What Is a Bitcoin ETF Anyway? (And Other Questions You May Have)

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You’ve probably been hearing a lot about Bitcoin ETFs in the news lately. But, what exactly is a Bitcoin ETF? Simply put, it’s a new way to trade and invest in Bitcoin. This new investment vehicle, when approved, might precipitate massive inflows of institutional cash into the worldwide cryptocurrency markets. It might even offer very attractive tax advantages, compared to investing in Bitcoin on its own.

ETFs Explained

The first exchange-traded fund (ETF) was SPY, which began trading on the AMEX in January 1993. SPY now boasts a market cap of $259 billion. This is more than 1.25 times more than the current worldwide market cap of all cryptocurrencies. To create a new ETF, a bank or other custodian takes investor funds and purchases shares in either the underlying asset or its futures contracts. Each ETF investor becomes a shareholder of the fund. They do not actually own the underlying assets that the ETF is tracking. 

All Day Long

ETF’s normally trade during retail trading hours (9:30-16:00 EST). You can buy, sell, and short sell them all day long. There are small management fees, but these aren’t directly charged to investors. The net asset value (NAV) of the fund is adjusted to compensate for the fees. Some ETF investors are subject to the same onerous wash sale tax rules that govern stock trading. Other ETFs are taxed as futures contracts, and these receive favored tax treatment.

Today, thousands of ETFs are listed on the US and worldwide stock exchanges. They offer equity, bond, forex, and commodity investors a myriad of convenient, safe, and liquid vehicles for financial speculation and/or hedging purposes. Some ETFs (like SPY) track the performance of a major stock index (the S&P 500 index). Others like GLD track the spot price of a specific commodity (gold). 

Rejection Hurts

Over the past eighteen months, numerous proposals for Bitcoin ETFs have been gunned down by the US Securities and Exchange Commission (SEC). Regulators cited concerns over low Bitcoin futures trading volumes and significant disparities in worldwide Bitcoin bid/ask spreads as two of the main reasons for the rejections. Another SEC concern was that the vast majority of Bitcoin transactions occur on non-US exchanges. The price of Bitcoin reacted badly with each new “no” uttered by the regulatory body. Certainly, the road leading to ETF approval has been a rocky one.

But Wait, Just Follow the Money

Cryptocurrency investors remain hopeful that a Bitcoin ETF will be approved in 2019 or 2020, despite the SEC’s ongoing rejection of the various proposals. Given the astronomical sums of institutional money waiting to enter the cryptocurrency market upon a Bitcoin ETF approval, you need only connect the dots and follow the money to envision a Bitcoin ETF sometime in 2019. Perhaps with many more crypto-based ETFs to follow.

What Is a Bitcoin ETF? 

A Bitcoin ETF is a passive investment vehicle that tracks the price of Bitcoin or Bitcoin futures to determine its value. The ETF custodian will buy positions in Bitcoin and/or Bitcoin futures contracts using investor funds. You, as the investor, will own shares in the fund, but not actually own any Bitcoin.

As an investor in the ETF, you get to choose if you want to buy, sell, or sell short the ETF. If you guess right on the direction, you make money. If you’re wrong, you lose money. At least once a year, management fees will lower the NAV of the ETF by a tiny amount. Every April 15th, US taxpayers will need to calculate their capital gains and losses for the previous tax year.

Will Its NAV Be Calculated by Cash (Spot) Bitcoin Prices or by the Price of Bitcoin Futures Contracts?

Assuming the SEC views Bitcoin as a commodity, such as gold, it’s most likely that the spot Bitcoin price will be used to help determine the NAV of the Bitcoin ETF. However, other ETF’s such as VXX, base their NAV on the front-month VX futures contract.

What About the Risk of Being Hacked or Ripped off by Wide Bid/Ask Spreads?

Assuming proper vetting by the SEC, the ETF would be insured against theft/hacker losses. The custodian would also be required to use a verified, reliable source of daily Bitcoin transaction figures, thus providing pricing transparency. Both requirements would be confidence-builders for potential cryptocurrency market participants.

What Happens to the Bitcoin ETF When the Smart Money Starts to Invest?

As institutional money (hedge funds, banks, billionaire investors) flows into the ETF, the price of Bitcoin should begin to stabilize. This massive inflow of liquidity would help eliminate market manipulation and also help foster more predictable trading strategy outcomes. Prices of altcoins could be affected as crypto traders/investors flock to the more liquid Bitcoin market and/or the Bitcoin ETF.

I’m Scared of Big Overnight Moves in Bitcoin and Bitcoin Futures. Would the Bitcoin ETF Be a Better Choice?

An advantage of speculating/hedging with the Bitcoin ETF would be the limited liability factor. For example, say Bitcoin jumped by 10 percent in one day. If you were short Bitcoin or Bitcoin futures on margin (borrowed money) you’d be liable for all losses that exceed your initial margin deposit. Those amounts could be substantial, perhaps even causing the loss of your house, business, marriage, you name it. But if you’d instead shorted the Bitcoin ETF without using margin, you’d only be down by 10 percent. A big loss for you, but not necessarily a catastrophic nor permanent one.

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How Will the Bitcoin ETF Be Taxed?

A Bitcoin ETF linked to the Bitcoin futures contract is likely to receive the coveted Section 1256 capital gains tax status that SPY, GLD and other futures-markets linked ETFs are bestowed with by the IRS. With Section 1256 status, you’re exempt from wash sale restrictions. Even better, 60 percent of your capital gains are taxed at long-term rates and 40 percent are taxed at short-term rates. Bitcoin investors, however, are stuck with the nasty IRS wash sale restrictions, and they must also pay regular capital gains tax rates (no Section 1256 tax advantage), too. If the Bitcoin ETF is granted Section 1256 tax treatment, the ETF investors will have a clear tax advantage over the ordinary Bitcoin investors. 

What Kind of Trading/Investing Strategies Work with Bitcoin ETFs?

The exact same strategies that you’re already using. No difference at all. You can buy, sell, and short sell ETFs all day long (we can’t emphasize this enough). However, if the Bitcoin ETF is only able to trade from 9:30 to 16:00 EST, there may be noticeable price gaps when the ETF opens for trading the next morning.

The reason for this: Bitcoin trades around the clock, and if the coin makes a large overnight move, the NAV of the ETF will need to be adjusted higher/lower at the opening of the next trading session. You may need to tweak your trading strategies to cope with the reality of price gaps on the ETF.

Are There Risks When Speculating with Bitcoin ETFs?

Yes. Although the ETF would be insured against hackers or custodian theft of investor funds, it is conceivable that the ETF custodian could face financial problems at some point, causing a liquidation of fund assets. Not to mention a haircut in your trading account balance. You also have the read the fine-print risk to consider. Earlier in 2018, the wildly popular volatility ETF, XIV, plummeted nearly 90 percent in one trading dayEven more shocking is that the crash occurred in the after-hours trading session. This meant that the vast majority of XIV holders were powerless to exit the trade until the following morning. 

The majority of those who lost their money in XIV likely failed to read the risk disclosure document. It warned investors that if the ETF lost 80 percent or more of its NAV in one day that the fund would be terminated. It was trading at more than $115 before the crash. Its final liquidation price was $5.99. You must read the fine print before investing in an ETF!

Will All Traders and Investors Be Eligible to Buy and Sell Bitcoin ETFs?

It’s possible that only accredited investors (high net worth) will actually be able to purchase shares in the Bitcoin ETF. You, dear reader, might be excluded from participation. However, the oldest ETF in existence, SPY, has no such restriction. Hopefully, the SEC will not infringe on the right of all investors, rich or not-so-rich, from participating in the Bitcoin ETF.

Is There Hope for a Bitcoin ETF in the Near Future?

Actually, there is. The SEC will most likely approve the ETF, but based on one key stipulation. That stipulation being: only US-based Bitcoin exchange transaction data will be used to determine the real-time price of Bitcoin data to be used for the Bitcoin ETF. US-based exchanges come under SEC jurisdiction and will have to provide accurate and able to be audited pricing data to the regulator. Custodian noncompliance creates the risk of their being heavily fined or even shut down by the SEC. 

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