How Do Cryptocurrency Exchange-Traded Funds (ETFs) Work?

What Is a Cryptocurrency ETF? 

A cryptocurrency exchange traded fund (ETF) is a fund consisting of cryptocurrencies. While most ETFs track an index or a basket of assets, a cryptocurrency ETF tracks the price of one or more digital tokens. Based on investor sales or purchases, the share price of cryptocurrency ETFs fluctuates on a daily basis. Just like common stocks, they are also traded on a daily basis.

How Does a Cryptocurrency ETF Work?

Cryptocurrency ETFs provide several benefits to investors, such as significantly lower cryptocurrency ownership costs and outsourcing of the steep learning curve required to trade cryptocurrencies.

There are two kinds of cryptocurrency ETFs:

1. The first type is backed by physical cryptocurrencies. The investment firm managing the fund makes purchases of cryptocurrencies, and ownership of the coins is represented as shares. When purchasing shares in the ETF, investors will indirectly own cryptocurrencies. Thus, owners can gain exposure to cryptocurrencies without the accompanying expense and risk of owning them outright.
2. The second type is a synthetic variant that tracks cryptocurrency derivatives like futures contracts and cryptocurrency exchange traded products (ETPs). For example, many ETFs proposed to the U.S. Securities and Exchange Commission (SEC) track prices of bitcoin futures contracts traded at the Chicago Mercantile Exchange (CME).

The first cryptocurrency ETF, the ProShares Bitcoin Strategy ETF (BITO), started trading in October 2021. This is an ETF that tracks bitcoin futures prices.

The ETF share price mimics price movements of derivatives, instead of prices of actual cryptocurrencies. Therefore, the price of shares in a given cryptocurrency ETF rises with an increase in futures contract prices. It declines with a corresponding decrease. Just like other derivatives, synthetic cryptocurrency ETFs carry added risk because their operations may not always be transparent.

Regulatory Status of Cryptocurrency ETFs

For cryptocurrency enthusiasts, ETFs are the holy grail that will boost liquidity and the adoption of cryptocurrencies for investment purposes. As far back as 2014, approximately five years after bitcoin (BTCUSD) first began trading at an exchange, the Winklevoss twins filed an ETF proposal for the cryptocurrency with the SEC.

The agency rejected their application. Since then, there has been a flurry of applications from various investment firms—including one set up by the Winklevoss twins, who applied again this year—seeking to profit off bitcoin’s price volatility. In 2021 alone, the SEC recorded receipt of at least 12 applications.

The SEC elucidated its concerns in a January 2018 letter and explained the rationale for rejecting ETF applications. Among its concerns are the absence of transparency at cryptocurrency exchanges (which set the price of individual tokens), the potential for market manipulation, and low liquidity levels in cryptocurrency markets.

The situation in cryptocurrency markets has changed since the agency published its letter. Trading volumes at exchanges have multiplied. As of April 2022, the overall market cap for cryptocurrencies has surpassed $2 trillion. (It had reached a peak of $800 billion when the SEC published its letter.) North America’s biggest cryptocurrency exchange, Coinbase Global Inc. (COIN), is now a publicly traded entity, and, as mentioned above, the first cryptocurrency ETF started trading in October 2021.

There has also been a changing of the guard at the agency’s helm. Former SEC Chairman Jay Clayton was an old hand who was considered hostile to cryptocurrencies. In 2021, he was replaced by former Commodity Futures Trading Commission (CFTC) chief Gary Gensler, who taught a course in blockchain and cryptocurrencies at the Massachusetts Institute of Technology. Gensler’s appointment has rekindled hopes for approval of a Bitcoin ETF, but he has said that he agrees with his predecessor’s assessment and views on crypto markets.

Benefits of Cryptocurrency ETFs

Cryptocurrency ETFs are a nascent asset class, and given the regulatory uncertainty, their market is still being defined. But they might be one of the best instruments through which to own cryptocurrencies. Some of the benefits of owning shares in cryptocurrency ETFs are as follows:

• Perhaps the biggest benefit of cryptocurrency ETFs is that they provide exposure to the crypto without the additional expenses of ownership. Physical ownership of cryptocurrencies entails many additional expenses. For example, there are custody charges associated with cryptocurrencies. Secure digital wallets to store purchased cryptocurrencies also charge an annual fee. These charges add up to a tidy annual sum. Cryptocurrency ownership also comes with other hidden charges, such as transaction and network fees. Cryptocurrency ETFs outsource these expenses onto ETF providers.
• Shares in cryptocurrency ETFs offer exposure to a fast-rising asset class at a fraction of the actual cost to purchase crypto. In the past couple of years, the price of cryptocurrencies—especially bitcoin—has skyrocketed. They have largely become inaccessible to the average investor. A cryptocurrency ETF is an affordable alternative for investors wishing to put money into the asset class. Consider the following situation: The price of bitcoin started 2021 at $29,405.12 and swelled to a peak of $63,569 in April, before retracting its gains to $35,045 by the end of June. During this time, the price for shares in Canada’s Purpose Bitcoin ETF (BTCC-B.TO) ranged from $10.09 to $6.44. A substantial investment in the ETF would have netted significant gains for a trader.
• Cryptocurrency jargon, steeped in its technological underpinnings, has remained a persistent roadblock to crypto adoption. It is difficult for average investors to grasp the scope and functioning of cryptocurrencies. Investors who are not familiar with technology may find crypto-speak, such as halving and blockchain, a fairly fraught learning curve. Investing in a cryptocurrency ETF outsources the learning curve to analysts.
  
• Cryptocurrencies have been hacked repeatedly since they were launched, leading to a big question over the security of the nascent asset class. Ensuring security for cryptocurrencies can be a tall order from individual investors, who may not be familiar with their workings. A cryptocurrency ETF outsources security functions to the providers of these ETFs. 
• There are more than 1,800 cryptocurrencies available in trading markets. The infrastructure to buy and sell these tokens is undeveloped as of yet. For example, some tokens are available on certain cryptocurrency exchanges, while others are not. There are also significant costs associated with the purchase of these tokens. Cryptocurrency ETFs enable investors to diversify without incurring the costs for each token.
  

Alternatives to Cryptocurrency ETFs

While there are no cryptocurrency ETFs trading in U.S. markets other than the above-mentioned ProShares Bitcoin Strategy ETF, investors can put their money into a number of other ETF-like products for crypto exposure. The closest product to a cryptocurrency ETF product is the Bitcoin Investment Trust (GBTC). The trust is a closed-end fund that resembles an ETF—it owns bitcoins on behalf of investors, and its shares trade in over-the-counter (OTC) markets.

But Grayscale’s Bitcoin Investment Trust is not an ETF. It is open only to investment firms, accredited investors, or high-net-worth individuals (HNWIs) and is not accessible to a mainstream audience. GBTC has a high minimum investment amount, and each purchase of its shares is accompanied by a lock-up period for investors.

As in the case of ETFs, the fund’s sponsor, Grayscale Investment Trust, charges an annual fee. But the fee—equal to 2% of the fund’s assets—is significantly higher than that for most ETFs. GBTC share prices are also prone to volatile swings, much like its underlying security. The shares also trade at a significant difference from bitcoin’s actual price. For example, during the 2017 run-up in bitcoin prices, investors were paying a premium of 100% over actual bitcoin prices to own GBTC shares.

There are also other products, similar to GBTC, available in the market. For example, the Bitwise Ethereum Fund and the Bitwise Uniswap Fund track the prices of Ethereum (ETHUSD) and the Uniswap token, respectively. It is important to remember that these funds have similar features to Grayscale’s products: They trade at significant price disparity to the actual token, they are only open to accredited investors, and they require a high minimum investment amount.

Investing in companies that hold bitcoin on their balance sheet is another way to invest in cryptocurrencies without direct ownership. Some publicly listed companies have become holdings for bitcoin. For example, MicroStrategy Inc. (MSTR) owned 129,218 bitcoins purchased at an average price of $45,714 as of April 4, 2022. The company’s share price has jumped by roughly 220% since it first announced the purchase in August 2020 to April 8, 2022, without a significant change in its business prospects.

This has led some observers to speculate that the jump in its share price is related not to its attractiveness as a company but due to its bitcoin holdings. By December 2021, electric carmaker Tesla Inc. (TSLA) purchased $1.5 billion of the bitcoin cryptocurrency. Other publicly listed companies with bitcoin on their balance sheets are Galaxy Digital Holdings Ltd. (BRPHF) and Square Inc. (SQ).

While these companies hold bitcoin on their balance sheets, their main business is elsewhere. Tesla makes electric cars, and Square is a payment services company. For those interested in a more concentrated exposure to companies associated with the crypto industry, Bitwise Investments has collected stocks of prominent publicly listed companies associated with the industry in its Bitwise Crypto Industry Innovators ETF (BITQ). Included in the fund are names like cryptocurrency exchange Coinbase and Riot Blockchain Inc. (RIOT).

Some investment firms are banking on investor enthusiasm for blockchain, the underlying technology for most cryptocurrencies, and have launched funds with shares of companies that utilize blockchain or are involved with the technology. Examples of such funds are the Amplify Transformational Data Sharing ETF (BLOK) and the Siren Nasdaq NexGen Economy ETF (BLCN).