How Does the Bitcoin ETF Work?

UPDATED April 8, 2024 – In the days leading up to the January 10, 2023 deadline for the SEC to rule on Ark21’s ETF application, Fund Issuers scrambled to amend their S-1s to finalize fees and Authorized Participants (BlackRocks $IBIT APs – Jane Street, JPMorgan, Macquarie Capital and UBS).

At 4:05pm EST on 1/10/24 The SEC approved the Bitcoin ETF with a 3-2 vote.

Gary Gensler (D) ✅
Hester M. Peirce (R) ✅
Caroline A. Crenshaw (D) ❌
Mark T. Uyeda (R) ✅
Jaime Lizárraga (D) ❌

Adding to the confusion, Caroline Crenshaw expressed dissent and highlighted that the ETF, (Exchange Traded Funds) registered under the Investment Company Act of 1940 is actually an ETP (Exchange Traded Product) under the Securities Act of 1933.

Commissioners Peirce and Uyeda, who both voted in favor of the ETF, released this joint statement expressing their disdain for the amount of time it took to get this done.

The ETF/ETP approval process has swung the pendulum and highlights the unpredictable paradigm shift that is taking place in crypto, specifically with Bitcoin.

Just a few weeks after former SEC Chief of Internet Enforcement John Reed Stark called the chance of approval ‘absolutely absurd’ he updated his position on Twitter “based upon my 20 years of SEC experience, the SEC’s approval of some iteration of some kind of Bitcoin Spot ETF seems likely”  due to the recent flurry of meetings between applicants and the SEC.

Late in the day on January 10, the CBOE updated their New Listings page with the January 11, 2024 as the first date of trading.

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*Ark 21Shares, Bitwise, BlackRock, Fidelity,  Franklin, Galaxy, Global X, Grayscale,  Hashdex, Pando (new applicant) Valkyrie, VanEck, and WisdomTree.

Next, the SEC uploaded what appeared to be an approval notice before removing it leading to even more uncertainty after Gensler’s Twitter account got hacked on Jan. 10th.

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Once the dust settled the SEC confirmed an approval of 11 applications so as not be become the king-maker for once.  

Over 24,209 BTC were acquired by the ETF Issuers over the first two days with ~$655M of net inflows and $4.6B in volume on their first day of trading.

Not everyone is apeing into Bitcoin ETFs (eh ETPs). Vanguard is blocking their clients from trading the ETF which Cathy Wood calls “a terrible decision” and a “strategic blunder.”

The first week of trading saw Bitcoin pump to $49,058 before drawing down below $42,000. This is normal short term volatility for Bitcoin, but newbie retail investor’s may not have the diamond hands like long term DCA hodlers.

How does the Bitcoin ETF Work?

Exchange Traded Funds (ETFs) hold a ‘basket’ of assets like stocks, bonds, commodities and soon to be Bitcoin.

The first Bitcoin ETF application, filed in 2013 by the Winklevoss Bitcoin Trust was denied along with dozens of other applications over the years. 

Rick Astley Pixel GIF

The SEC is “taking a new look” at Bitcoin ETFs after an August 2023 ruling that they unfairly prevented Grayscale’s first bid. 

On the table are a dozen applications, each proposing to set up a Grantor Trust where Bitcoin will be stored with a custodian, like Coinbase, similar to how physical assets like gold are stored in vaults for the Gold ETF.  The trust issues shares representing the ‘beneficial interest’ in the asset (Bitcoin BTC) safeguarded by the custodian.  

Authorized Participants are contractually the only parties that can interact directly with the ETF issuer when shares are created and redeemed through a process called creation and redemption.  

For example…

A retail investor (you and me) place a buy order in our brokerage account to purchase a specified dollar amount of a specific Bitcoin ETF ($IBIT, $HODL) on the secondary market via Listing Exchange (NASDAQ).  The Broker-Dealer (JP Morgan, Robinhood) will place a redemption order on the primary market with an Authorized Participants (APs) also called institutional investors or market makers (Jane Street, Wintermute, BlueSky) who are ‘approved’ (authorized & contracted) to exchange pre-specified assets (in-kind settlement with Bitcoin) or ‘cash creates’ (cash settlement) for a certain quantity of ETF shares sourced directly from the issuer (Blackrock, Ark21, Grayscale).  

How do Authorized Participants Make Money? 

Authorized Participants (AP) are market makers approved by the ETF issuer (BlackRock, Ark21 etc) whose role in the investment process is to create and redeem the ETFs shares.  

APs make money as a) market makers selling to broker-dealers (JaneStreet) and/or b) acting as broker-dealers (Morgan Stanley) on behalf of their retail customers.  

The AP can execute trades (even after the market closes) to create and/or redeem ETF shares with buy and/or sell orders to 1) close the trading spread between ETF Price: Net Asset Value (NAV) and 2) provide liquidity in the market.

There is not a fixed amount of an ETF’s shares available to the public due to creation and redemption of shares by the APs.  

The AP monitors the exchanges where you and I purchase the ETF shares and the AP deploys an arbitrage strategy to buy (create) or sell (redeem) ETF shares with the ETF issuer/provider.

Bitcoin ETF is trading at a premium… 

If Market Price (MP) is higher than the NAV, the AP may create new shares by purchasing from the ETF issuer on the primary market (at a discount). Typically, the AP would short sell the ETF shares and purchase Bitcoin (BTC) from an exchange.  The AP would execute a ‘creation’ transaction with the ETF issuer to buy/purchase new ‘creation’ units/shares based on the lower NAV.  These lower priced (newly created) units cover the short position while being sold to you and me on the secondary market. The supply shock of the new units/shares usually results in the ETF share price dropping to align more closely with the NAV of the ETF resulting in a profitable short sale trade and/or arbitrage margin for the AP.

The two most common methods for settlement between AP and ETF Issuer are:

  • In-kind settlement: AP buys Bitcoin (BTC), or uses their own  BTC holdings, to exchange the underlying asset (BTC) with the ETF Issuer to create new shares/units.  No capital gain tax levied when shares are exchanged as there is no cash involved in the transaction.  
  • Cash settlement: AP sells BTC/other assets for cash, or uses cash on hand to exchange the cash + fees with the ETF Issuer to create new shares/units.  Capital gains tax levied when assets or shares are bought or sold using cash settlement.

Bitcoin ETF is trading at a discount…

If Market Price (MP) is lower than the NAV, the AP may purchase ETF shares on the secondary market then tender/exchange the shares with the ETF issuer on the primary market in exchange for the ETFs underlying assets (Bitcoin) which is called redemption

As supply on units are reduced in the secondary market due to the redemptions, the discount is reduced and share prices moves more in line with its NAV. 

  • In-kind settlement: There is no capital gains tax for the ETF Issuer when AP redeems ‘In Kind’ (ETF shares for BTC) because nothing is sold (it’s exchanged).  This savings can help keep the fees low for retail investors because the ETF issuer realizes lower expenses which can be passed along to retail investors.
  • Cash Settlement: When AP redeems shares for cash, the AP exchanges the cash it usually requires to pay a transaction fee to offset the cost to the ETF issuer for liquidating assets (BTC) from their portfolio. As supply on units are reduced in the secondary market due to the redemptions, the discount is reduced and share prices move more in line with it’s NAV. 
ETF 102 Creation Redemption

Here are two more detailed examples of APs’ role in an ETF investment.  

Bitcoin ETF Share Creation (investing in the ETF):

A retail investor wants to invest (purchase) $10,000 worth of a specific Bitcoin ETF, like IBIT.  If the spot price for BTC:USD is $40,000 and the Bitcoin ETF IBIT is trading in the market at $40,010 the AP receives an order from the investor’s broker-dealer and trades (buys) $1,000 worth of IBIT at the fair value of the ETF ($40,010).  IBIT is trading at a ($10) premium to its NAV and the AP profits $2.50 because $10,000 is equal to 0.25 BTC given our example of Bitcoin (underlying asset) trading at $40,000 BTC:USD.  

The AP does not profit from the full $10 difference between the ETF spot and BTC spot, rather (0.25 x $10) = $2.50 USD.

Bitcoin ETF Share Redemption (liquidating ETF position):

A retail investor wants to sell their $10,000 position when the ETF is trading at $39,990 and the NAV of the ETF is $40,000 (spot price $40,000 BTC:USD).  

In this example, the ETF is trading at a discount. The AP (market maker) will open a trade to simultaneously buy $10,000 worth of the Bitcoin ETF shares (IBIT) and sell $10,000 worth of BTC (0.025 BTC) on an exchange where Bitcoin its trading at $40,000 BTC:USD netting a $2.50 profit (0.025 x $10 = $2.50 USD)

These numbers sound small, but you have to consider the volume multiplier.  APs are the middlemen between Broker-Dealers and the ETF issuer just as Broker-Dealers are the middlemen between retail investors (you and me) and APs.  

  • ETF issuers profit on fees paid by APs which are passed along the chain to Broker-Dealers and ultimately Retail Investors like you and me. 
  • APs profit on arbitrage + fees charged to Broker-Dealers. 
  • Broker-Dealers profit by charging a fee or commission on the $1,000 trade which may only purchase $993 worth of the ETF if the AP charges $7 fee/commission to make the trade.  

Cash Settlement vs. In-kind Settlement

In-kind redemption is the standard procedure for an ETF.  The SEC favors a cash settlement for Bitcoin ETFs which has caused a point of contention for issuers like Ark21and Black Rock.  

BlackRock recently revised their S-1 filing to prioritize cash settlement while reserving the option for in-kind settlement under their continuous creation/redemption process.  

When APs create new shares by settling with the ETF issuer, there are two types of settlement:

  • In-kind settlement: AP delivers the underlying asset (Bitcoin) to the ETF issuer.  The Bitcoin may be purchased in the market or allocated from the APs current BTC holdings in their custody.  Conversely, the issuer can pay the AP with Bitcoin when the AP redeems shares with the ETF issuer (BlackRock, Ark21 etc)  In-kind settlement benefits APs with strategic Bitcoin reserves previously acquired most often at a lower cost basis than the current BTC:USD spot.

Cash settlement (‘cash create’): Cash settlement, like a ‘prepay’, increases costs (fees and taxes) which will be passed along to retail investors making buying Bitcoin more attractive than the ETF.  These costs include the bid-ask spread, operational costs involved in calculating, executing, and accounting for transactions in Bitcoin markets.  This is maybe a cause for concern for smaller APs and tips the scales in favor of bigger banks with trillions of dollars on their balance sheet so they can get their piece of the action.  The workflow below was provided by Blackrock in their recent File No. SR-NASDAQ-2023-016 on November 28, 2023.  

Due to depository restrictions, banks CAN NOT hold Bitcoin until 2025 when Basel Committee on Banking Supervision (BCBS) guidelines may permit holding up to 2% of reserves in crypto.   

Cash redemption requires APs to sell their ETF shares, incurring capital gains tax, and handing the value in cash back to the ETF issuer rather than making a tax-free exchange of ETF shares for Bitcoin (BTC). 

The motivation behind the SEC’s decision for cash settlement could be due to pressure from the banks and/or they don’t want broker-dealers handling Bitcoin since there isn’t FDIC or SIPC insurance to cover damages from loss or mis-management of hot or cold wallet custodial storage.  

The BIG Problem with Cash Creation and Bitcoin

Let’s assume a 1 Bitcoin (BTC) = to 1,000 shares of the ETF. If the spot price of Bitcoin is $45,000 then the spot price a retail investor pays for 1 share of the ETF (listed on NASDAQ) would be $45 per share.

Cash creation requires the Issuer to receive cash from the Authorized Participants (APs) when the AP wants to acquire (create) new shares of the ETF to fulfill trade orders. Remember that APs are Broker-Dealers (BD) who execute trades on behalf of the BD’s retail investors (you and me) and neither the SEC nor FINRA have approved these broker dealers to trade spot Bitcoin asset.

With cash create, the Issuer maintains a real-time price quote that the AP must pay to create 1,000 ETF shares. The AP then makes a trade with the Issuer to create 1,000 shares at the Issuer’s quoted price.

Behind the scenes, the Issuer must disclose their cash position received from the AP then buy 1 Bitcoin (BTC) from an exchange or multiple exchanges to create 1,000 ETF shares transferrable to the AP.

The delay in time between receiving the cash and making the trade on-exchange for BTC creates a spread. The longer the delay, the greater the risk for the Issuer.

If the price of Bitcoin rises during the delay, the Issuer is forced to spend more to acquire BTC than they received from the AP. The Issuer then has a negative cash balance which directly lowers the fund’s Net Asset Value which reduces performance and investors may select one ETF vs. another based on performance or even the coolest ticker like VanEck’s ‘$HODL’.

The Issuer would have a positive cash balance and higher Net Asset Value if they are able to purchase Bitcoin for less money than they are receiving from the APs.

This scenario would incentivize the ETF (fund) Issuer to markup and quote higher prices (than the market) to create better performance by maintaining a neutral or positive cash balance.

Traders at the ETF Issuer will be tasked with using multiple exchanges (eg: Coinbase, Kraken) and/or market makers (eg: Jane Street, Wintermute) to purchase Bitcoin at the lowest possible average price to reduce their expense ratio.

Different ETFs may deploy different trading strategies and liquidity sources which would result in the ETF price and fees.

For example: ARK21 is waiving is’t 0.25% fee over 6 months for the first $1B of money in. BlackRock is offering 0.2% fee over 6 months for the first $5B of new money.

Retail investors will be paying close attention to this and the Issuer who’s trades more efficiently could ultimately end up the big winner.

Questions About the Bitcoin ETF

ETF issuers have likely been accumulating Bitcoin over the past few months in anticipation of in-kind settlements.  Coincidence or not, ArkInvest has been liquidating positions recently perhaps in preparation for cash settlement.  Blackrock committed $10M to seed their Ishares Bitcoin Trust on Jan. 3, 2024.  

If you’re wondering how much Bitcoin the US Government has, they just released that the the Department of Justice holds 120,000 Bitcoin (BTC) worth ~$5.4 Billion with a cost basis of $71 Million 😳.

How much the tax revenue would be if the applicants had to liquidate Bitcoin they’ve been quietly accumulating over the years at a significantly low cost basis.  Are those the ‘unidentified’ whales taking liquidity now?  

Will traders “sell the news” or has the ETF already been priced into this bull market closing out 2023?

Bitcoin shot up to $48,600 shortly after the ETFs were listed with $2B inflows over the first three days.

On January 23, 2024 Bitcoin was down ~20% trading below the $40k support level due to sell-side pressure. A classic sell-the-news was time well and led by Grayscale’s trust-to-ETF $2 billion liquidations and FTX reportedly offloading ~$1B as part of their bankruptcy proceedings.

On a positive note, these sales were expected and historically could have had far more reaching negative effect on price action. The market absorbed the sales and is optimistic that Bitcoin is flowing from weak hands to strong hands which could shore up the downside volatility.

The bear market reversal of 2023 was a ‘buy the news’ event but we’re not convinced that a 20% reversal post ETF launch was a ‘sell the news’ event.

If you’ve been in crypto for a while (pre-2018) this is par for the course and another reason to Dollar Cost Average with a recurring buy to catch the dip. Diamond Hands are taking advantage of the 20% off sale for Bitcoin and stacking sats waiting for a likely run-up to the halving.

What percent of assets will Financial Advisors allocate to Bitcoin through the ETF?

Typically, up to 5% of an investor’s portfolio is recommended for ‘risky’ assets like Bitcoin. A conservative 1-2% is forecasted to be allocated from the $30 trillion advised wealth in the US creating inflows of $300B as adoption increases. Grant Engelbart from Carson Group says, “handful of advisors allocating 3.5% of Bitcoin ETFs on average to client household portfolios.”

Only time will tell.

Vanguard is leading the anti-Bitcoin movement, which is to be expected given the 2017 comments from founder Jack Bogle’s advising investors to ‘Avoid Bitcoin Like the Plague’.

Ironically, a modest $100 weekly investment from 11/2017-Present would have yielded a ~250% return.

Vanguard is sticking with their thesis and currently NOT allowing clients to purchase the Bitcoin ETF. Reports are also circulating that Merrill Lynch is taking a similar stance.

According to Bloomberg senior ETF analyst, Eric Balchunas , it seems a lot of the demand is coming from the non-professional trader. Data suggests that BalckRock’s $IBIT has an average trade of ~326 shares or ~$13,000 investment.

Will the ETF lead do decreased volatility over time?

Wall Street has arrived. The Newborn Nine ETFs have amassed a staggering 100,000 BTC in the first week of trading.

Their approach is drastically different from what OG Bitcoiners are used to. Spread sheets, algorithms, and portfolio rebalancing could bring waves of increased selling pressure that could tamper the momentum of a bull run.

Hypothetically, if Bitcoin’s price increases 2x in 2024 Investment Advisors may choose to sell off part of their client’s Bitcoin ETF position to rebalance portfolio’s maintaining a their target (1-2%) max exposure.

Derivatives could also play a role in volatility as exposure could be increased or decreased without actually trading Bitcoin ($BTC).

Is is cheaper to hold Bitcoin in an ETF or on-exchange?

Bitcoin ETF fees range from 20 basis points (0.20%) up to 1.5% compared with Coinbase’s Advanced Taker fees 0.05% and 0.60% and Maker fees between 0.00% and 0.40% (based on trade volume).

The trade-off is that an ETF share is is like a promissory note that creates a liability for the Issuer which can be redeemed by the investor. You don’t actually own the Bitcoin because the Issuer hold the Bitcoin keys.

ETFs may prove to be more liquid, especially during a bull run or All-time-high (ATH) when the cost to liquidate on exchange or pay network fees to move from cold storage to an exchange could soar.

Another strategy would be to diversify exposure between the Bitcoin ETF and purchasing BTC on-exchange or P2P. The Bitcoin ETF shares may prove to be more liquid in a frenzied market if you need/want to take something off the table without dealing with Bitcoin, wallets or network fees.

When will the first sovereign wealth fund take a big position in Bitcoin via the ETF?

To date, neither a state-owned sovereign wealth fund nor pension fund has not taken a major position in Bitcoin through an ETF.

Is the Bitcoin ETF different from the Bitcoin ETP?

What are the differences in investors protections with a Bitcoin ETP vs. Bitcoin ETF?

The Government Pension Investment Fund of Japan acknowledged they requested information about ‘illiquidity assets’ which include Bitcoin in March 2024.

Does the Bitcoin ETF impact supply liquidity and price?

To better understand Bitcoin liquidity, let’s define the key terms from Glassnode

  • Max Supply: 21,000,000 bitcoins
  • Current Supply: ~19,600,000 bitcoins that have been mined (created) and are in circulation.
  • Adjusted Max Supply: 19,600,000 = Max Supply – Lost Coins (including Satoshi’s stack)
  • Adjusted Current Supply: Current Supply – Lost Coins (including Satoshi’s stack)
  • Illiquid Supply: Bitcoins held long term in wallets off-exchange.
  • Liquid Supply: Bitcoins actively traded and likely to move to exchange from short term holders.
  • Very Liquid Supply: Bitcoin available to be imminently moved to exchanges for trading.
  • Exchange Supply: Bitcoins held in exchange wallets that are likely ready to trade.

~4 Million BTC are considered liquid or ‘very liquid’ represent ~20% of the current supply.

If BlackRock maintained supply acquisition ~6,266 BTC per day, after the halving in April 2024 they would only be able to acquire ~1,000 BTC daily from Miners forcing them to tap into the liquid supply for the remaining 5,266 BTC. At these levels, assuming for example purposes, constant acquisition levels would create supply shock would force the price up.

Will ETF volume affect Bitcoin price?

ETF Issuers have been accumulating Bitcoin over the counter (OTC) which doesn’t directly affect the SPOT price. Coinbase had a record day on 1/11/2024 with $7.7 Billion in volume.

If and when the OTC market shrinks or dries up, Issuers will have to transact on the open market. Long term holders of BTC on-exchange or in cold storage are referred to as having diamond hands and represent ~75% of the market.

A shrinking OTC market forces buyers to bid up the price on the open market and the supply shock of the next halving event reduces circulating supply from 900 Bitcoin to 450 Bitcoin per day.

If long term holders resist the urge to sell, buyers will be forces to bid up the price highlighting Economics 101 supply and demand. More buyers than sellers = number goes up.

Can I short Bitcoin ETF?

Shorting the Bitcoin ETF is not the same as an inverse Bitcoin ETF.  You can open a long or short position in your brokerage account depending on your investment decision.  The Bitcoin spot ETF price will closely follow the spot price of Bitcoin thanks to APs creating and redeeming shares with the ETF Issuer.  If you believe the price of Bitcoin (BTC) will decrease, you can open a short position for the ETF ticker on your brokerage.  If the price of Bitcoin increases, the price of the ETF shares should also increase creating a loss on the trade.  One way to hedge this is if you hold Bitcoin (BTC) in a separate exchange account (or cold storage) which you may be forced to sell to cover the short.  

Should I buy a Bitcoin spot ETF or purchase Bitcoin (BTC) directly from Exchanges? 

There are many different opinions, even some comments filed with the SEC on whether the Bitcoin ETF will be good or bad for crypto.  

We can’t predict the future or perfectly time the market and I can’t provide financial advice.  Talk to a pro and do your own research.

Coinbase has won even more of my confidence after being named the Custodian for BlackRock’s iShare Bitcoin Trust.  BlackRock has too much on the line to trust this to anyone but the best.  

Another reason supporting our decision to integrate exclusively with the Coinbase exchange for our DCA bot.  

There’s a long road ahead for Bitcoin.  You’ll be able to set up a dollar cost averaging strategy with a recurring buy of ETF shares or Bitcoin (BTC) depending on your personal preference.

Personally, I’ll be stacking sats with our DCA bot and buying the dips making sure to minimize transfers off-exchange to limit the number of UTXOs especially in a high fee environment.  Additionally, the number of parties required for creation and/or redemption of ETF shares seems a lot more complicated than storing BTC in a cold wallet or even on-exchange.   

This is not financial advice.  Do your own research anon.

Note: Stratus does NOT provide investment, legal or tax advice.  All information in this article is for educational purposes and should not be interpreted as investment, legal or tax advice.  The opinions expressed are those of the author for informational purposes and neither Stratus nor the author are liable for any errors, inaccuracies or omissions.    Digital assets, such as cryptocurrencies or decentralized finance, present unique risks for investors.  For investment, legal, tax, or other financial guidance you should consult your own advisor.