Ben Fulton is an ETF pioneer and works as an independent consultant in the ETF industry, advising firms on product design and strategic management decisions. His opinions are his own and do not reflect the clients he serves.
Analyzing a new product that I did not create is always a risky endeavor. Typically this means I will step on toes that I did not intend to and my thoughts could be viewed as sour grapes since I was not part of solution. I will attempt to avoid these issues, but apologies ahead of time if I don't.
As expected, ProShares announced the SEC approval of the ProShares Bitcoin Strategy ETF (BITO) that is set to debut on the NYSE Arca on Tuesday, becoming the first ETF in the U.S. using a cryptocurrency derivative as its underlying asset. It’ll charge 0.95% basis points in expense. While BITO will primarily invest in bitcoin futures, the fund reserves the right to purchase stakes in foreign ETFs and investment vehicles that hold bitcoin directly. (Read: ProShares’ Bitcoin ETF Launches Tuesday)
So, what is the problem we are trying to solve with the approval by the SEC of the first bitcoin futures ETF, rather than a physically backed ETF?
- Bitcoin is extremely easy to purchase; even teenagers via Robinhood have access with minimal cost. Security from hackers for large holders is a problem.
- Volatility is a problem (such as running up Friday at over $1,000 an hour due to a potential bitcoin futures ETF coming to market this week)
- In your tax-deferred IRA held at one of the custodians, ownership is not easy.
- One major issue is the ability and limitations for mutual fund and asset managers to own bitcoin of any kind in their ’40 Act funds or ETFs.
Grading The Solutions
So how does a U.S. bitcoin futures ETF solve or enhance any of the above?
- The first problem, or lack of problem, is ease of ownership for individuals. This ETF will only add to the costs of ownership, introduce the roll cost of futures and slippage due to the curve of the contracts and potentially create premium and discounts once the CME limit to futures is reached. I would give this solution a “D+” at best
- Volatility may only be increased due to the spiking of volume in the futures contracts (look at oil contracts during the early days of the pandemic). Futures contracts are not limited by the amount of physical bitcoin mined. They are a bet on price movements, and the volume can exceed the supply, thus creating chaos. I would give this answer an “F” if reducing volatility was a goal.
- Ease of ownership within your financial advisory account will be easier because it is an ETF. This is a win for the new bitcoin ETFs. I will give them an “A” for this. I will give the loophole-finding product developers an “A+” and the SEC a big “F” for the risk potential, which is much like buying a 16-year-old a case of beer and giving them the keys to your Ferrari! (See below for my further analysis.)
One key point may have been overlooked by the SEC and others. Great investors such as Cathie Wood of ARK Invest and other ETF issuers have driven performance in their disruptive technology funds by obtaining exposure to bitcoin and digital assets.
However, it has been difficult for fund managers like them to maximize that exposure due to constraints enacted by the SEC on ownership of bitcoin directly or via closed-end products such as Grayscale or foreign ETF solutions.
ETF and fund ownership rules of “nonaffiliated funds” are very developed and refined. Typically, it is hard to own more than 3% of other companies' funds without onerous obligations. When it comes to owning your own “affiliated funds” though, it is much easier.
ETF issuers are typically not restricted in owning 100% of another fund in their family of products. I have been told by good sources that the SEC does not restrain this since a board would not permit one fund to harm another fund that is an affiliate. What does this mean for bitcoin?
Well, smart minds like those at ARK filed for their own bitcoin futures product. And in theory, as I understand, ARK and any issuer can allocate large sums of assets through other funds into their new bitcoin futures, once launched.
While ARK’s product is not going to be approved next week, be aware: Huge flows into any bitcoin futures ETFs could be from other ETFs within the issuer's fund family complex.
ProShares is a firm I know well since I only left there a year ago. I have many friends there, so I'm certaintly dancing on at least someone's toes. The firm's bitcoin futures ETF is the result of ingenious efforts by the product development teams.
My concern is about the systemic risk that could be developed due to an unnatural supply-and-demand imbalance. The risk would stem from limits on bitcoin futures contracts by the CME, volatility due to excitement in bitcoin futures ETFs being launched in the U.S., and internal portfolio managers looking to improve their returns without constraint of ownership.
The real shame is that better answers for all these problems are available elsewhere in the world.
For example, the ETC Group’s novel bitcoin solution in Europe offers direct exposure to physical bitcoin with a focus on minimizing risk, but developing an elegant answer that provides a safe-keeping solution of transferring from Cold Wallet to Cold Wallet during the create/redeem process and most importantly, no dislocation in pricing due to futures contracts.
I am a big believer in the futures market, for both hedgers and speculators. But this is assuming that the underlying is complicated to own directly (who wants to have 5,000 bushels of corn delivered to your front driveway?).
Technology has lapped the SEC and provided easy ways to own bitcoin, and the ETC Group is now providing that in a user-friendly wrapper to Europe. The same is happening in Canada and other countries with physically backed bitcoin ETFs.
The time is now for the SEC to protect investors where they need protection while providing access to something that has not been previously accomplished. ETFs have always done that. The SEC is avoiding the right answer and inadvertently allowing the fox to rule the hen house.
There’s a very good potential these funds will gather huge flows, due to associated funds alone buying them. Unfortunately, I fear the client experience in the U.S. will not go well when it comes to bitcoin ETF performance in comparison to the futures product and our friends in Europe.
Ben Fulton works as an independent consultant in the ETF industry, advising firms on product design and strategic management decisions. His opinions are his own and do not reflect the clients he serves.