Exchange-traded funds, or ETFs, have become incredibly popular investment vehicles in recent years. Especially in crypto world, as we gear up for the anticipated approval of several spot Bitcoin ETFs.
But have you ever wondered exactly how an ETF is created in the United States? The process involves several careful steps, approval by the Securities and Exchange Commission (SEC), and thoughtful structuring to give investors the desired experience.
First, let’s start with the basics: an ETF is an investment fund that trades on a stock exchange like a regular stock. ETFs offer investors an easy way to get exposure to a variety of market sectors, industries, commodities, styles, or regions without having to purchase each individual stock or asset.
For Bitcoin, and other crypto assets, which can be complicated to custody and trade, an ETF is a god-send.
So why would someone want to go through the lengthy process of creating their own ETF? ETF sponsors may believe there is an unmet need in the marketplace for an ETF targeting a specific niche.
Or they may aim to provide an ETF that tracks a unique proprietary index designed by their firm. The choices are nearly endless. In the past, successful ETFs have been based on gold , property, or other financial assets.
The first step in creating an ETF is developing a concept and investment objective. Will the ETF track a basket of stocks, bonds, commodities, or other assets? The index or portfolio composition must be clearly defined upfront.
Next, the ETF provider researches demand for their proposed fund and files a prospectus (BlackRock’s paperwork is here as an example) with the SEC. This registration statement outlines details including investment strategy, risks, costs, trustees, and more. The SEC will review the statement to ensure regulatory standards are met.
However, one of the sticking points in spot Bitcoin ETF applications has been surveillance-sharing agreements. These arrangements allow exchanges to share trading data to detect fraud or manipulation.
The SEC recently denied Grayscale Investment’s application due to its apparent inadequate surveillance protocols.
However, a court overruled the decision, ruling that the SEC had not demanded similar standards for Bitcoin futures ETFs (namely the Teucrium Bitcoin Futures Fund and the Valkyrie XBTO Bitcoin Futures Fund) so why this product? Especially considering that both spot and futures funds are based on Bitcoin’s price.
Though details are private, these surveillance agreements facilitate oversight across markets, and help assuage regulators that everything is above-board. Despite, the SEC’s court loss on the matter, expect robust surveillance-sharing agreements to still be included.
While waiting for SEC approval, the ETF provider establishes the fund structure. Two common structures are a trust, which issues shares backed by underlying assets, or a corporation that issues shares and invests proceeds. Service providers are also selected like a custodian to hold assets and a trading agent to handle orders.
The SEC may come back with questions or requests for revisions. Once all requirements are satisfied, the SEC declares the registration statement effective and the ETF can prepare to launch.
Leading up to the launch date, the fund manager creates new ETF shares, known as creation units . These units are acquired by approved organizations called authorized participants which provide the underlying assets to back the ETF shares.
In BlackRock’s application, authorized participants are crucial in creating and redeeming Baskets of 40,000 Bitcoin ETF shares. They deposit Bitcoin with the custodian, pay a fee, and receive Baskets. The Basket size changes daily based on Bitcoin prices.
Only authorized participants can do this, helping keep share prices in line with Bitcoin’s value. They can also redeem Baskets to withdraw Bitcoin. Their role ensures the ETF’s performance mirrors Bitcoin’s price accurately.
And—voilà! Finally, the authorized participants can list the new ETF shares on an exchange where they can be traded by individual investors and institutions. For most ETFs, this is an exciting, but relatively ordinary occurance. For crypto-world, the consequences could be game-changing.