SPOT BITCOIN ETF: WHAT IS IT & IS IT RIGHT FOR YOU?

In January 2024, the SEC approved eleven spot bitcoin ETFs. In record time, combined total assets reached $60bn. Today, the spot bitcoin ETF market is 6x the size of silver ETFs, exceeds 50% of physical gold ETFs, and daily volumes have surpassed the S&P 500 on several occasions. A stunning debut!

Spot bitcoin ETFs provide easy access to bitcoin’s price performance in a familiar format from well-known managers. This seems easy. And indeed, it is. Assessing whether a spot bitcoin ETF is right for you can, and should, be viewed from different perspectives. 

A bitcoin ETF is an investment allocation and portfolio construction question which needs to be balanced with your values-based lens. Importantly, before making any decision, the risks and trade-offs should be explored.

In Brief:

A spot bitcoin ETF may be right for you if you:

• Are willing to pay the management fees.
• Are comfortable with the counterparty risk.
• Are okay with price deviations from the price of bitcoin.
• Want to view your assets on one dashboard.
• Don’t want to own bitcoin directly.
• Don’t want to manage digital wallets or private keys.
• Are subject to regulatory requirements that prevent buying bitcoin directly, such as in a 401k. 

 

Other ways to own bitcoin:

• Custodial service provider.
• Directly with private keys.

 

In this article, we dig into the detail to cover several questions and comments that have been coming up. The goal is to arm you with a depth of resources that you can come back to and, ultimately, establish a framework that may help you assess whether a spot bitcoin ETF is right for you. The first section provides an overview of a regular ETF and a spot bitcoin ETF. The second section reviews the costs and risks for a bitcoin ETF and a bitcoin bought outright. The final section provides a decision tree. 

EXCHANGE TRADED FUNDS OVERVIEW

Base Layer: ETF Primer

Before describing a spot bitcoin ETF (which is technically an exchange traded product ETP), we start with a quick primer on exchange-traded funds (ETF) because most people do not understand the structure of these highly popular investment vehicles. 

• An ETF is a pooled investment security that tracks the price of an index or basket of underlying assets, without owning these assets directly. 
• The underlying assets are not registered in the name of the ETF. Instead, an Authorized Participant (AP) records a book-entry that the ETF has a beneficial interest in the assets. (This creates some of the tax efficiency of ETFs.)
• APs are self-clearing broker-dealers (such as Jane Street, Virtu, or JPMorgan to name just a few). The ETF issuer (e.g., BlackRock, Ark, Vanguard, etc.) appoints which APs are allowed to trade with the ETF issuer to create and redeem baskets of shares. This is the primary market.
• The AP trades ETF shares in the secondary market, where investors buy and sell. The ETF issuer never trades in the secondary market.
• Throughout the trading day, APs buy and sell the underlying asset(s) with the goal to match the net asset value of the ETF with the underlying assets value. At the end of each trading day, the APs net the ETF shares traded and the ETF either creates or redeems ETF shares to match the shares outstanding. 
• For more, the Investment Company Institute has an accessible description.

 

ETFs come in three structures: 

1. Unit Investment Trusts, the original structure.
2. Open-Ended Funds, the most common ETF structure today.
3. Grantor Trusts, the structure most used for commodity ETFs.

State Street provides a clean overview of their characteristics and differences. You can find it here and below is an extract:

Exchange Traded Product Structure	Unit Investment Trust	Open End Fund	Grantor Trust
SEC Registration	Investment Company Act of 1940	Investment Company Act of 1940	Securities Act of 1933
Portfolio Management	Full replication	May sample/optimize	Typically a commodity
Dividend Reinvestment	Cannot reinvest	May reinvest	N/A
Securities Lending Permitted	No	Possible (see prospectus)	No
Use of Options/Swaps/Futures	No	Possible (see prospectus)	Possible (see prospectus)
Investment Advisor/Trustee	Trustee	Investment Advisor	Trustee

Base Layer: Spot Bitcoin ETP (colloquially referred to as ETF)

The structure of a spot bitcoin ETF is different than a regular ETF. Beware, it’s more complicated!

The following diagram from BlackRock shows the flow for redeeming a basket of spot bitcoin ETF shares (e.g., investors are selling). Reverse the arrows to follow the flow for creating a basket of spot bitcoin ETF shares (e.g., investors are buying). 

Who does what:

• The Listing Exchange is NYSE, NASDAQ, or CBOE.
• The U.S. Market Maker trades ETF shares in the secondary market with investors. These include the Authorized Participant and other broker-dealers.
• The Authorized Participant trades with the ETF issuer in the primary market of creating and redeeming ETF shares. They also trade in the secondary market along with the Market Makers. 
• The ETF issuer handles the marketing and administration.
• The Transfer Agent and Cash Custodian records the buyers and sellers of ETF shares. This is frequently BNY Mellon.
• The Offshore Market Maker is necessary because U.S. regulations do not permit financial institutions to hold or trade bitcoin. The Offshore MM receives/sends cash to the Cash Custodian and trades bitcoin for cash with the Spot Crypto Exchange.
• The Spot Crypto Exchanges regulated in the U.S. are Coinbase, Kraken, Bitstamp, and Paxos. 
• The Prime Broker holds bitcoin in a hot wallet to provide liquidity, and transfers bitcoin to the Bitcoin Custodian. 
• The Bitcoin Custodian holds bitcoin in cold storage.

 

Walking through a transaction

1. You buy 100 shares of the Bitcoin ETF through your broker (e.g., Schwab, Fidelity). 
2. Your broker delivers cash to the Transfer Agent/Cash Custodian via the Authorized Participant, who informs the ETF issuer. 
3. The ETF issuer instructs the Cash Custodian to send the cash to the Offshore Market Maker, who buys bitcoin.
4. The bitcoin is delivered to the Prime Broker. 
5. The Prime Broker sends the bitcoin to the Bitcoin Custodian who holds it in cold storage.

As you can see, there are additional moving parts in a spot bitcoin ETF which imply two things: 1) more entities need to profit and 2) more places where something can go wrong.

FEES & RISKS

Fees and Costs

ETFs

ETF management fees are expressed as an expense ratio and cover expenses such as manager salaries, custodial services, and marketing costs. These fees are based on the market value of the ETF, accrue daily, and are deducted from the ETF assets monthly. An investor doesn’t see this fee deducted directly. Rather, it is reflected in the net return. For example, if the expense ratio is 0.25% and the ETF total return was 10%, then the investor would receive a return of 9.75%. 

Spot bitcoin ETF management fees range from 0.12% to 1.5% per year. Some issuers waived their fees for a period. Some committed to donating a share of profits to the bitcoin developer community. 

Directly owning bitcoin

Bitcoin-direct purchases incur no annual management fees. There are one-time trading fees and, if you want to self-custody, there is the cost of a hardware wallet (ranging $70-$400). If you want help with self-custody, there may be an additional annual flat fee (approximately $250 per year). 

Tracking Error Risks

For the most part, with regular ETFs, tracking error is nominal, either because the underlying asset trades without delay during the same hours as the ETF or because the underlying asset has low volatility. 

Bitcoin as the underlying asset in an ETF can present challenges to maintaining low tracking error. The structure of the bitcoin ETF involves a second trading exchange, which can cause delays in trade execution; bitcoin trades outside regular trading hours; and bitcoin has higher volatility. Each may lead to price deviations from NAV.

While the fund’s net asset value (NAV) will generally reflect the prices of spot bitcoin, less the management fee, it is relevant to remember that the fund is measured by the performance of the selected Bitcoin Reference Rate Index, and that the NAV is determined at 4 p.m. ET on days the market is open (weekdays excluding holidays). 

Counterparty Risks

ETFs

Counterparties in an ETFs include Banks, Transfer Agents, Market Makers, Custodians. Most of these are the same whether in an S&P ETF or a spot bitcoin ETF. Thus, counterparty risk in spot bitcoin ETFs can be narrowed to the bitcoin Custodian and Prime Broker. 

Directly owning bitcoin

There are no counterparty risks. This is an original feature of bitcoin. Owning bitcoin outright means that you are your own custodian. To be an effective self-custodian, there are technology and administrative risks which are discussed in Custodial Risks below.

Custodial Risks

Custodial risk is the risk of loss on assets held in custody in the event of a custodian’s insolvency, negligence, fraud, poor administration, or inadequate recordkeeping. 

Custody of bitcoin also carries technology risks, particularly around key management, and cybersecurity. While you want full security, there is often the competing goal of being able to trade relatively quickly. Assets held in offline cold-vaults can take a few days to unlock. Assets held in online hot-wallets are more susceptible to hack and cybercriminals. 

ETFs

Eight of 11 spot bitcoin ETFs appointed Coinbase as the Custodian. Fidelity appointed itself and Van Eck appointed Gemini. The SEC has stated that it expects security measures to protect against theft, loss, and unauthorized access. In short, the qualified custodian should implement strong access controls, encryption, multi-factor authentication, and regularly test these security systems. 

Questions you can ask to evaluate these factors include: 

• How is the offline, cold-vault storage managed?
  • Look for physical security, multi-person/multi-organization consensus controls. These should include encrypted hardware security and advanced access controls, both for multi-factor authentication and quorum-based approvals.
• How are assets segregated?
  • Most qualified custodians manage bitcoin assets in a pooled omnibus account and then segregate the beneficial ownership in a book-entry ledger system.
  • Look for transparent record-keeping that is verifiable on-chain (even if you don’t know how to verify it yourself).
  • The assets and procedures should be audited regularly by internal and external specialists. 
• How are the private keys managed?
  • Private keys are the access to your asset. 
  • The key management should be fully redundant even if one or more of the sites is unavailable. 
  • Look for multi-site, geographically diverse locations managed by separate teams.
• What does the custodian’s insurance cover?
  • There will be two insurances: one for commercial crime insurance and one for offline cold storage insurance. 
  • Commercial crime insurance covers losses if the custodian suffers a breach. Offline cold storage insurance covers physical destruction of devices that store private keys by fire, flood, etc., theft of devices at rest, and theft or copying of private keys while in transit. 
• What is the reputation for robust compliance frameworks?
  • Check the veracity of compliance statements with an internet search for deficiencies, investigations, and legal cases. 
  • Client satisfaction with incident responses can be a leading indicator.
  • Monitor this regularly. 
• What are the bankruptcy protections?
  • Check that the cold-vault bitcoin assets have bankruptcy remoteness.
  • Look in the Service Agreement for segregated accounts that are exempt from the custodian’s general creditors. In the U.S., compliance with UCC Article 8 is regarded as providing protection, although there is no case law to support that the courts would uphold this protection.
  • Know that bitcoin in a hot-wallet always forms part of the custodian’s general creditor assets. 
  • Default and bankruptcy can, and do, happen to large companies. Now that bitcoin custodians have a fiduciary responsibility to Wall Street investors (and reputation responsibility to the world’s largest asset managers), the more likely scenario may be that the custodian would be bought before full-on bankruptcy. However, Silicon Valley Bank went under, so best to remember that risks always exist. 

Directly owning bitcoin

Where you store bitcoin that you buy directly is usually dependent on its purpose. 

Buying bitcoin to spend is best accomplished with a lightning wallet. These are custodial accounts owned by the money transfer company, such as Strike, CashApp, and others.

If you choose to use a custodian for longer-term holdings, qualified custodians available to individuals (other than the ones listed above) include BitGo, Bakkt, and others.

For all custodial situations, the questions above apply. 

If you choose to self-custody, it is advisable to move your holdings to an offline wallet solution. Investigate the company that makes the device that will store your private key. For this, look for reputation regularly. Also, check to see where the device is manufactured and the quality controls. You should only purchase a device directly from the manufacturer and it should arrive in tamper-proof, tamper-evident packaging.  Reputable companies include Coinkite, BitKey, Ledger, and Trezor.

For long-term holding, you might also investigate support for self-custody with concierge and multi-signature services such as those offered by Unchained, Casa, River, Swan among others. These companies can also help you establish a bitcoin IRA account. 

Bitcoin-direct purchases that are moved to a cold storage device do not have custodial risk; however, you do need to keep your private key and your recovery phrase safe in offline locations (and not together). Your recovery phrase enables you to restore your private key on another hardware device. You should check the cold storage device every six months to confirm that it is functioning. Note, your bitcoin is not on this device. It is recorded in the blockchain. The device is an access point to the block where your bitcoin is recorded. 

A DECISION TREE

Do regulatory requirements prevent you from buying bitcoin directly? 

YES  Buy a Bitcoin ETF

NO ⬇️

Do you want your bitcoin on the same platform as your brokerage?

YES ☐ Accept that asset is a proxy for bitcoin price performance.

Be comfortable with counterparty risk.

Be comfortable with custodial risks. 

Recognize that tracking error may impact performance.

Pay annual fees.

Buy a Bitcoin ETF

NO ⬇️

Are you comfortable with counterparty risk and custodial risks?

YES ☐ Willing to pay annual fees?

             YES ☐ Buy a Bitcoin ETF

             NO  ☐ Buy Bitcoin with a reputable custodial service

NO ⬇️

Are you willing to manage your digital wallet and private keys?

YES ☐ Buy Bitcoin and withdraw to cold storage.

NO  ☐ Rethink your objectives and intentions.

Remember, a successful strategy is not “set it and forget it” – whether it’s an ETF strategy, a bitcoin strategy, or a life strategy. Regular reviews of your journey, your goals, and your achievements allow you to adjust and chart the path best for you. 

_________

Author’s Disclosure: I own bitcoin and have positions in BITB, a spot bitcoin ETF. I wrote this article myself, and it expresses my own opinions, which are for informational purposes only. I am not receiving compensation for it. I have no business relationship with BTC-FAN or any company whose stock is mentioned in this article. 

Bitcoin Financial Advisors Network’s Disclosure: The comments, opinions, and analyses expressed are for informational purposes only. Read the disclaimer for more info. Bitcoin, bitcoin exchange traded products, and strategies may not be suitable for all investors, can be speculative and volatile, may be difficult to analyze, and present unique custodial risks. All investments involve the risk of loss. Since everyone’s situation is unique, a qualified and bitcoin-competent professional should be consulted before making financial decisions.