The world of cryptocurrency trading has evolved significantly since the inception of Bitcoin (BTC) in 2008. As the flagship digital asset, Bitcoin has become a significant force in the global financial market. With its increasing popularity, investors now have multiple avenues to engage in Bitcoin trading, including traditional exchanges and innovative exchange-traded funds (ETFs).
This article aims to explore the differences between these two methods, shedding light on the benefits and potential drawbacks.
What is an exchange-traded fund (ETF)?
An ETF is an investment fund traded on stock exchanges, much like stocks. ETFs hold a collection of assets such as stocks, commodities or bonds and can track an underlying index, sector or particular investment strategy.
In the case of Bitcoin ETFs, the fund holds Bitcoin as its underlying asset, offering investors a way to gain exposure to the cryptocurrency without directly owning or managing it.
Within the Bitcoin ETF world, the difference between a futures Bitcoin ETF and a spot Bitcoin ETF is worth noting. The futures Bitcoin ETF doesn’t hold BTC and, therefore, doesn’t perfectly track the asset’s price. Conversely, the spot Bitcoin ETF must hold Bitcoin and follow the asset’s price closely.
Spot Bitcoin ETFs: A game-changer for crypto legitimacy and mainstream adoption
The United States Securities and Exchange Commission’s approval of the 10 spot Bitcoin ETF in January 2024 was a monumental occasion. Spot Bitcoin ETFs are important for several reasons, but the biggest one is the legitimacy they bring to the cryptocurrency asset class.
Historically, central banks, regulators and mainstream capital market participants have been skeptical and, in some contexts, cynical about this asset class. The Bitcoin ETF is the first instance where that sentiment has changed.
For instance, within the first two days of Bitcoin ETF trading, BlackRock had managed inflows of more than 10,000 BTC. This is due to several advantages that the ETFs offer, including:
Regulated operations
Bitcoin ETFs operate within a regulated environment, providing a level of security and transparency that appeals to institutional investors and traditional financial players. This can potentially increase Bitcoin’s legitimacy and attract more capital to the crypto market.
Portfolio diversification
Bitcoin ETFs offer investors an easy way to diversify their portfolios without the need to understand the intricacies of the crypto market. This can be particularly appealing to those who are new to cryptocurrencies or have limited experience trading digital assets.
Accessibility
Investing in a Bitcoin ETF is as simple as buying shares of a stock through a brokerage account. This makes it more accessible to a wider audience, including those who may not have the technical know-how to trade on a crypto exchange.
Differences between trading Bitcoin on crypto exchanges and trading Bitcoin ETFs
The Bitcoin ETFs offer investors and traders opportunities that are generally more seamless and smoother compared to directly owning and handling the underlying asset (BTC). This is particularly true for market participants who were either constrained by regulatory controls or found dealing directly with Bitcoin technically complex.
When a user trades Bitcoin on an exchange, they directly buy and sell the digital currency. It exposes the user to all the ups and downs of Bitcoin’s price movements. However, they control their own Bitcoin and can store it in a digital wallet or on the exchange.
In contrast, when trading Bitcoin ETFs, investors purchase shares of an ETF that tracks Bitcoin’s price, either directly (spot ETF) or through futures contracts (futures ETF). Spot Bitcoin ETFs hold actual Bitcoin, offering exposure to its real-time price. This allows investors to gain exposure to Bitcoin’s price movements without owning the cryptocurrency directly, bypassing the need for a crypto wallet and dealing with the complexities of cryptocurrency exchanges.
Futures-based Bitcoin ETFs, on the other hand, are linked to Bitcoin futures contracts. They do not hold Bitcoin directly but track the prices of futures contracts, which can be influenced by market conditions like contango and backwardation. Trading Bitcoin ETFs is done through traditional brokerage accounts and is subject to standard stock market trading hours and regulations.
When future Bitcoin contract prices exceed the current spot price, a situation known as “contango” in the cryptocurrency space arises. This can cause futures-based ETFs to underperform as contracts are renewed at higher prices. For instance, there is contango when the market price of Bitcoin is $30,000 and the futures contract price for the next three months is $32,000.
In contrast, backwardation occurs when futures contract prices are less than the current spot price, which could be advantageous for ETFs that are based on futures. For instance, let’s say that the spot price of Bitcoin is currently $30,000, but a futures contract expiring in three months is only $28,000.
Strategies for trading Bitcoin ETFs
There are several investment strategies that market participants can employ to make the most of the ETF products.
Dollar-cost averaging (DCA)
This strategy involves investing a fixed amount of funds at regular intervals regardless of the price of Bitcoin. By using a Bitcoin ETF, investors can easily implement this strategy through their brokerage account, reducing the need to actively monitor the market and make decisions on when to buy or sell.
Sector rotation
With a Bitcoin ETF, investors can easily shift their focus between different sectors or asset classes. For example, if an investor believes that the crypto market is poised for growth, they can increase their exposure to Bitcoin ETFs while reducing exposure to other sectors, such as technology or real estate.
Diversification
Diversification becomes a breeze, allowing investors to combine Bitcoin exposure with traditional assets in a single ETF holding. For tactical players, options contracts on Bitcoin ETFs enable advanced hedging strategies to manage risk and potentially profit from market dips.
Risk management: Bitcoin ETFs vs. exchanges
Risk management is a crucial aspect of any investment or trading strategy. It is extremely critical to have a robust risk management framework when operating in a regulated space. As large institutional investors like pension funds start allocating to these ETFs, they expect high-quality risk measures to be in place.
When it comes to trading Bitcoin through exchanges or ETFs, there are several factors to consider:
Counterparty risk
Bitcoin ETFs are managed by professional fund managers and are subject to strict regulations. This reduces the risk of fraud or mismanagement compared to trading on an exchange, where investors must rely on the security and integrity of the platform.
Custody
Bitcoin ETFs hold the underlying assets in secure custody, which is typically insured against theft or loss. On the other hand, when trading on an exchange, investors are responsible for securing their own digital assets, which can be a complex and risky process. This has particularly been identified as an Achilles heel through the FTX collapse episode.
Market manipulation
Bitcoin ETFs operate within mainstream capital markets, which helps to mitigate the risk of market manipulation. In contrast, the crypto market is known for its volatility and has been subject to numerous instances of manipulation, making it a riskier environment for investors.
The road ahead
Bitcoin ETFs have opened up new avenues for investors to engage in the crypto market. By offering a regulated, accessible and secure way to invest in Bitcoin, ETFs can attract a broader audience and potentially increase the legitimacy of the digital asset.
While each method of trading Bitcoin has its own set of advantages and disadvantages, understanding the differences between trading on an exchange and using a Bitcoin ETF can help investors make informed decisions and manage risks effectively.
Written by Arunkumar Krishnakumar