Crypto ETFs, traded on stock exchanges, allow investors to monitor cryptocurrency price performance. Following regulatory disputes, the Securities and Exchange Commission (SEC) authorized the first spot crypto ETFs in early 2024.
These investments allow retail traders to gain direct exposure to cryptocurrency prices without owning the assets, allowing speculation without the need for direct crypto exchange transactions.
How Does a Cryptocurrency ETF Work?
Although most exchange-traded funds (ETFs) replicate the functionality of indexes by maintaining a collection of underlying assets, crypto ETFs have a few methods of monitoring the performance of a digital currency.
Spot ETFs directly hold the cryptocurrency, thereby constructing a portfolio that mirrors the performance of the digital assets it contains.
Other cryptocurrency exchange-traded funds (ETFs) invest in futures contracts, which are agreements to purchase or sell cryptocurrency at a predetermined price and date.
As a result of their portfolios, the share prices of these ETFs are modeled after fluctuations in the price of derivatives rather than the cryptocurrencies themselves.
Consequently, the price of shares in a specific cryptocurrency exchange-traded fund (ETF) fluctuates in accordance with the prices of crypto futures contracts.
Synthetic cryptocurrency exchange-traded funds (ETFs) are subject to an additional risk due to the absence of governance and valuation concerns in the crypto exchanges from which the funds would be extracted, as is the case with other derivatives.
Even though U.S. regulators refused to sanction crypto ETFs for several years—the SEC rejected approximately 20 proposals for spot ETFs from 2018 to 2023—they were readily accessible to investors in Canada and Europe.
The SEC authorized the initial crypto futures ETFs for the U.S. market in October 2021 and the initial spot crypto ETFs in January 2024.
Cryptocurrency Futures ETFs
This analysis of the ProShares Bitcoin Strategy ETF, the first crypto ETF to be listed on U.S. markets, illustrates the operation of crypto futures ETFs.
The fund allocates approximately half of its portfolio to Chicago Mercantile Exchange (CME) bitcoin futures that expire at the end of the current month. In contrast, the remaining half is allocated to CME bitcoin futures that expire the following month.
The fund changes over its investments as the expiration of the contracts in the portfolio approaches, selling the expiring contracts and purchasing contracts for the up-coming month.
Some of the discrepancies between the performance of the ETFs and their underlying cryptocurrencies may be justified by the costs associated with turning over the contracts.
ProShares also offers the Ether Strategy ETF (EETH), which is an ether futures ETF similar to the one it offers for bitcoin.
The fund employs futures contracts to monitor the price of ether. For investors seeking exposure to various crypto tokens, ProShares offers ETFs that monitor a combination of bitcoin and ether using equal or market-cap weighting.
Additionally, there are inverse exchange-traded funds (ETFs), including the ProShares Short Bitcoin Strategy ETF.
This employs futures to produce the inverse of bitcoin’s returns, enabling investors to profit on days when cryptocurrency prices decline.
Spot ETFs that Specialize in Cryptocurrency
Additionally, investment funds can exchange and maintain cryptocurrencies directly. Spot crypto ETFs are funds that acquire cryptocurrencies and securitize them.
Like a conventional exchange-traded fund (ETF), investors acquire and dispose of shares as required.
The fund can issue and redeem shares in a spot crypto ETF, providing retail and other investors with a stake in the crypto market.
Beginning in 2014, asset managers pursued approval from the SEC for spot bitcoin exchange-traded funds (ETFs).
The SEC received over 3,500 applications for crypto-related funds between October 2022 and October 2023.
The SEC certified the first 11 spot bitcoin ETFs in January 2024, which paved the way for the introduction of additional spot cryptocurrency ETFs in the future.
Additionally, the SEC initiated the process of facilitating the introduction of spot ether ETFs in May 2024. The SEC has approved a rule change that will enable the listing and trading of eight spot ether ETFs.
The SEC had previously expressed apprehensions regarding Ethereum’s staking feature and its previous concerns regarding bitcoin’s volatility, fraud, and inadequate investor protections in crypto markets prior to this approval.
A critical component of Ethereum’s consensus mechanism is “staking,” which enables ether proprietors to generate income by securing their tokens to validate network transactions.
This income-generating feature, implemented on the ether platform in 2022, prompts inquiries regarding the taxation and reporting of staking rewards.
This gave the SEC an additional reason to be hesitant about approving spot ether ETFs, as there was a lack of regulatory clarity regarding their tax status.
It is important to note that the SEC’s approval of a rule change for spot ether ETFs does not imply that they can begin trading. The investment managers’ applications must be assessed, and additional approvals must be granted.
Advantage of Crypto ETFs
In the future, the market may differ due to regulatory uncertainty, as cryptocurrency ETFs are a developing asset class.
However, there are certain benefits to possessing shares in cryptocurrency exchange-traded funds (ETFs) when accessing the cryptocurrency markets:
- Exposure without ownership
- Reducing the Learning Curve
- Enhanced Security for Investors
- Reduced Investment Costs
Exposure without ownership
The most substantial advantage of cryptocurrency exchange-traded funds (ETFs) is that they offer exposure to cryptocurrency without the risk of possessing and holding it in a crypto wallet or incurring additional ownership expenses.
For instance, custody fees are assessed for cryptocurrencies, and certain digital wallets that are considered secure impose an annual fee.
These fees can accumulate rapidly. The ETF providers are responsible for the transaction and network fees associated with cryptocurrencies, even if you indirectly pay them through the fund’s expense ratio.
Reducing the Learning Curve
The adoption of cryptocurrency is still hindered by the jargon that is primarily derived from its technological foundation.
It is frequently challenging for average investors to comprehend the scope and functions of cryptocurrencies.
Additionally, these investors may be unfamiliar with networking technology, which further dissuades them from understanding crypto-speak, including blockchain and halving.
The process of acquiring the necessary knowledge to enter the cryptocurrency market is significantly simplified by investing in a cryptocurrency exchange-traded fund (ETF).
Enhanced Security for Investors
Wallets, storage devices, cryptocurrency exchanges, and certain blockchains that were inadequately designed have all been hacked since their inception, resulting in ongoing concerns regarding security in the cryptocurrency community.
Individual investors unfamiliar with the necessary procedures may find it challenging to ensure the security of their cryptocurrency. This is addressed by a cryptocurrency exchange-traded fund (ETF).
Reduced Investment Costs
As of January 2024, there are over 9,000 cryptocurrencies available on trading markets worldwide.
Although the infrastructure for purchasing and selling them is improving, it remains relatively unregulated compared to securities exchanges.
For example, certain cryptocurrency exchanges offer tokens that are not available on others, and exchanges may be operational in certain countries but not others.
Additionally, there are additional expenses associated with purchasing cryptocurrency.
Cryptocurrency exchange-traded funds (ETFs) enable you to diversify your portfolio without incurring the costs and complications of purchasing and exchanging tokens independently.
Disadvantages of Crypto ETFs
One of the drawbacks of cryptocurrency ETFs is their novelty, particularly because the future of regulations in this field remains uncertain.
It is crucial to be cognizant of the potential issues associated with the emergence of additional crypto ETFs. Here are some disadvantages of Crypto ETFs:
- The Potential for Tracking Error
- Increased fees for exchange-traded funds
- Unpredictability
- Absence of Direct Ownership
- Substitutes for Exchange Traded Funds (ETFs) in the Crypto
- Cryptocurrency Trusts
The Potential for Tracking Error
Crypto ETFs do not always replicate the price movements of the underlying digital token.
This is particularly true for exchange-traded funds (ETFs) that rely on futures contracts to monitor cryptocurrencies, as they must turn over their positions as the contracts expire.
Increased fees for exchange-traded funds
Although crypto ETFs assist investors in circumventing certain expenses associated with directly owning digital currencies, they are subject to their own fees.
Crypto ETFs may have higher expense ratios than others due to their frequent active management. For instance, the expense ratio of the ProShares Bitcoin Strategy ETF is 0.95%. In contrast, the SPDR S&P 500 ETF has an expense ratio of merely 0.09%.
Unpredictability
Even though cryptocurrency exchange-traded funds (ETFs) facilitate the process of trading digital currencies, they are still susceptible to the volatile price fluctuations of the crypto markets.
This results in an increased level of risk for you, which may be even more concerning if you are more acclimated to the lower volatility of more conventional exchange-traded funds (ETFs).
Absence of Direct Ownership
The digital assets are not owned by the investors in crypto ETFs. Although cryptocurrency exchange-traded funds (ETFs) offer convenience, they do not grant shareholders control or access to the cryptocurrency itself, and the decentralization and anonymity commonly associated with cryptocurrency do not apply to ETFs.
Substitutes for Exchange Traded Funds (ETFs) in the Crypto
Investors have the option of investing in a variety of ETF-like products in addition to futures and spot ETFs to gain exposure to the cryptocurrency market. We should investigate these alternatives.
Cryptocurrency Trusts
The SEC has only reluctantly approved a handful of crypto ETFs, despite the fact that a similar product has been available for years: bitcoin investment trusts.
These are closed-end funds that bear a resemblance to the spot crypto ETFs that are currently being considered. They are the owners of cryptocurrencies on behalf of investors, and their shares are traded in over-the-counter (OTC) markets.
However, these are not exchange-traded funds (ETFs). They are exclusively accessible to accredited investors, high-net-worth individuals, and investment firms, and are not available to the general public.
The minimum investment amount is typically high, and investors are subject to a retention period with each share purchase.
Exchange-traded funds (ETF
Of the exchange-traded products (ETPs), exchange-traded funds (ETFs) are one type. However, when discussing crypto ETPs, they are specifically defined as debt securities issued by special purpose vehicles (SPVs) that retain the underlying crypto assets.
The ETPs are traded on exchanges, and the SPV uses the crypto as collateral to issue them.
Crypto ETPs are less regulated than ETFs and are governed by the Securities Act of 1933. Location In other words, crypto ETPs are not investment companies that are registered under the Investment Company Act of 1940.
Consequently, shareholders are not afforded the protections that are typically associated with the ownership of ETF shares.
Another distinction is that crypto ETFs have the ability to generate and redeem shares in accordance with market demand, which assists in the alignment of the share price with the fund’s net asset value.
Crypto ETPs typically have a fixed supply of shares that trade at market-based prices, which may differ from the underlying crypto value.
