The Problem With a Bitcoin Futures ETF

We’re in the countdown for the approval of the first Bitcoin futures ETF, and as I suggested a few weeks ago, the race to be the first product out of the gate has yet to be decided.

I still think the most likely outcome is not that the “first in” filing (ProShares, which mirrors their mutual fund) gets approved first, but that all the proposals get kicked down the road another few months. Still, it wouldn’t be much of a reach for the SEC to just let the ETF launch, or approve Valkyrie’s cleaner “futures only, we promise” proposal instead/as well.

But lost in the mix here is the fact that, for most folks, Bitcoin futures are honestly a pretty second-rate way to get exposure to crypto. I’ve listed a few of their drawbacks below.

None of these are deal killers by any means, and when one of these Bitcoin futures ETFs launches, hundreds of millions of dollars will jump into the first movers. That’s really without question. But investors should at least know what they’d be getting into, especially should they, for some reason, be really successful in a hurry.

Bitcoin Futures Are in Contango

The biggest issue with any Bitcoin futures ETF — indeed, with any futures-based ETF at all — is that buying the ETF does not mean that you’re buying the actual headline asset. With a Bitcoin futures ETF, you’d no more be buying bitcoin than you would be buying barrels of oil by owning the United States Oil Fund (USO). Instead, you’re buying exposure to derivatives based on that asset — in the case of Bitcoin funds, it’s first- and second-month futures contracts.

That raises the question of contango and backwardation.

Once upon a time (say, ~2500 BC), futures contracts were used primarily by farmers and bakers to pre-sell their crops and lock in prices. Because commodities like crude oil are costly to store, we used to talk about “normal backwardation,” which is essentially the idea that tomorrow’s barrel of oil should cost less than today’s, by at least the amount of renting the storage space in Cushing, Oklahoma.

I also remember when I had spiked, black-dyed hair so I could look cool for Cure concerts in the ’80s. Times change.

Nowadays, most commodities exist in a world where tomorrow’s price is higher than today’s price, which is a condition known as “contango.” There are reasons for this contango for each market (e.g., uncertainty about future supply, less-than-expected short-term demand, the endless appetite for the leverage in the futures market, etc.), but contango is just the state of play for the majority of futures contracts right now.

What that means is that any futures portfolio in Bitcoin is buying up expensive Tomorrow-Bitcoin and watching its price in relation to the Today-Bitcoin price, until it comes time to sell that contract (or “roll”) and buy more Tomorrow-Bitcoin. Below are the prices for the next three months’ worth of futures contracts (as of this writing, spot bitcoin was at $57,395):

That constant state of “buy high today, sell lower tomorrow” means that Bitcoin futures funds will face consistent headwinds. Since its launch in late June, for instance, the ProShares Bitcoin Strategy ProFund (BTCFX) mutual fund is lagging about 0.60% behind a theoretical spot bitcoin position (including the impact of expenses). That’s actually not too shabby, considering that the United States Natural Gas Fund (UNG), which tracks a near-month futures strategy for natural gas, is 154% behind spot natural gas over the past 12 months.

However, it’s important for investors to realize that by investing directly into the teeth of contango, their returns can (and will) diverge from spot bitcoin. How large that divergence is doesn’t depend solely on how much the price of bitcoin rises and falls. It’s a complex set of relationships between custody and trading costs and the appetite for directional leverage (which is currently very long). And this is all so new that the contango/backwardation dance can’t, I don’t think, be modeled on what we’ve seen to date.

Bitcoin Futures Are Subject to Position Limits

The second big issue with investing in futures contracts rather than the underlying asset is that you’re trapped in the market structure of the futures market. Specifically, that means every futures contract has an associated “position limit,” or number of open contracts that any one owner is allowed to have at any given time.

Position limits exist to prevent anyone from cornering a market and blowing up global commerce (like the Hunt Brothers tried in the 1980s). Individual investors are subject to them — and so are ETFs.

The current position limit for Bitcoin CME Futures Contracts is 10,000. Since each contract represents 5 bitcoin, that means, as I type this, the notional maximum exposure any individual owner could get of Bitcoin futures would be 10,000 * 5 Bitcoins, or $2.8 billion. While that may seem like a lot, it’s basically exactly how many contracts USO has in hand right now.

But that’s the maximum theoretical level. The potentially more problematic position limit threshold is the exchange’s “accountability level,” which is set at half the position limit, at 5,000 contracts (worth $1.4 billion in today’s prices). Once a holder hits the accountability level, they would be subject to having their position capped, or even being forced to reduce it, by the exchange.

So it’s not inconceivable that a fund could have a good opening run, then run right smack into CME position limits. This would leave the fund with very little good recourse, and when similar issues have plagued other funds, they’ve ended up scrambling for less-efficient swap counterparties, or have just flat out failed to track their intended investment objective very well.

This is admittedly a high-class, success-dependent problem, perhaps one that in retrospect will look like an outlier. But it’s still a real thing that might impact investor experience, nonetheless.

Could a Bitcoin Futures ETF Even Get the Leverage It Needs?

I mentioned this in my previous piece. SEC Chair Gensler has made it abundantly clear that he wants to see the magic phrase “’40 Act” in a Bitcoin futures ETF proposal. However, the problem is that the IRS has pretty strict rules (thanks, Jeremy!) regarding how a ’40 Act fund must diversify its portfolio.

’40 Act funds — that is, the vast majority of mutual funds and ETF — have strict IRS diversification requirements. They’re not supposed to own just one or two things, such as a single month’s worth of futures contracts.

To obtain exposure to “one thing,” say, front-month futures contracts, a fund must hold at least 50% of its assets in cash or cash-like securities. Only then can it put up to 25% of its assets in that “one thing” — and that “one thing” may be a foreign subsidiary that can use leverage.

This is the structure used by every popular commodities ETF like the Invesco Optimum Yield Diversified Commodity Strategy No K-1 (PDBC), which has “No K-1” in the name, a signal that this is an actual ’40 Act fund. It’s also how a Bitcoin futures ETF might work: the ETF would keep 75% of its assets in cash here in the U.S., then send 25% of its AUM to a subsidiary located in the Cayman Islands. That Cayman subsidiary then employs 3:1 leverage to get, essentially, 100% Bitcoin futures exposure. (NOTE: I have no idea how the ProFunds mutual fund manages this, because it doesn’t show its daily holdings — another reason I’m eager for an ETF!)

But this opens up another issue. Normally, the way a Cayman Islands pool obtains its exposure to the asset is by using the inherent leverage of the futures contracts. In oil, for example, I can buy a contract worth $81,000 right now with an initial margin of just $5,100; that gives me a 16:1 leverage.

However, in Bitcoin, margin requirements are hovering just under 3:1, meaning you can’t quite get to 100% in the same way. As Bitcoin becomes more volatile, it’s possible that those margin requirements could get even tighter. Then how would the Bitcoin futures ETFs meet their leverage needs? There are answers there (lines of credit, swaps) and you could still invest some of the US domiciled cash in things you hope track Bitcoin. But as you can see, it gets messy.

Canadian Bitcoin ETF Taxes for U.S. Shareholders Unclear

Last time I checked (and it moves every day), all but one of the Bitcoin futures ETF filings carve out an alternative means to get exposure to the price movements of bitcoin: They allow themselves room to buy Canadian Bitcoin ETFs.

This blatant regulatory arbitrage makes all the sense in the world — on paper. (Sidebar: The Ontario Securities Commission is always ahead of the SEC. They’re like the Y Combinator for American regulatory innovation.) Instead of buying bitcoin directly, the fund can just buy the Purpose Bitcoin ETF (BTCC:TSX), and since Canadians have already figured out how to buy and hold bitcoin inside a regulated ETF, we’ll just have what the Canadians are having.

This is a great idea, with one enormous caveat: Canada’s tax code is paranoid about foreign investors.

One of the big ways this shows up is in the “Tender Requirement”; that is, any time a foreign entity owns 20% of a company, they have to tender an outright offer to all shareholders. (This is why the indexes underneath big gold miner ETFs had to change a few years back.) The Tender Requirement gets waived in the case of something like BTCC, though.

The second consequence is that foreign investors can’t own more than 50% of a fund in aggregate. It can be really bad for the fund if this is violated; the fund loses its tax status, and a lot of green eyeshade folks end up working hell-shifts until the end of time trying untangle the mess. So most Canadian prospectuses have language like the following, from BTCC’s prospectus:

If the Manager determines that more than 40% of such units are beneficially held by non-residents and/or partnerships that are not Canadian partnerships, the Manager may send a notice to such non-resident Unitholders and partnerships, chosen in inverse order to the order of acquisition or in such manner as the Manager may consider equitable and practicable, requiring them to sell their ETF Units or a portion thereof within a specified period of not less than 30 days.

By Canadian ETF standards, BTCC has been pretty successful; it has total assets of about $1 billion. But that foreign investment clause significantly limits the potential size of the “Canada hack” for the U.S. industry. And importantly, note that these are “last in, first out” provisions, meaning that should a product using the Canada hack be approved, they are incentivized to go all in on exposure to Canadian ETFs as fast as possible, so that they’d be last in line for forced liquidations.

Sound messy? It would be. Far fetched? Who knows.

Ecosystem Issues Around Custody, Cash Management

One last area of concern I have is about cash management and custody in the Bitcoin futures ETF ecosystem. In terms of managing crypto exposure versus traditional derivatives markets, there are only a handful of participants playing at the highest level. Those are the folks acting as Authorized Participants for the European and Canadian physical Bitcoin ETFs, and who likely are also acting as liquidity providers in the futures markets.

To do that job, you need to be able to cross-exchange finance. That’s one of the big jobs a prime broker traditionally does. You want to sell Indian equities and buy French ones? A good prime broker helps you deal with the settlement mismatches, funding trades, and so on.

But when it comes to crossing back and forth between the securitized notional and crypto notional economies, that function seems, well, less developed. Yes, I know there are a ton of smaller crypto-centric startups doing this, and several large custodians and prime brokers on the securities side working on it, too. But by definition, the group is smaller and less well-baked than a traditional prime brokerage.

I say this not as a prediction that things will break. I don’t want to come across like a hand-wringy “some worry” headline. Rather, I believe that where ecosystems bridge is where things get interesting, and thus, I’m trying to learn more here about how flows are settling and where the trade financing happens when crypto is half the trade. My opening assumption is that the provenance of the players in the ecosystem will matter. So, I’m reading the darn paperwork.

In the end, as much as I am enjoying the horse race around who will be first to launch a Bitcoin ETF, I think paying attention is appropriate here. If you’re an advisor who’s interested in getting a little crypto exposure for your clients, I continue to think that education is your #1 job. We’ve got some cool stuff on our Crypto Channel, for starters. Coindesk exists. The folks at OnRamp are just busting with ideas. An investment in learning something is always profitable, as some old stooge likely said.

And if and when you do choose to pull the trigger, really wade in. Ask providers how they’re handling all these issues — I will be!. Find out who the players are. Explore their contingency plans.

But as always, be skeptical. It’s the job.

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