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CRB Monitor Chart of the Month: An Update On Spot Cryptocurrency ETFs

James B. Francis, CFA, Chief Research Officer, CRB Monitor 

Peter Simcox, Senior Analyst, CRB Monitor                                                     

In January 2024 The U.S. Securities and Exchange Commission (SEC) approved eleven spot Bitcoin-based exchange traded funds and in doing so introduced a new level of accessibility for investors in cryptoassets. CRB Monitor originally reported on this event with our February Chart of the Month. These eleven ETFs, which have now been trading for close to six months, invest in and designate spot Bitcoin (BTC) as their benchmark index. These exchange traded funds allow US investors to gain daily exposure to the world’s largest and most liquid cryptocurrency without directly holding it, and as a result they simplify and limit some (but not all) of the risks related to the process of investing in Bitcoin.

Since their launch in January, the prices of these ETFs have surged along with their benchmark BTC. In addition, several of these crypto ETFs have listed and commenced trading on the London Stock Exchange (LSE) and there is a new wave of listings on the Hong Kong Stock Exchange as well. Consequently we are seeing interest in these ETFs coming from the world’s largest financial institutions as they enter the field, apparently less concerned about holding these ETFs than they would be about investing directly in spot Bitcoin.

Here is a snapshot of these 11 as of a week into the month of June 2024: 

After almost six months of trading, the overall asset size of these 11 ETFs has more than doubled, from $26 Billion to $59 Billion (+127%), which represents close to 80% asset growth over and above the market return of 50%. And looking at the table above, with only two exceptions (DEFI and BTCW) these funds appear to have achieved critical mass and should be profitable given their current asset size.

What can we say about the chart above, which is essentially 11 lines stacked on top of each other for several months? There are definitely some things to focus on here. What we see is enough dispersion between the ETFs and Bitcoin to make us curious about these funds’ operations. Truth be told, their relative performance should look a bit tighter to the benchmark (BTC), not only for the outlier DEFI (-7.9% vs. BTC), but for veteran ETP GBTC as well. The rest look reasonably close to each other. Granted, a return of 49.7% with a variation of +/-1.70% is not the end of the world, especially for crypto-based ETFs. But with that said, each of these funds had one job: to deliver the return of BTC. And what the above performance says to us is that they have all failed.

When we first looked at this chart we knew we’d have to figure out what happened with DEFI that caused it to underperform BTC by nearly 8%. We know that at 0.92% DEFI’s expense ratio is unsustainably high. We also know that DEFI lost about half of its assets over the period and is now only $12 million in AUM. The small size should not cause too much turmoil, but the large redemptions could have had an impact.

And further review uncovered the fact that essentially all of the underperformance came in the first three months of 2024, as DEFI transitioned from a Bitcoin futures fund to a spot Bitcoin fund. DEFI tracks the rest of the field nearly perfectly during the period from 3/15/24 – 6/07/24 (see chart above as DEFI and GBTC are in line for this period). This is great news for investors in DEFI; however there will be no celebration until the issuer reduces the fund’s expense ratio to compete with its peer group.

There are no surprises in this correlation matrix, which shows that the field of 11 ETFs is highly correlated throughout as well as with its benchmark, BTC. With that said, this table points out one fact that is difficult to dispute: that these ETFs are, by and large, the same. Historically when investors have a choice between two or more similar funds they will opt for the lowest expense ratio. And as we have seen with the market for US index ETFs, this is the perfect recipe for a race toward zero. What we would expect is for the Greyscale ETF (GBTC) to continue to shrink as an expense ratio of 1.50% is not sustainable while there are near-identical funds offering the same return for 0.25%. But time will tell.

Challenges Presented by Spot Bitcoin ETFs

Spot Bitcoin ETFs represent a significant opportunity for the crypto industry and for investors, as they provide a convenient and cost-efficient way to access the world’s largest cryptocurrency. They also have the potential to attract new institutional and retail investors to the crypto space, increasing the liquidity, adoption, and credibility of Bitcoin.

With that said, spot Bitcoin ETFs face a number of challenges and risks to investors, given that the ETFs will not provide cover from the embedded risks that are inherent in the digital asset industry. This is because in the eyes of the regulators (specifically the SEC) Bitcoin does not meet the criteria to be defined as a “security”. Consequently, spot Bitcoin ETFs are not covered by the Investment Company Act of 1940 and so investors in these ETFs are not afforded the protections that they enjoy when they hold more conventional investments.

For example, the prospectus for the iShares Bitcoin Trust (IBIT) describes a critical and risky aspect of the create/redeem process as follows:

"The Trust will create Shares by receiving Bitcoin from a third party that is not the Authorized Participant and the Trust—not the Authorized Participant—is responsible for selecting the third party to deliver the Bitcoin. Further, the third party will not be acting as an agent of the Authorized Participant with respect to the delivery of the Bitcoin to the Trust or acting at the direction of the Authorized Participant with respect to the delivery of the Bitcoin to the Trust. The Trust will redeem Shares by delivering Bitcoin to a third party that is not the Authorized Participant and the Trust—not the Authorized Participant—is responsible for selecting the third party to receive the Bitcoin. Further, the third party will not be acting as an agent of the Authorized Participant with respect to the receipt of the Bitcoin from the Trust or acting at the direction of the Authorized Participant with respect to the receipt of the Bitcoin from the Trust. The third party will be unaffiliated with the Trust and the Sponsor...The Prime Execution Agent facilitates the purchase and sale or settlement of the Trust’s Bitcoin transactions. Bitcoin Trading Counterparties settle trades with the Trust using their own accounts at the Prime Execution Agent when trading with the Trust."

What all this suggests (and why investors should take note) is, because of the fractured nature of how digital assets transact, that the success of a critical link in the operational chain cannot be guaranteed. And while we will not go into the mechanics of typical, standard ETFs, suffice it to say that trade and settlement are not left to “unaffiliated third parties”.

And as such, we conclude that investors in these 11 new ETFs are subject to the same risks as investors in the underlying digital assets themselves:

• Regulatory uncertainty: The SEC has approved the spot Bitcoin ETFs under the condition that they comply with the Securities Act of 1933, the Securities and Exchange Act of 1934, and the Commission’s rules regarding cryptocurrency. However, the SEC has also expressed its skepticism and caution about the crypto industry, and has warned investors about the risks involved in investing in Bitcoin and crypto-related products. The SEC may also impose additional requirements or restrictions on the spot Bitcoin ETFs in the future, or even revoke their approval, depending on the market conditions and the regulatory environment.
• Market volatility: Bitcoin is known for its high volatility, as its price can fluctuate significantly in a short period of time, due to various factors such as supply and demand, news and events, speculation, and manipulation. Investing in spot Bitcoin ETFs exposes investors to the same volatility risk as investing in Bitcoin directly, and may result in substantial losses or gains. Investors should be prepared for the possibility of extreme price movements and have a long-term perspective when investing in spot Bitcoin ETFs.
• Operational risk: Spot Bitcoin ETFs rely on third-party custodians to store and safeguard the Bitcoins backing the ETFs. While these custodians are professional and regulated entities that provide insurance coverage and regular audits, investors should understand the underlying risks involved related to trade, pricing and settlement of the coins held by each ETF.

Finally, from the GBTC Factsheet risk disclosures: “Digital assets represent a new and rapidly evolving industry. The value of GBTC depends on the acceptance of the digital assets, the capabilities and development of blockchain technologies and the fundamental investment characteristics of th digital asset. Digital asset networks are developed by a diverse set of contributors and the perception that certain high-profile contributors will no longer contribute to the network could have an adverse effect on the market price of the related digital asset.”

BIS Digital Asset Classification

New challenges persist beyond the wide range of quality among digital asset regulators. Despite notable strides, risks endure, particularly in the global circulation and trading of digital assets. The heightened exposure of Bitcoin ETFs to underlying risks emphasizes the need for a comprehensive understanding of evolving standards.

As major financial institutions prepare for new Basel Committee on Banking Supervision standards by January 1, 2026, the landscape becomes more intricate, categorizing Cryptoassets into 4 risk classes (Group 1a & 1b and Group 2a & 2b), with the 2’s presenting higher levels of operating risk and directly affecting a bank’s capital requirements.

Source: Basel Committee on Banking Supervision

Bitcoin's placement in Group 2, specifically subgroup 2A, confirms the necessity for institutions to adapt risk management strategies that are in line with the elevated risk that is assigned by this new classification, which goes into effect in January 2026. This new set of standards would then place all spot Bitcoin ETFs in group 2A, given that Bitcoin is essentially all that they hold.

Why is this important? Because regulators will require financial institutions to report their exposure to Group 1 and Group 2 Cryptoassets as their exposure to them will need to be limited and disclosed. In the words of the Basel report, “A bank’s total exposure to Group 2 Cryptoassets must not exceed 2% will apply the more conservative Group 2b capital treatment to the amount by which the limit is exceeded. Breaching the 2% limit will result in the whole of Group 2 exposures being subject to the Group 2b capital treatment of the bank’s Tier 1 capital and should generally be lower than 1%. Banks breaching the 1% limit.”

Digital Asset Global Regulatory Risk - Update

While it is appropriate to describe the digital asset industry as “heavily” regulated, it is also accurate to describe digital asset regulation as “complicated”. Truth be told, there are now 100’s of regulatory agencies worldwide that are doing their best to keep up with several different categories of market participants, with varying degrees of success. But the reality is that, given its attraction for bad actors, regulating the crypto industry is a challenge and financial institutions that facilitate trading and custody of digital asset ETPs should be aware of this added layer of risk.

As such, CRB Monitor has developed a model which applies “quality” scores to many of the world’s largest licensing authorities. A summary of this model can be found in our August 2023 article Applying Risk Ratings to Digital Asset Regulators. In a nutshell, financial institutions are wedged between a rock and a hard place, craving a transparent, regulatory framework while trying to accommodate the needs of their clients and shareholders to hold crypto assets. And while these institutions expand their participation in the still-nascent digital asset industry through custody, trading, and even new digital asset issuance, the desire for greater transparency and a global regulatory framework persists. This table (updated through 5/31/2024), which contrasts the degree and effectiveness of regulators in digital asset space, highlights the differences in risk across most of the largest regulatory authorities, and brings to light one of the hidden challenges associated with investing in a spot Bitcoin ETF.

Relative Quality Scores – Global Regulatory Authorities - 5/31/2024

Source: CRB Monitor, Regulatory Authorities 

As crypto investors begin to wade into this vast sea of operational risk and volatility, there are a number of considerations that will be essential components of compliance and risk management beyond those required for typical ETF investing. Rather, it can be assumed that an investment in a spot Bitcoin ETF is akin, from a risk perspective, to an investment in Bitcoin itself. And it should not be overlooked that Bitcoin is actively traded on global exchanges of varying qualities and degrees of regulation, and as such lends itself to illicit activity. CRB Monitor reviews global regulators of crypto activity on an ongoing basis to ensure that our clients are fully aware of all the embedded risks in this volatile space.

Wondering what a Tier 1, Tier 2 or Tier 3 DARB is?

See our seminal ACAMS Today white paper Defining ‘Digital Asset-related Business’ and Digital-Asset Related Businesses - What Financial Institutions Need to Know