simeon

When the ProShares Bitcoin Strategy ETF (BITO) launched back in October, it became the fastest ETF to reach $1 billion dollars in assets under management. Since its debut, BITO has remained highly active, exhibiting trading significant daily volume even as additional bitcoin futures-based products have entered the market.

Recently, ETF Trends and ETF Database’s managing editor Lara Crigger took a moment to sit down with ProShares’ head of investment strategy Simeon Hyman to discuss BITO’s launch, as well as some persistent myths and misconceptions about how the product works. 

Lara Crigger, managing editor, ETF Trends & ETF Database: For readers who might have been living under a rock for the past few months, could you briefly tell us about the ProShares Bitcoin Strategy ETF (BITO) and how it uses bitcoin futures to access bitcoin exposure?

Simeon Hyman, head of investment strategy, ProShares: BITO is the first U.S.-listed bitcoin-linked ETF. The fund is designed to provide investment results that correspond to the performance of bitcoin. That’s it. Straightforward. The fund does this by investing in bitcoin futures contracts and not actually in spot bitcoin directly. Using futures is in many ways an advantage over investing in spot bitcoin directly.

Crigger: How so?

Hyman: First, there’s a belt and suspenders aspect to it. The futures market is a regulated place and so is the ETF wrapper, and both contribute some key advantages. Also, there’s some evidence that bitcoin futures more quickly and accurately reflect market sentiment.

A lot of folks have the misconception that spot bitcoin is this simple thing, but you can’t invest in the price in the corner of your TV screen. There are multiple bitcoin exchanges. And from a liquidity standpoint, CME bitcoin futures market actually trades more volume than the largest U.S. bitcoin exchange.

Plus, it’s almost impossible to manipulate the futures market. It’s governed by the Commodity Futures Trading Commission (CFTC). There are no custody issues; you don’t have to worry about a wallet that could be hacked, or whether to use a cold key or a hot key.

So, [there are]very important positives about the user experience and the ability to have exposure to bitcoin in an ETF wrapper that can be purchased through an investors’ brokerage account.

Crigger: You said that bitcoin futures better reflect actual market sentiment in bitcoin better than spot. How can that be the case?

Hyman: It’s not a revolutionary concept for a futures or derivatives market to have this benefit. When people say price discovery, we just mean that information is more quickly reflected in price. One example many folks may be more familiar with is the credit default swap market (CDS). CDS reflect changes in credit quality of companies before cash bonds can change their spreads in the marketplace.

So this isn’t a new thing. There is some evidence that information is being disseminated very quickly in the bitcoin futures market. Some of the evidence is that volume: the average daily volume (Q3 ’21) of front month CME bitcoin futures trading activity was about 74% greater than the largest U.S. bitcoin exchange.

Crigger: You had a massive launch — but how have trading volume and flows been in BITO since the first few days? Have things quieted down?

Hyman: We certainly did have a huge launch. And, of course, we’re very pleased with the initial success of BITO. We think that’s evidence that there was a need, and there are many investors who wanted to include bitcoin in their investment portfolios, but found it was just too complicated. The whole notion of decentralized finance, the core of what bitcoin is, is necessarily a little tricky — the blockchain, ledger, keys, etc. That makes it a little bit tricky to invest in. Now an ETF solves that problem for lots of people, in the same way the first gold ETF did many years ago. You don’t have to be a metallurgist to invest in gold, and neither do you need to go back to the original anonymous white paper that created bitcoin to get exposure to this asset in your portfolio.

Crigger: For any other ETF, in any other context, people would be crowing.

Hyman: True! But aside from the assets, what’s important is also the robustness of the trading. We’ve been trading on average around $400 million [in volume]each day. Spreads are super tight, and there are options on the ETF. All those things create a very robust and healthy ecosystem, and efficient marketplace.

It’s funny, people have asked us, “Are these long-term holders of BITO, or are they traders?” We don’t know. There’s no questionnaire you fill out. Both are really important. Because if you’re going to hold this fund for two or three years, the day you buy it you want activity there to make sure you can buy it efficiently. And if you elect to sell your position, you’re going to want those traders there that day as well.

So, it’s really important to have both those constituencies involved, and the trading volume, tight spreads, and the availability of options are all manifestations of the health of this ETF’s ecosystem.

Crigger: There’s been a lot of talk about why one would even bother with bitcoin futures and an ETF wrapper — why not just go buy bitcoin on a crypto exchange? What are the advantages to buying a bitcoin futures ETF versus just buying a spot holding?

Hyman: There are a number of pieces to that answer. One, I mentioned a couple of the shortcomings of the spot market itself. Remember, there are multiple exchanges — so you don’t really know exactly what price you’re going to get. And there’s no way to trade bitcoin that’s absolutely free. That’s key. Also, you still see some goofy price behavior: mini flash crashes and things in that spot market itself that don’t really happen in the futures market. Bitcoin futures, and the settlement of bitcoin futures, actually relies on a measure that takes an average of prices across five different exchange to address this.

In addition to the issues within the spot market itself, of course, there’s also just the transactional complexity of investing in bitcoin directly, even through an exchange. I was looking at the disclosures on one of the exchanges that offers bitcoin, and in the small print was this text: “You could lose all your money in a fork.” I then spent about three hours making sure that I understood what a fork was on the blockchain. There are a lot of people who will be comfortable with that, but certainly there are folks who are not amenable to the challenges of being in a new asset like that in its raw form.

Then, of course, there’s the issues of custody and the wallet. Once you’re in an exchange, that’s only the beginning of your decision process. Then you have to decide whether the exchange holds your wallet, whether you hold your own wallet, whether you hold your wallet and your code is on a memory stick, or it’s on a piece of paper in a vault, and so on. So there are challenges. For many people, they find that to be a reasonable path. But we can see from the activity in our ETF that that for many, many people, a simpler and more straightforward solution right in your brokerage account that sits transparently alongside all your other assets — was a substantial innovation.

Crigger: But there’s also been a lot of folks saying that a spot ETF would be much better than a futures ETF. You wouldn’t have to worry about rolling contracts from month to month, or about contango and backwardation. What’s your take: Would a spot ETF be better?

Hyman: We’re obviously going to watch the maturation of the market itself and see how that spot market evolves. But that’s really the key, that the spot market is not really ready for primetime for many investors and it wasn’t ready for the SEC. But if you read the SEC comments [on the filings], they’re all the things that we’re talking about. All those shortcomings of spot bitcoin are the things that make the futures — at this point in time — a more robust way for many investors to access bitcoin exposure.

Crigger: So let’s dive into the nitty gritty of futures contracts. One thing I think a lot of folks don’t really grasp yet is the idea that holding futures subjects you to position limits. You can’t just continue to amass futures contracts in the market ad infinitum; there is a limit to the number of contracts which any one investor can hold. How does BITO approach position limits? And what do you plan to do if you get to the point where you’re bumping up against them?

Hyman: There are position limits in futures-land, but I think there’s a lot of misunderstanding, so let me see if I can just clarify the pieces of the puzzle here.

First, the front month contracts. That’s where we start with BITO. There is indeed a limit of 4,000 contracts. Now, by the way, 4,000 — that’s five bitcoin per contract, at roughly $60,000/bitcoin. So, you can do the math. That’s a lot of contract space available in the front month contract.

But then there are the other month contracts. There is no set limit on the number of non-front month contracts that could be held. There’s an accountability level, which means you might get a phone call, and that might happen around 5,000 contracts. But it’s not a hard limit.

Also — and some people get this wrong — those 5,000 contracts are on top of the 4,000 front-month contracts. So there is a lot of headroom.

Finally, there are also additional front month contracts that could be potentially bought under an exemption that can be applied for that that the CME may grant. So there’s a lot more room there than I think people have appreciated.

Crigger: Can you talk about the benefits of the RIC structure of your product versus those who may be structured differently? And could you parse for us what that means to an investor?

Hyman: The key is whether you’re a C-corp, or a good old-fashioned pass-through RIC, which is how just about every investment vehicle is constructed in the U.S.

C-corps are an unusual choice for an investment vehicle, because it creates double taxation. A C-corp is a regular company that pays taxes, and an investment vehicle generally doesn’t pay taxes, it just passes all of its benefits to the shareholders without paying taxes. Who would want to pay taxes twice?

There is an ability, over time, in some situations, for the C-corp structure to offer some benefits to a taxpayer over time that can offset, but it’s very hard to come up with a scenario that would offset all the detriments of the double taxation. But you could come up with corner cases.

But really importantly, you can’t come up with a justification for putting a C-corp structured investment vehicle in an entity that doesn’t pay tax, like your retirement account, or a foundation or endowment, or an international investor. That would be like putting a municipal bond in your retirement account. It would make no sense. You’d be paying this 21% corporate tax at the fund level, and there’d be no way for you to get any benefit offset, because you’re not a taxpayer. So, it doesn’t make sense in a tax-exempt vehicle.

Just to put the period in the sentence, guess where those taxes show up? Well, immediately they show up in performance, because as soon as a C-corp makes a profit, it must accrue the tax liability. But it also shows up in the management fee. So, if you’re touting a 50 basis point management fee, and then the fund was up 20%, lo and behold, it would have paid 420 basis points of taxes. Guess what your management fee is? 470 basis points. These are the things we like to highlight to make sure that people understand the pros and cons of different structures.

Crigger: What’s next for ProShares? Are you planning on more crypto ETFs, such as other crypto futures, or perhaps a miners ETF?

Hyman: Innovation is core to what we do. We’re roughly a $75 billion asset manager with nearly 25 years of experience, and we’re sizeable, but not trillions and trillions. So that means that we have the ability to be flexible and innovative, but still have the size to execute well. That’s part of our DNA. We’re watching the evolution of the market, and whether it’s other coins, whether it’s other pieces of the space, companies involved in the blockchain and DeFi, these are all things that, of course, are part of our continual exploration to see what solutions to bring to market that help investors build better portfolios.

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