11. What are ETFs and what role do they play in the cryptocurrency market?
We usually associate ETFs (Exchange Traded Fund) with stock indices. So what does it have to do with cryptocurrencies? A great deal. While the vast majority of ETFs track stock market indices, a cryptocurrency ETF tracks the price of one or more digital assets. Their price changes daily, which makes them even more interesting. What are they and what role do they play in the world of cryptocurrencies? We answer.
Traditional ETF vs cryptocurrency ETF
To understand the essence of cryptocurrency ETFs, we must first understand what these ETFs actually are. An ETF is a financial instrument that allows us to track the value of an asset or several types of assets. This allows investors to diversify their holdings without physically owning them. Example: an oil exchange-traded fund will track the value of its reserves, which it represents. Such funds can be found on traditional exchanges.
Cryptocurrency ETFs work in the same way as traditional ones. Cryptocurrency ETFs allow investors to profit from assets, using existing brokerage accounts. However, they have a few differences, which we will look at today. Firstly, they come in two forms:
Backed by physical cryptocurrencies. This occurs when the investment firm managing the fund buys cryptocurrencies, creates a fund representing the value of the assets held and lists it on an exchange. Investors then do not bear the risk of owning cryptocurrencies outright and avoid unnecessary costs.
Synthetic option. Follows cryptocurrency derivatives – features contracts and exchange traded products (ETPs) of digital assets. They are far less risky than physical ETFs.
How do they work?
When investing in ETFs, you focus on prices. Why? Because the prices of ETF shares mimic the price movements of derivatives, not the actual prices of cryptocurrencies. The higher the price of the features contracts, the higher the share price of a given cryptocurrency ETF. Conversely, the lower the price of the contracts, the lower the price of the shares. By investing in futures contracts, we do not own any, actual cryptocurrency. Operations on ETFs are not always transparent and therefore carry some investment risk.
History and attempts to regulate ETFs
In 2021, the SEC gave the green light to the first US-based bitcoin futures ETF. But their history is more interesting. We first encountered ETFs in 2014, when the Winklevoss twins submitted an ETF proposal for BTCUSD. As you might guess – the SEC rejected their proposal. What followed was a rash of such proposals to the agency. Investment firms were looking to profit from bitcoin’s price volatility.
In 2018, the SEC explained why it rejects all such requests. Concerns included: lack of transparency on cryptocurrency exchanges (this problem fortunately does not apply to everyone), market manipulation and low levels of liquidity on crypto exchange markets. Fortunately, the situation in the cryptocurrency markets has changed drastically by 2022. There was also a change in the chairman of the SEC. In 2021, Gary Gensler, who had taught, among other things, a course on blockchain and cryptocurrencies at the Massachusetts of Technology, took over this position. The result of the change was the trading of cryptocurrency ETFs, which began in October 2021.
| Advantages | Disadvantages |
| ∙ Lack of complex cryptocurrency terminology, making investment easier, especially for those unfamiliar with the industry. ∙ No need for a cryptocurrency wallet or physical assets. ∙ They are closely monitored. Consequently, authorities protect ETFs from price manipulation. ∙ No need for a crypto exchange account. ∙ We do not need to spend a fortune on cryptocurrencies. ∙ The fees that ETFs carry are significantly lower than in traditional funds. ∙ Cryptocurrency ETFs allow diversification without incurring costs per token. | ∙ There are very few ETFs available. Consequently, we have limited investment choice. ∙ They carry risks linked to the underlying asset they represent. ∙ Funds backed by physical assets are not immune to hacking attacks. |
Alternatives to ETFs
We will start our discussion of the topic with an interesting fact. Did you know that…the first, cryptocurrency ETF was the ProShares Bitcoin Strategy ETF (BITO). It tracks the price of feature contracts on bitcoin. It started its listing in 2021.
Besides, the market for ETFs is still in its young phase and still developing. True – it is an interesting alternative, but investors can place their funds in other products, very similar to ETFs. We will use the US market:
∙ Grayscale Bitcoin Investment Trust (GBTC). This is a closed-end fund, very similar to an ETF. It holds bitcoins in its exposure on behalf of investors. Its shares trade on OTC (over-the-counter) markets.
∙ Bitwise Ethereum Fund and Bitwise Uniswap Fund. They track ETHUSD and the Uniswap token, respectively. Like GBTC, they typically trade at high price dispersion and have a high minimum investment price.
∙ MicroStrategy, Tesla, Galaxy Digital Holdings Ltd, Square INC (SQ), or investing in companies with cryptocurrencies on their balance sheet, without necessarily owning them.
Trivia
∙ On 21 February 2022, a Metaverse-linked ETF, the CSOP Metaverse Concept ETF, was launched on the Hong Kong Stock Exchange.
∙ On 2 February 2021, the Grayscale Future of Finance ETF was launched. This is the first ETF to reflect the performance of the Bloomberg Grayscale Future of Finance Index.
∙ Even India! In January 2022, Torus King Blockchain IFSC partnered with India INX to launch a bitcoin and ethereum ETF. This was the first feature ETF to debut outside the US.
Summary
The cool thing about ETFs is that we can invest in them using the platforms where we invest in traditional equities. We don’t have to set up new accounts or delve into the cryptocurrency industry. They are based on futures contracts, so the whole process is trivial. No wonder they attract such attention from investors.
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