What Are Cryptocurrency Exchange-Traded Funds (ETFs)?

Cryptocurrency exchange-traded funds (ETFs) provide an option to invest in cryptocurrencies without purchasing and storing digital assets. Although spot ETFs, which directly invest in cryptocurrency, have not received regulatory approval in the US yet, they are available in other countries. However, the Securities and Exchange Commission (SEC) has sanctioned other ETFs that use futures contracts to track cryptocurrency prices. The ProShares Bitcoin Strategy ETF, the first and largest US cryptocurrency ETF, commenced trading in October 2021.

Basics

Cryptocurrency exchange-traded funds function by monitoring the price movements of multiple cryptocurrencies through investments in a portfolio linked to their respective instruments. Similar to their counterparts, these crypto ETFs are traded on conventional stock exchanges and can be retained within standard brokerage accounts. This facilitates exposure to cryptocurrency price fluctuations without necessitating transactions on a crypto exchange or managing the intricacies and costs associated with direct ownership of digital assets. Notably, the expense ratio of crypto ETFs tends to surpass that of other ETFs.

Despite the burgeoning array of ETFs providing investors access to diverse market segments and commodities, the Securities and Exchange Commission has, after approximately a decade of regulatory deliberations, yet to authorize an ETF directly holding crypto assets. Meanwhile, cryptocurrencies have permeated mainstream investment avenues as anticipation for regulatory approval lingers.

How Cryptocurrency ETFs Work

Cryptocurrency ETFs employ distinct strategies to mirror the performance of digital currencies, deviating from traditional ETFs that replicate index behavior through asset baskets. Spot ETFs directly hold the cryptocurrency, creating a portfolio that inherently mimics the digital assets' performance. Conversely, other crypto ETFs opt for futures contracts, engaging in agreements to buy or sell crypto at predetermined dates and prices.

Despite the Securities and Exchange Commission withholding approval for spot ETFs directly investing in crypto assets, these instruments are accessible to investors in Europe and Canada. There are indications that crypto advocates' efforts to introduce spot ETFs in US markets may be successful soon.

Present US regulations permit only a synthetic variant of cryptocurrency ETFs, tracking cryptocurrency derivatives like futures contracts and exchange-traded products. Predominantly, these ETFs follow the prices of bitcoin futures contracts traded on the Chicago Mercantile Exchange (CME).

Due to their portfolio structures, these ETFs exhibit share prices aligning with changes in derivative prices rather than the cryptocurrencies themselves. Consequently, the shares of a given cryptocurrency ETF fluctuate in tandem with crypto futures contract prices. Like other derivatives, synthetic cryptocurrency ETFs entail additional risk due to the occasional lack of transparency in their operations.

Cryptocurrency Futures ETFs

The inaugural entry into the US crypto ETF realm, the ProShares Bitcoin Strategy ETF, exemplifies the workings of cryptocurrency futures ETFs. As of October 2023, approximately 64% of the fund's portfolio was dedicated to CME bitcoin futures expiring at the current month's end, with the remaining 36% allocated to CME bitcoin futures expiring in the subsequent month.

Approaching contract expiration, the fund executes a strategic rollover, divesting from expiring contracts and acquiring contracts for the forthcoming month. Expenses incurred during these rollovers may contribute to performance differentials between the ETFs and their underlying cryptocurrencies.

Following ProShares' foray into the crypto ETF domain, VanEck swiftly joined, unveiling the VanEck Bitcoin Strategy ETF in November 2021. This ETF, beyond investing in CME bitcoin futures contracts, employs US Treasurys as collateral.

ProShares extends its offerings to include an ether ETF, mirroring its bitcoin counterpart. The Ether Strategy ETF traces ether's price through futures contracts. For diversified exposure to multiple crypto tokens, ProShares presents ETFs that track a blend of bitcoin and ether, utilizing equal or market-cap weighting. An innovative addition is the ProShares Short Bitcoin Strategy ETF, utilizing futures to generate inverse returns compared to bitcoin. This allows investors to capitalize on days when cryptocurrency prices decline.

In a pivotal development, the District of Columbia Circuit Court of Appeals, in August 2023, overturned the SEC's rejection of converting Grayscale's Bitcoin Trust to an ETF. The court mandated a review of the application, potentially paving the way for authentic crypto ETFs.

Spot Cryptocurrency ETFs

The Securities and Exchange Commission has yet to endorse ETFs that hold cryptocurrencies directly, commonly known as spot crypto ETFs. These funds engage in the acquisition of cryptocurrencies, subsequently securitizing them. Similar to traditional ETFs, investors trade shares as needed. Spot crypto ETFs, uniquely, can issue and redeem shares, providing increased liquidity in the crypto market and offering investors an avenue for exposure to these assets.

Since approximately 2014, entities have sought SEC approval for spot bitcoin ETFs. This quest has prompted a surge in endeavors to capitalize on bitcoin's price volatility, with over 3,500 crypto-related fund applications submitted to the SEC between October 2022 and October 2023.

Advantages and Drawbacks of Cryptocurrency Exchange-Traded Funds

Advantages

• Facilitates trading on stock exchanges through standard brokerage accounts
• Grants exposure to cryptocurrency without the need for direct ownership
• Eliminates expenses associated with crypto custody and trading
• Alleviates the learning curve for investors

Drawbacks

• Encounters regulatory uncertainties
• Incurs elevated fees and expenses
• Vulnerable to the inherent volatility of crypto markets
• Lacks direct ownership or control of cryptocurrency assets

Benefits of Cryptocurrency ETFs

Cryptocurrency ETFs represent a burgeoning asset class, and amid regulatory uncertainties, the future landscape of the market remains uncertain. However, holding shares in cryptocurrency ETFs yields several advantages when navigating the crypto markets.

1. Exposure Without Ownership: Cryptocurrency ETFs offer exposure to crypto without incurring additional ownership expenses or exposing investors to associated risks. Custody charges, annual fees for secure digital wallets, and hidden costs such as transaction and network fees are absorbed by ETF providers, streamlining the investment process for indirect fee payments.
2. Lowering the Learning Curve: The intricate jargon surrounding cryptocurrencies, rooted in their technological foundations, often poses a barrier to widespread adoption. Average investors, unfamiliar with networking technology, may find terms like halving and blockchain daunting. Investing in a cryptocurrency ETF simplifies the learning process, making entry into the crypto realm more accessible.
3. More Security for Investors: Concerns about security in the crypto world persist due to hacks targeting exchanges, storage devices, wallets, and inadequately designed blockchains. Handling cryptocurrency security can be challenging for individual investors unfamiliar with requisite methods, but a cryptocurrency ETF addresses this concern.
4. Lower Costs for Investors: With over 8,900 cryptocurrencies available in trading markets, the landscape remains relatively untamed compared to securities exchanges. Cryptocurrency ETFs provide a cost-effective means of diversifying holdings without the fees and complexities associated with direct token acquisition and exchange.

Challenges in Cryptocurrency ETFs

The nascent nature of cryptocurrency ETFs introduces challenges primarily rooted in the evolving regulatory landscape. With the anticipation of more crypto ETFs, including potential spot ETFs in the US, it is crucial to recognize the associated issues.

1. Tracking Error Risk: Crypto ETFs may not consistently mirror the price movements of the underlying digital tokens, especially those relying on futures contracts that necessitate position rollovers as contracts expire.
2. Elevated ETF Fees: While crypto ETFs alleviate some costs linked to direct ownership of digital currencies, they introduce their own fees. Often actively managed, these ETFs can carry higher expense ratios compared to other ETFs. For instance, the ProShares Bitcoin Strategy ETF boasts an expense ratio of 0.95%, and the VanEck Bitcoin Strategy ETF is at 0.76%, in contrast to the SPDR S&P 500 ETF with a mere 0.09% expense ratio.
3. Market Volatility: Despite streamlining certain aspects of digital currency trading, cryptocurrency ETFs remain susceptible to the volatile price fluctuations inherent in crypto markets, posing heightened risk compared to the relatively stable nature of typical ETFs.
4. Absence of Direct Ownership: Investors in crypto ETFs lack ownership of the digital assets. While offering convenience, crypto ETFs do not provide control or access to the cryptocurrency itself, diverging from the decentralized and anonymous attributes associated with direct crypto ownership.

Diversifying Crypto Exposure Beyond ETFs

Investors exploring alternatives to cryptocurrency ETFs can consider various products for crypto exposure beyond futures ETFs or potential spot ETFs awaiting approval.

Crypto Trusts

In the absence of spot crypto ETFs in the US, bitcoin investment trusts provide a parallel option. Functioning as closed-end funds, these trusts mirror proposed spot crypto ETFs by holding bitcoins for investors. However, they are limited to investment firms, accredited investors, or high-net-worth individuals with a high minimum investment and associated lock-up periods.

Companies Holding Crypto

Investing in publicly listed companies with cryptocurrencies on their balance sheets offer an indirect route to crypto investment. Notable examples include MicroStrategy Inc., which held 152,800 bitcoins as of July 31, 2023, along with Galaxy Digital Holdings Ltd. and Square Inc., both featuring bitcoin on their balance sheets.

Crypto-Related ETFs

Numerous ETFs provide diversified exposure to companies active in the crypto markets. For instance, the Amplify Transformational Data Sharing ETF maintains a portfolio of companies engaged in the development and utilization of blockchain technologies.

Taxation Variances Between Crypto ETFs and Direct Investments

Understanding the tax implications of crypto ETFs versus direct cryptocurrency ownership is crucial. Generally, crypto ETF gains are treated as capital gains in many jurisdictions, potentially offering a more favorable tax treatment compared to direct cryptocurrency transactions. It is advisable to seek guidance from a tax advisor tailored to your specific circumstances.

Conclusion

Navigating the bottom line, ETFs present a retail-friendly avenue for cost-effective exposure to otherwise pricey assets. Brokers aspire to facilitate cryptocurrency investment for average investors by incorporating exchange-traded funds that hold digital assets. Although regulators have hindered direct cryptocurrency holdings within ETFs, the ongoing tussle between the SEC and brokers persists, underscoring the ongoing battle over the legality of these funds in the quest for broader crypto exposure.