Crypto ETFs explained
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There was a lot of buzz around cryptocurrency exchange-traded funds (ETFs) over the past week, amid reports and rumours that the US Securities and Exchange Commission (SEC) was set to approve the launch of one or more bitcoin ETFs.
On Thursday, Bloomberg reported that the SEC was set to allow the first US bitcoin futures ETF to begin trading next week, in what would be a “watershed moment” for the crypto industry.
The next day the SEC’s investor education office tweeted: “Before investing in a fund that holds Bitcoin futures contracts, make sure you carefully weigh the potential risks and benefits.” Those 20 words caused the price of bitcoin to break $60,000 for the first time in six months, close to an all-time high of $64,895.
But what are crypto ETFs and why is this all such a big deal?
What is a crypto ETF?
To answer that, we need to back up a little. An exchange-traded fund, or ETF, is a financial instrument that tracks the value of a particular asset or a collection of assets. Its main benefit is that it allows investors to diversify their holdings without actually owning any of the assets themselves. For example, a gold ETF would track the value of gold reserves it represents. Similarly, a crypto ETF would track the value of one or more crypto assets and a bitcoin ETF would track the value of just bitcoin.
Importantly, ETFs are traded on traditional market exchanges rather than crypto exchanges.
Bitcoin ETFs already exist in some countries. Many such funds have been launched in Canada, Brazil, Europe and Dubai just this year. But approval from the SEC represents the holy grail for cryptocurrency enthusiasts — one that would spur the adoption of crypto ETFs worldwide and give further legitimacy to cryptocurrencies in the process. SEC approval is crucial not just because the US is the world’s largest and most sophisticated financial market. It now also accounts for the largest share of the world’s bitcoin mining as China has been cracking down on crypto miners and traders since May.
How do crypto ETFs work?
The main appeal of crypto ETFs is that they work exactly like ETFs backed by traditional assets. They come in two forms:
■ Physical-backed: To create this type of crypto ETF, an asset management company must buy some actual coins from the market, just as it would buy shares for a traditional ETF. It can then set up a fund that represents the value of the crypto assets it holds and list it for trading on the stock exchange. If the value of the fund’s digital coins increases, so does the value of your investment.
■ Futures-backed: In this type of ETF, shares in the fund aren’t based on actual coins but on crypto futures contracts. A futures contract is simply an agreement to buy or sell an asset at a predetermined price at a specified time in the future. These are less risky than physical-backed ETFs because there are no physical assets to be protected. This is the type of bitcoin ETF the SEC is reportedly set to approve.
Pros of crypto ETFs
Convenient: When it comes to crypto, the biggest advantage ETFs have over direct investments is that investors don’t have to handle the underlying asset. While crypto exchanges have made it easier to buy and sell cryptocurrency in the past few years, things like setting up digital wallets and understanding how private and public keys work remain hurdles to large-scale crypto adoption. Crypto ETFs let investors benefit from the new asset class with their existing brokerage accounts.
Safe(r): Since they’re traded to traditional exchanges, all ETFs are highly regulated. This means regulators can monitor and analyse their performance and protect against price manipulation within the ETF markets. However, the underlying asset’s price can still be manipulated through unregulated crypto exchanges. Crypto exchanges and wallets are also susceptible to hacking attacks and theft. Crypto ETFs protect against these risks as you don’t own any actual crypto. And in a futures-backed crypto ETF, the fund doesn’t own any crypto either.
Cheaper: Buying a large collection of cryptocurrencies is a long and complicated process that involves opening accounts with several crypto exchanges and maintaining numerous digital wallets. Crypto ETFs give you exposure — albeit indirectly — to numerous crypto assets through a single investment. ETF fees are also generally lower than those of traditional managed funds.
Cons of crypto ETFs
Limited choice: There are few such funds currently available to invest in. But if the SEC were to open the door to crypto ETFs, that could change quickly. Limited choice is a concern at the asset level, too. Traditional ETFs include a wide range of securities to minimise risk. But most crypto ETFs track only a few digital currencies.
Crypto-related risks: While they are in some ways safer than investing directly in cryptocurrencies, crypto ETFs nonetheless carries over many of the risks of the underlying assets they represent. Cryptocurrencies are volatile and so are crypto ETFs. And physical-backed funds, which buy and store actual cryptocurrencies, need to manage other crypto-related risks, such as hacking.
A cop-out? To cryptocurrency purists, these virtual assets represent a hedge against fiat currencies and the central banks and governments that control them. A bitcoin ETF would by definition be regulated by a government, and investors wouldn’t actually be buying any crypto either.
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