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What Is ETF (Exchange-Traded Funds) in Crypto Industry?

October 23, 2022
10
min. read

What is a cryptocurrency ETF and how does it work?

An ETF (Exchange-Traded Fund) allows an investor to invest in an exchange-traded ready-made asset portfolio. Since the ETF is compiled by professionals, it is well-balanced in terms of the profit-risk ratio and allows those who want to quickly invest money in a particular sector of the economy not to waste their time and effort on analytics.

ETFs typically comprise stocks and bonds, but there are other ETFs where precious metals (gold, silver, platinum, etc.) can be used as assets. An investor does not need to buy and store physical gold, since this is the task of the fund itself, whereas buying and selling an ETF on an exchange is as easy as buying or selling a stock or a bond.

As the crypto industry developed, a natural idea arose to launch a cryptocurrency ETF. Their convenience is also based on the fact that the investor does not need to puzzle over how to enter the cryptocurrency market - it is enough to buy a suitable crypto ETF.

What is a cryptocurrency ETF?

What is an ETF in the crypto industry? Crypto ETFs can include a portfolio of assets related to the crypto industry, with a certain balance of risks along with some diversification. There are also single-asset ETFs. For instance, the first registered cryptocurrency ETF for Bitcoin (BTC) began trading only at the end of 2021. It tracks the price of Bitcoin futures launched in 2017 and traded on the Chicago Mercantile Exchange (CME).

As of the beginning of 2023, all registered crypto ETFs are not invested in cryptocurrencies directly - the SEC does not approve such applications. Such ETFs track the prices of crypto assets indirectly, for example, through futures or shares of companies related to the crypto industry (e.g., the Coinbase exchange).

There are over-the-counter cryptocurrency funds, but these are riskier forms of investment and they are not ETFs.

How does a cryptocurrency ETF work?

Ideally, a crypto ETF should own cryptocurrencies and tokens like an ETF for precious metals, then investors get an easy way to invest in the sector without buying physical assets (e.g., Bitcoin or gold). However, crypto industry regulation is rather vague, while pricing, according to the regulator, is opaque, and the possibilities of reliable reporting are limited. Therefore, the emergence of such ETFs is unlikely at this time.

Nevertheless, Bitcoin futures or shares of mining equipment manufacturers, large mining companies and companies like MicroStrategy investing directly in Bitcoin objectively reflect the market condition and may well act as ETF assets. However, while the futures price usually doesn’t differ much from the price of the underlying asset, the volatility of mining companies' shares in the fall 2021 cycle turned out to be about 4 times higher than the volatility of Bitcoin itself.

Investing in such funds is critically important for companies, since most cannot afford to invest in crypto assets directly, like Tesla does. Crypto ETFs can be interesting in terms of the profit-risk balance, especially for those without an ardent desire to dive deeply into the subject of cryptocurrency.

Why are ETFs important?

ETF meaning in cryptocurrency shouldn't be underestimated. Since cryptocurrencies are still partially outlawed, and each country has its own view on the crypto industry, the emergence of crypto ETFs is very important in terms of crypto asset adoption by regulators as a new phenomenon in the financial world. The approval of the first Bitcoin futures ETF was essentially a revolution. Later on, BITO Valkyrie (BTF) and VanEck (XBTF) were added to the list.

The approval of the first Bitcoin futures ETF was essentially a revolution
as of the ending of 2022

However, most ETFs focus on shares of high-tech companies that are in one way or another connected with the crypto industry. These securities are usually very responsive to trends, but at the same time, being accumulated in ETFs, they provide an excellent opportunity to implement a long-term investment strategy in cryptocurrency-related technologies.

Regulatory status of cryptocurrency ETFs

Today, the main role in the process of global cryptocurrency adoption is played by the SEC and its head Gary Gensler, who, unlike the many market titans (e.g., Warren Buffett and to an even greater extent Charlie Munger) has relatively progressive views on the crypto industry. Nevertheless, the SEC should protect investors, and not get them into trouble, so cryptocurrency adoption in terms of regulatory status is proceeding in minimal steps. Therefore, the emergence of cryptocurrency ETFs is a significant breakthrough, since, albeit indirectly, cryptocurrencies have entered the legal market.

Today, the main discussion is whether a particular cryptocurrency is a security from the SEC's point of view. If so, it should be regulated by a relevant law, as a result of which it practically ceases to be a cryptocurrency, losing all its inherent features - anonymity, decentralization, freedom, etc. Bitcoin is the only cryptocurrency that the SEC does not consider a security (perhaps not yet) a priori.

Therefore, Bitcoin futures ETFs today are probably the best that the legal market can offer for traditional investors who want to invest in cryptocurrencies. Do not expect pleasant surprises from the SEC - most likely, regulatory pressure on the crypto industry will only increase, but the ETFs already traded now are the most legitimate means of investing in the crypto industry.

Cryptocurrency ETFs benefits

Owning cryptocurrency entails additional risks. The investor must figure out how to buy cryptocurrency, how to store and how to sell it. In addition, it is advisable to figure out how to report and how to pay taxes. Owning cryptocurrency means a constant threat of losing your funds as a result of fraudulent actions, phishing, hacker attacks, etc. Cryptocurrencies are not protected by the state like bank deposits, so investors purchase them at their own risk.

In this sense, crypto ETFs are an ideal opportunity to avoid technical problems and risks associated with owning crypto assets directly. When dealing with ETFs, an investor pays out minimal commissions, and at the same time doesn’t need to immerse himself in any of the subtleties of working in the cryptocurrency market.

ETFs for high-tech companies are not only an investment in cryptocurrencies, but also in technology in general, e.g., in blockchain technology. The risks of such investments are largely diversified, since the crypto industry does not only include cryptocurrencies, but also entire segments, e.g., metaverses, ecosystems, blockchains, etc.

There are no ambiguities in ETF taxation and, regardless of the jurisdiction, it is extremely clear to the investor. Mining or staking cryptocurrencies can cause great difficulties when trying to calculate income tax or capital gains.

ETFs are as liquid as ordinary stocks or bonds, so an investor can easily buy or sell them at any time. When working on the stock exchange, it may be more convenient for an investor to manage securities and ETFs on the same platform, without spreading his attention over many assets.

Cryptocurrency ETFs alternatives

ETFs are intended for a wide range of investors and traded on exchanges, and there are many tools for professional investors on the so-called over-the-counter (OTC) market. Typically, they are distinguished by a high entry threshold, a certain discount on the price of the underlying assets, or even a temporary lock after purchase.

On the OTC market, trading is carried out through a broker-dealer network. Assets that do not meet the listing requirements of official exchanges are traded here, i.e., the Bitcoin Investment Trust (GBTC) - a closed-end fund that owns Bitcoins on behalf of investors.

Bitwise products are also focused on certain cryptocurrencies and allow investors to indirectly own them. Bitwise also offers the Bitwise Crypto Industry Innovators (BITQ) ETF, which includes shares of companies related to the crypto industry.

One of the closest ways to direct cryptocurrencies ownership is investing in companies that themselves have Bitcoins on their balance sheet. This includes Elon Musk's Tesla (TSLA), but the most prominent one is Michael Saylor's MicroStrategy (MSTR), which owned 132,500 Bitcoins at the end of 2022.

Comparing ETFs and mutual funds

Mutual funds are funds that buy assets with the funds of their depositors. Mutual funds can be focused on a particular industry. The participation of a large number of small investors in a mutual fund, as well as its professional management, reduce the overall risk of investments. At the same time, mutual fund investments are more difficult to understand, and carry more variable values that can influence the final result.

The ETF does not have an actual manager, since the composition of an ETF does not change. Accordingly, commissions when working with ETFs are minimal, whereas when working with a mutual fund they are quite high, since a mutual fund requires constant management by a professional team.

Active management of a mutual fund implies increased uncertainty, since it can lead to both high profits and significant losses due to the actions of managers. An ETF’s behavior is more predictable: once you buy it, you will own the same product from that point on, while with participation in a mutual fund, your product will be constantly modified.

Also, active mutual fund management may result in an increased tax burden, e.g., capital gains tax. Anyway, mutual funds are designed for professional players, whereas ETFs are aimed at the widest range of investors and are easier to understand.

What is ETF? FAQ

Are cryptocurrency ETFs safe?

Yes, crypto ETFs are more secure than cryptocurrencies themselves, because by buying an ETF, you remove the risk of losing access to your wallet or of it being hacked, the risks of erroneous transactions, the risks of working with exchanges, etc. If you don’t want to get into the intricacies of working in the cryptocurrency market, crypto ETF is perfect for you, since it’s a ready-made product compiled by professionals.

Is owning a Bitcoin ETF the same as owning Bitcoin?

The Bitcoin futures ETF is an absolutely legal product that an investor can buy to have the maximum possible connection with Bitcoin as such. The price of this crypto ETF is closely aligned with the price of the underlying asset, however, it does not follow it to a T. In addition, owning Bitcoin forces you to pay more attention to security, since Bitcoins need to be stored somewhere. Owning an ETF is almost completely free from risks in terms of security and technical problems.

Can you lose money investing in ETFs?

Any investment involves risk, so even ETF ownership does not protect you from losing your funds. Nevertheless, an ETF is the safest and most legal way to invest in cryptocurrencies, since it does not require technical knowledge of the cryptocurrency market, and has a clear legislative framework. While investing in ETFs, you can lose funds only if the market collapses, whereas investments directly in cryptocurrencies - can be lost as a result of technical errors, malicious intent and other factors unrelated to the asset’s price behavior.

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