Analysing a new product, that I did not create, is always a risky endeavour. Typically, this means I will step on toes that I did not intend to and could be viewed as sour grapes since I was not part of solution.
I will attempt to avoid these issues but apologies ahead of time if I do.
So, what is the problem we are trying to solve with this week’s expected approval by the Securities and Exchange Commission (SEC) of the first bitcoin futures ETF, rather than a physically-backed ETF?
- Bitcoin is extremely easy to purchase, even teenagers via Robinhood have access with minimal cost. Security from hackers for large holders is a problem.
- Volatility is a problem (such as running up Friday at over $1,000 an hour due to potential a bitcoin futures ETF coming to market this week)
- In your Tax Deferred IRA held at one of the custodians, ownership is not easy.
- One major issue is the ability and limitations for mutual fund and asset managers to own bitcoin of any kind in their ’40 Act funds or ETFs.
Grading the solutions
So how does a US bitcoin futures ETF solve any of the above or enhance?
- The first problem, or lack of problem, is the ease of ownership for individuals. This ETF will only enhance the costs of ownership, introduce the roll cost of futures and slippage due to the curve of the contracts and potentially create premium and discounts once the CME limit to futures is reached. I would give this solution a “D+” at best
- Volatility may only be enhanced due to the spiking of volume in the futures contracts (look at oil contracts during the early days of the pandemic). Futures contracts are not limited by the amount of physical bitcoin mined, it is a contract for cost, so the volume can exceed the supply thus creating chaos. I would give this answer an “F” if reducing volatility was a goal.
- Ease of ownership within your financial advisory account will be easier because it is an ETF, this is a win for the new bitcoin ETFs. I will give them an “A” for this. I will give the loophole-finding product developers an “A+” and the SEC a big “F” for the risk potential, much like buying a 16-year-old a case of beer and giving them the keys to your Ferrari! (See below for my further analysis)
One key point that may have been overlooked by the SEC and others. Great investors such as Cathie Wood, founder, CEO and CIO of Ark Investment Management, and other ETF issuers, have driven performance in their disruptive technology funds by obtaining exposure to bitcoin and digital assets.
It has been difficult for fund managers like them to maximise that exposure due to constraints of ownership enacted by the SEC on ownership of bitcoin directly or via closed-end products such as Grayscale or foreign ETF solutions.
ETF and fund ownership rules of “non-affiliated funds” are very developed and refined. Typically, it is hard to own more than 3% of other companies fund without onerous obligations. When it comes to owning your own “affiliated funds” though, it is much easier.
ETF issuers are typically not restricted in owning 100% of another fund in your family of products. I have been told by good sources that the SEC does not restrain this since a board would not permit one fund to harm another fund that is an affiliate. What does this mean for bitcoin?
Well, smart minds like ARK Invest filed for their own bitcoin futures product. And in theory, as I understand, ARK Invest and any issuer can allocate large sums of assets through other funds into their new bitcoin futures, once launched.
While ARK’s is not going to be approved next week, be aware. Huge flows into bitcoin futures ETFs next week could be by other ETFs within the fund family complex.
ProShares, which all indications point to its bitcoin futures ETF to be first approved this week, is a firm I know well since I only left there a year ago. The firm's bitcoin futures ETF is ingenious by the product development teams.
My concern is about the systemic risk that could be developed due to an unnatural supply-and-demand imbalance. The risk would be evident due to limits on bitcoin futures contracts by the CME, volatility due to excitement in bitcoin futures ETFs being launched in the US and internal portfolio managers looking to improve their returns without constraint of ownership.
The real shame is that better answers for all these problems are available elsewhere in the world.
For example, ETC Group’s novel bitcoin solution in Europe, the BTCetc Bitcoin Exchange Traded Cryptocurrency (BTCE), offers direct exposure to physical bitcoin with a focus on minimising risk but developing an elegant answer that provides a safe-keeping solution of cold wallet to cold wallet during the creation-redemption process and most importantly, no dislocation in pricing due to futures contracts.
I am a big believer in the futures market for both hedgers and speculators. This is assuming that the underlying is complicated to own directly (Who wants to have 5,000 bushels of corn delivered to your front driveway?)
Technology has lapped the SEC and provided easy ways to own and ETC Group is now providing that in a user-friendly wrapper to Europe. The same is happening in Canada and other countries with physically-backed bitcoin ETFs.
The time is now for the SEC to protect investors where they need protection yet provide access to something that has not been accomplished. ETFs have always done that. The SEC is avoiding the right answer and inadvertently allowing the fox to rule the hen house.
There is a very good potential these ETFs will gather huge flows due to associated funds alone buying their funds. Unfortunately, I fear the client experience in the US will not go well when it comes to bitcoin ETF performance in comparison to the futures product and our friends in Europe.
Ben Fulton is an ETF pioneer and works as an independent consultant in the ETF industry, advising firms on product design and strategic management decisions
This story was originally published on ETF.com
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