Hey there,
The SEC finally approved the spot bitcoin ETF on January 10, 2024. It was a decade-long endeavour. The Winklevosses first applied in July 2013 when BTC traded at $100. This ETF blurs the line between digital assets and traditional finance.
If you view crypto assets as a separate island from the mainland of traditional investments, the ETF is the bridge connecting the two landmasses. This transition did not happen overnight. The image below tracks a timeline of the key events that lead up to the ETF approval over the past decade.
Why It Matters
An ETF can represent anything from a single asset to a basket of stocks or commodities. It increases accessibility and reduces costs for investors. Before the spot bitcoin ETF approval, investors would have to buy and manage BTC independently. With a spot ETF, bitcoin becomes available to investors in their brokerage accounts. The ETF approval also helps change the perception around BTC and, by extension, other crypto assets.
Institutions or HNIs no longer have to look for an exchange with the highest liquidity to buy bitcoin and a custody solution provider to hold the BTC they bought. They can simply buy the ETF from their existing brokerage account and outsource it to BlackRock or Fidelity for a small cost. Buying BTC and gold now takes the same effort.
The SEC has a rigorous process when it comes to allowing ETFs. The means to monitor market movement needs to be in place before an ETF is allowed to trade. The fact that bitcoin ETF is allowed means these conditions are fulfilled and the necessary oversight is in place. The SEC’s approval also dispels the stigma around bitcoin.
Before the bitcoin ETF launched, stocks like MicroStrategy and Coinbase acted as a bet on bitcoin. These were the vehicles TradFi investors could use to bet on bitcoin and the general crypto ecosystem. With 189k bitcoins, MicroStrategy owns almost 1% of all the 21 million BTC that will ever be in circulation. The percentage is higher if you consider the ~4 million BTC that is forever lost.
Coinbase’s earnings are directly proportional to volume, which tends to be a function of price. So, when bitcoin does well, Coinbase also does well. The following chart shows how the return profile of MicroStrategy has been closely linked with bitcoin since the March 2020 Covid lows.
The first ETF backed by gold was launched in March 2003 in Australia. Later, in November 2004, SPDR Trust launched a physical gold-backed ETF in the US. The ETF increased the accessibility of gold as an investment. The ETF now manages $55 billion in value. The chart below is a good breakdown of what happens to certain commodities when an ETF is launched for them.
Understanding Flows
When investors buy a new share of the ETF, they add new money to its underlying market. So when someone buys a new BlackRock bitcoin ETF share, BlackRock purchases BTC on the investor’s behalf. Buying new ETF shares contributed towards ‘inflow’.
Conversely, outflow is when someone pulls the money out of the fund. Currently, the SEC has not allowed in-kind redemptions, meaning when someone redeems a BlackRock bitcoin ETF, they can only get cash out of the ETF, not bitcoin. So, BlackRock has to sell BTC whenever an investor wants to redeem the ETF share.
The following chart tracks inflows and outflows from different bitcoin ETFs. So far, newly approved ETFs have attracted a net 15.3k BTC, including ~116k outflow from Grayscale’s Bitcoin Trust (GBTC) (i.e., excluding GBTC, other ETFs have gained ~131.3k BTC).
GBTC was formed in 2013. Unlike present day ETFs, the trust did not have a redemption mechanism. So, a qualified investor would go to Grayscale and either deposit BTC (in kind) in the trust or pay Grayscale to buy shares in the trust. Both ways would result in the investor holding shares in the Grayscale trust. After a certain lockup period, these shares would become tradeable on the secondary markets.
Since this is a closed-ended fund, investors could not redeem BTC by paying GBTC shares. The only way to get out of the position was to sell GBTC shares.
The reasons for GBTC outflows can be two-fold:
Higher fees – while the rest of the ETFs have average fees of ~30 basis points, GBTC charges 150 basis points. Investors redeeming GBTC shares for BTC due to high fees may end up considering other ETF providers.
Investors have been locked up in GBTC for a long time, and they could just be selling close to par value.
The following chart shows the GBTC premium versus its price. Before we unpack what the chart shows, here’s a short summary of how GBTC worked before the ETF. As per the chart, until 2021, GBTC traded at a premium to implied underlying.
Every share in the trust is worth some BTC. Implied value in this context tracks the price of BTC received per share multiplied with the price of Bitcoin at the time. So the trade was simple: buy BTC, keep it with the Grayscale trust, and sell the GBTC shares on the secondary market to pocket the premium. There was a catch though. The shares were not available for trading right away. You had to hold on to them for a six-month lock up period, during which the price of Bitcoin could tumble.
However, the dynamics changed in 2021. GBTC is no longer traded at a premium. Investors were exposed to the bitcoin price risk in a period between depositing BTC into GBTC and being able to trade those shares in the secondary markets. Firms like Alameda, BlockFi, Genesis Trading, and Voyager were likely exposed to this risk.
And before some of their GBTC shares were tradeable, the premium had turned to a discount. This meant they might have had to book losses in BTC terms (as well as the price of BTC).
The absence of a redemption mechanism meant the second leg of arbitrage was unavailable. So it would trade at a par value only when it was certain that GBTC could be redeemed for BTC in the trust: when the SEC would approve for the trust to be converted into an ETF.
The GBTC discount was more than 45% at one point in 2023, but when it started becoming clear the SEC would eventually approve the ETF, the discount started fading. Days after the SEC approved spot bitcoin ETFs, the discount almost vanished.
Fees charged are on basis of the AUM of the ETF. That is, the provider receives a small portion of the number of bitcoin (or value of assets held) as a source of revenue. So, at an AUM of ~500K BTC or ~$21 billion, Grayscale makes $315 million yearly in fees at 1.5%. Grayscale has the highest fees. The second-highest is Invesco at 0.39%, while BlackRock is at 0.25%.
BlackRock would have to have an AUM of 3 million BTC (~14% of the total supply to ever exist) to earn the same fees as Grayscale annually. Even if Grayscale loses 90% of its AUM, it’ll make more revenue than the rest all put together do now.
Why isn’t Grayscale reducing the fees then? When an investor redeems BTC from the Grayscale ETF, it will likely be a taxable event. So, unless the fee difference is worth the tax due, investors will likely not move to other products. Grayscale is likely taking advantage of this, but given they have been ahead of the pack by miles, thanks to managing the product for a decade. They will likely be able to keep the fee higher for some time before they have to give in to curb the outflow.
State of the ETF Launch
The total AUM of all the bitcoin ETFs is ~$26 billion. The largest ETF in the world – SPDR S&P 500 ETF Trust – has $485 billion in AUM. The highest-ranked commodities – ETF, SPDR Gold Shares – has $55.8 billion in AUM.
Although it is clear from these numbers that there’s massive room to grow, bitcoin ETFs are off to a good start. This week, BlackRock’s IBIT has seen the fourth-largest (at $1.3 billion) inflow among all the ETFs.
TradFi moves slowly. I’ve witnessed it first-hand in my previous jobs. For example, when I was a part of the investment committee at a bank, recommendations took over a month to materialise. Now that ETFs are live, those incentivised to sell them will make a push. BlackRock’s webinar is one such attempt at selling bitcoin to their clients.
It is very likely that the inflows so far are organic from those who already wanted to get exposure to bitcoin. We will likely see more conversion in a few weeks to months as asset managers explain the benefits of having exposure to Bitcoin to their clientele.
It is worth wondering what the distribution of Bitcoin looks like beyond the ETFs at this point. The chart below breaks it down.
As far as treasuries are concerned, Grayscale is the largest holder, with ~25% of the total BTC. Governments like the US (217K BTC) and China (194K BTC) possess BTC, mostly because they seized it from somewhere. The US and China represent ~66% of the BTC in governments’ possession. Mt. Gox still accounts for 200K BTC, close to half of the BTC controlled by private companies. MicroStrategy owns ~68% of the BTC owned by public companies.
What Next?
Grayscale’s GBTC has seen a trading volume of $12.6 billion. IBIT and FBTC have traded $4.8 billion and $4.2 billion, respectively. Trading volumes, as well as inflows, suggest there’s interest in bitcoin ETF. Given that bitcoin ETF is a success so far, it is natural that asset managers start thinking about the next asset. This is evident by the fact that BlackRock has already applied for a spot with ETH ETF.
An ETF manager typically employs a market maker (MM) to cater to investors buying and redeeming. MMs don’t want to take on directional risk and are often hedged. I mean that when a trader buys an asset, an MM sells that asset. At this time, the MM is short. They need to long the asset as soon as possible so that they are not exposed to price risk (in this case, the asset price going up).
Derivatives play a critical role in MMs managing their book. While bitcoin futures markets are already live and thriving, options markets have much room to grow. Interestingly, ETFs for an asset don’t stop at this spot. There may be more bitcoin-related ETFs, like 2X/3X leveraged ETFs, inverse ETFs, and covered call ETFs.
Grayscale filed for a covered call ETF for the Grayscale trust immediately after the spot ETF was approved. GBTC will work as the reference asset for actively managed ETFs. A covered call typically benefits investors who are okay with selling an asset they hold after a short-term upside.
A covered call strategy typically sells out-of-the-money calls (when the strike price exceeds the current price, as the previous example explained) for short-term expires. It is one of the most widely used strategies to earn a yield on stocks or assets an investor owns. For example, if you hold 1 BTC at the current price of $42K and are willing to sell it for $45K within 2 weeks, a covered call means you sell the right to buy 1 BTC for $45K on or before 14 days from today.
For this privilege, you charge the option buyer a premium. If the price stays below $45K, you keep the premium and 1 BTC. You lose out if the price jumps above $45K (plus the premium) within 14 days.
Possible investors in a covered call ETF include miners and other stakeholders who want to earn a yield on their BTC. A covered call ETF is one possible variant of a spot ETF.
As bitcoin futures ETFs already exist and both futures and options already trade on CME, the SEC may be less hawkish on derivations of bitcoin spot ETFs. Upcoming elections in the US and the performance of spot ETFs in a few months are some factors that will determine which direction the SEC takes.
Options in crypto are a solution looking for liquidity. They are a tool that sometimes allows much more efficient hedging. It remains to be seen whether developments related to options-based ETFs will invigorate crypto options markets. Still, if and when any options-related ETFs go live, the CME will likely be a large beneficiary.
The ETF brings a flair of legitimacy to the industry that did not exist previously. It reminds me of the creator economy. In the 2010s, nobody would have taken you seriously if you suggested you would live off creating content on the internet. And yet, by the 2020s, being an influencer has become one of the most coveted jobs by young children. Distribution and scale lend legitimacy to industries. The ETF brings both distribution and scale to crypto.
On the flip side, a major criticism of the ETF could be that one or two ETF managers may control a significant chunk of bitcoin, and it may pose centralisation risks to bitcoin and its development. Thankfully, we have seen this movie before with mining pool centralisation. The beauty of bitcoin is that holding bitcoin doesn’t give you any governing right. These are not your class A shares in equity that you can use for a hostile takeover.
Yes, you will be a part of the stakeholders and have all the rights to express your opinions, but by no means will you be able to hijack the protocol and amend it how you see fit. Bitcoin Cash is an example of what happens when someone tries to break the social consensus. At the end of the day, social consensus is the last line of defence.
One way to think of the ETF is as a rabbit hole that will onboard a new batch of finance professionals to the industry. Professionals at large institutions looking at Bitcoin ETF would inevitably grow more curious about the industry and explore what smart contracts enable. In this sense, it becomes a funnel for new talent to enter the ecosystem.
A new generation of startups that interface between traditional finance and on-chain economies will likely sprout from this. It matters because sectors like real-world assets in crypto have been stagnant for a while and could use a pair of fresh eyes.
At the same time, it is necessary to recognise that the age of wisdom of not your keys, not your coins is applicable in this context, too. An investor cannot expect any of the censorship resistance or decentralisation holding bitcoin in a self-custodied wallet offers if their only exposure to the asset is through the ETF.
There are decades where nothing happens, and there are weeks where decades happen, is something Vladimir Lenin said a century back. When you consider what the ETF means for legitimacy and integrating wall-street with on-chain economies, it is safe to say that the 10th of January was when a decade happened.
Until next time,
Saurabh