The new bitcoin ETFs are close to the Platonic ideal of two things at the heart of the financial industry, arbitrage and gambling. And a third thing: Without the distortions the financial industry created in the first place, they would have no reason to exist.
The whole concept of a bitcoin ETF is odd. Bitcoin is a cryptocurrency; it’s easy to buy and, for individuals who want to speculate on its future value, easy to hold. All you have to do is download some software, pick a secure password, sign up to a crypto broker, transfer the bitcoin into your blockchain wallet and you’re done. If you wanted a traditional currency you wouldn’t pay a 0.95% annual fee, plus hefty futures costs, to get something that roughly tracks the value of a dollar—you’d just hold some dollars.
That didn’t stop many from finding the idea attractive: the ProShares Bitcoin Strategy ETF, the first, attracted more money than any other ETF launch and had the second-highest trading on its first day. A week after launch it holds $1.2 billion. Much of this money is likely to be a new layer of gambling, as traders bet on other people wanting it. But the expected underlying demand is from those who can’t or won’t take the simple option of buying bitcoin directly, so prefer to use a structure listed on the stock market and approved by the Securities and Exchange Commission.
That all sounds reasonable—until you ask why they prefer it, given the high costs and the ease of buying directly. The answer is that it’s all about trust, which is pretty ironic given that bitcoin was created to solve a problem of trust.
Michael Sapir, chief executive of ProShares, contrasts the regulated futures market with what the SEC itself calls the “Wild West” of crypto trading. He warns that lots of exchanges “have a degree of manipulation embedded in them,” so there might be hidden costs to buying bitcoin direct, as well as risks.
There are certainly risks. If you hold bitcoin directly on the blockchain, and you lose the password to your wallet, you’ve lost your bitcoin. If someone steals your password, you’ve lost your bitcoin. And if you give it to someone else, they now control your bitcoin. For an individual, this is manageable, if scary; choose a unique secure password you can remember, don’t write it down or keep it on the internet where it could be hacked, and don’t tell anyone.
But in the financial system most of our investments are handed over to others, with the vast bulk of assets world-wide run by institutions such as insurance companies, pension funds, mutual funds and endowments, or by advisers. These institutional investors and advisers have a serious trust problem. Whom do they trust to hold the bitcoin password? Ultimately someone has to have custody of it, and that person can suddenly become very rich by running off with it—something they can’t (easily) do with stocks, bonds or property. The trust problem is hard to manage, as shown by founders of crypto firms occasionally vanishing along with all the bitcoin their investors thought they were looking after.
The new ETFs sidestep the trust problem by buying bitcoin futures instead of bitcoin, introducing a new layer of gambling and arbitrage. Bitcoin futures are merely side bets on the price of bitcoin, settled in dollars; they are to bitcoin what a bet on the Kentucky Derby is to the horse. Their connection to the price of bitcoin comes from the final settlement and from arbitragers who profit by selling overpriced bitcoin futures and buying actual bitcoin. (The same could apply in reverse, but usually the futures price is higher.)
In turn, the price of the ETF is kept in line with the value of the bitcoin futures it owns by arbitragers, like other ETFs.
All these layers of arbitrage cost money—real money, not bitcoin. The ETF has a 0.95% annual fee, but the main cost comes from the futures being more expensive than bitcoin. The ETF buys them a month ahead, but they fall in price as they approach maturity, so it makes a loss, known as the roll cost. This approach has made about 13 percentage points less than bitcoin’s 118% so far this year, according to the Horizons Bitcoin Front Month Rolling Futures index calculated by Solactive; Mr. Sapir says it is more like five points a year since 2017.
There are plenty of people offering technical solutions to the institutional custody problem of bitcoin, and several are trying to persuade the SEC to approve an ETF that just buys bitcoin. It would strip out the layers of arbitrage and gambling created by using futures, leaving just the arbitrage inherent in ETFs and the gambling inherent in bitcoin—but would only succeed if investors trust the solution.
Still, the basic principle of any bitcoin ETF is an arbitrage between the blockchain and the traditional financial system, the inverse of what Tether and other stablecoins are doing. The stablecoins let you think in dollars on the blockchain; bitcoin ETFs let you think in bitcoin in the mainstream system. And as with everything else in finance, that comes with costs—costs ordinary people can easily avoid if they want bitcoin, just by buying bitcoin instead.
Write to James Mackintosh at james.mackintosh@wsj.com
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