What We Think About The Bitcoin Futures ETF
Image Credit: Art Rachen

What We Think About The Bitcoin Futures ETF

16th November 2021 | 7 min read

In Collaboration With QCP Capital

In the past few weeks, Bitcoin has made an impressive rally on the back of potential ETF approvals and reached a new record high of USD 66,974.77 (and has climbed even higher since), when the SEC greenlit the first futures-based bitcoin ETFs: Proshares Bitcoin Strategy ETF, which began trading on October 19, and Valkyrie Bitcoin Strategy ETF, which began trading on October 22. Here’s Bread and QCP Capital’s take on the matter.

The approval of a Bitcoin ETF was a watershed moment as it represents a major shift in regulatory sentiment towards digital assets at large. While futures-based ETFs were approved, much of the industry wanted a physically backed product; a spot ETF that would allow investors to directly own and track the price of bitcoin. 

What are Bitcoin futures ETFs?

A futures contract is the obligation to sell or buy an asset at a later date at an agreed-upon price. This allows buyers to lock in a price upfront, in case prices soar by the specified date. Sellers may also want to lock in an acceptable price upfront in case market prices fall.

For example, if the price of Bitcoin on the specified date is more than the price that was agreed on, the investor profits (trading at a premium). If the price is lower than the predetermined price, the investor makes a loss (trading at a discount) Therefore, a Bitcoin futures ETF allows investors to bet on the potential that bitcoin futures will be worth more later. 

However, some crypto enthusiasts have criticised the futures-based ETF, claiming that it will not be able to accurately track the price of bitcoin due to the costs of buying and selling futures contracts. 

An ETF based on futures contracts would likely sideline institutional players and become a largely retail product. 

Most institutional players have direct access to CME futures. The main reason they would choose to trade ETFs instead of futures would be to avoid tracking error (against spot price) from futures roll costs or price deviations from contango (price of future delivery higher than spot price) or backwardation (price of future delivery lower than spot price). 

Therefore, an ETF based on CME futures negates the fundamental advantage of ETFs; to track spot prices as closely as possible. However, a futures-based ETF is suitable for retail players. The tracking error would still be significantly lower than the current Bitcoin proxies in the equities market like Grayscale, Microstrategy or even Coinbase. 

Futures-based ETFs

Futures-based ETFs tend to underperform ETFs with physical underlying 

Chart 1 takes a look at the various gold ETFs available, the blue rows are the physical ETFs, the yellow rows are futures-based ETFs and the orange rows are ETNs. Number 11, with a 1x futures underlying product shows gross underperformance in return compared to any of the physical ETFs. 

Chart 1

The reasons, as highlighted above, are the futures roll costs and the fact that gold futures are usually in contango. As mentioned earlier, this means the futures price is above the physical spot price, which means that the futures-based ETF is effectively buying at a higher price. This will be the same for Bitcoin except that the contango in Bitcoin is much steeper. Bitcoin futures have been trading at a 15-20% premium to spot on an annualised basis. Compared to this, the gold contango looks negligible.

A futures-based ETF is typically only necessary when the product includes some financial engineering such as leverage (2x-3x) or an inverse (i.e. short futures) product. 

For these reasons, the physical ETFs are way more popular than futures in the case of Gold. In Chart 1, the top seven ETFs are all physical with a combined AUM (assets under management) of $91 billion. This overshadows the size of the remaining ETFs and ETNs with just $846 million in total. 

Futures-based ETFs might not be able to draw enough new money to trigger an exponential move higher like the one we saw in Q4 2020. 

According to MicroStrategy Inc. CEO Michael Saylor, bitcoin is on track to completely replace gold ETFs within the next two to three years, and spot ETFs would be able to serve as an institutional on-ramp for investors.

Inflow from investors switching out of gold ETFs into BTC can be expected. However, with BTC trading above USD 60,000, its market capitalisation now stands at above $1.1 trillion. It’s going to take a lot to move the needle.

The market has also priced in the Bitcoin ETF approvals ahead of time. Besides the obvious rise in spot price and also an increase in the futures premium, there have been large inflows into foreign-listed ETFs this week (the largest since May. 73% of that was attributed to the European listed Physical Bitcoin ETF (Chart 2 – Red Highlight).

Chart 2: Weekly Crypto Asset Flows (USD)

It’s suspected that after SEC Chair Gensler indirectly ruled out a physical BTC ETF in the US for the foreseeable future, investors who are able to access overseas markets have decided to participate there rather than investing in the upcoming futures ETFs in the US.

The various ETF applicants have distinct differences in their applications and it will be interesting to see if the SEC approves them wholesale or with specific conditions. For example, while the Valkyrie application is entirely futures-based with a fixed rolling strategy, the Proshares application includes clauses that would give the fund the ability to hold other Bitcoin-related instruments without touching the physical coins itself.

What might come after Bitcoin ETF approvals

An Ethereum ETF might soon be introduced as the CME already offers Ethereum futures contracts. However, this also means that until other cryptocurrencies have a futures contract, the US market will only have access to Bitcoin and Ethereum ETFs. 

Bitcoin and Ethereum ETFs could reverse the sharp decline in Bitcoin and Ethereum dominance in the crypto market. 

CME market share in Bitcoin trading has risen and will continue to increase. With ETFs out of the way, attention could be shifted to regulation of stablecoins. This effort would be led by Janet Yellen and the US Treasury. Any negative outcomes from this would impact native crypto exchanges which depend on stablecoin as the base asset.

Futures-based ETF approvals could be positive for institutional derivative markets. CME options only occupy a small portion  of the entire crypto options market. There might be some growth and development in CME options as a result.

Growth in crypto options and interest rate related instruments could come from Exchange Traded Notes (ETNs). The large number of Gold ETNs is highlighted in Chart 1 (orange). 

ETNs are yield-focused products that actively use options, bonds and interest rate swaps to generate yield. 

As mentioned, bitcoin ETFs would possibly lead to the GBTC (Grayscale Bitcoin Trust) discount persisting. The premium reached a record -20% in mid-October, with the approval of the new bitcoin ETFs (Chart 3). What might happen for GBTC in the future is a possible takeover and delisting. It’s still unclear what market impact this might have but it might be worth keeping an eye on what happens with the largest private bitcoin treasury, with 680,000 BTC.

Chart 3 Premium

One key effect of a futures-based ETF is the possible increase in yield in the space. With the ETF funds forced to buy futures instead of spot, the futures premium would be driven higher. The recent spike in futures premium and funding rates both on the CME and other exchanges is something that could persist with the additional focus on futures. A “risk-free” rate of 10-20% could be the new norm.

This might ironically be a positive for DEXs (decentralised exchanges) and DeFi (decentralised finance). The SEC’s view that it’s safer for ETFs to be based on a derivative of physical bitcoin as opposed to physical bitcoin itself is perplexing. It’s apparent that regulators will continue to struggle with their understanding of the industry, therefore potentially driving interest away from regulated venues and towards DeFi. The emergence of exchanges like DYDX that have the infrastructure comparable to that of centralised exchanges will further exacerbate this trend. 

As of 9 November, crypto lender BlockFi Inc has filed for a physically backed bitcoin ETF with the SEC. BlockFi NB Bitcoin ETF, a joint venture with an affiliate of Neuberger Berman Group LLC, will hold bitcoin, therefore allowing investors to directly invest in the cryptocurrency. Other issuers such as Bitwise Asset Management and Grayscale Investments have also filed applications for physical ETFs with the SEC. However, the SEC continues to be reluctant to approve a physical bitcoin ETF for the time being, citing various concerns including liquidity and price manipulation risks. 

The SEC also announced on November 12 that it rejected an application filed in March by the Cboe BZX Exchange, which wanted the SEC to make a rule change allowing it to list an ETF by VanEck that sought to track Bitcoin directly. There are several other similar bitcoin ETF applications awaiting decisions.

Following the announcement, VanEck has said that its Bitcoin futures ETF will start trading Tuesday under the ticker symbol XBTF.

QCP Capital is one of the world’s largest digital asset trading firms. QCP runs a $2 billion book in crypto derivatives and is an early investor in prominent blockchain companies including Axie Infinity, Algorand, and Nansen AI. 

Written by Bread News Team
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