Research Focus: The Bitcoin ETF (15 Oct 2021)
In the last few weeks, Bitcoin has made an impressive rally on the back of potential ETF approvals and just pushed to a 62,910 high on the back of the Valkyrie and Proshares approval. Here’s our take on the matter.
1. The approval of a Bitcoin ETF is a positive development. Whatever the case may be, a progressive step from the regulator is good for Bitcoin and the cryptocurrency market at large.
2. We’ve always said a Bitcoin ETF would be a game-changer. However, in our minds this ETF would have physical Bitcoin as its underlying. The ETFs currently in line for approval have CME futures contracts as the underlying instead. This makes a huge difference.
In fact, an ETF based on futures contracts would likely sideline institutional players and end up becoming a largely retail product.
To begin with, most institutional players have direct access to CME futures. Typically, the main reason they would choose to trade ETFs instead of futures would be to avoid tracking error (against spot price) from futures roll costs or price deviations from to contango or backwardation.
As such, having the ETF based on CME futures defeats the fundamental advantage of ETFs; to track spot price as closely as possible.
It would make sense for retail players though. The tracking error of a futures-based ETF would still be significantly lower than the current Bitcoin proxies in the equities market like Grayscale, Microstrategy or even Coinbase.
3. Futures-based ETFs tend to underperform ETFs with physical underlying.
Chart 1 takes a look at the various Gold ETFs available, the blue rows are the physical ETFs, the yellow rows are futures-based ETFs and the orange rows are ETNs. Number 11, with a 1x futures underlying product shows gross underperformance in return compared to any of the physical ETFs.
The reasons, as highlighted above, are the futures roll costs and the fact that Gold futures are usually in contango. This means the futures price is above the physical spot price and the futures-based ETF is effectively buying at a higher price. This will be the same for Bitcoin except the contango in Bitcoin is much steeper. Bitcoin futures have been trading at a 15–20% premium to spot on an annualised basis. Compared to this the Gold contango looks negligible.
A futures-based ETF is typically only necessary when the product includes some financial engineering such as leverage (2x-3x) or an inverse (i.e. short futures) product.
For these reasons, the physical ETFs are way more popular than futures in the case of Gold. In Chart 1, the top seven ETFs are all physical with a combined AUM of $91 billion. This overshadows the size of the remaining ETFs & ETNs with just $846 million in total.
4. We are not sure if these futures-based ETFs will be able to draw enough new money to trigger an exponential move higher like the one we saw in Q4 2020.
We do expect inflow from investors switching out of Gold ETFs into BTC. However, with BTC above 60k, the market capitalisation is above $1.1 trillion. It’s going to take a lot to move the needle.
The market has also priced in the Bitcoin ETF approvals ahead of time. Besides the obvious rise in spot price and also an increase in the futures premium, we’ve seen large inflows into foreign-listed ETFs this week (the largest since May. 73% of that was attributed to the European listed Physical Bitcoin ETF (Chart 2 — Red Highlight).
We suspect that after SEC Chair Gensler indirectly ruled out a physical BTC ETF in the US for the foreseeable future, investors able to access these overseas markets have decided to participate there rather than investing in the upcoming futures ETFs in the US.
5. The various ETF applicants have distinct differences in their applications and it will be interesting to see if the SEC approves them wholesale or with specific conditions (full list of ETFs in Chart 3).
For example, while the Valkyrie application is entirely futures based with a fixed rolling strategy, the Proshares application includes clauses that would give the fund the ability to hold other Bitcoin-related instruments without touching the physical coins itself.
6. The following are some of our thoughts and market views about what might follow on from the Bitcoin ETF approvals:
a. An Ethereum ETF will likely follow soon after as CME already offers Ethereum futures contracts. However, this also means that until other coins have a futures contract, the US will only be limited to Bitcoin and Ethereum ETFs for the time being.
b. Bitcoin and Ethereum ETFs could reverse the sharp decline in Bitcoin and Ethereum dominance in the crypto market (Chart 4).
c. CME market share in Bitcoin trading has risen and will continue to increase.
d. With ETFs out of the way, attention could be shifted to regulation of stablecoins. This effort would be led by Janet Yellen and the US treasury. Any negative outcomes from this would impact native crypto exchanges which depend on stablecoin as the base asset.
e. Futures-based ETF approvals could be positive for institutional derivative markets. CME options are currently a very small part of the whole crypto options market. Perhaps we could see some growth and development in CME options as a result.
f. Growth in crypto options and interest rate related instruments could come from Exchange Traded Notes (ETNs). We highlighted above the large number of Gold ETNs in Chart 1 (orange).
ETNs are yield-focused products that actively use options, bonds and interest rate swaps to generate yield. The emergence of crypto ETNs would be of particular interest for us as a firm that is focused on crypto derivatives.
g. We previously mentioned that Bitcoin ETFs would possibly lead to the GBTC discount persisting. The discount is at a record -20% now with the approval of the new Bitcoin ETFs (Chart 5). What could happen for GBTC in the future is a possible takeover and delisting. We are not sure what market impact this might have but it would be worth keeping an eye on what happens with the largest private Bitcoins treasury with 680,000 BTC.
h. One key effect of a futures-based ETF is the possible increase in yield in the space. With the ETF funds forced to buy futures instead of spot, the futures premium would be driven higher. We discussed the recent spike in futures premium and funding rates both on the CME and other exchanges. This is something that could persist with the additional focus on futures. A ‘risk-free’ rate of 10–20% could be the new norm.
i. Strangely, this is a positive for DEXes and for Defi in general. At the end of this long article we are still confused by the SEC’s view that it is safer for ETFs to be based on a derivative of physical Bitcoin as opposed to physical Bitcoin itself. Our takeaway from this fiasco is that regulators will continue to struggle with understanding the space, driving interest away from regulated venues towards defi. This is especially so now with exchanges like DYDX having infrastructure comparable to that of centralised exchanges.
