1. Introduction
2. What is a spot bitcoin ETF
3. Working of spot bitcoin ETF
4. Differentiating Spot Bitcoin ETF Vs Futures Bitcoin ETF
5. Advantages of Spot Bitcoin ETFs
6. Potential Downside of Spot Bitcoin ETFs
7. Global Market Overview
8. Potential Impact of a Spot Bitcoin ETF
9. Conclusion

Introduction

In 2013, The Winklevoss Bitcoin Trust made a filing for the first Bitcoin ETF, but the first Bitcoin ETF was approved in 2020 and was listed on the Bermuda stock exchange. Since then, the crypto industry has moved leaps and bounds. The first Bitcoin Spot ETF was launched on August 15, 2023 in Europe. However the spot Bitcoin ETF is yet to be approved in the United States.

If you are an investor or a financial advisor, you might know about the incoming changes in the traditional financial sector. The recent interest of investors in Bitcoin Spot ETF is increasing as the approval from SEC is coming soon. More and more traditional financial institutions and individual investors want to invest in the crypto markets but the technical nitty gritty and the non-regulated space acts as a barrier. The increasing interest in bitcoins calls for an investment tool which can offer exposure to institutions and funds. This can be made possible by using spot Bitcoin exchange-traded funds (ETF).

Different types of Bitcoin ETFs exist in the market. The futures ETFs are approved by the Securities and Exchange Commission (SEC) and are gaining more traction. They track the contracts speculating on the future price of bitcoin and do not offer actual ownership of bitcoin. Near the expiration date they are settled or exchanged for the new ones.

What Is a Spot Bitcoin ETF

A spot Bitcoin Exchange Traded fund (ETF) is an investment instrument that allows the regular investors to invest in Bitcoin without directly investing into the cryptocurrency. The traditional investor will thus not have to know about the technicalities of maintaining and securing a digital wallet. The spot Bitcoin ETF directly invests into bitcoin as the underlying asset, and not into the derivatives derived from the price of bitcoin. It is like owning bitcoin.

These ETF can be traded on the stock exchange through the brokerage account of the traditional investors. The broker will have the custody of the asset. This allows the investors to make certain investments and gain without having to navigate through the complexities of a crypto exchange. This can allow a whole new fund flow since traditional investor will be more willing to trade and acquire a taste of the digital currency.

Working of Spot Bitcoin ETF

Spot Bitcoin ETFs aim to mirror the price of bitcoin. They have bitcoin as their underlying assets. Spot Bitcoin ETFs hold the bitcoins securely in digital wallets and are managed by the custodian. In the beginning the ETF buys the bitcoin from the holder or from the cryptocurrency exchange and stores them in the digital wallet. This trade is cleared and settled through the sub-custodian.

The ETFs then issue a number of shares according to the amount of bitcoin it holds. The price of the ETF should reflect the prevailing market price of the cryptocurrency. They track the prices as closely as possible by rebalancing its holding (buying or selling the cryptocurrency as per the demand). 

The amount of units needed according to the demand is provided by the market makers (or Authorised Participants). They are typically large financial institutions, which buy/sell the cryptocurrency according to the demand. Market Makers will decide the buy/sell price and the number of ETF units to be created or redeemed. If the price of the ETF varies from the original price of the cryptocurrency, then the market makers arbitrage the difference so that the ETF price aligns with the price of the cryptocurrency. 

An investor can buy the spot bitcoin ETF on the exchange just like any stock. The market is kept in check by the market makers. They maintain the liquidity in the market and ensure a stable market where investors can buy or sell easily. 

Spot ETFs will allow the traditional investors to come and invest in bitcoin. This means more money will flow into the crypto industry which allows for better growth. The investors on the other hand will not have to be worried about securing the private keys and other technical challenges while managing cryptocurrency.

Differentiating Spot Bitcoin ETF Vs Futures Bitcoin ETF

Spot Bitcoin ETF tracks the prices of bitcoin directly. Bitcoin is the underlying asset in this case. In the case of bitcoin Futures, the ETF gives investors a chance to invest in bitcoin derivatives. The futures ETF provides exposure to Bitcoin’s price movement through futures contracts rather than direct ownership of the crypto. 

Advantages of Spot Bitcoin ETFs

• Increased Liquidity: When the mainstream investors will be able to trade bitcoin. A spot Bitcoin ETF would increase the liquidity of the market which makes the price movement more predictable and less volatile
• Better Ease of Access: Removing the technical barrier will allow more traditional investors to invest in this asset class. Investors can have exposure to bitcoin without having to buy the cryptocurrency or managing it in a digital wallet. This means that less tech savvy investors can also participate with their traditional brokerage accounts.
• Regulatory Oversight: Purchasing Bitcoin directly from the exchange and storing in your wallet, this is without the backing of standard regulations. Bitcoin ETFs are regulated financial products. This way, the investor can invest in the market with less risk of potential fraud or theft.
• Transparency and Security: ETFs provide more security to investors otherwise investing directly in bitcoin because they are subject to regulation and standardised reporting.
• Market Legitimization: The Bitcoin ETF will increase the acceptance of this asset among the traditional investors as a recognised asset class. This could also mean more demand for Bitcoin as the ETF providers will actually have to purchase the bitcoin from the exchange. This could even drive up the price of bitcoin.

Potential Downside of Spot Bitcoin ETFs

• Tracking Error: Since the spot ETF will mirror the real time price of Bitcoin, there can be instances when the cryptocurrency is overpriced or underpriced with respect to the ETF share price. This can be due to certain market factors like liquidity in the market or rebalancing the funds.
• Fees: The ETF providers will charge a management fee which can diminish the returns over time. The providers have to buy the bitcoin from the exchange, hence they have to pay the transaction fee to the exchange, this may lead to higher management fees. This is absent when you buy Bitcoin directly, but there may be potential storage costs. 
• Regulatory concern: Since the ETFs are highly regulated, it will react more closely to any of the regulatory changes in the market. Negative regulatory action can affect the price of the ETF which will affect the price of Bitcoin. There remains a great deal of uncertainty as to how the cases of fraud and theft will be handled.
• Market Manipulation: The ETFs do not provide protection for the inherent risk in the cryptocurrency market. Large Bitcoin holders will potentially try to manipulate the price of the ETFs and Bitcoin to benefit themselves, though this risk is present in the normal cryptocurrency market too.
• Security Risks: The ETF provider holds a substantial amount of Bitcoin with them. This will make them a potential target for cybercriminals. While they will use the safest possible storage options and high level of encryption, no system is impenetrable in the digital world. The stolen bitcoin can be swiftly transferred anonymously to other account and hence will be hard to recover without the trail,

Global Market Overview

The month of October Saw significant developments in the digital asset market. This was due to the heightened speculation that the SEC is soon going to approve the spot Bitcoin ETF. There was an increasing participation from the financial institution during the period. As a result the price of Bitcoin appreciated 28% month on month and achieved a year to date performance of over 108%. This was clearly seen in the upward trajectory of Bitcoin’s dominance. The percentage of Bitcoin’s market cap compared to the total market cap of digital assets peaked in October at 53%. This marks the highest level for Bitcoin since April 2021.

October saw less trading supply of bitcoin. The percentage of bitcoin held by long term investors reached 76%. This means that more than two-third of the circulating supply was not involved in any transaction in the past five months. There is limited market liquidity because it was observed that a considerable number of market participants were moving there holding in long term holding wallets (in order to do minimum transactions and keep the asset safe). Considering that the long term participants in bitcoin are more seasoned investors, they are hesitant to book the profit now, which can mean that there can be a potential upward trend in the near future which they are looking to capitalise on. 

The tradable supply of bitcoin is decreasing and there is growing interest from new market participants like the traditional financial investors. All this can drive the price of Bitcoin forward given that long term holders have also produced illiquidity in the market. 

With the increasing geopolitical tensions and war in different parts of the world, there exists various macro uncertainties. Bitcoin, deemed as a digital gold is evident in changing its correlation with different traditional assets. During the month of October, the 30 day correlation between gold and bitcoin was averaged at 0.65, indicating a similar price movement pattern. In November, the 30 day correlation decreased but the 90-day trend remained consistent.

Additionally, as the global landscape leans more towards digitization, as evidenced by the rising number of internet users and increased online activity, the necessity for a non-sovereign asset is poised to grow. Whether it’s remote work, gaming, or engagement with the metaverse, internet users may increasingly seek a borderless, internet-native form of currency that isn’t dependent on restrictive centralised entities for value transfer. It’s noteworthy that the current 425 million crypto users make up just 8% of the population with internet access, indicating significant untapped potential. From a financial standpoint, it’s also worth highlighting that the market capitalization of bitcoin is a mere 9% of that of gold, showcasing substantial room for growth.

Bitcoin might serve as a hedge against governmental policy missteps, offering a non-sovereign alternative. This becomes particularly significant as fiscal and monetary interventions on a global scale become more substantial. The notion of Bitcoin as “digital gold” stems from its probably finite supply, suggesting that it could serve as a safeguard against inflation, negative interest rates, and other adverse consequences resulting from unconventional or potentially detrimental policies. While Bitcoin’s history is relatively brief to definitively establish its efficacy in this regard, there has been a notable correlation between the cryptocurrency’s price and inflation expectations, as depicted below. 

Potential Impact of a Spot Bitcoin ETF

Bitcoin stands as the non-sovereign reserve currency within the digital realm, offering a unique and cost-effective means for diversifying well-balanced investment portfolios, thereby enhancing overall risk-adjusted returns. Despite various avenues for exposure to this leading cryptocurrency, a notable gap has persisted—the absence of a U.S. spot bitcoin ETF, often deemed the holy grail of access.

So, what makes a U.S. spot bitcoin ETF such a significant opportunity? The sheer size of the U.S. capital markets plays a pivotal role. SIFMA (Securities Industry and Financial Market Association) estimates that the U.S. accounts for a substantial 40% of total global fixed income assets and equity market cap. Additionally, U.S. ETFs represent a greater percentage of total assets compared to other regions, constituting 7% of equity and fixed income assets, in contrast to 4% in Europe and 2% in Asia-Pacific.

In total, this amounts to a $7.0 trillion U.S. ETF market, several times larger than Europe’s $1.5 trillion market and Asia-Pacific’s $1.0 trillion market. Another perspective is that assets managed by broker-dealers, banks, and RIAs in the U.S. total nearly $50 trillion. Thus, even a small percentage of managed and brokerage assets flowing into a spot bitcoin ETF could have a substantial impact.

To gain a deeper understanding of why the crypto market is eagerly anticipating a spot ETF, it’s insightful to draw historical parallels with the creation of gold ETFs and their impact on the gold market. Gold, like Bitcoin, had a relatively fixed supply and was challenging for investors to access before the launch of the first spot ETF, the SPDR Gold Trust (GLD), by State Street Global Advisors in late 2004.

The SPDR Gold Trust quickly reached $1 billion in assets within three days, setting a record at the time, and currently holds around $55 billion in assets, equivalent to over 3,200 tonnes of gold, representing approximately 1.5% of the gold supply. While acknowledging that the analogy isn’t flawless, given differences in accessibility and market conditions, the introduction of a spot ETF significantly impacted the gold market, with gold’s price increasing over fourfold since the inception of the first spot gold ETF.

Similar to gold ETFs, a bitcoin ETF would simplify the process for a broader range of investors to access and invest in bitcoin. It eliminates the need for investors to directly purchase and store bitcoin, which can be a complex process, particularly for those less familiar with the technology. Before the advent of gold ETFs, investors had to resort to less efficient options like closed-end funds or investing in gold-related companies. With the introduction of a gold ETF, investor demand for gold surged. Similarly, a bitcoin spot ETF could lead to increased buying from retail investors.

Beyond increased accessibility, a bitcoin spot ETF could contribute to greater liquidity and trading volume in the bitcoin market. Improved liquidity and a more diversified investor base could help stabilise prices and mitigate volatility caused by illiquid market conditions. This shift in the investor base may move from tech-savvy retail investors and crypto enthusiasts to more mainstream, long-term investors seeking diversification from fiat currencies. The launch of a bitcoin ETF might catalyse further institutional adoption by delegating the acquisition and storage of digital assets to qualified custodians. The ETF structure, being a familiar and regulated investment vehicle, could encourage more hedge funds, asset managers, and pension funds to allocate capital to bitcoin.

Similar to how the gold ETF facilitated additional diversification in investor portfolios, a bitcoin ETF could serve a parallel purpose. Investors looking to diversify might allocate some of their assets to bitcoin through the ETF, viewing it as a store of value or an uncorrelated asset class. While this addition of bitcoin to investor portfolios may be relatively small percentage-wise due to the asset class’s youth and volatility, it could still represent a significant flow of capital into the cryptocurrency space.

Conclusion

The introduction of a bitcoin ETF signals the maturation of the market, indicating that bitcoin is transitioning from a niche asset class to one accepted and regulated within the traditional financial system.

Despite uncertainties surrounding ultimate approval, potential AUM (assets under management), and the subsequent impact on price, there is an anticipation that, similar to the transformative effect on the gold market, a spot ETF could be a game-changing moment for Bitcoin and digital assets as a whole. Notably, Bitcoin may experience a more significant impact on its price for each new investment dollar compared to gold in 2004, considering Bitcoin’s market cap is only 27% that of gold during that period.

Banking on the advantages of a spot ETF product and the transformative effect observed in the gold market, there is a sense that the world could be on the brink of a truly pivotal moment for Bitcoin and the broader digital assets space.