Bitcoin ETFs: How Do They Work?

One can buy the most popular cryptocurrency, the bitcoin, at any designated bitcoin exchange. But what if one wants to buy and hold bitcoins as a long-term investment like a stock? For those who are excited about the better future valuations of bitcoin, but are less tech-savvy or worry about bitcoin thefts from their digital wallets, the recently announced bitcoin exchange-traded fund (ETF) is a way to go.

The increasing popularity and mass adoption of bitcoin just got another shot in the arm. The first bitcoin ETF started trading on May 4, 2015 on the over-the-counter markets with the symbol GBTC. It provides individual investors an opportunity to invest over the long-term in bitcoins, without the need to buy the bitcoins directly. It also eliminates the hassles of managing digital wallets. Short-term traders can bet their money on short-term price moves of bitcoin ETF units and attempt to benefit from trading profits.

The Basics

A bitcoin ETF is issued by the Bitcoin Investment Trust (BIT), which is owned and operated by Grayscale Investments, LLC. It trades with symbol GBTC, and is also known as “BIT Share.” Other identifiers include:

  • CUSIP – 09173T108
  • ISIN – US09173T1088
  • Bloomberg Identifier – XBTFUND

As of March 2015, the number of shares freely tradable (public float) was 558,469.

How The Bitcoin ETF Works?

The BIT, which invests solely in bitcoins, started operations in September 2013. Based on its bitcoin holdings, the trust issues shares in multiples of 100, which are called “baskets”. Due to regulatory requirements applicable during the initial phase of trust operations, such baskets are issued to and redeemed by only accredited investors or authorized partners, such as SecondMarket, Inc., which is the only authorized participant for BIT.

The accredited owners of the “shares” are allowed to sell them to other interested participants after twelve months of fund operations, and after receiving the necessary approval from the Financial Industry Regulatory Authority, Inc. (FINRA), the regulatory body. BIT received FINRA approval in March 2015, making BIT eligible to issue and trade shares publicly on the open market.

The bitcoin ETF or BIT share, which now trades as a “common stock,” can be bought and sold by any individual. Each GBTC share (or bitcoin ETF unit) represents ownership of approximately 0.1 bitcoins. Essentially, price of one GBTC unit, BIT share, or bitcoin ETF, represents 10% price of the actual bitcoin.

The creation and redemption of BIT shares follow the standard process of any ETF. Depending on the demand of BIT shares, the authorized participant, SecondMarket, purchases bitcoins and provides the shares / ETF unit to the BIT share buyer. At the time of redemption, the equivalent number of bitcoins is sold, and the money is given to the BIT share seller. The bitcoins are held in safe custody of the designated custodian–in this case, SecondMarket Holdings on behalf of the trust (BIT). BIT charges a 2% annual fee towards associated cost and fund management.

Valuation Of BIT Units

ETF units closely mirror the price of the underlying. For example, the price of one share of the popular gold-based SPDR Gold Shares ETF (GLD) closely reflects price of one-tenth of an ounce of physical gold. Similarly, the BIT Unit or bitcoin ETF will closely reflect one-tenth of price of one bitcoin. Taking 10 shares of GBTC will allow exposure equivalent to one bitcoin, with the benefits of holding a dematerialized bitcoin share without worrying about its security.

Advantages Of The Bitcoin ETF

  • Many investors interested in taking positions in the cryptocurrency are still skeptical about bitcoin, given that it is not traded on a standard exchange. There are also doubts about its regulation. Bitcoin ETFs will allow standard trading of bitcoin on known exchanges.
  • The ownership and responsibility to securely hold the underlying bitcoins will lie with the Bitcoin Investment Trust, and not the bitcoin ETF investor.
  • Bitcoin ETF trading will allow shorting of bitcoins for traders who may have a bearish view.
  • High price swings have been observed in bitcoin valuation (above $1000), which may keep actual bitcoins out of reach of common investors. Bitcoin ETFs allow fractional 10% investments that can make investing in bitcoins affordable to common investors.

Risk Factors Of Bitcoin ETFs

A BIT share or bitcoin ETF is solely concentrated on a single underlying asset, the bitcoin. Most of the risk factors pertain to the characteristics of the underlying bitcoin cryptocurrency.

  • Bitcoin valuation is highly speculative in nature, very volatile and currently unregulated by any central authority. There is no authority to approach in case of problems with bitcoins. This risk will eventually be borne by bitcoin ETF investors.
  • The ETF is exposed to the general market risk and liquidity risk.
  • With no designated clearinghouse or central depository for custody of bitcoins, BIT bitcoins are prone to digital theft and loss even from the Trust’s custodian.
  • The bitcoin transactions are irrevocable, which means that it will be impossible to recover bitcoins for any incorrectly executed transactions (including theft).
  • The trust does not have any insurance protection for its bitcoin holdings.
  • The fee of 2% appears to be high by ETF standards.

Competition For BIT Shares

The Winklevoss twins, Cameron and Tyler, are expected to launch their own bitcoin ETF shortly. Nasdaq has already launched Bitcoin Tracker One (BTO) on the Nasdaq Nordic Exchange in Stockholm. BTO is an exchange-traded note that uses bitcoin as the underlying asset. And more players are expected to follow with similar products in the global markets.

The Bottom Line

A quick history of popular ETFs indicates that investments in that underlying asset actually improved once the ETF was launched. Introduction of tradable instruments, enabling them to be within the reach of common investor, has usually resulted in making the underlying asset popular. Bitcoin ETFs are expected to provide a convenient and cost effective mode to common individuals to hold bitcoin stakes with small amount of money. Already increasing in popularity, bitcoin is expected to benefit from BIT Shares, and other bitcoin ETFs.