The chances of the Securities and Exchange Commission (SEC) approving a Bitcoin (BTC) exchange-traded fund (ETF) before a physical Bitcoin ETF are higher than ever, thanks to Chairman Gary Gensler’s now-repeated preference for the former.
But here’s the problem: an ETF based on crypto futures isn’t the most efficient, cost-effective, or simple route. Products with a physical backing are. They are likely to attract more assets and attract more investors to the crypto market. And they are much easier to understand for investors.
This is why fund issuers would be better off pressing the SEC for clarification on what is required to get the Bitcoin spot ETF approved rather than racing to the finish line with the more complex and expensive futures-backed product.
A complete framework, but with insufficient reasoning?
One of the primary arguments in favor of a crypto futures ETF is that the regulatory framework for futures is clear and well established at this point, especially when compared to physical crypto assets.
Futures are regulated by the Commodity Futures Trading Commission. Contracts are all the same. There is no need for digital wallets in the case of Chicago Mercantile Exchange (CME) futures, and the lack of a physical asset means fewer questions about the crypto custody puzzle. Because there is no decentralized asset that can be moved from one address to another, Know Your Customer, or KYC, is less of a concern. In general, futures markets are more heavily regulated and monitored than spot markets are currently.
These futures-backed ETFs would be subject to the Investment Company Act of 1940. As a result, they would be “liquid alternatives,” allowing them to invest in more complex instruments or strategies. Mutual funds, including those that employ hedge fund-like strategies, are classified as ’40 Act funds.
What are the advantages of Bitcoin futures ETFs being registered as ’40 Act funds? They avoid many regulatory stumbling blocks, in part because their mandate is to invest primarily in futures listed on a regulated U.S. exchange, such as the CME.
Futures add more complication.
To be sure, simplicity is good, especially when the goal is to attract new money that has been patiently waiting on the sidelines. Futures, on the other hand, introduce more complexity by definition, which goes against the spirit of ETFs in the first place.
ETFs were created as a low-cost, high-liquidity alternative to actively managed funds. Futures, on the other hand, are not particularly cost-effective. They require collateral in the form of margin at disproportionately higher rates than other asset classes.
Furthermore, trade volumes at US-regulated exchanges are relatively low, with the majority of the action taking place offshore. This raises the question of whether there will be enough liquidity on SEC-approved exchanges like the CME to meet demand, particularly during periods of high volatility.
In practice, this first generation of futures ETFs will most likely be made up of a variety of assets in addition to Bitcoin futures contracts. In addition, due to the complexities of taxation and asset diversification, a subsidiary must be established to hold these investments, typically in a low-tax jurisdiction such as the Cayman Islands. Of course, complexity means higher costs for investors.
There is also the issue of price disparities between futures and spot markets. Futures contracts do not perfectly track the underlying assets. In the case of Bitcoin, there can be significant differences between the projected price of Bitcoin in 30 days (as represented by a futures contract) and the actual price when that date arrives. A rolling position in Bitcoin futures trailed the price of Bitcoin by 38 percentage points for the fiscal year ending September 2, 2021. (295 percent to 333 percent , respectively).
Finally, it’s worth noting that investor demand for futures-based ETFs has historically been much lower than for spot ETFs. As an example, the largest gold spot ETF currently has more than $50 billion in assets, while the largest gold futures ETF has around $40 million.
This is a reasonable step in the right direction.
Is this to say that a Bitcoin futures ETF causes more harm than good?
Certainly not. Though not as simple or inexpensive as a spot ETF, a Bitcoin futures ETF is a step in the right direction for providing prospective investors with access to cryptocurrency.
It will make crypto investing more accessible to a broader investor base. Financial advisors and others will find it much easier to incorporate Bitcoin into their portfolios and standard processes thanks to the ETF structure. It will also include all of the 1940 Act’s investor protections. The SEC’s rigorous oversight of ’40 Act funds will assuage many investors’ concerns while also imposing governance checks on fund management.
Given the SEC’s recent harsh rhetoric and critical stance in crypto discussions, the approval of a Bitcoin futures ETF would be a significant step forward. It would demonstrate the SEC’s willingness to allow more crypto asset products to enter the market with a regulatory oversight wrapper, potentially alleviating recent concerns about government overreach.
However, the success of these funds should not divert issuers’ attention away from the primary goal: establishing the clarity required to get a spot Bitcoin ETF approved with the SEC and other regulators.
That procedure could be time-consuming, but the end result would undoubtedly be worthwhile. It would finally provide investors with a low-cost, highly liquid vehicle for precisely tracking Bitcoin — and thus better aligning their crypto investments with their overall portfolio. This, we believe, will eventually bring in a new, substantial wave of assets that industry proponents, investors, and issuers alike have long awaited.