Cash or In-Kind? Spot Cryptocurrency ETP Mechanics
James B. Francis, CFA, Chief Research Officer, CRB Monitor
Peter Simcox, Senior Analyst, CRB Monitor
In our most recent entry to the Chart of the Month blog, the CRB Monitor Securities Research team provided a 6-month update of our original article from February 2024 regarding the launch of 11 new spot Bitcoin ETFs. We reviewed performance, relative size and growth in the market, and correlations amongst the participants, while providing an update on the regulatory environment related to investors who hold these and other crypto-themed exchange traded products (ETPs). We don’t want to sound self-serving, but it was quite an informative piece.
One might ask, therefore, why come back so soon with another crypto ETP-related article? The fact is that there is quite a bit of concern from financial institutions that have chosen to invest in cryptocurrency exchange traded products (ETPs), that stretches beyond fund performance and quantitative risk measures. Furthermore, it is important to note that the universe of exchange traded products is broad and existed for years prior to the 11 new US-listed spot Bitcoin ETFs. [As a side note, this list has since been expanded to include the US listings of 9 new Ethereum-based ETFs.]
The pie charts below provide an illustration of the current crypto-themed ETP landscape. Interestingly, these pie charts pull from the same data set, which is the current universe of more than 350 ETPs that are covered by CRB Monitor. The pie chart on the left is the breakdown (by cryptocurrencies) of approximately $81 Billion in AUM held by the ETP universe. The pie chart on the right represents the number of ETPs that holds each of the 52 cryptocurrencies that make up their collective crypto exposure.
Here's why we care about this: It is important to note that while a large percentage of the underlying ETP exposure is in just a few cryptocurrencies (see the pie chart on the left), the 351 ETPs that we track hold, collectively, 52 different flavors of crypto (see the pie chart on the right). This is critical to institutions that must monitor underlying cryptocurrency exposure, as they understand that even the smallest holdings in non-Bitcoin, non-Ethereum assets must be monitored for their individual contributions to risk. And furthermore, they need to be aware of how each exchange traded product works operationally, and more specifically, how it handles settlements of spot cryptocurrencies, as it will have a profound impact on risk to institutions, particularly those that custody these ETPs for their clients.
Financial institutions that seek exposure to cryptocurrencies via investment in crypto-themed ETPs have become increasingly aware of a number of risks associated with this investment choice. While these ETPs are themselves technically not spot cryptocurrencies, we would argue that they are no less risky, as there are embedded risks in crypto-themed ETPs that investors might not be aware of, and we have written about these in prior articles (see our recent Chart of the Month).
In a nutshell, because cryptocurrencies are not considered “securities” by US regulators, spot crypto ETPs are not covered by the Investment Company Act of 1940. As such, investors in spot crypto ETPs are not afforded the standard protections under the 40 Act. This becomes a very big deal when an ETP faces a significant operating loss due to a break in the create-redeem process, or a settlement failure in the facilitation of a shareholder liquidation. In those cases, shareholders of the ETP could very well face absorbing any losses incurred due to operational breakdowns.
We therefore present this analysis on a rather narrow but essential area of risk: Crypto-Themed ETP mechanics, and more specifically the Creation/Redemption process and Shareholder Liquidations, and why financial institutions seem more interested than ever in these processes.
ETF Mechanics, in a Nutshell
While this article is not intended to be an exhaustive primer on the operating procedures of exchange traded products, there are some basic concepts that are important for investors to understand, particularly the Creation and Redemption functions [we have referenced an ETF.com page that provides a summary of the processes]. These two events are the main reason why these ETPs are popular, as they are beneficial from both an operational and a tax perspective. The benefit comes from the fact that these transactions are accomplished via in-kind transfers of shares that occur away from the open market, which simplifies valuation and minimizes capital gains taxation.
It is for this reason that spot crypto ETP issuers (like BlackRock, Fidelity Investments, and WisdomTree) favor in-kind settlement (over cash settlement), and have gone so far as to lobby US regulators to approve in-kind settlement for US-listed spot crypto ETPs. For example, early in 2024 Blackrock (the issuer of the largest spot Bitcoin ETF in the US) made its feelings known about the prohibition of in-kind settlement for the 11 new spot Bitcoin ETFs listed in the US in January.
With that said, in-kind settlement of cryptocurrency amounts to something of an operational nightmare for financial institutions that provide custody services for ETPs. The reason for this is that fund custodians generally lack the necessary infrastructure (specifically, a crypto wallet) required to deliver and receive physical cryptocurrency in client accounts. That problem goes away when a crypto-themed ETP opts for Cash Creations/Redemptions and Cash Liquidations for all shareholder activity. Financial institutions are wildly in favor of settlement in cash, in spite of the fact that it places investors and issuers at a less advantageous position from a valuation and tax perspective. And that is why spot crypto-themed ETPs that allow in-kind settlement have landed on institutions’ restricted lists.
Now let’s take a quick look at what happens under the hood when a trade is submitted to buy or sell a significant quantity of a conventional (allows in-kind) ETP, which triggers a creation or redemption.
Source: CRB Monitor, ETF.com
ETP creations and redemptions require the actions of two main players: Authorized Participants (APs) and ETP issuers. Creation: To create (buy) shares, APs purchase and deliver a basket of securities to the issuer which represent the ETP's holdings and in turn they receive newly created ETP shares, which they in turn sell on the open market at their own risk. Redemption: To redeem (sell) shares, APs purchase and deliver ETP shares to the issuer, receiving in exchange a basket of securities which represent the ETP's holdings. Because it requires movement of shares in kind (therefore avoiding the open market) the creation/redemption process helps keep the ETF's market price in line with its net asset value (NAV). It also provides liquidity and flexibility to investors, allowing them to enter or exit ETF positions efficiently, typically at prices closely aligned with the underlying assets' values. An added benefit to moving securities in-kind is the avoidance of capital gains taxes, which would have been triggered if the underlying basket were traded on the open market. [Note: the process of converting ETPs to shares and vice-versa is completed by a designated transfer agent].
Cash Creation: For cash creation, APs provide cash (rather than physical assets) to the ETP issuer, who then uses this cash to purchase the underlying cryptocurrency on the open market. The APs receive ETP shares in return, which represent ownership of the newly acquired cryptocurrency. The AP can then in turn sell the newly-issued ETPs on the open market at their own risk. Redemption: To redeem (sell) shares, APs purchase and deliver ETP shares to the issuer, then the issuer must sell the underlying basket of cryptocurrencies on the open market (the risk is to the ETP). The sale proceeds are then moved out to the AP and transferred to the investor.
For crypto-themed ETP Liquidations, which include those for a single shareholder or a complete fund closure, the process is simpler but institutions will need to know each fund’s rules for this process as well. And like the creation/redemption process, for financial institutions in-kind liquidations of cryptocurrencies can be operationally problematic.
While the differences in these two operational processes (cash vs. in-kind transactions) are subtle, when cryptocurrencies are involved they are consequential to institutions and therefore it is essential for them to fully understand the methodologies used by each fund when establishing compliance and monitoring procedures for their global custody accounts.
The following table is a snapshot of the current universe of 351 crypto-themed ETPs, broken down by their methodology for the creation/redemption process (left) and liquidations (right). Financial institutions can take comfort in that roughly 62% of the universe settles cash-only for the creation/redemption and liquidation processes; however, identifying which funds follow each methodology is the tricky part and requires not only an initial analysis of each prospectus but ongoing monitoring as this space evolves.
[Recall that the ETP issuers are currently lobbying for US regulators to approve in-kind crypto settlement for these ETPs, which could conceivably happen in due course. CRB Monitor maintains this list and will provide updates whenever an issuer announces a change to their methodology.]
As crypto investors begin to dip their toes 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 ETP investing. Rather, it can be assumed that an investment in a spot cryptocurrency-themed ETP is akin, from a risk perspective, to an investment in the underlying cryptocurrency itself. And it should not be overlooked that these cryptocurrencies are actively traded on global exchanges of varying qualities and degrees of regulation, and as such lend themselves to illicit activity and operational pitfalls. CRB Monitor researches, curates, and maintains a wealth of risk-related data for our institutional partners who need essential information about this emerging investment space.
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