersion is further exacerbated by the ETFs pattern of trading. Within the current ProShares structure, the fund must roll their futures contracts into the next month, creating rolling risk. In order to maintain their bitcoin exposure, the fund will purchase the nearest futures contract on bitcoin. Once that contract comes closer to expiration, the fund will buy the next closest month’s contract. This pattern of trading can potentially distort the market, especially if the ProShares ETF represents a large portion of the market.

Since the ProShares bitcoin ETF has surpassed the $1Bn mark, the ETF already owns a substantial portion of the outstanding bitcoin futures contracts. To put into context, the ETF owns about 3,800 contracts expiring at the end of December and represents over 60% of the volume on the CME futures platform, which is being used by the fund. The fund’s volume of trading does have the potential to push the price up of the next month’s contract price as the expiration date nears.

Sources:
CME Group, November 2021, Bitcoin: Futures and Options
ProShares, November 2021, Bitcoin Strategy ETF
Wall Street Journal, October 2021, ETFs Are a Bad Way to Bet on Bitcoin

The rolling risk in the ProShares bitcoin ETF also creates an arbitrage opportunity for outside traders but may negatively affect the performance of the bitcoin ETF. Since the ETF must roll their existing bitcoin contracts to the next month, arbitrageurs can front-run the ETF by buying the following month’s contracts beforehand, creating a surge in demand, and driving up the price. These investors can profit once they sell these higher-priced contracts when the ETF fund rolls their contracts into the next month. This higher price comes out of the return in the Proshares Bitcoin ETF.

Source: Financial Times, October 2021, Investors look to exploit lucrative trade after US bitcoin ETF launch

Below is a graph showing the divergence between bitcoin’s price performance and futures-only return. According to the Horizons Bitcoin Front Month Rolling Futures index calculated by Solactive, this strategy has made around 13 percentage points less than bitcoin’s 118 percent so far this year in 2021.

Source: Wall Street Journal, October 2021, ETFs Are a Bad Way to Bet on Bitcoin

Furthering the dispersion of the ProShares Bitcoin ETF are the expenses associated with the fund. According to the prospectus, the fund’s annual operating expenses comprise the Management Fee, which is 0.95%, and Other Expenses, which are estimated to be 0.00% in the prospectus.

Other Expenses include the transaction and financing costs incurred as the fund buys and sells the securities or “turns over” its portfolio.

A greater portfolio turnover rate may suggest higher transaction expenses and, as a result, higher taxes for those investing in a taxable account. These expenses, which aren't included in annual fund operating expenses, impact the fund's performance. As of the date of the Prospectus, the fund has not yet begun operations and, as a result, is not able to provide portfolio turnover data to investors.

Source: ProShares, November 2021, Bitcoin Strategy ETF Prospectus

In discussing the recent ProShares bitcoin ETF, we’ve established some of the benefits and drawbacks of the structure. Bitcoin’s price has been known to have frequent run-ups and sell-offs. The futures market will likely see the same volatility, if not more, given its nascency. Before making an allocation, financial advisors should also note the high volatility of the asset class and the growing number of options that can provide exposure to bitcoin and other cryptocurrencies for their clients.

Source: Wall Street Journal, October 2021, ETFs Are a Bad Way to Bet on Bitcoin