On Physical Versus Futures-Backed Bitcoin ETFs

A bitcoin-based exchange traded funds (ETF) continues to be the most eagerly awaited financial instrument on the horizon as investors await a verdict from the U.S. Securities and Exchange Commission (SEC) in near future. Two leading investment management firms, ProShares and VanEck (in partnership with financial services company SolidX) are the front-runners in their applications for bitcoin ETFs. (See also: Are Bitcoin ETFs "Nearly Certain"?)

ProShares, which has one of the largest lineups of ETFs, with more than $30 billion in assets, has two proposals for its bitcoin ETF and both are based on bitcoin futures contracts. On the other hand, the proposal by VanEck-SolidX is based on a physical-backed bitcoin ETF. This article looks at the key differences between the two kinds of offerings.

Let’s begin with a quick primer to recap how ETFs work. ETFs are a blend of mutual funds and stocks. An ETF offers a good degree of diversification based on the underlying index or basket of securities it tracks (like a mutual fund), and offers the convenience of trading with real-time tick-by-tick price changes (like a stock). ETFs are launched by investment management firms and asset management companies (AMC) that purchase (or sell) the underlying securities based on supply and demand. These AMCs create and then sell ETF shares (sometimes called units) to investors, and the price of these shares reflect the changes in the price of the underlying assets as the AMC holds the underlying basket of securities in given proportion. There may be minor differentials in prices owing to the tracking error, which accounts for transaction costs and management charges. ETF securities allow a convenient way for common investors to own a well-diversified portfolio of securities with a single ETF holding.

An ETF investor should note that purchasing a share of an ETF implies that they don't actually own the underlying security (or basket of securities), but they own a piece of the overall fund of the AMC. (See also: An Inside Look At ETF Construction.)

In the case of a bitcoin ETF, the price would reflect the bitcoin-linked holdings of the corresponding AMC.

In case of a physical-backed bitcoin ETF, the investment management firm will purchase the actual bitcoins and create smaller sized shares, which can then be sold, traded and redeemed on stock exchanges. The investment management firm will be responsible for purchasing or selling the necessary bitcoins, securely storing them and maintaining the private keys to their wallets or vaults. (See also: What Are Cryptocurrency Custody Solutions?)

Common investors will simply hold the bitcoin ETF shares in their demat account similar to holding a common share of a listed company. The price of these bitcoin ETF shares will keep changing to reflect the price of bitcoin. Theoretically, if the bitcoin price changes by 1.5% in an hour, the price of physical-backed bitcoin ETF can also be expected to move by the same magnitude and in the same upward direction (and vice versa). Such physical-backed bitcoin ETFs are better for investors who want to take exposure in bitcoins without actually holding them.

A futures-backed bitcoin ETF will base the shares in the fund by taking positions in bitcoin futures contracts instead of holding real bitcoins. Since futures are speculative instruments that may trade at a premium or at a discount, it is possible that the share price of a futures-backed bitcoin ETF may deviate to a larger degree compared to the actual bitcoin prices. For instance, if the price of bitcoin has moved up by 1.5% but the price of bitcoin futures is trading at a discount of 2%, it is possible to see the price of futures-backed bitcoin ETF units going down. While such moves can offer profitable opportunities to active traders, they risk getting hit with losses when caught on the wrong side of the trade.

Since the investment management firms operating such futures-backed bitcoin ETFs only hold a bitcoin-based derivative security, they don’t have to worry about thefts and hacks often associated with cryptocurrency holdings. While such futures-backed bitcoin ETFs save on costs of secure storage and don’t run the risk of hacking and thefts of actual bitcoins, these benefits are partially nullified by trading overheads. Since futures contracts come with expiry dates, such ETFs need to rollover their underlying futures holdings. It often involves buying futures at high prices earlier in the month(s) and selling them later around expiry date at relatively low prices. Such mandatory rollovers not only reduce the profit potential owing to the above mentioned price gaps, but also increase the cost of operations due to the regular transactions required.

As of August 2018, there are 10 bitcoin-related funds pending SEC review, and decisions are due over the next two months, according to CoinDesk. Interestingly, only one among them (by VanEck-SolidX) is a physical-backed bitcoin ETF and rest nine are futures-backed. It indicates that AMCs are placing higher stakes on securing approval for futures-backed offerings compared to approval for physical-backed offerings.

Daniel Masters, executive chairman for CoinShares, attributes this to the requirement for safe storage of cryptocurrencies, "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."

No wonder the leading investment firms are now eyeing a big market for cryptocurrency custody services. (See also: Goldman Sachs Is Planning a Crypto Custody Service.)

Any attempt to reap profits from a financial security built atop other securities requires a clear understanding before interested investors jump in with their hard-earned money. While SEC decisions are expected soon, it may take time for investors to get accustomed to the variety of potential bitcoin ETF offerings.

Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") is highly risky and speculative, and this article is not a recommendation by Investopedia or the writer to invest in cryptocurrencies or ICOs. Since each individual's situation is unique, a qualified professional should always be consulted before making any financial decisions. Investopedia makes no representations or warranties as to the accuracy or timeliness of the information contained herein. As of the date this article was written, the author owns no cryptocurrencies.