The ProShares Bitcoin Strategy ETF uses futures contracts to gain bitcoin exposure, which has downsides.
Over the past couple of days, there’s been a lot of coverage of the news that the US has seen the launch of its first bitcoin exchange-traded fund (ETF).
Earlier this week, ProShares Bitcoin Strategy started trading. It has been hugely popular having already reached over $1 billion in assets under management. This is the fastest time any ETF has gathered £1 billion from launch.
However, despite the fanfare, UK investors will not be able to buy this product. Nor is it likely that UK regulators are going to approve a similar product anytime soon.
Last year, the Financial Conduct Authority (FCA) banned cryptocurrency exchange-traded notes (ETN), specifying that they believed these “products to be ill-suited for retail consumers due to the harm they pose”. The regulator outlined the following problems:
- inherent nature of the underlying assets, which means they have no reliable basis for valuation
- prevalence of market abuse and financial crime in the secondary market (eg cyber theft)
- extreme volatility in cryptoasset price movements
- inadequate understanding of cryptoassets by retail consumers
- lack of legitimate investment need for retail consumers to invest in these products.
But despite the unlikelihood of this or a similar ETF being available to UK investors anytime soon, the launch does mark a milestone. So, it is worth investors understanding the ETF and how it works.
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First, it should be noted that the ProShares Bitcoin Strategy ETF is not the first bitcoin exchange-traded product, as there are listings in both Europe and Canada. In February, Purpose Bitcoin ETF listed on the Toronto Stock Exchange. Meanwhile, several bitcoin and ethereum exchange-traded commodities (ETCs) have listed on various European exchanges. UK investors cannot buy these products either.
The ProShares Bitcoin Strategy ETF uses futures contracts to gain bitcoin exposure, rather than investing directly in bitcoins.
If you were to look inside the ETF’s portfolio, you would find some bitcoin futures contracts, but mostly cash and cash equivalents (such as short-dated bonds). The bitcoin futures are essentially cash-settled bets that the price of bitcoin will rise. If the price of bitcoin goes up, the ETF’s cash holdings will rise. If the price of bitcoin goes down, the cash in the ETF’s portfolio will decrease.
The use of futures contracts was insisted on by the Securities and Exchange Commission (SEC). Bitcoin futures have been traded on the Chicago Mercantile Exchange since 2017. As a result, the bitcoin futures are regulated, unlike the market for ‘physical’ bitcoins. In the mind of regulators from the SEC, using bitcoin futures offers investors more protection.
However, not everyone agrees that using futures is the best way to offer investors bitcoin exposure. Using futures contracts means investors are likely to experience a notable drag in performance.
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As investors in commodity ETFs will know, using futures contracts introduces the prospect of ‘roll yield’. If an ETF invests in futures contracts, it will usually invest in the shortest-dated contracts i.e, those that are the closest to expiration. As the ETF does not want to actually hold the contract when it expires (and therefore receive delivery of the commodity in question), they sell the contract before expiration and ‘roll’ into the next dated contract.
Usually, the further from expiration a futures contract, the more expensive it is. When this is the case, which it is most of the time, the market is said to be in ‘contango’. However, for ETFs buying the shortest-dated futures contracts available, it means that rolling into new contracts incurs a loss – or a negative roll yield.
The bitcoin futures market is in contango, as the longer-dated contracts are trading above the shorter-dated contracts. Therefore, investors in the new futures-based bitcoin ETF will see negative roll yield and a drag on their performance, compared to the actual price of bitcoin. Matt Hougan, chief investment officer of Bitwise Invest, which is trying to launch a physically replicated bitcoin ETF, estimated the cost of this roll yield at 5% to 10% a year, according to the Financial Times.
So why would anyone use this ETF over buying directly into bitcoin? First, there is the regulated nature of the product. While the situation has improved, the past few years has seen several scandals involving cryptocurrency exchanges. However, another big attraction will be the potential ability to hold the ETF in a tax wrapper (US versions of ISAs and SIPPs, essentially). Even if the ETF underperforms bitcoin, the ability to avoid capital gains will likely prove attractive to many.
Of course, there is talk of the US launching a physically replicated bitcoin ETF eventually. Indeed, Invesco recently pulled its application to launch a futures-based bitcoin ETF in the US and it is understood to be hoping to instead launch a physically replicated version. Time will tell whether US regulators allow this.
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