In the traditional market, index investing in vehicles such as exchange-traded funds (ETFs) has become highly popular over recent years as an accessible and low-cost means of gaining broad exposure to a market or asset class. However, launching a cryptocurrency-backed ETF has proven to be a regulatory challenge for issuers. This article examines the case for cryptocurrency index investing and the current state of digital asset index investing in major trading jurisdictions.
Investing in so-called “physical” cryptocurrencies, as in purchasing the digital asset itself rather than any derivative product, comes with inherent risks. Centralized exchanges are well-documented points of failure, while self-custody comes with its own operational headaches. Not only are private keys at risk of loss or theft by hackers, but the need to spread risk across multiple accounts whilst also trying to achieve best execution makes it more operationally difficult for portfolio managers to run a single portfolio in the manner of traditional Asset Managers.
Therefore, as soon as Bitcoin began to reach prices that made it attractive to a broader base of investors, operators in the cryptocurrency space have been seeking ways to make it easy to invest in cryptocurrencies without necessarily taking custody of the underlying assets.
ETFs based on major stock indices emerged in the early 2000s and now represent a global investment market worth over $10 trillion. They allow investors to purchase shares in a fund representing a particular index, with some of the most popular tracking major indices like the S&P500 or the FTSE100. As ETFs are traded on exchanges, they are regulated financial products that must be approved for issuance by financial authorities. This has proven to be the biggest inhibitor to the emergence of Bitcoin ETFs and other digital asset index investment products. However, over the last year or two, there has been some encouraging progress.
Switzerland’s regulated digital asset industry has fostered a thriving crypto ETP industry, and there are currently around 150 crypto-related products listed on the Swiss SIX exchange tracking all large-cap cryptocurrencies and various bundles thereof. All are under the supervision of FINMA, the Swiss Financial Market Supervisory Authority.
Canadian regulators have also been particularly forthcoming in allowing the issuance of crypto-backed ETFs, with the Ontario Securities Commission having approved Purpose Investment’s Bitcoin ETF in March 2021, the first of its kind in the world. Since then, it’s been joined by similar products issued by Evolve, Fidelity, and 3iQ.
EU legislators have not made any specific rulings regarding Bitcoin ETFs, and there are no explicit provisions governing digital asset index investing in the upcoming Markets in Crypto Assets Regulation, set to come into force in 2023. However, regulators have approved the issuance of cryptocurrency exchange-traded products on a case-by-case basis at the state level, meaning that investors in the bloc now have a range of options.
Deutsche Börse-operated Xetra was the first regulated platform to begin listing exchange-traded notes tracking crypto products in the summer of 2020. It now lists crypto-linked ETNs from 13 providers tracking twenty single assets and nine bundles.
In June, Jacobi Asset Management issued Europe’s first Bitcoin ETF, tradable on Amsterdam’s Euronext exchange and regulated by the Financial Services Commission in Guernsey. The fund is fully collateralized with Bitcoin and held in custody with Fidelity Digital Assets.
The refusal of the US Securities and Exchange Commission (SEC) to approve a Bitcoin ETF has been a longstanding bone of contention for would-be issuers in the digital asset sector. The Winklevoss brothers were the first to file an application nearly a decade ago in 2013, but many others have tried and failed since. The most recent refusal was in December 2022, when the regulator rejected a proposal from Grayscale to convert its Bitcoin Trust into a spot ETF.
The SEC’s argument has always been that the Bitcoin spot markets are unregulated and, therefore, could be subject to fraud or manipulation. However, in 2021, the regulator did concede approval for the first-ever ETF based on Bitcoin futures on the basis that there is an established, regulated market for Bitcoin futures in the US on the Chicago Mercantile Exchange. So in October 2021, ProShares became the first issuer of a regulated Bitcoin futures ETF. Since then, others, including Valkyrie and Van Eck have followed suit.
While Bitcoin futures ETFs should, in principle, broadly follow the markets, there have been scenarios in the past where Bitcoin futures prices have experienced contango or backwardation, where contract prices deviate from the spot market rates, a phenomenon that occurs more frequently close to a contract expiry date. Where this happens, investors in ETFs can find they end up paying substantial fees for the cost of rolling over contracts that may outstrip any gains.
The UK FCA has not approved any Bitcoin ETFs or synthetic ETFs such as those now available in the US. The closest products that UK investors will find to a Bitcoin ETF are funds that invest in blockchain or cryptocurrency-related companies. While the value of such companies can broadly follow similar trends to the digital asset markets, they cannot be guaranteed to track prices.
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