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In our most recent Q&A, a paid subscriber asked about exactly how ETFs work, especially within the context of crypto and the highly anticipated BTC ETF.
We’ll answer the specific questions first, then provide broader context.
Let’s dive right in.
For stocks, the bulk of an ETF's holdings usually consists of the actual shares of the companies that are part of the underlying index. For instance, if an ETF is tracking the S&P 500, it will own shares of the companies that are part of the S&P 500 in proportion to their weight in the index. So, if Vanguard's ETF is tracking an index where Apple is a constituent, then yes, Vanguard will directly own shares of Apple.
Some ETFs, especially those that aim to achieve a specific goal (like leveraged ETFs or inverse ETFs), might use derivatives such as options or futures to help achieve that goal. However, the majority of traditional ETFs primarily hold the actual securities that they are tracking.
As for how much spot BTF the SEC would require to start a BTC ETF, there’s no way for us to put a figure on it. The best we can offer is to say.. A lot, probably. They’re going to want to know that the ETF has enough liquidity and isn’t overly reliant on derivatives.
Could you start your own ETF and just churn fees? It sounds cool in theory but there are a lot of hurdles beyond simply clicking a button and starting the ETF (unless you’re on-chain!). First off, gaining approval from the SEC or other regulators to launch an ETF is a complex (and expensive) process. They would scrutinize the structure, holdings, and strategies of the ETF. Launching your own ETF is not “permissionless.”
On-chain, anyone can create an index, and a token which tracks the index (like an ETF) in a few clicks by using existing smart contracts maintained by Index Protocol. An example is Index Coop’s “DeFi Pulse” Index. Running an on-chain ETF isn’t easy: these products can lose significant money when rebalancing their holdings (due to slippage in DEX pools).
Regulators know that any ETF that is overly reliant on derivatives (like options) could face liquidity concerns. ETFs have a unique redemption mechanism. When there's a demand for redemptions (investors selling the ETF), the ETF provider might need to sell its holdings to meet those redemptions. If the ETF is heavily reliant on illiquid derivatives, it might struggle to sell those holdings quickly without incurring significant costs or impacting the derivative's price.
If there's a sharp market movement, these ETFs might need to adjust their derivative positions quickly. If the derivatives market is not sufficiently liquid, the ETF could face challenges in adjusting its positions, leading to tracking errors or increased costs.
There’s also the matter of counterparty risk. If an ETF has a significant portion of its value tied up in derivatives and a counterparty defaults, it could create liquidity challenges.
In the end, the value of the BTC ETF is to avoid creating just another GBTC, where the price of the ETF deviates substantially from NAV. Even if you were to get regulatory approval, would anyone buy your more complex, higher fee, higher risk ETF? Our view is that it’s unlikely.
Understanding ETFs
There is an immense amount of literature out there on ETFs, so we don’t need to go through every little detail. We’ll focus on simplifying the complexities and the parts that are relevant to crypto.
An ETF is an investment fund that holds a collection of assets, such as stocks, bonds, or commodities, and is traded on stock exchanges, much like individual stocks. ETFs aim to replicate the performance of a specific index, sector, or asset class.
The unique structure of ETFs revolves around the "creation and redemption" process, which involves large financial institutions known as Authorized Participants (APs).
When there's demand for an ETF, an AP assembles a "creation basket," which is a specified list of securities that the ETF aims to track. The AP then exchanges this basket with the ETF provider for an equivalent value of ETF shares, which are then sold on the stock market.
Conversely, when investors want to sell their ETF shares, APs buy these shares from the market, return them to the ETF provider, and receive a "redemption basket" of the underlying securities.
This in-kind exchange mechanism minimizes the tax implications for the ETF and its investors.
There has been some criticism online about the BTC “ETF”, with people saying it is a trust and is therefore “just another GBTC.” This is an incorrect characterization. While it’s true that the BTC ETF is a trust, the key difference is that there is a redemption mechanism. GBTC cannot be redeemed, which is why it trades at a discount to NAV. While it might seem like just one detail, it makes all the difference.
Besides, while it’s true that the majority of ETFs in the U.S. are structured as open-end investment companies (a type of mutual fund), there are plenty of ETFs structured as trusts. “GLD”, the SPDR Gold Trust, is a trust.
ETFs inherently have two layers of liquidity:
Primary Market: This involves the creation and redemption process with the APs. The liquidity here is determined by the underlying assets of the ETF.
Secondary Market: This is where most investors trade ETFs, buying and selling shares on stock exchanges. Here, liquidity is determined by trading volume and market makers who provide bid-ask quotes.
The price of an ETF is influenced by:
Net Asset Value (NAV): total value of the ETF's assets minus its liabilities, divided by the number of shares outstanding. Calculated at the end of each trading day.
Market Forces: Supply and demand dynamics on the stock exchange can lead to ETFs trading at a slight premium or discount to their NAV. Typically short-lived due to arbitrage.
ETFs disclose their holdings daily and can be bought / sold during trading hours. This creates an interesting dynamic for the BTC ETF as BTC is traded 24/7. Unlike stocks where there might be a waiting period before investors can react to overnight news, Bitcoin's 24/7 market allows for almost immediate reactions, leading to rapid price changes. That means events, regulatory news, or market sentiment from any part of the world can influence its price at any time.
Assuming the trust's shares are traded during regular stock exchange hours, this could lead to discrepancies between the trust's share price and the actual price of Bitcoin, especially if significant price movements occur outside of stock exchange hours. The ETF provider may decide to update NAV more frequently than at the end of each trading day.
Significant price movements in Bitcoin during off-hours for stock markets could lead to a backlog of buy or sell orders for the ETF when the market reopens. This may cause delays in order fulfillment and unexpected prices for market orders.
If liquidity providers or market makers are uncertain about Bitcoin's price direction due to events happening in the 24/7 market, they might set wider bid-ask spreads for the ETF to mitigate potential risks.
Blackrock is no stranger to ETFs - they manage over $2 trillion of assets through their ETFs. It’s safe to assume they’ve carefully considered the implications of 24/7 trading. Still, crypto is an unpredictable and unforgiving market. There will surely be entertainment to come from this at some point!
For our thoughts and opinions on the Blackrock Bitcoin Trust, you can read our past article here.
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Until next time..
Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.
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