Explainer: Cryptocurrency Exchange Traded Funds (ETFs)

There are a number of ways to invest in cryptocurrency. Perhaps the simplest is to sign-up to an exchange like Coinbase and buy cryptocurrencies including Bitcoin, Ethereum and Litecoin, using fiat currencies like US dollars and euros. These can then be transferred to a cryptocurrency wallet for safe storage. But even this very straightforward approach can seem complicated and risky to retail investors unfamiliar with the emerging asset class of digital currencies.  

Those investors might choose to give their cash to a hedge fund or venture capital fund to invest on their behalf and take care of the associated custodial requirements, accepting that they have less control of the underlying asset holdings than if they were to invest directly themselves. Indeed, less control may even appeal to some investors. But this approach comes with much higher fees than investing on one’s own account. There may also be gate provisions which permit the fund manager to limit or even halt redemptions if market conditions warrant it.

Using ETFs to gain exposure to asset classes

Alternatively, some investors prefer to use investment vehicles called exchange-traded funds (ETFs) to gain exposure to the asset class. These vehicles pool investors’ funds and invest them in a portfolio of assets. The value of the fund then follows that of the underlying assets that it tracks. As there is no active management of the assets, the fees charged by ETFs are relatively low compared with those of active fund managers. Moreover, the ETF itself is listed on a stock exchange, so investors can sell their holdings without forcing divestments by the fund. Of course, even an ETF is not as flexible as holding the asset oneself, as cryptocurrency markets are open 24 hours a day. And there may also be constraints on redemptions under some circumstances.

To some extent, the discussion is moot, because as yet, there is no ‘true’ crypto ETFs. To date, cryptocurrency-related ETFs have achieved exposure to the asset class by investing in companies in the tech sector. Essentially they are equity-based investments. Examples include Amplify ETF TR/Transformational DA (BLOK) and Innovation Shares NextGen Protocol ETF (KOIN), both of which are listed on the New York Stock Exchange, and Reality Shs ETF/Nasdaq Nexgen Econo (BLCN), listed on the Nasdaq.

Can ETFs be invested in crypto?

In principle, ETFs could be invested directly in actual cryptocurrencies. As yet, however, there are no ETFs that do this. In the United States, the Securities Exchange Commission (SEC) has rejected several applications for Bitcoin ETFs, including from a fund backed by the Winklevoss twins. The vehicles fall foul of two primary concerns. In its ruling on the Winklevoss application, the SEC stated that  “First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated.” A Bitcoin ETF fails to satisfy these requirements.

Bitcoin futures

However, the launch of Bitcoin futures, which trade on a regulated, and much more transparent, market than the underlying cash instrument, might assuage some of the concerns of regulators. And several applications for futures-backed ETFs are already under review by the SEC. Many in the industry have high hopes that the first fully-fledged cryptocurrency ETF might be given the go-ahead by the SEC in 2018. Although, recent comments from the body suggest that early next year may be more realistic. 

It remains to be seen whether these will be successful. At the start of this year, the SEC expressed concerns regarding the paucity of historical data available for Bitcoin futures, which makes it impossible to estimate with much confidence factors like price volatility, trading volume, and market depth. Without such information, the risk to retail investors, and their ability to redeem funds in different types of market conditions are very difficult to evaluate.

Nevertheless, if these issues can be addressed to the regulator’s satisfaction, cryptocurrency ETFs will open the door to investment in the asset class by a much greater range of investors than at present. This will increase the demand for Bitcoin futures and, in turn, lead to a rise in the price of the underlying asset, Bitcoin.

How crypto ETFs affect the wider cryptocurrency ecosystem

To understand why note that a flow of capital into a futures-backed ETF would increase demand for the future and so push up on its price relative to the spot price - the price of Bitcoin in the underlying cash market. This price difference will then induce speculative investors to buy the underlying and sell it forward via the future, pushing up on the price of Bitcoin in the cash market.

We remain hopeful about the possibility of a fully fledged cryptocurrency-backed ETF (whether by the future or the underlying) in the near term. For many investors, both retail and institutional, cryptocurrency ETFs would offer a straightforward, low cost, liquid means of gaining exposure to the asset class and the outsized gains that it can deliver. This would deliver an enormous injection of new money from those pools of capital currently locked out of the market. 

Equally importantly, any spur to Bitcoin would inevitably generate positive spillovers to altcoins and the wider crypto ecosystem. Cryptocurrency is still in its infancy, with low levels of adoption both as an investment and a utility. ETFs would create another gateway to this emerging industry and help to foster a better understanding of the wide range of innovative real-world applications that this breakthrough technology can offer.