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How Do Cryptocurrency Exchange-Traded Funds (ETFs) Work?

Last Updated November 19, 2023 5:12 AM
Andrew Kamsky
Last Updated November 19, 2023 5:12 AM

Key Takeaways

  • Crypto ETFs allow stock exchange trading that works by mirroring cryptocurrency prices without any direct crypto purchases from crypto exchanges.
  • Spot ETFs hold cryptocurrencies directly, reflecting real-time values, while Futures-Based ETFs speculate on future prices.
  • Crypto ETFs are regulated for investor protection, with oversight ensuring market integrity and legal compliance.
  • Crypto ETFs offer simplified crypto market access, balancing reduced ownership costs against potential market volatility.

Cryptocurrency exchange-traded funds (ETFs) mirror price movements of specific cryptocurrencies by investing in portfolios that are tied to that specific asset. 

The ETFs are traded on conventional stock exchanges, allowing investors to include crypto ETF and gain exposure to this industry. This implies that ETFs offer investors an avenue to purchase and enter the cryptocurrency market without the need to purchase a cryptocurrency on a crypto exchange

How Does A Crypto Exchange Traded Fund Work?

Traditional ETFs function by tracking specific indexes, which they achieve by holding a portfolio of underlying assets. These assets can include stocks, bonds, or commodities, and the ETF’s value fluctuates based on the performance of all these assets. 

In contrast, cryptocurrency ETFs operate differently. Instead of tracking a broad market index, they focus on tracking the prices of cryptocurrencies, offering investors exposure to the crypto market without the need to directly own any digital currency.

Types Of Cryptocurrency ETFs

Primarily, there are two distinct types of crypto ETFs, namely:

Spot ETFs

The performance of a spot ETF closely reflects the real-time value of the digital asset it holds. This direct investment approach allows investors to benefit from the actual price movements of cryptocurrencies. 

However, it’s important to note that in the U.S. the Securities and Exchange Commission (SEC)  has yet to approve any spot ETFs that invest directly in cryptocurrencies. 

Currently, firms like BlackRock, WisdomTree, and Valkyrie are in line for approval from the Securities and Exchange Commission to introduce a spot bitcoin ETF. Market experts predict that the first of these approvals could potentially be issued by early 2024. A full list of the ETF applications can be seen in the picture below.

Bitcoin Spot ETF Applications Set For Approval | Credit: Bloomberg
Bitcoin Spot ETF Applications Set For Approval | Credit: Bloomberg

Futures-Based ETFs

In contrast to spot ETFs, some crypto ETFs invest in futures contracts. These are agreements to buy or sell a cryptocurrency at a predetermined future date and price. This type of ETF does not hold the cryptocurrency itself but rather contracts that speculate on the future price of these digital assets.

In the U.S., where spot ETFs are not yet available, futures-based ETFs have become the standard. These ETFs typically track the price movements of Bitcoin futures traded on platforms like the Chicago Mercantile Exchange (CME) .

What Is The Difference Between A Crypto Spot ETF And A Crypto Futures-Based ETF?

Spot ETFs offer a more direct correlation to the actual real-time price of the cryptocurrency that is represented by the Spot ETF, whereby Futures-based ETFs normally exhibit price movements that differ from the underlying digital assets due to their focus on futures contracts. 

As the cryptocurrency market continues to evolve, there is growing optimism that Spot ETFs might soon be introduced to the U.S. market. This development could provide investors with more options to engage with the crypto market through regulated financial products.

Are Crypto ETFs Regulated? 

Regulatory clarity is necessary for significant institutional investment in the cryptocurrency sector, which in turn is fundamental for the growth and functioning of the cryptocurrency market and its respective ETFs. 

As financial instruments that bridge the gap between traditional markets and the digital currency space, crypto ETFs are subject to scrutiny and regulatory oversight. 

This oversight ensures investor protection, market integrity, and compliance with financial laws. In various jurisdictions, regulatory bodies like the U.S. SEC assesses and approves these products, often with a focus on market stability and transparency. 

As regulations continue to develop, they will significantly shape the availability, structure, and appeal of crypto ETFs to both retail and institutional investors.

Examples Of Active Spot ETFs

Several countries outside the U.S. such as Europe and Canada, have launched Bitcoin Spot ETFs. Here are a couple of examples:

Purpose Bitcoin ETF (Canada)

Launched in February 2021, the Purpose Bitcoin ETF was the world’s first Bitcoin ETF. Trading under the ticker symbols “BTCC.B” and “BTCC.U” on the Toronto Stock Exchange, this ETF directly holds Bitcoin, and its performance is tied to the daily price movements of the cryptocurrency. Investors can buy shares of this ETF in Canadian dollars or U.S. dollars.

3iQ CoinShares Bitcoin ETF (Canada)

Another example is the 3iQ CoinShares Bitcoin ETF, which trades on the Toronto Stock Exchange under the ticker “BTCQ” for its Canadian dollar-denominated units and “BTCQ.U” for U.S. dollar-denominated units. Like the Purpose Bitcoin ETF, it directly holds Bitcoin and offers investors exposure to its price movements.

Jacobi FT Wilshere Bitcoin ETF (Amsterdam)

An ETF regulated by the Guernsey Financial Services Commission (GFSC), trades under the ticker “BCOIN” on Euronext Amsterdam. It represents Europe’s first spot bitcoin exchange-traded fund (ETF), a significant development as it precedes the introduction of a similar product in the U.S. market.

Examples Of Futures ETFs In The US

Proshares Bitcoin Futures ETF (BITO)

An example of a Futures ETF in the cryptocurrency space is the ProShares Bitcoin Strategy ETF, which trades under the ticker symbol “BITO.” This First U.S. Bitcoin-Linked ETF on October 19. Oct 30, 2021. The ProShares Bitcoin Strategy ETF does not invest directly in Bitcoin. Instead, it focuses on Bitcoin futures contracts. 

Valkyrie Bitcoin Strategy ETF (BTF)

This ETF also focuses on Bitcoin futures contracts. BTF aims to provide investors with exposure to Bitcoin in a regulated and more traditional investment vehicle, without the need to directly purchase and store Bitcoin.

VanEck Bitcoin Strategy ETF (XBTF)

Launched shortly after BITO and BTF, the VanEck Bitcoin Strategy ETF offers similar exposure to Bitcoin through futures contracts.

Bitcoin ETFs: A Strategic Approach For Institutional Investors

Direct investment in Bitcoin often entails intricate considerations, including storage and exchange selection. As a result, Bitcoin ETFs simplify this somewhat complex process by consolidating crypto futures contracts into an ETF format and offer Spot ETF exposure to the price of Bitcoin.

This ETF structure facilitates easier market entry for institutional investors, potentially sustaining Bitcoin’s demand and offers investors a gateway into mainstream institutional investors to engage with Bitcoin, bypassing the concerns of storing Bitcoin in vulnerable hot wallets.

Purchasing Bitcoin ETFs: Which Platforms And Options Are Available 

Bitcoin ETFs can be acquired through various online brokers that also provide access to standard securities like stocks and bonds. While some of these brokers offer direct investment in Bitcoin, others restrict trading to Bitcoin futures.

As a result, ETFs are traded on conventional exchanges, including the New York Stock Exchange and Nasdaq. For those seeking a broader range of cryptocurrencies and direct investment in digital coins, opening an account with a cryptocurrency exchange, such as Binance or Kraken, would be necessary.

Pros Of Crypto ETFs

Crypto ETFs offer a blend of accessibility and exposure to cryptocurrencies for both retail investors and institutional investors and with this financial vehicle offering, investors should weigh the pros and cons of crypto ETFs to understand the impact on investment strategies.

Exposure Without Direct Ownership Of A Cryptocurrency

Crypto ETFs offer exposure to the crypto market without the additional costs or risks of direct ownership. This includes avoiding custody charges, annual fees for secure digital wallets, and transaction or network fees.

Reduced Costs And Hassles

Crypto ETFs offer a way to diversify holdings without the fees and complexities of buying and exchanging individual tokens.

Enhanced Security For Investors

With the history of hacks in the crypto world, security of capital becomes a major concern. Crypto ETFs provide a level of security that individual investors might find challenging to achieve on their own or too much of a risk to self-custody on their own.

Simplified Learning

The complex entry knowledge necessary to enter the crypto sphere along with an understanding of the technological aspects of cryptocurrencies can be a stumbling block for most future investors. Crypto ETFs therefore simplify the entry into the crypto market, making it more accessible and safer for average retail investors and institutional investors.

Cons Of Crypto ETFs

With every new application or investment vehicle offering comes a level of risk or drawbacks that might arise upon the release of said financial instrument. Some of these drawbacks include:

Lack Of Direct Ownership

Investing in crypto ETFs will not provide owners of the ETF shares an ownership of the actual digital asset. This means investors miss out on the benefits of decentralization and anonymity inherent with cryptocurrencies.

Market Volatility

Despite simplifying crypto trading, crypto ETFs are still subject to the crypto market’s dramatic price swings, posing additional risks.

Risk Of Tracking Error

Crypto ETFs may not always accurately replicate the price movements of the underlying digital tokens, particularly those relying on futures contracts. Whilst ETFs aim to track the price movements of underlying digital tokens. Due to various factors, the ETF’s performance might not align precisely with the actual movements of the cryptocurrency prices. The tracking error is therefore a measure of how closely the ETF follows the crypto asset it is tracking.

Higher Management Fees

Crypto ETFs often have higher expense ratios due to active management, compared to traditional ETFs.

Conclusion

ETFs aim to offer regulated investment avenues into the crypto market. These ETFs simplify crypto investment, offering benefits like reduced costs and enhanced security, but also come with drawbacks like market volatility and higher fees. 

As the crypto market evolves, ETFs look like they will become a key into mainstreaming digital currency investments, linking traditional and digital financial worlds.

FAQs

What are cryptocurrency exchange-traded funds (ETFs)?

Cryptocurrency ETFs mirror the price movements of specific cryptocurrencies, traded on conventional stock exchanges, allowing inclusion in regular brokerage accounts.

How do crypto ETFs differ from traditional ETFs?

Unlike traditional ETFs that track indexes, crypto ETFs focus on cryptocurrency prices, offering market exposure without requiring direct digital currency ownership.

What are the main types of crypto ETFs?

There are two main types of crypto ETFs these include Spot ETFs, holding cryptocurrencies directly, and Futures-Based ETFs, investing in futures contracts, each with distinct market exposure methods.

What are the pros and cons of crypto ETFs?

Pros include market exposure without direct ownership and reduced costs, while cons involve lack of direct digital asset ownership and potential market volatility.

Disclaimer:

Cryptocurrency ETF investments involve high risk due to market volatility, regulatory uncertainty, and speculative nature. Prices can fluctuate significantly, leading to potential gains or losses. Investors should carefully consider these risks and conduct thorough research before participating in crypto-related ETFs.

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