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Monthly Market Review - October 2021

Updated: Mar 8, 2022

In this note, we look at the approval of the Bitcoin ETF and its potential structuring issues compared to holding the underlying asset.

October was a very bullish month with high percentage rises across the board in the broader crypto market. The news of the upcoming release of the first US Bitcoin ETF - ProShares Bitcoin Strategy ETF - supported the rally during the middle of the month. The ETF officially launched on 19th October and has generated record inflows (over $1 billion in the first two days). Valkyrie Investments’ Bitcoin Fund was the second ETF and launched a few days later.

ProShares Bitcoin Strategy ETF inflow. Source: Bloomberg

The critical drawback of both ETFs is that they track Bitcoin via futures contracts and have no underlying Bitcoin holdings. This structuring was a requirement as no underlying-based digital asset ETF has been approved in the US yet. This seemingly small structuring detail may have a significant impact on the potential performance of these ETFs, as they are exposed to the pricing difference between the underlying price and the futures price. If the future contract of Bitcoin is trading in Contango, then the ETF must buy Bitcoin at a higher price than the underlying price. This phenomenon is called Contango bleed as the ETF ‘bleeds’ profit to this pricing difference - the more significant the pricing difference, the greater the bleed.

Even in mature markets, this bleed plus the transaction costs of trading the futures contracts can be a significant performance drag of the ETF compared to the underlying. For example, the United States Oil Fund, a $2.4bn ETF based on oil futures contracts, has underperformed the price of WTI crude, which it is supposed to track by 70 per cent over the past decade.

So, it’s clear that an underlying based ETF is a better product structure for US investors; the question is, why doesn’t the SEC approve one? According to reports, the SEC still believes that the spot asset market is too immature and susceptible to manipulation and this potential risk outweighs the risk of Contango bleed. The SEC just delayed the deadline for its decision on an application for an underlying-backed ETF product until January 7, 2022. So, it appears that futures-based ETFs are the only option for US retail investors for the immediate future.

The other viable exposure to Bitcoin via a listed US product is the Grayscale Bitcoin Trust (GBTC). However, GBTC is trading at a considerable discount to its NAV. It is unlikely that this will reverse because redemptions of the underlying are prohibited - due to its trust structure1. Thus, investors in this product have also badly underperformed compared to holding spot BTC.

Grayscale Bitcoin Trust's Discount or Premium to NAV. Source: yCharts

The ETF structuring issues show how US regulators are still grappling with the trade-off of preventing harm via investor protections versus increasing investor harm via poor market access (and thus poor performance). We suspect that the futures-based ETF was an attempt to compromise; however, as the above shows, the three-letter US agencies still have a way to go before US retail investors have easy access to a well-structured product.


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