Could a Bitcoin futures EFT electrify US investors?
Are crypto exchange-traded funds (ETFs) finally coming to the United States of America? Dozens of cryptocurrency-based ETFs or ETF-like products are currently selling on regulated exchanges in Europe, while Canada and Brazil have already introduced their own versions this year. Over the past eight years, however, not a single investment firm has won the U.S. Securities & Exchange Commission’s (SEC’s) approval for a cryptocurrency-backed ETF. The winds may now be shifting.
“A futures-based Bitcoin ETF will be approved in the coming weeks, not months,” John Sarson, co-founder and CEO at Sarson Funds LLC, told Hedgewane, adding that “the futures market for Bitcoin is now extremely well tested and very liquid at three years of age.”
The outlook wasn’t nearly as promising a month ago, but things gained momentum on Aug. 3rd when SEC chief Gary Gensler signaled in a statement that the U.S. regulatory agency was not necessarily opposed to futures-based Bitcoin (BTC) ETFs.
Gensler said that he was looking forward to his staff’s reviews of recent filings from firms looking to market exchange-traded funds with an indirect exposure to the world’s leading cryptocurrency, “particularly if those [fund offerings] are limited to CME” — i.e, Chicago Mercantile Exchange — “traded Bitcoin futures.”
“Gensler took us all by surprise,” Kathleen Moriarty, senior counsel at Chapman and Cutler LLP, commented to Hedgewane. The Gensler statement, along with the subsequent withdrawal of Ethereum (ETH) ETF filings by fund administrators VanEck and ProShares, prompted two Bloomberg analysts to opine that a futures-based Bitcoin ETF could be approved as early as October.
Is this reading too much into the agency’s tea leaves? Is a futures-based BTC ETF really imminent, and if so, why can’t an ETF take direct ownership in Bitcoin? Gensler, who once headed the CFTC which regulates U.S. derivatives markets — including futures — may believe that a futures-based crypto ETF offers another layer of investor protection, i.e., CFTC oversight on top of SEC supervision.
Consider, too, that a futures-based BTC mutual fund, Bitcoin Strategy ProFund (BTCFX), won SEC approval in July without a lot of fanfare. Maybe the SEC is using futures-based crypto funds as a transition product to test the regulatory waters with physical-based crypto ETFs to follow in 2022, say, if all goes well. Then again, is a futures-based Bitcoin ETF really the best product for investors?
Are Bitcoin ETFs close at hand?
Chris Kuiper, vice president at CFRA Research, told Hedgewane: “We only think it is a matter of time. Given that the SEC allows gold ETFs based on futures, it would be hard for them to not eventually approve a Bitcoin ETF also based on the now well-established Bitcoin futures market.”
How the Bloomberg analysts Eric Balchunas and James Seyffart could interpret the VanEck and ProShares’ withdrawal of proposals for Ethereum ETFs as a good sign for crypto ETFs may be baffling at first glance, but as CEO of Banz Capital John Iadeluca explained to Hedgewane: “While VanEck and ProShares’ quickly withdrew their Ethereum futures ETF applications, they didn’t do the same with their Bitcoin futures ETF applications, which seems to be a positive sign for approval of a Bitcoin ETF.” When those funds providers saw one door crack open, there was no need to surveil all doors, presumably.
Iadeluca further noted that when the Chicago Mercantile Exchange took its first steps into cryptocurrency futures, it began with Bitcoin futures, and Ethereum futures following several years later. “It would make sense for the same order to occur with futures ETFs, and the recent ETF application activity seems to hint at that happening sooner than expected,” Moriarty added:
“The other curious thing that no one has mentioned is that on May 11, 2021, the [SEC’s] Division of Investment Management issued a statement regarding its current views on funds registered under the 1940 Act investing in Bitcoin futures. The statement said that it does not yet permit the offering of 1940 Act-registered funds that are ETFs providing Bitcoin exposure by investing in Bitcoin futures.”
Clearly, some ambiguity remains. “About an October approval, it’s anyone’s guess,” said Moriarty, who worked with Cameron and Tyler Winklevoss on the first SEC filing for a Bitcoin ETF in 2013, ultimately rejected by the agency in 2017.
The best product for investors?
Why might the SEC approve a future-based crypto ETF before a physical-based one? After all, “futures-based Bitcoin funds don’t directly invest in the cryptocurrency — don’t track BTC as closely as physically held funds,” and they can be more costly, Kapil Rathi, CEO and co-founder of an institutional cryptocurrency exchange CrossTower, told Hedgewane. The firm “is not convinced that it is the best vehicle for investors. It creates significant inefficiencies in terms of constant trading and roll-over costs.”
Neena Mishra, director of ETF Research at Zacks Investment Research, told Hedgewane: “Investors would prefer physical Bitcoin ETFs, but if investors see no physical BTC coming, they will buy futures ETFs.” She thinks approval for the futures-based version is likely soon, perhaps in November.
Of course, this is not the crypto ETF that most were awaiting — Balchunas compared it to “serving O’Doul’s [non-alcoholic beer] when the party wants real beer” — but Sarson, for one, was unperturbed.
“A futures-based BTC ETF will be very popular, just as futures-based commodity ETFs are very popular with investors,” he told Hedgewane. “I think it will be hardly differentiated from a physical commodity ETF.” Nor will the “inevitable K-1” tax forms dissuade many from investing in the futures-based product, he added.
Could a futures-based ETF approval open the floodgates for other crypto-based ETFs in the U.S.? “The launch of a BTC ETF could bolster the prospects of ‘physical’ backed ETFs in the near future,” Rathi told Hedgewane. Administrators looking to launch physical-backed ETFs could point to the functioning futures-based ETF as a sort of proof of concept. Rathi added: “They could present clear data to the SEC as to why a physical-backed ETF would be significantly better for investors than a futures-based ETF.”
Concerns about market manipulation
Another question is why the SEC (seemingly) believes that a futures-based Bitcoin ETF would offer more investor protection than one that invests directly in the digital currency. After all, “the commodity futures market has been beset by large-scale market manipulations since its beginning,” as law professor J.W. Markham wrote some years back, and it’s still an issue.
In April, U.S. regulators launched “one of the biggest oil market manipulation investigations in history” in which traders allegedly squeezed the oil futures markets.
Kuiper acknowledged that such a position would be “somewhat odd,” given that a key SEC concern with regard to Bitcoin ETFs is the lack of regulation around the spot market and worries about market manipulation, telling Hedgewane:
“While the futures market is more regulated, futures are a derivative and therefore abstracted away from the underlying commodity. So, it seems like there should be more concern about potential market manipulation with the Bitcoin futures market given it is leveraged and cash settled, with no actual Bitcoin needing to be exchanged or settled with.”
Moreover, Rathi added: “Gensler is solving for counterparty credit risk by supporting a futures ETF. He is also pushing for a product that the SEC has seen in the past, like VXX [a volatility ETF] and USO [an oil ETF], which are also based upon futures.” However, he believes that while a Bitcoin futures ETF “solves one issue, it creates significant cost inefficiency. It also increases the risk that futures market makers could try to game the trades that the ETF administrator would be making every month.”
As noted, the SEC approved ProFunds’ open-ended BTC mutual fund in July, which principally invests in Bitcoin futures contracts, and some believe that this approval spurred more fund administrators to file for futures-based Bitcoin ETF.
ETFs are increasingly popular vis-a-vis mutual funds due to their lower fees, tax efficiency, and ability to be traded like equities. Among the firms filing to offer futures-based Bitcoin ETFs in August were Invesco, VanEck, Valkyrie Digital Assets, Galaxy Digital and ProShares, an affiliate of ProFunds.
Timeline for a ‘physical’ Bitcoin fund
When can one expect a U.S. ETF that invests directly in digital assets like Bitcoin and Ethereum — i.e. the “real beer?” “A real Bitcoin ETF backed by holding and storing real Bitcoin — similar to GLD with gold — is still not likely,” co‑founder and chief investment officer at Toroso Investments Michael Venuto told Hedgewane. The candidates for imminent approval are all Bitcoin strategies, he added, using futures and other securities “in an attempt to track the behavior of Bitcoin. The tracking error could be quite high.”
Mishra sees the futures-based Bitcoin ETFs as a transition product. Multiple U.S. approvals could come in November, and if they function smoothly, then the SEC might approve physical ETFs in the first half of 2022, perhaps.
When both futures and physical ETFs are finally available to investors, Mishra expects the physical ETF to be more popular than the futures-based one. Indeed, many of those holding futures-based Bitcoin ETFs might well migrate to the physical ETFs.
Related: The great crypto flippening: Can Ethereum overtake Bitcoin?
What about an Ethereum ETF? “No time soon,” said Mishra, adding that it is only likely after a physical BTC ETF is finally approved. Would approval of a physical-backed ETF in the U.S. be a big event? “Generally, it would be positive for the crypto world,” she told Hedgewane. Many investors have shied away from investing in crypto because of security concerns, like losing access to their wallets. “An ETF would be safer and easier to trade.”
Overall, it appears that a futures-based crypto ETF might be easier for the SEC to approve at this juncture, even if its Bitcoin tracking is imperfect and its fees are higher. It could play a positive role as a transition product, getting both investors and regulators more comfortable with the new crypto ecosystem. That said, “a physical backed ETF, more along the lines of GLD, would clearly be the optimal vehicle for investors,” as Rathi told Hedgewane.