It’s going to be challenging to write a blog about a financial product (an ‘exchange traded fund’) that’s more interesting than watching paint dry on a wall. And a white one at that. But I’ll rattle through the reason for its existence, and then get to some juicy bits on questions that you’ve probably got and some pros and cons that you might not know about.
As always, let’s use an example to explain the concept of an exchange traded fund: imagine that you’ve been doing lots of research on gold sovereigns and you’re convinced they’re going to go up in value. But you don’t know where to buy them and you don’t have the time to travel around the UK burrowing through antiques shops. Luckily your mate Frank (i don’t know, whatever) is an expert, and because you’re his friend, he agrees to travel around the county and buy them all up for you.
Instead of you just giving him £100 and him driving off into the sunset on the hope he’ll come back, he sets up a company, and you buy 100 shares in that company. £100 for 100 shares. He takes that money and uses it to buy gold sovereigns in the name of the company. So the company now owns £100 worth of gold. Simple maths, let’s say it’s got 100 ounces (which it won’t). £1, 1 share, 1 ounce of gold.
Now Frank’s having a great time doing this, and you were right: gold is going up in value. It’s doubled. It’s now £2 per ounce… ! It’s a gold rush. All of Frank’s family come along and give him money, and in return he creates more shares in the company, but this time 1 share is worth £2. Off he trots wearing his company hat to buy the gold, which he purchases for £2 per 1 ounce.
Three important things here: 1) the company that Frank has created will own the actual underlying gold sovereigns that he’s gone and bought with all the money that he’s raised from selling the company shares, which you and the other investors own; 2) Frank and the company will be responsible for storing the gold somewhere safe and 3) the price that Frank sells the shares in the company for will go up and down based on the value of the underlying gold.
The company is basically an ETF. All it’s doing is providing a way to own exposure to the change in value of gold sovereigns, without the investor needing to obtain and store the underlying asset itself. That’s it. So with a bitcoin ETF, instead of buying bitcoin, you can own a share of a fund, and that share will go up and down in value as the price of bitcoin fluctuates. And there are plenty of people that will be willing to sell you that share if you want to buy it.
Now there are a few immediate questions from the example… what happens if Frank gets bored of buying all this gold and wants to be paid for it? Where does all this gold get stored? Can you trust Frank for ever? What happens if he buys some dodgy fake gold? These are all totally valid questions, and ones that apply to the ETF.
A friend got in touch and asked “the thing i don’t get with this spot bitcoin ETF business is that the ETFs are literally buying bitcoin with cash. so the only thing that changes is the medium through which investors get access, which includes some fee and tax benefits - not insignificant but also not groundbreaking. what am i missing?”
Here is a summary of my answer. The problems the ETF solve are:
access - it’s quite difficult to buy a large amount of bitcoin through a personal account on an exchange
confidence - not everyone is happy managing their own keys and storing their own bitcoin
security - people trust BlackRock more than Binance
trade execution - execution teams are meant to get the best market price when they buy the bitcoin for the ETF
regulation - it's approved by regulators so there are certain standards that have to be met
integration - it's can be a part of your pension portfolio now rather than sitting in your crypto wallet
tax - in some jurisdictions, there are tax benefits to holding an ETF versus holding bitcoin itself.
Some of the negatives are:
fees - banks and asset managers are not doing this (anything) for free
tracking error - based on how the back end works, sometimes the shares in the ETF might trade at a premium to the bitcoin price
cyber theft - whilst the infrastructure is pretty robust, there is still a risk of a cyber attack
For hedge funds like mine, the ETF creates a significant opportunity for arbitrage across exchanges; there are many different exchange prices that go into pricing the shares of the ETF, and when we look at the differences between those prices, and compare them to whether the ETF is trading at a premium or discount to NAV, we’re able to make a bit of money by taking on some directional exposure and taking the opposite position in the ETF. This is good for the market as it helps with price discovery and keeping the issuers of the ETFs honest!
So what are some of the issues with the bitcoin ETF? I’ll focus on two…
Firstly, it’s important to remember that bitcoin doesn’t do anything. It’s an ingenious creation and is probably the best way that we have to convert physical energy into digital value. But at the end of the day, its price is really only dependent on what anyone that buys bitcoin is willing to pay for it.
Now… think about the BlackRock salesman that’s going into meet with a pension fund to try to sell them shares in the bitcoin ETF. What’s he going to say? He might try to sell the ETF as a debasement hedge as this is the most common story; limited supply versus seemingly unlimited amounts of dollars. So in effect its a tool that you can use when building a portfolio. Only it’s not… because a tool needs to have a relatively predictable price action; when x happens in the market, I expect y to happen to the price of the asset. But bitcoin hasn’t had that at all; in 2022 it lost -65% of its value, and whilst it had a gang busters 2023 and was up 156%, this wasn’t in the face of massive debasement of the dollar (compared to previous years), in fact it was mostly extraneous events and things happening on capital hill that moved the price; in other words, the price action hasn’t really been that predictable based on macroeconomics. Right now, I think it’s going to be a challenge for a BlackRock salesperson to pitch the ETF as a portfolio management tool like gold or bonds as the price action hasn’t been predictable enough and the volatility is way too high.
This leaves one option: buy it because it will go up in value and make you money. This is clearly a totally different proposition because it’s pure speculation. Bitcoin doesn’t do anything, it doesn’t have any cash flows or gross margins associated with it, like a stock for example. That means that the only reason that it can possibly go up in value is that someone else is willing to buy it from you at a higher price; and it’s very difficult to know what someone else thinks and even harder to know what they might do. Michael Saylor of MicroStrategy has built up a huge position of bitcoin on his balance sheet, turning his company into a proxy ETF. What happens if he decides to sell or is ousted from the company and replaced with a more moderate? Known unknowns beyond our control.
This will impact price action. Investors that have purchased bitcoin will have a target sell price and a certain level of tolerance during drawdowns. If the pain gets too much, then a momentum behind selling will ensue and a spiralling price action will be a self fulfilling prophecy. This is IF investors are holding it to make short term gains.
If, however, everyone agrees that they are holding it for the reason that it was created - as a store of value that is to be purchased and held as a better option than US Dollars or government bonds - and indeed that more of it should be purchased when the US government is debasing the dollar and sold in more certain times, then it has the capacity to become a global tour de force, the de facto store of digital value; if you like, the global reserve currency. We could go from gold to dollars to bitcoin. But for that to happen, it HAS to be used for the reason that it was created.
Phew. Nearly there.
Second point.
You’ll recall from my post on blockchains that the network is secured by miners (or validators) who solve complex mathematical problems (through expending energy and therefore cost) to ‘win’ the right to secure a block, for which they are rewarded with bitcoin. But that amount halves roughly every 4 years, which is a design feature that counteracts inflation and promotes scarcity. In 2009, the reward was 50 bitcoin, at the moment it’s 6.25 but in about 3 months it will be halved to 3.125. Ultimately, the amount of bitcoin that can be earnt by the miners trends to zero.
Now this is clever but it poses a problem (much longer term): if the price of bitcoin doesn’t double every four years, the miners will earn less and less bitcoin from securing blocks. Which poses the question: if you don’t get paid enough to secure the network, how can you afford to pay for the electricity required to do bitcoin mining? Who is going to secure it?
There is another way that miners can earn bitcoin; from transaction fees, which are paid every time bitcoin is bought and sold. And here we return to the problem with the ETF: if BlackRock and the other motley ETF crew have bought up tons of bitcoin and are storing it, and all investors that get exposure to the bitcoin price movement are doing it through buying and selling shares in the ETF, then the underlying bitcoin isn’t moving anywhere; it’s not being bought and sold and there are no transaction fees. Eventually we end up in a situation where miners aren’t earning fees from securing blocks OR from transaction costs… I haven’t done the maths yet, but there will be a minimum price supported by a minimum number of transactions that will be required for the bitcoin network to eventually be maintained as the mining reward trends to zero, based on an assumption around the cost of electricity. Incidentally, this is the reason why bitcoin HAS to eventually be mined on free, green energy. There isn’t any other way. But that discussion is for another day.
Ultimately, this is about choice, and the bitcoin ETF offers investors the opportunity to own the price action of an asset that has completely unique characteristics in a secure way. It’s an alternative to precious metals, IOUs (bonds) and fabricated fiat money whose supply seems to be unlimited and is ultimately controlled by central banks. But it’s not a straight line upwards. We need to move away from speculation and get rich quick schemes, to more mature use of this valuable tool that can eventually be a positive for investor portfolios.