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

Cryptocurrency ETFs: An Overview

Cryptocurrency exchange-traded funds (ETFs) track the price performance of cryptocurrencies by investing in a portfolio linked to their instruments. Like other such funds, crypto ETFs trade on regular stock exchanges, and investors can hold them in their standard brokerage accounts.

A growing roster of ETFs—a type of exchange-traded product (ETP)—in early 2024 began offering investors the chance to invest in bitcoin through their holdings. After about a decade of regulatory wrangling, the Securities and Exchange Commission (SEC), under pressure from a 2023 D.C. Circuit Court of Appeals ruling, authorized the first spot crypto ETFs in early 2024.

These investments allow retail traders to gain direct exposure to crypto prices without owning the assets directly. This makes it possible to speculate on cryptocurrency prices without doing business on a crypto exchange or dealing with the costs and complexities of directly owning digital assets.

However, crypto ETFs generally have higher fees than other ETFs, and while the funds themselves are regulated, there is no such oversight in the crypto markets where the funds are invested. For example, the SEC has argued that without proper oversight and surveillance-sharing agreements with regulated markets, it's difficult to prevent fraudulent activities and ensure fair trading practices in the crypto markets.

Below, we take you through how these funds work, what worries the SEC still has around these products, what benefits they might have, and what this all means for everyday investors.

How Does a Cryptocurrency ETF Work?

While most ETFs replicate how indexes work by holding a basket of underlying assets, crypto ETFs have a couple of ways of tracking the performance of a digital currency. Spot ETFs directly hold the cryptocurrency, building a portfolio that replicates the performance of the digital assets it contains. Other crypto ETFs invest in futures contracts, which are agreements to buy or sell crypto at a preset date and price.

Given their portfolios, these ETFs have share prices that mimic changes in the price of derivatives instead of the cryptocurrencies themselves. Therefore, the price of shares in a given cryptocurrency ETF rises and falls in line with crypto futures contract prices. Like other derivatives, synthetic cryptocurrency ETFs have an additional risk because of the lack of oversight and valuation concerns in the crypto exchanges from where the funds would be pulling crypto.

While U.S. regulators refused to approve crypto ETFs for several years—the SEC turned away some 20 proposals in spot ETFs from 2018 to 2023 alone—they were readily available to investors in Europe and Canada. The SEC approved the first crypto futures ETFs for the U.S. market in October 2021 and the first spot crypto ETFs in January 2024.

Cryptocurrency Futures ETFs

An analysis of the ProShares Bitcoin Strategy ETF, the first crypto ETF on U.S. markets, shows how crypto futures ETFs work. The fund assigns about half of its portfolio to Chicago Mercantile Exchange (CME) bitcoin futures that expire at the end of the current month and another half to CME bitcoin futures expiring the following month.

As the expiration of the contracts in the portfolio approaches, the fund rolls over its investments, selling the expiring contracts and buying contracts for the coming month. The costs associated with rolling over the contracts may account for some of the differences between the performance of the ETFs and their underlying cryptocurrencies.

ProShares also has Ether Strategy ETF (EETH), an ether futures ETF like the one it provides for bitcoin. The fund tracks the price of ether with futures contracts. ProShares has ETFs that track a mix of bitcoin and ether using equal or market-cap weighting for investors looking for exposure to several crypto tokens.

There are also inverse ETFs, such as the ProShares Short Bitcoin Strategy ETF. This uses futures to generate the inverse of bitcoin's returns, allowing investors to profit on days when cryptocurrency prices decline.

Spot Cryptocurrency ETFs

Investment funds can also directly trade and hold cryptocurrencies. Spot crypto ETFs are funds that buy cryptocurrencies and securitize them. Investors buy and sell shares as needed, just like a traditional ETF. In a spot crypto ETF, the fund can issue and redeem shares, offering retail and other investors a stake in the crypto market.

Starting in 2014, asset managers sought approval from the SEC for spot bitcoin ETFs. Between October 2022 and October 2023, the SEC received more than 3,500 crypto-related fund applications. In January 2024, the SEC approved the first 11 spot bitcoin ETFs, opening the door to more spot cryptocurrency ETFs later.

In May 2024, the SEC also started to pave the way for spot ether ETFs. The SEC approved a rule change that would allow for the listing and trading of eight spot ether ETFs.

Prior to this approval, the SEC expressed concerns about Ethereum's staking feature and its previous worries with bitcoin for fraud, volatility, and low investor protections in crypto markets.

"Staking," which allows ether holders to earn income by locking up their tokens to help validate transactions on the network, is a crucial feature of Ethereum's consensus mechanism.

This income-generating feature, which began on the ether platform in 2022, raises questions about how staking rewards should be taxed and reported. This gave the SEC another reason to be reluctant to approve spot ether ETFs, given the lack of regulatory clarity about their tax status.

Note that the SEC's approval of a rule change for spot ether ETFs does not mean that these ETFs can start trading. Applications from the investment managers need to be reviewed and further approvals need to be given.

Advantages of Crypto ETFs

Cryptocurrency ETFs are a developing asset class, and given the regulatory uncertainty, the market may look different in the future. Nevertheless, owning shares in cryptocurrency ETFs has some advantages when accessing the crypto markets.

Exposure Without Ownership

The most significant benefit of cryptocurrency ETFs is that they provide exposure to crypto without additional ownership expenses or exposure to the risk of owning and holding them in a crypto wallet. For example, there are custody charges for cryptocurrencies, and some secure digital wallets charge an annual fee.

These charges can add up quickly. Cryptocurrencies also come with transaction and network fees, which the ETF providers take care of, even if you pay indirectly through the fund's expense ratio.

Lowering the Learning Curve

Cryptocurrency jargon, derived mostly from its technological makeup, is still a roadblock to crypto adoption. Average investors often find it difficult to grasp the scope and roles of cryptocurrencies. Plus, these investors might be unfamiliar with networking technology, making crypto-speak, such as halving and blockchain, even more disinviting. Investing in a cryptocurrency ETF makes learning enough to get into crypto much more manageable.

More Security for Investors

Cryptocurrency exchanges, storage devices, wallets, and some poorly designed blockchains have been hacked since they were launched, leading to constant worries in the crypto world about security. Cryptocurrency security can be a tall order for individual investors, who may not be familiar with the required methods. A cryptocurrency ETF takes care of this for you.

Lower Costs for Investors

There are more than 9,000 cryptocurrencies available in trading markets worldwide as of January 2024. The infrastructure to buy and sell them is becoming more sound, but it's still relatively untamed territory compared with securities exchanges.

For example, some tokens are available on certain cryptocurrency exchanges while others are not, and exchanges can operate in some countries but not others. There are also extra costs that come with buying crypto. Cryptocurrency ETFs allow you to diversify your holdings without the fees and hassles of buying and exchanging the tokens yourself.

Disadvantages of Crypto ETFs

The novelty of cryptocurrency ETFs is one of its drawbacks, not least since it's still unknown how regulations in this area will evolve. Given the likelihood that more crypto ETFs will emerge, it's important to be aware of their potential issues.

The Risk of Tracking Error

Crypto ETFs do not always duplicate the price moves of the underlying digital token. This is especially true for ETFs that depend on futures contracts to track cryptocurrencies, which have to roll over their positions as contracts expire.

Higher ETF Fees

While crypto ETFs help investors avoid some costs of directly owning digital currencies, they have their own fees. Since they are often actively managed, crypto ETFs can have higher expense ratios than other ETFs. For example, the ProShares Bitcoin Strategy ETF's expense ratio is 0.95%. For comparison, the expense ratio for the SPDR S&P 500 ETF is just 0.09%.

Volatility

Although cryptocurrency ETFs simplify some of what's involved in trading digital currencies, they are still subject to the dramatic price swings of the crypto markets. This means more risk for you, which can be even more worrying if you are more accustomed to the lower volatility of more typical ETFs.

Lack of Direct Ownership

Investors in crypto ETFs are not the owners of the digital assets. While crypto ETFs do bring convenience, you won't have control or access to the cryptocurrency itself, and the decentralization and anonymity associated with crypto don't apply to ETF shareholders.

Alternatives to Cryptocurrency ETFs

In addition to allocating funds to futures and spot ETFs, investors can put their money into several other ETF-like products for crypto exposure. Let's dig into these options.

Crypto Trusts

While the SEC has only reluctantly approved a handful of crypto ETFs, a similar product has already been available for years: bitcoin investment trusts. These are closed-end funds that resemble the spot crypto ETFs being proposed. They own bitcoins on behalf of investors, and their shares trade in over-the-counter (OTC) markets.

But these are not ETFs. They are open only to investment firms, accredited investors, or high-net-worth individuals and are not accessible to the retail public. They tend to have a high minimum investment amount, and each purchase of shares is accompanied by a lockup period for investors.

Crypto ETPs

ETFs are one variety of exchange-traded products (ETP). Crypto ETPs, when discussed, refer, however, to those that specifically hold debt securities issued by special purpose vehicles (SPVs) that hold the underlying crypto assets. The SPV uses the crypto as collateral to issue the ETPs, which are traded on exchanges.

Crypto ETPs fall under the Securities Act of 1933 and are less regulated than ETFs. Spot Crypto ETPs, in other words, are not investment companies registered under the Investment Company Act of 1940. As a result, shareholders do not have the protections associated with ownership of ETF shares.

Another difference is that crypto ETFs can create and redeem shares based on market demand, helping the share price align with the fund's net asset value. Crypto ETPs typically have a fixed supply of shares that trade at market-based prices which can deviate from the underlying crypto value.

Companies That Hold Crypto

Investing in companies that hold cryptocurrencies on their balance sheet is another way to invest in crypto without owning the digital tokens. Some publicly listed companies hold a large number of bitcoins. For example, MicroStrategy (MSTR) owned about 214,000 bitcoins as of May 2024. Galaxy Digital Holdings (BRPHF) and Tesla (TSLA) are other publicly listed companies with bitcoins on their balance sheets.

Crypto-Related ETFs

Plenty of ETFs offer diversified exposure to companies that engage with blockchain technology or crypto companies. For example, the Amplify Transformational Data Sharing ETF (BLOK) holds a portfolio of companies that develop and use blockchain technologies.

The Bottom Line

ETFs are a retail investor-friendly way to gain exposure to assets that might otherwise be too costly. Brokers want to offer ETFs that hold cryptocurrency so that average investors can participate in cryptocurrency investing. However, these funds tend to come with additional risks and expenses, so it is important to research them thoroughly before making an investment decision.

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