The Discussion On Physical Versus Futures-Backed Bitcoin ETFs

What Are ETFs?

In the current scenario, there is a Bitcoin-based exchange-traded fund that continues to be the most eagerly awaited financial instrument on the horizon as investors await a verdict from the US Securities and Exchange Commission in near future. Therefore two leading investment management firms, ProShares, and VanEck are the front runners in their applications for Bitcoin ETFs. Here the ProShares as one of the largest lineups of ETFs, more than $ 30 billion in assets has two proposals for its Bitcoin ETF and both are based on Bitcoin futures contracts. Therefore, on the other hand, the proposal by VanEck-SolidX comes based on a physical backed Bitcoin ETF. 

How ETFs Work?

ETF s come as a blend of mutual funds and stocks as they offer a good degree of diversification based on the underlying index or basket of securities it tracks offering the convenience of trading with real-time tick by tick price changes. These ETFs when launched by investment management firms, and asset management companies that purchase the underlying securities based on supply and demand here are these AMCs create and sell ETF shares to investors and the price of these shares reflect the changes in the price of the underlying assets as the AMC holds the underlying basket of securities in a given proportion. Eventually, there may be minor differentials in prices owing to the tracking error accounting for transaction costs and management charges. Therefore ETF securities allow a convenient way for common investors to own a well-diversified portfolio of securities with a single ETF holding.

How Are The Physical-Backed Bitcoin ETFs Working ?

This is where in case of a physical backed Bitcoin ETF, there is an investment management firm purchasing the actual bitcoins and create smaller sized shares that can be sold, traded and redeemed on stock exchanges, with the investment management firm responsible for purchasing or selling the necessary bitcoins securely storing them and maintaining the private keys to their wallets or vaults.

Some common investors will simply hold the Bitcoin ETF shares in their Demat account similar to holding a common share of a listed company. Here is the price of these Bitcoin ETF shares that keep changing to reflect the price of the Bitcoin. It is then that theoretically if the Bitcoin price changes by 1.5% in an hour, the price of physical backed Bitcoin ETF can also be expected to move by the same magnitude and in the same upward direction. Thereby such physical backed Bitcoin ETFs are better for investors who want to take exposure in bitcoins without holding them. 

How Do The Futures-Backed Bitcoin ETFs Work ?

It is well known that futures backed Bitcoin ETF will base the shares in the fund by taking positions in Bitcoin futures contacts instead of holding real bitcoins. So the futures are speculative instruments that may trade at a premium or at a discount where it is possible that the share price of futures backed Bitcoin ETF is set to deviate to the larger degree when compared to those actual Bitcoin prices. For instance, now in case, the price of Bitcoin has moved up by 1.5% but the price of Bitcoin's future trading at a discount of 2%, possible to see that the price of these futures backed Bitcoin ETF units are thereby going down. Here these moves can offer profitable opportunities to active traders risking getting hit with losses when caught on the wrong side of the trade. 

Whereby the investment management firms operating such futures backed Bitcoin ETFs there is only to hold Bitcoin-based derivative security as they don’t have to worry about thefts and hacks often associated with cryptocurrency holdings. It is found that such futures backed Bitcoin ETFs are set to save on those costs of the secure storage and they don’t run the risk of hacking and thefts of actual bitcoins where these benefits are partially nullified by trading overheads. These future contracts have since come with expiry dates, such ETFs need to rollover their underlying futures holdings. This means that it often involves buying futures at high prices earlier in the months and selling them later around expiry date at relatively low prices. Here these mandatory rollovers not only reduce the profit potential while owing to the above-mentioned price gaps as also increase the cost of operations due to the regular transactions required. 

Why Do The Market Prefer Futures-Backed Bitcoin ETFs ?

As of August 2018, there are 10 Bitcoin related funds pending SEC review as the decisions are due over the next two months according to CoinDesk as interestingly the only one among them is a physical backed Bitcoin ETF with the rest nine are futures backed. Here it indicates that the AMCs are being placed higher stakes on securing approval for futures backed offerings compared to approval for physical backed offerings.

The executive chairman for CoinShares, Daniel Masters says this to be the requirement for safe storage of cryptocurrencies. Therefore no wonder the leading investment firms are now eyeing the big market for cryptocurrency custody services. 

The Bottom Line

So any attempt to reap profits from financial security is built atop other securities where the ETFs are requiring a clear understanding before interested in investors jump in with their hard-earned money. It is while SEC decisions are expected soon that it may take time for investors to get accustomed to the variety of potential Bitcoin ETF offerings.