What are cryptocurrency ETFs and how do they work

May 10, 2022 Fortuna Capital

Exchange traded funds or Exchange Trade Funds (ETFs) are among the newest investment instruments with cryptocurrencies today. They offer multiple advantages, among them, and perhaps the fundamental one, the possibility of capitalizing on this type of investment in highly liquid markets such as The Wall Street.

The ease they offer for their purchase or sale and their low transaction costs make cryptocurrency ETFs very attractive and efficient investment instruments to diversify the portfolio of any investor.

Like traditional ETFs, these funds require registration with the United States Securities and Exchange Commission (SEC), as open investment companies, in accordance with the provisions of the Investment Company Act of 1940.

Since its release on the market, with the approval of the product presented by ProSahares (Bitcoin Strategy Fund – BITO), on October 19, 2021 in the United States, Bitcoin futures ETFs have become increasingly popular tools among institutional and retail investors.

The supply of cryptocurrency ETFs continues to grow and there are high expectations regarding their future value and contributions to the growth of the crypto industry. As regulators approve ongoing projects, the market will continue to diversify and grow.

In this article we explain everything you need to know about Bitcoin ETFs and other cryptocurrencies to start trading in the market of your choice.

What are cryptocurrency ETFs?

They are one of the most anticipated financial tools in the crypto industry. Cryptocurrency ETFs are making it easier for traditional investors and Bitcoin enthusiasts to access the digital currency market.

This is because they are less complex to understand than cryptocurrencies themselves and are well established financial products that the markets understand. This allows investors to have access to the asset class in a form that they already understand.

The first antecedent of cryptocurrency ETFs was presented in 2013. That year, the Winklevoss brothers filed an application for approval of this type of financial product before the SEC. The SEC refused their application at that time.

Multiple benefits with potential risks

According to experts, both the benefits and the potential risks involved in cryptocurrency ETFs are multiple. While on one hand, ETFs are well understood, the underlying asset aren’t always well known and understood. The absence of a strong regulatory framework for cryptocurrencies is also an area of concern globally.

Currently, in addition to the US, ETFs are listed on several markets such as Germany, Liechtenstein, the Jersey Islands and Brazil. But they are not yet available in India, although they can be purchased in global markets through mutual fund companies.

Until there is a law regulating them, it is very likely that Indian asset management companies will not launch crypto ETF projects, industry experts say.

How do they work?

For the new investor it is important to know how cryptocurrency ETFs work. These investment instruments facilitate the process of exchanging securities on the stock market. They operate like any other type of listed asset, for example shares. The fundamental characteristic of ETFs is that they are traded on secondary stock markets. Cryptocurrency ETFs, like other mutual funds, track the performance of one asset or a group of assets.

You don’t buy the asset but its value

In other words, the investor does not buy the asset or token itself, but the value that marks its price. We can exemplify as follows. A Bitcoin ETF will track the price of the cryptocurrency which is worth $40,000 at the time.

By buying a part of it, the investor makes a profit when its price rises to $42,000. Or it loses when it trades below the purchase price. The investor does not need to buy bitcoins themselves but to play with the volatility of its price.

In simpler terms, Bitcoin ETFs allow traditional investors to integrate into the cryptocurrency markets and the reverse is happening as well. Crypto is becoming main stream and becoming a part of the traditional financial asset class.

No wallets required

Another advantage of cryptocurrency ETFs is that their holders do not require a wallet to store these digital assets. They also don’t have the worry that their funds might be hacked or stolen. The security aspects of cryptocurrencies must be covered by crypto exchanges.

Regarding the legality of operation of an ETF, it is imperative that the company that issues it is legally established. That is, it must have an operating license issued by the country’s regulatory authorities. For example, the United States Securities and Exchange Commission (SEC).

Difference Between Cryptocurrency ETFs and Cryptocurrency Index Funds

Although it is true that both tools are very similar with respect to their objectives, there are also clear differences. The main difference between cryptocurrency ETFs and index funds is in the way they perform this task. Let’s see:

• Trading on the stock market like a stock, an ETF can be bought or sold at any time. While an index fund operates like a traditional mutual fund that can be subscribed to and redeemed once a day.
• The funds available in an ETF must be fully invested within a market. On the other hand, in an index fund, a percentage of the funds must be set aside as a mandatory liquidity requirement.
• ETF trading fees are generally lower. Although commissions must also be paid for purchase – sale later, because they are passive management instruments.
• On the other hand, the taxation of ETFs and index funds is different. ETFs have a more flexible tax treatment than mutual funds, because they have a unique structure.
• By creating and redeeming shares with in-kind transactions, ETFs are not properly considered sales. Therefore, they do not generate taxable events. Except when an ETF is sold, you do have to pay taxes there.
• Investments or purchases in ETFs are made month by month. While in index funds, contributions can be made periodically to increase participation.

How are ETF prices determined?

Exchange-traded mutual funds sell futures contracts. They are basically agreements between two parties to exchange a contract unit of the cryptocurrency, in this case bitcoin.

These funds, in turn, create stocks whose prices are based on the current price of a contract unit. It then offers them on an exchange platform where they are traded.

For the purposes of the investor, the calculation of the price of ETFs is not very different from certain purchases that we make in daily life. There are two concepts that the investor must keep in mind when investing: the Market Price and the Theoretical Value.

For example, imagine buying a late-model car that you’ve wanted all your life. The first thing you will surely ask the seller is how much it costs. That is the market price that the seller has established according to a series of marketing parameters.

You may find that the value of the car is a bit high and you want to determine with certainty it’s true price. Then get an appraisal of the vehicle. Several values ​​come into consideration there: engine, assembly, seat materials, technology, etc.

After doing this analysis and comparing prices, you will have a price that you can consider fair to pay for the car. The same happens with the determination of the Theoretical Value of an ETF or NAV (Net Asset Value), which clearly indicates what the approximate fair value of an ETF is in the market.

How to buy and sell cryptocurrency ETFs

Investing in cryptocurrency ETFs requires consultation with a stockbroker that offers them or an expert financial advisor. Don’t forget that Bitcoin ETFs are traded on traditional exchanges not cryptocurrency exchanges.

There are several Bitcoin ETFs available that are listed on the ARCA New York Stock Exchange and on Nasdaq such as:

• Proshares Bitcoin ETF Strategy (BITO).
• Valkyrie Bitcoin ETF (BTF) Strategy.
• VanEck Bitcoin ETF Strategy (XBTF).
• Global X Blockchain and Bitcoin ETF Strategy (BITS).

Other ETFs listed on stock exchanges in Europe and America are:

• iShares MSCI Brazil Capped (EWZ)
• iShares MSCI EAFE (EFA)
• iShares MSCI Emerging Markets (EEM)
• iShares MSCI Eurozone (EZU)

The latest Bitcoin ETF was approved by the SEC on April 6. This is the Teucrium Bitcoin Futures Fund (BCFU) project, presented by the Teucrium Trading firm. But there are many more similar companies and projects that will surely be added to this growing list this year.

The composition of these ETFs is not only Bitcoin futures. These funds also invest in traditional securities and hold BTC futures contracts as part of their strategy and when they are profitable, as is the case with the Proshares ETF.

The companies that manage these crypto assets and many investors still dream that an ETF for bitcoin and other spot cryptocurrencies will soon be approved, which would provide direct exposure to the cryptocurrency and not indirect as is currently the case.

Before investing in these instruments, investors are advised to fully understand the tax consequences of ETFs so that they can be proactive with their strategies. Also, talk to a trusted financial advisor who allows you to navigate the pros and cons of these instruments.