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How Does a Crypto ETF Work?

Posted on Sep 21, 2023
How Does a Crypto ETF Work?

Since the mid-1990s, ETFs have been witnessing an upward trajectory in their popularity as investment vehicles, attributed to their inherent intraday liquidity and minimized transaction expenses. Typically, ETFs are designed to mirror a specific index and are predominantly traded on exchanges, offering a contrast to mutual funds, which only allow investors to buy or redeem shares at the trading day’s close. This characteristic of ETFs permits continuous trading of shares throughout the trading day in the securities market.

For numerous years, large mutual fund corporations have been striving to obtain authorization for cryptocurrency exchange-traded funds (ETFs) without success, largely due to the reluctance of the U.S. Securities and Enforcement Commission to endorse such high-risk asset classes. Nevertheless, a breakthrough occurred in October 2021 when the SEC approved the inception of futures-based crypto ETFs.

What is a Crypto ETF?

A crypto ETF operates as an advanced form of investment tool that follows the value fluctuations of one or more digital currencies and is essentially similar to a conventional ETF, traded as a standard share on stock exchanges. Such ETFs, including Bitcoin ETFs, offer mainstream investors an opportunity to invest in a regulatory compliant asset that is representative of Bitcoin or other cryptocurrencies, thus negating the necessity to own or handle the crypto assets directly, a process often fraught with complexities and security risks, as evidenced by the near $2 billion in crypto losses in the first half of 2022.

Crypto ETFs allow investors to have indirect exposure to the volatile crypto market by purchasing shares that symbolize their rights in the exchange-traded fund. The companies issuing these ETFs need to hold custody of the underlying digital coins and provide a relatively safer and more straightforward way for investors to gain exposure to cryptocurrencies' price movements.

To qualify as an exchange-traded fund, the fund must invest in companies innovating through the creation and deployment of blockchain technology or be blockchain-based and invest in cryptocurrency investment products provided by renowned asset managers like Bitwise or Grayscale, or in futures and options, whose prices are correlated with the performance of leading cryptocurrencies like Bitcoin and Ether.

The utilization of crypto ETFs represents a broader application of blockchain technology, with the first crypto ETFs aiming to track the value of Bitcoin, the predominant digital asset. However, the accessibility of such investment tools is still evolving, with major developments occurring in October 2021 when entities like ProShares, Valkyrie, and VanEck initiated the trading of Bitcoin ETFs. It is crucial to note that the products managed by these entities observe the price of BTC through futures markets, and none are directly tethered to the spot price of Bitcoin.

Investors should exercise caution while navigating such volatile investment avenues, as substantial holdings in the futures market by an ETF can pose additional risks. The landscape of crypto ETFs is anticipated to experience continuous evolution, with increased regulatory clarity and advancements in blockchain technology potentially leading to the development of more diverse and sophisticated crypto investment products in the near future.

Blockchain ETF vs Crypto ETF

ETFs offer a comparatively secure avenue for investing in assets powered by blockchain. Occasionally, investing in blockchain-related entities implies acquiring a stake in a blockchain ETF, enabling an investor to engage with ETFs reflecting the ownership of stocks in a company involved in blockchain technology, the foundational technology behind digital currencies.

A representative example of a blockchain ETF is BLOK, introduced in 2018. This exchange-traded fund allocates 80% of net assets to companies engaged with decentralized ledger technology (DLT).

In August 2022, Schwab Asset Management initiated its Schwab Crypto Thematic ETF. This fund does not offer direct exposure to crypto assets but focuses on companies investing in them, such as MicroStrategy, Coinbase, and Riot Blockchain. While innovative, it does not qualify as a true crypto ETF, and concerns are being raised over the proliferation of such crypto-themed ETFs.

The operationalization of a crypto ETF requires regulatory approval from the financial regulatory bodies in the jurisdictions it wishes to operate in. For instance, to draw investments from U.S. residents, a crypto ETF must secure approval from the U.S. Securities and Exchange Commission (SEC). The fundamental prerequisite is to ensure alignment with regulatory standards and secure a 'go-ahead' from relevant financial overseers to gain legitimacy in attracting investments.

How does a cryptocurrency ETF work?

Cryptocurrency ETFs represent a groundbreaking stride in financial investments, offering a structured, transparent approach to investing in digital currencies, and they are seen as pivotal for enhancing cryptocurrency acceptance and liquidity. These funds are either backed by actual cryptocurrencies or are synthetic, reflecting the price movements of cryptocurrency derivatives like futures contracts.

Crypto ETFs aim to replicate the price fluctuations of the underlying cryptocurrencies but don't hold the cryptocurrencies themselves, focusing instead on futures, options, or other crypto-based securities. This results in a scenario where the movements of the ETF might not precisely mirror those of the underlying cryptocurrency at times. In instances where ETFs are backed by physical cryptocurrencies, investors indirectly own the cryptocurrencies without incurring the expenses or risks of direct ownership, represented by shares in the ETF, thus allowing exposure to crypto assets without the accompanying risks and complexities of handling them outright.

Like their traditional counterparts, cryptocurrency ETFs are listed on major exchanges and, unlike mutual funds, their share prices fluctuate throughout the trading day, providing continuous trading opportunities and enabling investors to react to market changes in real time. ETFs generally serve as an aggregation of many individual securities, providing a convenient way for investors to diversify their portfolios with a single purchase, blending the benefits of stocks and mutual funds, and operating as an attractive means for retail investors to diversify their investments.

The significance of crypto ETFs is underscored by their ability to offer portfolio diversification beyond conventional securities markets, enabling investors to gain exposure to multiple crypto assets. The first cryptocurrency ETF, the ProShares Bitcoin Strategy ETF (BITO), commenced trading in October 2021, marking a pivotal development in the investment landscape.

Despite the advancements and the rush of applications from various financial entities, the SEC has expressed reservations, citing concerns such as lack of transparency, potential for market manipulation, and low liquidity levels in cryptocurrency markets. However, the landscape is rapidly evolving, with increasing exchange trading volumes and total market value surpassing US$2 trillion as of April 2022.

With the advent of leaders like Gary Gensler at the SEC, who has a background in blockchain and cryptocurrency, there’s renewed hope and expectations for the establishment of more cryptocurrency ETFs, despite him sharing his predecessor’s concerns. The integration of cryptocurrency ETFs in the investment domain signifies a transformative phase in the financial sector, amalgamating conventional investment mechanisms with groundbreaking digital assets.

Benefits

Crypto ETFs offer distinctive advantages to investors. They provide an accessible avenue for anyone to gain exposure to the dynamics of the cryptocurrency market, allowing trading during volatile periods without the necessity of setting up a specialized crypto trading account and incurring associated costs.

Accessible through conventional stock trading platforms, Crypto ETFs operate similarly to stocks, offering seamless integration for traders. The subtle management fees, execution, spreads, and commissions, among other hidden expenses usually encountered in cryptocurrency trading on exchanges, are not prominent hassles when dealing with crypto ETFs.

Being registered securities, Crypto ETFs come under the regulatory purview of entities like the SEC and the CFTC, necessitating regular disclosures of their holdings, enhancing their transparency and reliability.

One significant advantage they offer is the possibility to short-sell the ETF, which can be advantageous in a declining crypto market or can serve as a protective measure for long positions. While the volatility of Crypto ETFs can mirror that of the underlying cryptocurrencies, this volatility is often mitigated due to the ETFs’ relatively lower trading prices. For instance, the effect of a 2% price movement on an ETF trading at $30 is considerably less impactful compared to a cryptocurrency valued at $50,000, making them a more stable investment option in comparison to the direct acquisition of cryptocurrencies.

Challenges and Constraints in Trading Crypto ETFs

Trading crypto ETFs brings about its own set of challenges and constraints, offering a unique set of limitations to be considered by investors. One prominent limitation is the potential disparity between the ETFs and the underlying cryptocurrency. The reflection of the underlying crypto by ETFs isn't precise; divergence occurs due to factors like backwardation and liquidity. ETFs strive to mirror the behavior of underlying assets, but exact replication isn’t guaranteed.

Legal language contained within an ETF's prospectus serves to completely cover them, indicating that assuming crypto ETFs as exact replacements for cryptocurrencies would be incorrect. Currently, most crypto ETFs grant synthetic exposure primarily to a restricted array of cryptocurrencies, with altcoins generally not included in more liquid crypto ETFs.

Liquidity is another vital consideration, with established crypto ETFs often enjoying higher liquidity. However, the advent of new ETFs disperses liquidity pools, potentially impacting the less liquid ones, which may also exhibit limited options contracts with minimal volume. Additionally, the relatively elevated management fees, such as 2%, associated with crypto ETFs can accumulate over time. This can notably impact short-term speculation endeavors, becoming particularly burdensome when the prices of crypto ETFs decline.

In conclusion, crypto ETFs, despite their imperfections, facilitate convenient speculation on crypto markets for equity traders, allowing them to execute trades via their primary brokerage accounts without the necessity of creating new accounts to trade cryptocurrencies. Even with the existing limitations, the crypto ETF domain is poised for numerous innovations and enhancements in the forthcoming years, highlighting their pivotal role for traders not inclined to engage directly with cryptocurrencies.

Canada's Embrace of Crypto ETFs

Canadian regulatory bodies have emerged as pioneering authorities, endorsing the advent of crypto ETFs. In February 2021, Canada saw the introduction of a Bitcoin ETF which remarkably amassed over $420 million in assets under management within a span of just 48 hours.

This ETF, initiated by Purpose Investments, became accessible to investors on the Toronto Stock Exchange (TSX) and trades under the symbol "BTCC." Soon after, another Bitcoin ETF, represented by the ticker "EBIT," commenced trading on the TSX, with Evolve Funds Group acting as its custodian. EBIT allows investors to gain exposure to Bitcoin, enabling them to navigate its daily price movements in relation to the US dollar.

By June 2022, according to a study by National Bank Financial, Canada housed approximately 40 cryptocurrency ETFs, encompassing Bitcoin and Ethereum funds. The sector marked a cumulative asset value of $4.3 billion. Remarkably, there has been no adverse impact on the nation’s economy, even with substantial investments from the citizenry in what some skeptically term as magic internet money. The continued resilience and growth of these investments illustrate the country's progressive stance and adaptive approach to innovations in financial instruments.

What Is an Ethereum ETF?

An Ethereum Exchange-Traded Fund (ETF) serves as a crucial conduit for investors to gain exposure to Ethereum, the world's second-largest cryptocurrency, by trading on stock exchanges. This form of investment bears resemblance to trading stocks or bonds, with the crucial distinction being the underlying asset, Ethereum (ETH).

For many enthusiasts lacking technical acumen, Ethereum ETFs represent a safer and simpler avenue to invest in this cryptocurrency, circumventing the need to acquire actual ETH and the associated complexities and risks of storing it securely. Ethereum ETFs, by design, negate the necessity for investors to possess the ETH directly, entrusting the secure handling to custodians who usually implement enhanced security measures, compared to an average investor.

Given the evolving dynamics of the crypto space, the timing for endorsing an ETH ETF seems optimal. A landmark event in 2022 was the Ethereum Merge in September, a transition for Ethereum's network from a proof-of-work (PoW) to a more eco-friendly proof-of-stake (PoS) consensus mechanism, promising a reduction in energy consumption by 99.95%. This transition is poised to make Ethereum an attractive prospect for institutions aiming for ESG-compliant investments, especially amid soaring global energy prices.

The enhancements such as Ethereum's EIP-1559 burning mechanism anticipate a promising trajectory and positive price momentum for ETH, contingent on macroeconomic stability, potentially elevating it to a coveted asset. However, it's paramount to note that the future is laden with uncertainties, and these insights do not serve as financial counsel.

The pertinent question revolves around whether Ethereum's metamorphosis will sway regulators to authorize an ETH ETF, potentially preceding a BTC ETF. The prospect seems improbable, given the existing reservations and stringent stance of U.S. financial regulators who have yet to endorse an Ethereum ETF, attributing their reluctance to the volatility and security concerns surrounding cryptocurrencies.

Contrastingly, Canada has exhibited a more progressive approach, having sanctioned three Ethereum ETFs—by Purpose Investments, CI Global Asset Management, and Evolve ETFs—in April 2021 in a single day and persisting in its approvals of more such funds, showcasing a divergent regulatory perspective and a conducive environment for the proliferation of such innovative financial instruments.

ETFs Are Centralized

ETFs, or Exchange-Traded Funds, inherently operate within a centralized framework, functioning as a pivotal instrument in the traditional financial ecosystem. They are crafted to provide investors with the opportunity to diversify their portfolios by investing in a collection of stocks, bonds, or other assets, without the necessity to purchase each component individually. This centralized structure is overseen by regulatory bodies and managed by professional entities or investment firms, ensuring compliance with established financial norms and regulations.

The centralization of ETFs is contrasted starkly against the decentralized ethos of cryptocurrencies and blockchain technology, which seek to eliminate intermediaries and grant autonomy to individual users. In the centralized ETF model, the management of assets, decision-making processes, and allocation of funds are concentrated within the managing entities or fund managers. They execute strategies, ensure regulatory adherence, and handle the intricacies of asset management on behalf of the investors. While this centralization brings a layer of trust, security, and professionalism to ETFs, it simultaneously restricts the autonomy and direct control of individual investors over their investments. The existence and popularity of ETFs underscore the ongoing relevance and demand for centralized financial solutions, even as decentralized finance (DeFi) platforms gain traction in the financial landscape.

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Any questions?

To invest in a Bitcoin ETF, follow these steps: Open an account with a brokerage that offers access to the stock exchange where the Bitcoin ETF is listed. Fund your brokerage account. Search for the Bitcoin ETF by its ticker symbol. Select the number of shares you want to buy. Place a buy order. Review your investment regularly. Remember to research the ETF thoroughly and consider your investment goals and risk tolerance before investing.

A Bitcoin ETF is an investment fund traded on stock exchanges that tracks the price of Bitcoin. It allows investors to gain exposure to the price of Bitcoin without the need to buy, store, or secure the actual cryptocurrency. Bitcoin ETFs aim to offer a more accessible and regulated means for investing in Bitcoin.

To buy a crypto ETF, follow these steps: Open a brokerage account with a firm that allows access to ETFs. Deposit funds into your brokerage account. Search for the crypto ETF you want to buy using its ticker symbol. Place a buy order for the number of shares you want. Review and confirm your transaction.

A crypto ETF is a type of investment fund and exchange-traded product, i.e., it is traded on stock exchanges. Crypto ETFs hold assets such as stocks or bonds and track an underlying index; in this case, a cryptocurrency like Bitcoin or Ethereum, allowing investors to gain exposure to crypto without owning the actual cryptocurrencies.