What is a Bitcoin ETF and how does it work?

Flexible traders who prefer diversifying their portfolios at a lower cost and tax benefits often invest in ETFs. But, what is an ETF? ETF refers to the exchange-traded funds that are a collection of assets whose shares are traded on a stock market. They blend the characteristics and potential benefits of mutual funds, stocks and bonds. 

ETF shares, like individual stocks, are traded throughout the day at varying prices based on the supply and demand in the market. Similarly, Bitcoin (BTC) ETFs track BTC's value and trade on traditional stock exchanges rather than crypto exchanges, i.e., they are not cryptocurrency exchange-traded funds. In addition, they allow investors to invest in Bitcoin without the inconvenience of using a cryptocurrency exchange while also giving price leverage.

The ProShares Bitcoin Strategy ETF (ticker: BITO), which is trading on the NYSEArca, is an example of a Bitcoin ETF. However, it is crucial to note that the Securities and Exchange Commission (SEC) of the United States has rejected multiple earlier proposals for Bitcoin ETFs, citing the crypto market's lack of regulation as the key reason for their opposition.

The majority of Bitcoin ETFs employ futures to simulate the cryptocurrency's performance. Futures allow investors to protect themselves against turbulent markets by ensuring that they can buy or sell a specific cryptocurrency at a particular price in the future.

Investing in cryptocurrency and blockchain companies that provide leverage to the crypto market is another option for obtaining exposure to Bitcoin without actually acquiring it. 

An ETF monitors the price of an underlying asset or index. For example, a Bitcoin ETF would function similarly, with the price of one share of the exchange-traded fund fluctuating in lockstep with the price of BTC. 

If Bitcoin's value rises, so does the ETF's, and vice versa. However, the ETF would trade on a stock exchange like the NYSE. ETFs are now accessible for various assets and industries, including commodities and currencies.

In this article, we will explain what Bitcoin exchange-traded funds are, the advantages of Bitcoin ETFs, the approval of Bitcoin ETFs by the SEC, Bitcoin spot ETFs, Bitcoin futures ETFs and how to buy Bitcoin ETFs.

Bitcoin futures and Bitcoin spot ETFs

A futures ETF is a fund that represents the value of a cryptocurrency that you can buy or sell based on contract conditions. However, you do not own the underlying crypto asset when purchasing or selling futures. Instead, you possess a contract that promises to buy or sell cryptocurrency at some point in the future.

As a result, futures are shielded from market instability and price swings. On the other hand, futures do not allow you to stake or use coins for voting like you would if you owned the currency outright.

Unlike futures contracts, spots are one-time digital asset purchases that give buyers and sellers direct ownership of the cryptocurrency. This works similarly to any of the existing crypto exchanges.

The Bitcoin futures ETF structure has been criticized because holding BTC futures to price instead of spot Bitcoin can lead to underperformance. Another reason traders dislike futures is that they often trade at a higher price than the underlying asset, although they can also trade at a lower price.

Therefore, the key difference between a Bitcoin futures ETF and a spot ETFs is that a futures ETF is backed by derivatives (in this case, Bitcoin futures contracts), whereas real BTC backs the spot-based ETF. 

More crucially, the price of Bitcoin futures contracts may deviate from the current market price due to investors' emotions, and it may also track the price incorrectly occasionally. However, in the case of a spot-based ETF, this risk does not exist.

How does Bitcoin futures ETF work?

If you invest in Bitcoin exchange-traded funds, it means you agree to purchase or sell BTC at a given price on a specific date, regardless of market conditions. The contract settlement date or expiration date is the agreed-upon date by which both parties must satisfy their obligations. 

The party that agrees to buy BTC at the expiry of a Bitcoin futures contract would have to buy it either at a discount or premium. The futures market is termed to be "premium" when the future price is trading higher than the Spot price. 

Formulas to calculate Bitcoin futures contract price at a discount and premium

On the other hand, a “discount” occurs when the spot price is higher than the futures price. Backwardation is the term used in the commodity derivative market, while discount is used in the equity derivative market. The situation is regarded as normal when the futures price converges with the current price.

The amount that needs to be paid depends upon the spot price and the value of futures contracts bought by the buyer. Moreover, investors might hypothetically arbitrage away the spread between the ETF and the underlying asset if it becomes too broad; the price of an ETF will generally maintain a high correlation with the price movement of the underlying asset.

Downsides of the Bitcoin futures ETF

The most prominent problem with Bitcoin futures ETFs is the lack of accuracy in their price trackers. A negative indicator for investors in Bitcoin futures, called a "contango," emerges when the price of Bitcoin futures is greater than the spot price, conveying that the ETF is following the price of BTC incorrectly. However, situations where the futures price is lower than the current Bitcoin price leads to "backwardation."

In a case where the new contract's price is higher than the Bitcoin futures contract's price, the funds from selling contracts that are about to expire will not be enough to buy the same number of contracts that will expire at a later date. As a result, the ETF's performance will be affected due to this predicament.

How does Bitcoin spot ETF work?

In the United States, there are now no spot Bitcoin mutual funds or ETFs available, and there are unlikely to be for some time. However, the Fidelity Advantage Bitcoin ETF (FBTC) is designed to invest in physical spot BTC, a strategy that has been rejected by the SEC. The U.S. regulator also rejected the application for spot Bitcoin ETF listings by the New York Digital Investment Group and fund manager Global X.

Nonetheless, the first launch of the FBTC in Australia is planned shortly; however, certain jurisdictions, including the United Kingdom, have not even approved them, with the U.K. regulator warning that anyone investing in crypto assets "should be prepared to lose all their money."

Bitcoin futures ETFs are preferred over spot ETFs because the Commodity Futures Trading Commission regulates the futures market and has enormous trading volumes, which can be a prominent place for price discovery. 

The actual, tangible BTC price would be tracked via a regular spot-based Bitcoin ETF to give investors access to Bitcoin through a financially familiar and regulated product without requiring them to hold the underlying asset. Additionally, users cannot bet on the price falling in spot-based investing. However, if an ETF exists, investors can short the ETF's shares to profit from downward swings.

Currently, spot BTC ETFs are available in Canada. Three significant funds — Purpose Bitcoin, 3iQ Coinshares and CI Galaxy Bitcoin — are all directly invested in spot Bitcoin. Additionally, the 21Shares Bitcoin exchange-traded products, which are 100% exposed to spot BTC, are listed on various German exchanges and the Swiss Exchange with assets under management of about half a billion dollars.

Investing in Bitcoin ETFs

In the United States, BTC exchange-traded funds can be purchased through the Bitcoin Strategy ETF, which is listed on the Mercantile Exchange of Chicago. Another fund that goes under the ticker BITO allows investors to gain exposure to Bitcoin without buying the notoriously volatile digital currency.

BITO can be purchased through online brokerages, just like any other ETF. You'll need to open a brokerage account with a platform like Robinhood or Fidelity if you don't already have one. Determine how many shares of BITO you want to buy and at what price you're comfortable buying once you've opened an account.

You can use a market order to buy shares of a mutual fund at the current market price. A limit order, on the other hand, lets you specify the highest price you're ready to pay for a stock.

To understand various order types, please read, “Crypto trading basics: A beginner's guide to cryptocurrency order types.”

So, is it good to invest in a Bitcoin ETF? If you want to invest in Bitcoin for the long-term, futures-based ETFs are a poor choice. Additionally, before investing in ETFs, traders should consider some factors like the possibility of deviating from the net asset value, fund fees and roll expenses.

Pros and cons of Bitcoin ETFs

Investing in a Bitcoin ETF allows you to have exposure to the price of Bitcoin without dealing with a cryptocurrency exchange, having to learn how BTC works or taking on the risks of directly owning Bitcoin. Without the fear of losing your wallet password, the process of investing in Bitcoin is made more accessible with Bitcoin futures or spot ETF.

Furthermore, as an ETF is a combination of various securities like Google stocks, BTC and more, it allows investors to diversify their portfolios and reduce their risk exposure. Since Bitcoin futures ETFs are regulated by the SEC as they trade on traditional exchanges, they are eligible for tax efficiency.

A large amount of Bitcoin ETFs means high management fees. Also, an ETF has multiple holdings, which means that a rise/decline in BTC's price may lead to price inaccuracy. In addition, because an ETF is not a cryptocurrency (but rather an investment fund that tracks the price of BTC), a Bitcoin ETF would not be allowed to be traded in exchange for other virtual currencies.

Bitcoin eliminates third parties and provides decentralization and security through the Bitcoin blockchain, but these advantages would be lost because the government would regulate a Bitcoin ETF.

Alternatives to Bitcoin ETFs

Owning Bitcoin gives the investors direct exposure to the cryptocurrency market. So, if you don't want to invest in Bitcoin ETFs, you can directly invest in other virtual assets like BTC, itself, Ether (ETH) or Tether (USDT) through cryptocurrency exchanges like Binance, Coinbase and KuCoin.

Alternatively, you can buy stocks of public cryptocurrency exchanges like Coinbase. These are called blockchain ETFs, which can provide you with technology-related exposure without directly investing in the currencies.

Bitcoin ETFs vs. Blockchain ETFs

While Bitcoin exchange-traded funds are relatively new, the number of blockchain ETFs continues to expand. Blockchain technology is not prohibited nor under regulatory examination. On the other hand, virtual currencies have been limited or outright banned in several countries.

Bitcoin ETFs track the price of Bitcoin and trade on standard stock exchanges, whereas Blockchain ETFs like the Bitwise Crypto Industry Innovators ETF track the stock market prices of corporations that have invested in blockchain technology in their fund.

The road ahead

Bitcoin ETFs can help investors find a middle ground between the rapidly changing cryptocurrency market and traditional investment vehicles. Buying and selling ETFs through your favorite brokerage is similar to trading shares, so it's a straightforward process. However, the future of this type of investment is uncertain.

The environment might shift quickly as more applications for Bitcoin ETFs based on spot trading are originating. Also, more futures-based ETFs are approved by regulators like the SEC. So before you invest, be sure you're well aware of the risks involved in this type of investment instrument.