Bitcoin ETFs: What’s the nature of the crypto-based financial instrument?

Lately, financial institutions like BlackRock, Invesco, Fidelity, Greyscale, and others have been pushing for Bitcoin ETFs, portraying them as safer investment options as compared to direct investments in cryptocurrency due to the volatility. But what are Bitcoin ETFs, and what is the risk associated with them?

What is an ETF?

ETF stands for exchange-traded fund. In simple words, it is a type of pooled investment security that tracks a particular index, sector, commodity, or other asset. ETFs can be purchased or sold on a stock exchange in the same way that a regular stock can.

What is a Bitcoin ETF?

Based on the definition of an ETF, a Bitcoin ETF tracks the price of Bitcoin. They are pools of bitcoin-related assets offered on traditional exchanges by brokerages to be traded as ETFs. The intent behind these ETFs is to allow retail investors and investors not comfortable investing in cryptocurrencies an option to trade in them.

How are Bitcoin ETFs different from direct investments in Bitcoin?

For starters, in the case of Bitcoin ETFs, an investor would not need a crypto wallet since they are not directly holding the Bitcoin. Secondly, they would not have to register with a crypto exchange and maintain an account for holding their investment.

Thirdly, while investing in a Bitcoin ETF, the investment is not directly into the cryptocurrency but an indicator of its value.

How do Bitcoin ETFs operate?

Based on the proposals and the regulator’s comments on Bitcoin ETFs, there are a few ways in which the financial instrument could operate and assign value to the underlying asset.

The first is the fractionalised holding of the cryptocurrency. For instance, the institution running the fund would purchase Bitcoin at a particular rate and hold it. Based on the price movements of the crypto, the institution would offer fractionalized shares of its holdings on a traditional exchange. This is commonly referred as Bitcoin Spot ETF.

However, the United States Securities Exchange Commission (US SEC) has not approved of this method to operate a Bitcoin ETF. They have in turn put forth an alternate method to operate the financial instrument, based on the Bitcoin futures contract on the Chicago Mercantile Exchange (CME). This is commonly referred as Bitcoin Futures ETF.

In simple words, a futures contract is a financial agreement between two parties to buy or sell an asset, such as commodities, currencies, or financial instruments, at a predetermined price on a specific date in the future. The price at which the asset will be bought or sold is known as the “futures price.” This allows individuals and businesses to hedge against price fluctuations or speculate on the future direction of an asset’s price.

The profit or loss in a futures contract indeed depends on the difference between the agreed-upon futures price and the actual market price of the asset at the time of contract expiration.

Are there any mainstream Bitcoin ETFs?

The US SEC has been rejecting applications of Bitcoin ETFs pointing out the volatility of the underlying asset. But the latest developments, the US courts favouring Greyscale over US SEC in the matter and BlackRock’s latest filing, indicate that Spot Bitcoin ETFs might soon be on the horizon.

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