ETFs Are a Bad Way to Bet on Bitcoin

The whole concept of bitcoin ETFs is weird. Bitcoin is a cryptocurrency; It is easy to buy and, for individuals who wish to speculate on its future value, easy to hold. All you have to do is download some software, choose a secure password, sign up for a crypto broker, transfer bitcoins to your blockchain wallet and you’re done. If you want a traditional currency you won’t pay the 0.95% annual fee, plus hefty futures costs, to get something that roughly tracks the value of a dollar – you’ll have just a few dollars.

That didn’t stop many people from finding the idea appealing: The ProShares Bitcoin Strategy ETF, first, attracted more money than any other ETF launched and had the second highest trading volume on its first day. It has $1.2 billion a week after launch. Much of this money is likely to be a new layer of gambling, as traders bet on other people seeking it. But the expected underlying demand is from those who cannot or cannot afford the simple option of buying bitcoin directly, therefore preferring to use a structure listed on the stock exchange and approved by the Securities and Exchange Commission.

It all sounds reasonable – until you ask why they love it, given the high cost and ease of buying outright. The answer is that it’s all about trust, which is pretty ironic because bitcoin was created to solve the trust problem.

Michael Sapir, chief executive of ProShares, likens the regulated futures market to the “Wild West” of crypto trading by the SEC itself. He warns that many exchanges have “some degree of manipulation inherent in them,” so there may be hidden costs, as well as risks, of buying bitcoin outright.

There are definitely risks. If you keep bitcoins directly on the blockchain, and you lose your wallet password, you have lost your bitcoins. If someone steals your password, you have lost your bitcoin. And if you give it to someone else, they now control your bitcoins. For one person, this is manageable, if intimidating; Choose a unique secure password that you can remember, don’t write it down or keep it on the Internet where it can be hacked, and don’t tell anyone.

But most of our investments in the financial system are delegated to others, with the bulk of assets held worldwide by institutions such as insurance companies, pension funds, mutual funds and endowments, or operated by advisors. These institutional investors and advisors have a serious trust problem. Who do they trust to keep bitcoin passwords? Eventually someone has to take custody of it, and that person can suddenly become very wealthy, by running away with it – something they can’t (easily) do with stocks, bonds, or assets. The trust problem is hard to manage, as demonstrated by the founders of crypto firms that sometimes disappear along with all the bitcoin their investors thought they were looking for.

New ETFs address the trust problem by buying bitcoin futures instead of bitcoin, introducing a new layer of gambling and arbitrage. Bitcoin futures are side bets on the price of bitcoin settled in dollars only; They are for bitcoin which is a bet for a horse on the Kentucky Derby. Their relationship to the price of bitcoin comes from the final settlement and from intermediaries who make a profit by selling more bitcoin futures and buying actual bitcoins. (The same upside may apply, but the futures price is usually higher.)

In turn, the ETF is priced in line with the value of bitcoin futures owned by arbitrageurs, like other ETFs.

All these layers of arbitrage cost money – real money, not bitcoin. The ETF has an annual fee of 0.95%, but the main cost comes from futures being more expensive than bitcoin. The ETF buys them a month in advance, but as they near maturity, their price falls, so it incurs a loss, known as a roll cost. According to the Horizons Bitcoin Front Month Rolling Futures Index, calculated by Solactive, this outlook has reduced bitcoin by about 13 percentage points from 118% so far this year; Mr. Sapir says it’s like five points a year from 2017.

There are many people offering technical solutions to bitcoin’s institutional custody problem, and many are trying to persuade the SEC to approve an ETF that just buys bitcoin. This would remove the layers of arbitrage and gambling created using futures, leaving the arbitrage inherent in ETFs and the gambling inherent in bitcoins—but only successful if investors trust the solution.

Nevertheless, the fundamental principle of any bitcoin ETF is an arbitrage between the blockchain and the traditional financial system, unlike Tether and other stablecoins. Stablecoins let you think in dollars on the blockchain; Bitcoin ETFs let you think bitcoin in a mainstream system. And as with everything else in finance, that comes with a cost – a cost ordinary people can easily avoid if they want bitcoin, by simply buying bitcoin instead.