How Does a Bitcoin ETF Work?

Exchange-traded funds (ETFs) are relatively new compared to other forms of financial assets. The earliest ETFs were approved in the US in the early 1990s and were designed to use existing assets, particularly precious metals, stocks, real estate, and bonds, as their base assets. 

Nevertheless, ETFs have become a desirable asset class among many investors. The crypto community has long awaited bitcoin’s inclusion in the list of assets that are used as ETF base assets. Many saw it as one more way for the cryptocurrency to gain acceptance in the mainstream financial markets. 

The earliest bitcoin-related ETFs used bitcoin futures as the base asset. In January 2024, the first batch of 11 bitcoin spot ETFs was approved by the Securities Exchange Commission (SEC). More have joined the list since. 

What Is a Bitcoin ETF?

A bitcoin Exchange-Traded Fund (ETF) is simply a stash of bitcoin that is managed by an investment fund and whose ownership is split into shares that are traded on traditional exchanges such as the New York Stock and Exchange (NYSE) and the Chicago Board Options Exchange (CBOE). 

The concept of an ETF, in general, is in many ways similar to that of mutual funds, but with one critical difference. 

Mutual funds are pools of capital contributed to by many investors and used to purchase assets of different kinds to earn the highest yield on the money possible. When you put your money in a mutual fund, you become one of its shareholders, and that means you get a cut in the profits that it generates. However, you cannot sell your share of the mutual fund on an exchange like NYSE. 

Likewise, when you put your money into an ETF, you are technically contributing to a fund that invests in assets like bitcoin, and you become a co-owner of that fund. This also means you get a cut of the profits it generates. However, unlike with your share of the mutual fund, you can trade your ETF share on traditional exchanges as you would stock. 

It is important to point out that the investment firm that files for and gets approval for an ETF often uses its own funds to accumulate the bitcoin and then invites investors to buy the ETF shares. 

There are two primary types of bitcoin ETFs: futures and spot ETFs. 

Bitcoin Futures ETFs

These are ETFs that do not buy and hold actual bitcoin but bitcoin futures, which are contracts based on the settlement of bitcoin transactions at a future date. These are similar to commodity futures contracts. 

The bitcoin futures ETFs are more complex and, as a result, the most risky as they are not backed by the actual bitcoin. However, they could be more rewarding for highly experienced investors. 

The list of most notable bitcoin futures ETFs includes ProShares Bitcoin ETF (BITO), which launched in October 2021, Hashdex Bitcoin ETF (DEFI), which launched in September 2022; and the 2x Bitcoin Strategy ETF (BITX), launched in June 2023. 

Indeed, bitcoin futures ETFs have been around a little longer than spot ETFs because their approval is less rigorous compared to that of spot ETFs. A few of the futures ETFs have converted into spot ETFs. Most notably, Hashdex’s Bitcoin Futures ETF filed an application and was approved  In March 2024 to convert into a spot ETF. That means they changed their base asset from being futures certificates to actual bitcoin. 

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Bitcoin Spot ETFs

These are the ETFs whose primary base asset is actual bitcoin. That means the firm behind it buys and holds the cryptocurrency in wallets it controls directly or through selected custodians. This type of bitcoin ETF is more aligned with the bitcoin market and tracks the price of the underlying asset more accurately. It could be argued that the ETFs in this category are less complex and less risky than the bitcoin futures ETFs. 

The brothers Cameron and Tyler Winklevoss, who later founded the Gemini crypto exchange, made the first attempt to register a bitcoin spot ETF in 2013. Subsequently, many other unsuccessful applications were made in the US and around the world. 

It wasn’t until January 2024 that the Securities Exchange Commission (SEC) approved the first batch of bitcoin ETFs in the US. This step has been attributed to the rally that saw the bitcoin price cross $100 000 for the first time. 

The following is the list of most notable bitcoin spot ETFs that have been approved and are traded on the New York Stock Exchange (NYSE) and Chicago Board Options Exchange (CBOE):

• Grayscale Bitcoin Trust (GBTC)
• Grayscale Bitcoin Mini Trust (BTC) 
• VanEck Bitcoin Trust (HODL)
• TrustBitcoin ETF (EZBC)
• Bitwise Bitcoin ETF (BITB)
• WisdomTree Bitcoin Fund (BTCW)
• Ark 21Shares Bitcoin ETF (ARKB)
• iShares Bitcoin Trust (IBIT)
• Fidelity Wise Origin Bitcoin Fund (FBTC)
• Franklin Templeton Digital Holdings
• Invesco Galaxy Bitcoin ETF (BTCO)
• Valkyrie Bitcoin Fund (BRRR)
• Franklin Hashdex Bitcoin ETF (DEFI)

How Does a Bitcoin ETF Work?

The life of a bitcoin ETF begins with an investment firm filing an application with the regulator. In the US, the regulator responsible for approving ETFs is the Securities Exchange Commission (SEC). 

If the applying firm meets all the requirements, the regulator approves the application. With approval given, the investment firm is free to start issuing the security to investors and buy a stash of bitcoin to back it up. In essence, this stash becomes the underlying asset of shares that are then traded on exchanges. 

As an investor, you can buy the share directly from the investment firm or go to the exchange and buy it from those who have put it up for sale. You can subsequently hold or sell it for profit based on market sentiments and your goals. 

The bitcoin (or the bitcoin futures) is generally held on behalf of the investment firm by a custodian, a service provider responsible for keeping the asset safe. Usually, during the bitcoin ETF application process, an entity that will serve as custodian, an established service provider in the crypto space, has to be identified. Meanwhile, the regulator ensures that the conditions of the ETFs are maintained.

Benefits of Investing in a Bitcoin ETF

But should you buy a bitcoin ETF and not a stash of actual satoshis? 

A primary selling point of bitcoin is that it is an asset that you have full control over, and your ownership does not need to be countersigned by any authority. However, when you buy bitcoin ETF, you have no control over the bitcoin that serves as its base asset. Also, your ownership of the ETF shares has to be guaranteed by the investment firm, the exchanges, and the regulators.

Nevertheless, owning actual bitcoin can be complicated, especially for investors who do not have the technical know-how for handling crypto assets. That is made worse by the fact that when you hold bitcoin, all the responsibility and security burden falls on you. Even though many want a piece of the market action that bitcoin generates, they aren’t confident enough to carry that burden.

Bitcoin ETF offers the best of both worlds. Investors don’t need to worry about buying and securing bitcoin, but they can gain exposure to its market activity.

It is also the case that the investor gets regulatory protection by holding bitcoin ETF and not bitcoin. If anything were to happen to the assets, there are established mechanisms to help the investor recover or get shielded from certain losses. 

On the other hand, if something happens to your bitcoin stash, you may not be able to get the meaningful technical help you may need. 

Why Bitcoin ETFs Are Important for Crypto Industry

Bitcoin ETFs offer investors, including institutional investors, an easier mechanism through which they can expose their portfolios to the bitcoin market activity. Bitcoin itself has seemed to benefit from being approved as a base asset for ETFs.

In the months following the approval of the first batch of bitcoin spot ETFs, the cryptocurrency rallied and crossed the $100,000 mark. While institutional investors are not buying bitcoin, they are buying bitcoin ETFs. Meanwhile, the firms issuing the ETFs are accumulating bitcoin to serve as the base asset, which puts pressure on the price. 

This pressure on the price ultimately benefits all those holding the cryptocurrency, including bitcoin maximalists who want nothing to do with bitcoin ETFs. Meanwhile, bitcoin ETFs have given bitcoin publicity and visibility, especially to mainstream retail and institutional investors.

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Risks of Bitcoin ETFs

But bitcoin ETFs are not without risks. The following are some of the challenges that those who invest in this form of asset have to contend with:

Market volatility

Bitcoin is still a highly volatile asset. Since bitcoin ETFs track their prices, investors are exposed to this market volatility, which can sometimes swing so low that a significant amount of value is wiped out. Of course, this volatility can also be an opportunity, especially for experienced day traders. 

Regulatory uncertainty

Bitcoin is still a relatively new asset class. Given its technical and economic uniqueness, regulators have struggled to create frameworks for its trading, including how it can be incorporated into the traditional finance ecosystem. That uncertainty extends to bitcoin ETFs. Many regulators have been slow to approve them, and even after they are approved, it is still unclear how they should be treated in different scenarios. 

Management fees

Bitcoin is designed to be a bearer asset, but bitcoin ETFs are not bearer assets and are supported by a sizable centralized profit-making infrastructure. That means that as a holder of a bitcoin ETF, you have to pay fees to keep this infrastructure in place. That includes the custodians who store and secure the bitcoin. 

Tracking Discrepancies

Of course, the price of ETFs is based on the market performance of the underlying asset, bitcoin. Tracking the price is complicated, especially given the many marketplaces to consider, and slight differences can result in huge amounts. 

The Future of Bitcoin ETFs

We are still in the early days of bitcoin ETFs. More countries are likely to approve this new type of asset, and more crypto assets are joining Bitcoin as an underlying asset for ETFs. Already, a few investment firms are seeking to have Ethereum ETFs approved. 

In short, crypto ETFs will increasingly be a category of investment instruments that investors must consider adding to their portfolios. 

Takeaway

Bitcoin ETFs provide an opportunity for investors who don’t have the time, technical know-how, or legal room to buy and hold actual bitcoin to get exposure to the bitcoin market activity. This is also helping to bring bitcoin to the mainstream.