The ABCs of Cryptocurrency ETFs, PDQ.

Headline:  What are spot v. derivative ETFs? 


What is a Bitcoin ETF, and how does it work?

There are so many abbrieviations in the finance world.   KYC, AML, so many acronyms that I feel like I will need an EMT PDQ.  But, there is something important to the cryptocurrency space, and that is the ETF or Exchange Traded Fund.  To make things even less clear, there are a few different flavors, primarily, spot and derivative. 

So, to start, what is an ETF?

Think of the ETF as a mutual fund, shares of which are sold on the stock exchange itself.  The most attractive attribute of the ETF is that  fees are usually much lower than other mutual funds.  These lower funds are achieved because the ETF will track an agreed-upon index within the stock market.    Once the rules of the ETF have been set, most of the management can be done by automatic systems.  The difference here is that these ETFs invest (usually) in a preset ratio of Bitcoin, Ethereum and other cryptocurrencies.

I  have some fundamental questions, here

Ok, first thing, why is there a “spot” rate ETF, why not simply purchase cryptocurrency?  Well, this IS possible, but it is extremely difficult and expensive to construct a portfolio of cryptocurrencies on your own.  Secondly, if you own a cryptocurrency outside of an ETF, if you forget your wallet password (and these can resemble nuclear launch codes) you are completely out of luck.   But, if you purchased the ETF, your passwords are all recoverable.  Some of you will say, “but wait, there are management fees to think about.”   You are right, but as more ETFs are being permitted, the competition to minimize management fees is fierce.  And, more to the point, what is attractive enough about the derivative ETF for it to still exist?  Well, this is a futures market, so it is tightly regulated by the CFTC.  People get a warm feeling here, so  they don’t hesitate to trade.  There are 11 such ETFs in the U.S. that just received regulatory approval, though there have been such EFTs in Europe and Canada for a few years.

DANGER, DANGER, vocabulary is near.

It is rare that the spot rate perfectly matches the value of the futures contract.  Naturally, those twisted people of the crypto world have new vocabulary for it.  When the price of a future exceeds the spot price for that currency, it is called a “contango.”  (Ostensibly trying to con you as it tangoes away with your money?  Maybe.)  When the spot price exceeds the futures price, this is called backwardation.

Whew!!  Sorry for the bowl of word salad, there. 

What you talkin’ bout, Williams?

OK, start with the slightly easier one to define.   The first variety of ETF was a “spot”  ETF, usually involving Bitcoin.  So, when a new investor comes into one of these funds, more Bitcoin and other cryptocurrencies are allocated to their account. 

One variety of derivative ETF is one that invests in futures of these cryptocurrencies.  (A futures contract is essentially a bet that the value of a cryptocurrency will go up or down.  Guess wrong, and you might lose a lot of money.)  Interestingly, with respect to cryptocurrency, if one goes with a futures-based investment, one cannot take advantage of potential staking revenue.

So, do the Sports Center thing for me and tell me the pros and cons of a Cryptocurrency ETF.

Pro ETF ownership attributeComments
The ETFs trade on stock exchanges.This makes them very easy to find,  and ensures liquidity.
Provides exposure to cryptocurrency without direct ownership.There will always be high volatility in cryptocurrency, but owning an ETF spreads out risk better.
Avoid crypto custody and trading expenses.No crypto-related “gas” fees related to transactions.
Reduces the learning curve.Ordering from an online brokerage is easy, keeping a wallet secure can involve far more learning.

Of course, there is always another side.

Cons RE: ETF ownership attributeComments
Regulatory UncertaintyWill the government put an end to cryptocurrency?
Elevated fees and expensesThese fees can be quite large compared to other ETFs.
Subject to the volatility of crypto markets.Crypto prices can be more volatile than natural gas.

The Verdict.

The most important thing to see here is how INCREDIBLY  volatile and potentially dangerous the cryptocurrency derivatives are.  I have said it before, and I will repeat now.    Cryptocurrencies are volatile and move around a lot.   Derivatives also have the potential to move around A LOT  in valuation.  Each can be thought of as a rolling chair in an office environment.    If you have to change a lightbulb, it is recommended that you do NOT use the rolling chair to help you gain height.  But, investing in a fund that isn’t even backed by vaporous cryptocurrency, this is like straining to get more height by stacking one wheeled chair atop another.  This goes from not recommended to, CALL THE AMBULANCE PROSPECTIVELY!!