“1993 is remembered for the first equity ETF, 2002 for the first bond ETF, and 2004 for the first gold ETF. 2021 will be remembered for the first cryptocurrency-linked ETF”. – ProShares CEO Michael Sapir

It finally happened… sort of.  The first bitcoin-linked ETFs have arrived, with the ProShares Bitcoin Strategy ETF (BITO) and Valkyrie Bitcoin Strategy ETF (BTF) making much-anticipated debuts. The VanEck Bitcoin Strategy ETF (XBTF) is expected any day now.  All three funds hold CME-traded bitcoin futures, not actual bitcoin.  More on that later.

Despite the potential shortcomings of futures-based bitcoin ETFs, let’s start with an undeniable fact:  whether or not you believe bitcoin or bitcoin futures should be wrapped in an ETF, there is a segment of investors who want this exposure.  BITO became the fastest ETF to reach $1 billion in assets, hitting the mark in only two days!  The previous record was held by the SPDR Gold Shares (GLD), which took three days to achieve the milestone back in 2004.  It seems fitting that gold ETFs passed the baton to “digital gold” ETFs.

Source: Bloomberg’s James Seyffart

ETFs have long been touted as “democratizing” investing by offering access to assets and strategies previously only available to wealthy and/or sophisticated investors.  If you doubt that’s the case with bitcoin futures ETFs, take a glimpse at the weekly inflows for ALL crypto funds this year.  Notice anything?

Source:  Coindesk’s Lyllah Ledesma

Why the explosion in flows?  Because the vast majority of crypto funds were only accessible to accredited investors.  Futures-based ETFs, while imperfect, opened the door to everyone.

Skeptics might say, “Well, bitcoin is already available to anyone who wants it.  That’s the beauty of bitcoin.  Wealth and sophistication aren’t prerequisites to owning it”.  That’s true.  Bitcoin is extremely easy for anyone to buy “direct”.  Go to Coinbase or CashApp, setup an account in a few minutes, and start buying.  Pretty simple.  That said, what does it mean to actually own bitcoin?

Owning Bitcoin “Direct”

When you purchase bitcoin at Coinbase or CashApp, they manage the private keys – not investors.  Private keys govern actual ownership of bitcoin and other cryptoassets.  Think of a private key as the unique password allowing a user to control their crypto.  Ever heard the saying “Not your keys, not your coins”?

So, who really owns bitcoin purchased on a crypto exchange?  I guess it’s semantics.  Yes, you can move bitcoin off-exchange, but how many people actually do that?  Talk to most bitcoin owners and they’ll tell you they own bitcoin for the price exposure – they want to make money!  Coinbase, CashApp, and others are centralized exchanges.  When you boil it down, there’s not much difference between obtaining bitcoin price exposure in an ETF versus at Coinbase.  They’re both regulated access points and you don’t actually own the underlying bitcoin.

Now, there are all sorts of longer-term potential positives to bitcoin besides price appreciation.  Bitcoin can facilitate banking the unbanked, promote upward economic mobility (think El Salvador), or allow the near-instantaneous movement of money across the globe with minimal costs.  People owning bitcoin for those reasons certainly don’t need an ETF.  It’s also an entirely different discussion for people owning bitcoin simply because they wish to transact in it (buy coffee, get paid, etc.).  Finally, ETFs and crypto exchanges are irrelevant for individuals wishing to self-custody bitcoin.  Diehard crypto enthusiasts will say this is the only way to own bitcoin.  I’m not here to disagree, but simply highlight that not everyone is a bitcoin maximalist.  There are more Coinbase accounts than Schwab accounts, Coinbase is currently Apple’s #1 downloaded app, and a bitcoin futures ETF just smashed a 17-year-old ETF record.  That tells you not everyone wants to own their keys.

Even if you do want to self-custody bitcoin, that presents its own unique set of risks.  What if your private keys are lost or otherwise compromised?  Rare event?  Not so fast.  Current estimates are that 20% of all bitcoin has been lost forever!  At least the exchanges are professionally securing your (their) bitcoin.

Crypto Exchanges vs ETFs

Putting aside the discussion around whether you really own bitcoin through crypto exchanges, there are several important reasons some investors (and their financial advisors) prefer gaining bitcoin price exposure via ETFs:

Convenience.  Some investors simply want all of their investments under one roof.  They value the convenience of logging-in to Charles Schwab, for example, and viewing their entire portfolio.  They prefer monitoring, rebalancing, and tax-loss harvesting holdings via a single access point.  They like receiving one statement and one Form 1099 for investment income taxes.  They enjoy receiving email communications and electronic trade confirmations from a single source.  They value the ease of remembering one login and password to access their accounts.  Just because something like CashApp is easy, doesn’t mean it’s convenient.

Skepticism.  Speaking of passwords, some investors are still skeptical of crypto exchanges.  Sure, the largest crypto platforms employ world-class security and use state-of-the-art crypto storage solutions.  However, there were some nasty headlines in the early days of crypto, with exchanges hacked and investors losing millions.  Can you fault some investors for being a bit skittish?  There’s also a subset of investors scared to go through the “know your customer” (KYC) process at crypto exchanges they don’t know or trust.  Charles Schwab wants my social security number and driver’s license – sure.  Kraken – hmmm?

Retirement Accounts.  While one can debate how prudent it is, ETFs expand the options for investors to obtain tax-deferred or tax-free bitcoin price exposure.  Nobody knows where the price of bitcoin will go from here, but it would have been a massive advantage if investors had exposure in their IRAs and 401ks over the past decade.

Familiarity.  This is essentially a combination of convenience and skepticism, but warrants its own discussion.  Some investors are just more comfortable owning things they’re familiar with.  ETFs = familiar.  Crypto = foreign.  This isn’t a bad thing.  Instead, think of ETFs as a bridge between traditional financial services and crypto.  For some investors, the only way to get them interested and familiar with crypto is through ETFs.

While some of these reasons may not apply to you, they do apply to a subset of investors.  For financial advisors, there are some additional benefits to the ETF wrapper including that it fits neatly into their daily workflows and existing compliance framework.

Great, But Why Have Bitcoin Price Exposure to Begin With?

To the moon!  Just kidding, though there is no question a sizeable chunk of investors/traders own bitcoin because they’re hoping to ride a rocket ship.  The investment thesis for bitcoin is beyond the scope of this piece, but I will highlight that allocating a small portion of a well-diversified portfolio to bitcoin would have improved an investor’s risk-adjusted returns.  Given that bitcoin has only existed since 2009, this is admittedly a small sample size.  That said, the data speaks for itself.  With a high volatility asset such as bitcoin, the key is correct position sizing, disciplined rebalancing, and sticking with the strategy.

Source:  Onramp Q3 Guide to Cryptoasset Markets

And for financial advisors, not offering bitcoin exposure could give clients a reason to look elsewhere.

Fees Matter

All of this brings us to costs, which always matter in investing.  With the debut of the first bitcoin ETF, there is a narrative that these products are simply machinations of Wall Street middlemen to siphon money away from investors.

Let’s evaluate this with a fair, yet discerning eye.  The ProShares Bitcoin Strategy ETF and the Valkyrie Bitcoin Strategy ETF each charge 0.95% (or $9.50 for every $1,000 invested) annually.  VanEck’s Bitcoin Strategy ETF is already undercutting both of these ETFs, launching at 0.65%.  It’s the opening salvo in what I expect will be a brutal bitcoin ETF fee war.  Interestingly, bitcoin futures ETFs are already on the lower end of all publicly traded bitcoin funds globally:

That said, fees are fees and bitcoin funds and ETFs definitely have them.  The most popular bitcoin fund, the Grayscale Bitcoin Trust with nearly $40 billion in assets, charges 2% annually.

Ok, but what about buying bitcoin “direct” through crypto exchanges?  Let’s take a look at fees for CashApp, Coinbase, and Coinbase Pro:

Source:  Fool.com

The fee on a $1,000 bitcoin purchase at Coinbase is 1.47% ( $14.68/$1,000).  And it’s worth noting that Coinbase’s fee schedule isn’t exactly set in stone:

“Coinbase may charge fees when you buy, sell, or convert cryptocurrencies. Fees are calculated at the time you place your order and may be determined by a combination of factors including the selected payment method, the size of the order, and market conditions such as volatility and liquidity… Additionally, Coinbase includes a spread in the price when you buy or sell cryptocurrencies or in the exchange rate when you convert cryptocurrencies. This allows us to temporarily lock in a price for trade execution while you review the transaction details prior to submitting your transaction.”

There’s similar language on CashApp:

“Cash App may charge a small fee when you buy or sell bitcoin. If so, the fee will be listed on the trade confirmation before you complete the transaction.  When you buy or sell bitcoin using Cash App, the price is derived from the quoted mid-market price, inclusive of a margin, or spread.  The mid-market price is the average price of bitcoin currently selling across other major exchanges. Like any other financial market, this average price is not necessarily the price you are able to buy or sell at, but is how we calculate our bids.”

Crypto exchange Gemini actually walks through an example on their website:

“Web Order Buy Example – Kristen wants to buy $100 of BTC with USD. The prevailing Gemini market price of BTC is $4000 USD. On her website application, Kristen is provided a Quoted Price of $4020 USD to buy 1 BTC. This represents the Gemini market price of $4000 USD, plus the 0.50% Convenience Fee (Gemini market price × 1.005). When Kristen enters her buy Web Order for $100 USD and clicks on “Review Order,” the Transaction Fee of $2.99 USD is displayed on her website application along with the total BTC amount of 0.02413184 (($100 USD -$2.99 USD)/$4020 USD = 0.02413184 BTC) that she will receive for her buy Web Order. Kristen clicks on “Place Order” to place her Web Order to buy 0.02413184 BTC for $100 USD. Fees are only incurred when her Web Order is executed.”

A nearly 3.5% fee to buy bitcoin.  While Robinhood Crypto doesn’t explicitly charge transaction fees, they sell order flow to market makers which could potentially result in subpar trade execution for investors.  Oh, and you can’t actually transfer your crypto out of Robinhood.

I’m getting lost in the weeds, but the point is that transacting via crypto exchanges isn’t exactly cheap or transparent.

Now, there is an important distinction between bitcoin funds and purchasing bitcoin via exchanges:  bitcoin funds charge annually.  If you buy and “hodl”, those annual fees add-up, compounding over time.  If investors transact frequently (not a great idea in my opinion), then the exchange transaction fees can add-up.

One last point on fees: obviously, none of the above includes other third-party intermediaries – for example, financial advisors or services helping provide exposure to bitcoin.  Those intermediaries may charge a percentage of assets (say 1%) or a monthly or annual subscription fee.

What About the Roll Costs of Bitcoin Futures ETFs?

Most know the story by now.  The Winklevoss Twins submitted the first bitcoin ETF filing back in 2013.   The Winklevoss Bitcoin Trust (COIN) aspired to actually hold bitcoin, as opposed to bitcoin futures.  8+ years later and the SEC still isn’t comfortable with a spot or “physically backed” bitcoin ETF.  While the SEC’s reasons for not allowing this product are debatable, their explanation is straightforward.  The bitcoin spot market is unregulated.  The SEC doesn’t believe they can properly surveil crypto exchanges in an effort to spot fraud and manipulation.  Therefore, they don’t believe they can adequately protect investors, one of their primary jobs.

However, the SEC is comfortable with the CME bitcoin futures market, which is regulated by the Commodity Futures Trading Commission (CFTC) and can be surveilled.  Plus, bitcoin futures can be held in a 1940 Act investment wrapper, which the SEC likes because it offers additional investor protections.  Add it all together and voilà, we now have bitcoin futures ETFs.  The issue, as I mentioned earlier, is these are imperfect products.

Futures contracts offer exposure to the price of an underlying asset without actually holding that asset.  They represent agreements whereby two parties commit to buying/selling an underlying asset at a specific price at some point in the future.  Most importantly as it relates to bitcoin futures ETFs, these contracts have expiration dates.  In order for an ETF to maintain exposure to the price of bitcoin, they must sell their bitcoin futures contracts prior to expiration and “roll” the proceeds into new contracts.

For example, if an ETF owns November bitcoin futures, those contracts have an expiration date of November 26th.  Prior to that date, the ETF must sell those holdings and buy December futures to maintain bitcoin price exposure.  There’s a small problem, however.  The December futures cost more than the November futures.  And the January futures cost more than the December futures.  This is called “contango”, where later dated futures contracts cost more than near dated ones.  As futures contracts get closer to expiration, their prices converge to whatever the spot price of bitcoin is.  The end result is that the ETF is constantly buying high and selling low, not exactly ideal in investing.

This negative performance drag (you may also hear “negative roll yield”) is real.  And just like with fund fees, the impact compounds over time.  The below chart compares a bitcoin futures index (which holds front month bitcoin futures and rolls into the next months’ contract shortly before expiration) versus a bitcoin spot index.  There’s a big different in returns.

Source:  VanEck

Now, this can also work in reverse, if the futures curve is in a state of “backwardation” – where near-dated contracts are pricier than later dated ones.  But that is not the situation we are currently in.

There are some other nuances to futures-based ETFs including managing around contract position limits and performance slippage from not obtaining 100% notional exposure to the underlying market, but for brevity (if that’s possible at this point), I’ll save the details for another day.

So, What Does This All Mean?

Bitcoin futures are suboptimal products, but they do solve some real problems for investors and advisors.  If these ETFs had been available a year ago, investors could have scooped-up the nearly 275% gain shown above.  Not bad.  Bitwise’s Matt Hougan said it best:

“Ease of use is a killer app and even if you don’t get 100% of bitcoin price appreciation, it’s better to get 90% than sit on sidelines.”

However, investors would have also left some money on the table due to the negative impact of ETFs rolling futures contracts.  Physical bitcoin ETFs solve the contango issue and would allow investors to near perfectly track the spot price of bitcoin.  The problem is that nobody knows when, if ever, the SEC may approve these products.

Even the popular Grayscale Bitcoin Trust, which is backed by actual bitcoin, suffers from significant tracking error due to its structure (it can’t create or redeem shares on demand and thus can trade at a sizeable premium or discount).

Until the SEC approves a physical bitcoin ETF, investors are left to decide whether to gain bitcoin price exposure using inferior products or go “direct” to crypto exchanges, which may present some inconveniences.  Even if a physical bitcoin ETF is approved, investors will have to determine whether the annual fee of that product is a better value than going to Coinbase or CashApp.

My expectation is that physical bitcoin ETFs will ultimately be delivered at a similar fund fee to physical gold ETFs, the cheapest of which is now 0.15%.  I would also expect these ETFs to trade at a 0.01% spread (as BITO does today) and they’ll be commission-free at every brokerage.  Is that a better deal than going “direct” to a crypto exchange?  Investors will have to decide for themselves.

In the meantime, what’s getting lost in this entire discussion is the importance of the bridge.  I get it.  You think I’m an ETF cheerleader.  Ok, I am.  But I also believe crypto is the future.  The more people exposed to this technology, the better.  If an ETF helps with that, then sure – I’ll cheerlead.

As Matt Hougan pointed out, the launch of bitcoin ETFs “fits pretty neatly as the bridge from the Early Market to the Mainstream Market. The vast majority of investors are in the mainstream side of the market.”

That’s right, ETFs as a bridge between traditional financial services and crypto.  If crypto’s goal is to go mainstream, then bitcoin ETFs help with that.  Don’t underestimate this.  And as for ETFs’ shortcomings, here’s a unique idea from Onramp CEO Tyrone Ross: