We remain confident that we will see the first US-based/regulated bitcoin Exchange Traded Fund (“ETF”) backed by physical ownership over the next twelve months. The global demand for ETF structures, across all asset classes, is likely to be replicated with bitcoin (and, over time, other leading digital assets). This can only be supportive for the sector as it brings incremental new demand through increased investor adoption but also as it encourages research coverage and other value-add services most other asset classes currently take for granted. We believe the evolution of the ETF market for gold is the most relevant precedent which suggests around 6.0% of bitcoin, or just over 1m bitcoins based on current supply, could be held within the bitcoin ETF market as it matures — at current prices, and removing the coins already held in ETF/ETF-like structures this suggests around US$5.1bn of incremental demand.
The Global ETF Market
The increasing preference of retail investors globally to use ETFs to gain asset class exposure has seen substantial growth in the size of the ETF market and the assets (both class and geography) they provide access to. Over the last decade the industry has grown from US$700bn in Assets Under Management (“AUM”) to an estimated US$4,400bn — this translates to compound annual growth of around 22% over the last nine years:
We believe this growth has been driven by three primary factors:
- Poor Active Manager Performance: Managers in traditional securities classes have struggled to deliver consistent outperformance in central-bank dominated, low volatility/low-rate markets;
- Lower Costs: the low fees that ETFs can offer, given their formulaic selection model and execution, have attracted investor inflows — the benefit of these low fees has been magnified in a low interest rate/return environment; and
- Broadens Portfolio Options: ETFs have made it easier for retail investors to buy alternative assets and assets in offshore jurisdictions using established and relatively efficient channels, such as online brokers, that they are comfortable using and are integrated within their existing portfolio monitoring/reporting/tax regimes.
Whilst the rise in ETF ownership is not without problems (Jesse Felder has written some good articles on this), it is undeniable they are a popular product with global retail investors and are likely to remain a key structure within portfolios going forward.
We believe it is inevitable that ETFs are launched and become a popular way to gain exposure to digital assets. Retail avenues to physical bitcoin ownership (and other digital asset) remain relatively expensive with both high fees and spreads over liquid USD market prices. ETFs are likely to provide a cheaper entry, at or around net tangible asset value, with marginal ongoing management costs. An ETF will also remove (or at least dramatically reduce) storage risk by taking this responsibility away from individuals, who may have limited technology affinity, and “outsourcing” it to professionals with scaled security budgets and the ability to seek insurance protection.
Whilst we enjoy trading on the leading bitcoin exchanges and think the interfaces developed are innovative and always improving, our team has decades of experience trading in open-order book markets and understands placing, managing, and adjusting varying order types — for the broader potential investor pool this can be a significant hurdle. Access to bitcoin through familiar retail brokerage channels and interfaces will enhance the accessible investor pool.
With regard to existing products, Grayscale and XBT Provider's products have scale and combined assets of around US$1.8bn, but they both suffer from regulatory shortfalls. Grayscale is not listed on a broadly accessible exchange and has historically traded at significant premiums to its net asset value (partially validating the investor demand for this structure) whilst XBT Provider is a derivative construct that inherits some form of credit risk due to its structure. We believe demand will be significantly higher for products on regulated global exchange with physical ownership of bitcoin.
Will a bitcoin ETF receive regulatory approval soon?
Given the regulatory benefits of bitcoin ETFs over the existing markets in which bitcoin is traded (disclosure, regulatory approval/monitoring, incorporation in the existing tax reporting channels) we are surprised global regulators have not been more proactive in assisting ETF developers. To date, the key hurdle, in our opinion, both in the USA and many other jurisdictions, has been the lack of a bitcoin price determined on a regulated exchange. This was made clear in the SEC response to the Winkelvoss Bitcoin Trust — an extract of which is below:
“The Commission believes that, in order to meet this standard, an exchange that lists and trades shares of commodity-trust exchange-traded products (“ETPs”) must, in addition to other applicable requirements, satisfy two requirements that are dispositive in this matter. First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated”
This was again reiterated in comments made by the Chairman of the SEC, Jay Clayton on CNBC on 6 June, 2018 where he mentions price setting in an unregulated market as a key hurdle.
The race has commenced to launch regulated bitcoin exchanges with existing major and well financed players like Coinbase and Poloniex involved. Traditional exchanges, such as ICE and NASDAQ, have also signalled intent. It appears to only be a matter of time before bitcoin is traded on an exchange regulated in a manner the SEC would approve of. This will remove the SEC’s key concern and should facilitate the issuance of widely distributed ETFs in the US. This precedent, and a regulatory acceptable USD bitcoin price, will also likely see the launch of ETFs in other regional markets.
How large can the bitcoin ETF market become?
If bitcoin ETF products are inevitable, what size can the market grow to and will it make a difference to the current market dynamics?
As shown earlier, the current global market for ETF’s is estimated at US$4.4trn but this figure includes assets with markedly different risk and return profiles to bitcoin that represent much bigger portfolio allocations than bitcoin would receive. With this in mind, searching for assets that have a comparable demand/investor profile we believe the right precedent to consider is the development of the ETF market for gold given the similarities:
- Store of value: bitcoin is increasingly being seen, at least by the investment community, as an alternative or new form of gold/store of value;
- Bespoke storage required: bitcoin, like gold, needs alternative storage venues/formats that differ to the current broker/custodian channels and also, like gold, carries bearer risks; and
- Alternative asset: for the time being, bitcoin is seen by most investors as an alternative asset and is therefore likely to have a similar portfolio allocation (over time) or compete within that allocation with gold.
To understand the potential scope it is worth analysing the current gold market, its size and the level of investment and ETF activity. Putting the gold market in perspective, according to the Thomson Reuters GFMS Gold Survey of 2018:
- Total supply: there is 190,400 tonnes of gold above ground as-at the end of 2017 which, at current prices is worth around US$7.9trn;
- Non-investment stock: From this total supply, this survey estimates 113,500 tonnes, or 59.6% of this gold, is fabricated in jewellery (90,200 tonnes) and industrial products (23,300 tonnes);
- Investor market: Removing the distortions of hedging, we estimate that leaves around 76,900 tonnes held as investments by retail investors (bullion and coins), ETFs and central banks with gold ETFs accounting for around 2,484 tonnes of this as-as the end of May 2018 (according to the World Gold Council);
Bitcoin can’t (currently as least!) be used as jewellery or in commercial fabrication and we do not believe there will be any material central bank investment in bitcoin in the short to medium term so translating the above estimates to bitcoin suggest, in our opinion, that the Private Holdings and ETF tonnes are the most relevant segment for analysis (the non-central bank investor market for gold). In a bitcoin context Private Holdings are analogous to the physical bitcoin holdings of retail and institutional investors either stored on exchanges or in personal wallets.
Adding Private Holdings and ETF gives an estimate of the “store of value” market for gold, which, excluding Central Banks, is around 41,300 tonnes or around 22.1% of all gold supply. As an aside this has a value of around US$1.7trn at current prices which, at the current bitcoin supply, on a like-for-like basis, implies a bitcoin price of a little over $101,000.
Getting back to the central question, if you equate the total amount of gold held as a store of value by non-central bank investors, ETFs currently represent around 6.01% of this tonnage. If we extrapolate that 6.01% of bitcoin will be held in ETFs that equates to demand of around 1,026,713 bitcoins or, at current prices, total demand of around US$6.7bn amongst global ETF investors. Removing the holdings of Grayscale and XBT Provider (at NTA value) from this suggests incremental demand of around 780,000 bitcoin or US$5.1bn.
This analysis clearly relies on a number of estimates and is a broad estimate only but we believe the conclusion represents a realistic medium-term figure. Bitcoin is an asset well suited to ETF investing and ETF distribution channels are now highly efficient so we would also expect the market to develop relatively quickly. Whilst we remain focussed on the fundamental drivers of bitcoin’s value — namely tech improvements and user adoption — it’s helpful to also analyse significant potential market/investor-driven catalysts that can materially impact adoption and market-assessed value.