Primer: An Overview of the Bitcoin Investment Fund Landscape

Financial advisors who manage $31 trillion require compliant access to bitcoin. Are we there yet?

19 min readJun 29, 2020

Bitcoin exists as a self-sovereign, cryptographically verified digital asset that can be easily acquired and stored on a mobile phone. For retail investors, this convenience comes with a number of drawbacks, specifically around the risk of theft or loss. For professional asset managers such as financial advisors and institutional investors to get exposure to bitcoin, they have to satisfy a very high bar of legal and regulatory compliance. This paper and supplementary data will attempt to outline various fund structures and the current offerings.

Investment funds simplify the process of acquisition, custody and management of digital assets.
Various investment structures and legal constructs exist between public, private and international offerings.
Examples of funds include Exchange Traded Funds (ETFs), OTC Traded Trusts (OTC), Exchange Traded Notes (ETNs), and Private Placements (PPs) will be discussed further.

Until the SEC approves a rule change to allow a bitcoin ETF, there will be trade-offs to that investors will need to evaluate.

Almost all investors — retail, financial advisors and institutional investors prefer pooled investment products for ease and oversight of exposure to a new asset. It is difficult and inconvenient to store bars of gold, buy 500 individual shares of stock or make a small loan to an emerging market country. For investors who are simply interested in allocating a percentage of their portfolio to digital assets such as bitcoin, there are investment funds that are available to various levels of market participants. If we compare bitcoin to gold as this paper does in reference to the launch of an ETF, investors primarily just want asset price exposure, not always physical ownership. We may be witnessing this today as bitcoin custody flows away from digital asset exchanges and into derivative markets that provide leverage and decreases counterparty risk since less bitcoin is required to be in the exchange’s custody.

Over the last five years of my career — exclusively dedicated to digital assets, I have seen a general pattern that younger, more tech-forward individuals are more eager, educated and accepting of bitcoin. I teach a graduate level class at Pepperdine University titled Digital Assets Finance. My students were far more informed and excited about bitcoin than I expected. Research¹ from Charles Schwab clearly shows that millennials are allocating to bitcoin in higher amounts than stocks like Netflix or Microsoft. This data doesn’t even count the 30 million uses who have traded $150 billion on Coinbase, the largest digital asset exchange in the United States.

Of the 420,000 financial advisors in the United States and Canada managing $31 trillion according research² by McKinsey, only 25% of them are under the age of 44.

Bitcoin Investment Thesis

Uncorrelated Asset. Modern Portfolio Theory is a widely used analysis of how investors should expect a level of return based on a corresponding level of risk, charted out across an efficient frontier. Assets that fall below this theoretical portfolio allocation line fail to provide enough return for a level of risk. Bitcoin is one of the few assets that has historically been above that line, offering a higher amount of return based on the same level of risk of other assets. This concept is also captured in the Sharpe Ratio, that measures returns in excess of a risk-free unit of risk. According to a study³ by Bitwise Asset Management, adding only 5% of bitcoin to a traditional 60% equity / 40% bonds portfolio results in a Sharpe Ratio of 0.71, compared to only 0.31 without bitcoin over the last six years.
Digital Gold. Gold has been a popular investment for thousands of years due to its durable store of value. The fascination with gold has existed since the Egyptians first used gold bars as money as early as 4000 BCE. Investors often flock to gold during stressful periods of “flight to safety” to protect against inflation and preserve wealth. Gold and bitcoin are similar in the borderless transfer, not controlled by any one government and limited supply. Whereas bitcoin shows more promise into the future with internet based transfer rails, near unlimited divisibility and low storage costs.

Institutional Capital

There is no shortage of top Wall Street investors only recently speaking out about their investment thesis for bitcoin:

Paul Tudor Jones wrote a letter⁴ to investors in May 2020 outlining a “growing role for Bitcoin” in his inflation hedges along with treasuries, currencies and commodities. 30% of the letter was dedicated to his investment thesis in bitcoin.
Renaissance Technologies, a $75 billion quant hedge fund led by mathematician James Simons, submitted an SEC filing⁵ in March 2020 that would allow the flagship Medallion Fund to get exposure to bitcoin.
Chris Wood, the Global Head of Equity Strategy for Jefferies, a top investment bank, told investors⁶ in April 2020 to buy bitcoin in as a “hedge against central bank manipulated fiat money.”
JP Morgan authored a 74-page research paper⁷ in February 2020 saying, “The crypto market continues to mature, and cryptocurrency trading participation by institutional investors is now significant.”
Fidelity Digital Assets recently published a survey⁸ concluding in March 2020 of 800 institutions found nearly 80% of institutional investors see the appeal of digital assets.

Types of Bitcoin Funds

Exchange Traded Funds (ETF)

ERROR 404: Bitcoin ETF Not Found

ETFs give investors a low cost, highly liquid vehicle to passively invest in a diversified basket of securities like stocks, bonds or commodities on major exchanges such as NYSE and NASDAQ. The most popular ETFs replicate stock indices like the S&P 500, NASDAQ or MSCI. According to research⁹ by Morningstar, passive investment ETF inflows were +$407 billion for the trailing twelve months ending April 2020. Actively managed mutual funds witnessed outflows of -$386 billion during the same time. ETFs have exploded in popularity over the last 10 years.

Bitcoin’s rapid and controversial entry into investment funds vehicles is reminiscent of gold 20 years ago. In 2003, ETFS Metal Securities Australia Ltd (ASX ticker: GOLD) was the first gold ETF approved and offered to investors on the Australian Stock Exchange. Today, the fund has $1 billion of assets under management (AUM), a paltry amount by ETF asset manager’s standards. In 2004, 18 months later, the SPDR Gold Trust (NYSE ticket: GLD) launched and now has $58 billion of AUM. Unfortunately for Aussies, the ‘first mover’ advantage did not resonate across borders, in spite of the GOLD fund being available at brokerages in the United States.

Source: World Gold Council, Bloomberg as of May 31, 2020

This chart illustrates the phenomenal growth of fund flows into gold ETFs and the direct causation of price inflation. It is widely speculated (an appropriate descriptor for digital assets) that a similar pattern of global investment and price appreciation could follow the launch of a bitcoin ETF.

The sought after bitcoin ETF is one of the most popular, yet contentious issues surround digital asset investment.

After numerous applications for a rule change and public debates by a multitude of sponsors and stakeholders, the SEC has essentially quashed the concept of a bitcoin ETF in February of 2020 saying the proposal is not consistent with the current rules that are “designed to prevent fraudulent and manipulative acts and practices, and to protect investors and the public interest”.

Early applications from groups like the Winklevoss Twins in 2016 were denied due to the insufficient amount of qualified custodians for bitcoin. As of today, that is largely solved with almost a dozen qualified custodians in the United States, including firms like Fidelity Digital Assets, Coinbase and BitGo.

Groups like Van Eck, Bitwise and Wilshire Phoenix were sent home from Washington (in that order) primarily because they could not satisfy the SEC’s concern surrounding market manipulation in bitcoin trading venues. Prior to listing an ETF, an applicant must show that the stock exchange that will list an ETF has entered into a surveillance sharing agreement with a “regulated market of significant size” for bitcoin. Because most bitcoin trading venues are unregulated (and some emphatically anti-regulation), this has been difficult to obtain. Efforts continue and many believe that pathways exist to get over this hurdle, but none have succeeded to date. The most recent denial of NYSE Arca / Wilshire Phoenix application for a hybrid bitcoin / treasury bill fund centered around this issue of market manipulation.

Staunch supporters of the bitcoin ETF include Hester Peirce, SEC Commissioner who diligently outlined her dissent¹⁰ saying the denial “deprived investors (particularly retail investors) of the ability to access bitcoin in markets within our regulatory framework…to drive entrepreneurs…to other jurisdictions”. She says the SEC wanders into “dangerous territory of merit regulation” with this rule change denial.

“We recognize bitcoin’s attractive investment merits, but until there is an SEC approved ’40 Act fund that passes our compliance, we will likely remain on the sidelines.” says Jason Labrum, founder of Intelligence Driven Advisors wealth management group.

Over The Counter (OTC) Trusts

A grantor trust (“trust”) is a legal structure that appoints trustees to exercise authority over owned assets and the operations. Trusts differ from corporations in that investors do not have statutory rights in the trust that a shareholder in a corporation would over management or the board of directors. An investment in a trust is limited to an ownership claim on the underlying assets. The trustee, sponsor, brokers, transfer agents, custodian, largely enjoy limited liability, asset insulations and bankruptcy remote characteristics.

As an example of bitcoin trust (GBTC), the sponsor (Grayscale) issues shares to authorized personnel (Genesis Trading) that offer those restricted shares to accredited investors under the 506(c) exemption. After six month, those shares become unrestricted and are allowed to be quoted on the OTC secondary market (OTCQX) and are free to be sold to non-accredited investors through their broker dealers, (i.e. Fidelity, Robinhood).

Some trusts we will explore are limited to Qualified Institutional Buyers (QIBs), a higher burden of “sophistication” than accredited investors. QIBs include banks, trust funds, pension plans or any entity composed of sophisticated investors with assets of at least $100m or broker dealers with at least $10 million.

The most invested bitcoin fund structure of a trust is “closed ended” which is a pooled portfolio of assets that is raised on a fixed amount of capital. Traditionally, closed ended fund sponsors do an IPO for a fixed amount of shares. When a new investor places an order on the secondary market, the trade is routed to a broker dealer that has pre-existing inventory of the fund shares. Since the price of the shares are determined by both the 1) Net Asset Value (NAV) of the underlying assets and 2) supply and demand of the shares, closed ended funds commonly trade at a premium or discount to the NAV. In the case of GBTC discussed below, investors who purchase shares in the private placement rely on Rule 144 safe harbor to sell their restricted shares to the public when certain conditions are met.

Most all of the proposed ETF rule change applications are also structured as trusts, but their goal is to trade on the major exchanges such as NYSE and NASDAQ. Investors can get access to bitcoin trusts on OTC markets such as OTCQX upon the fund 1) having its shares gain FINRA Form 211¹¹ approval and 2) having met the reporting requirements¹² of the OTC Markets, which are much easier to satisfy than a public securities offering registration with the SEC.

Trade-offs include:

Lower liquidity which usually results in high bid / ask spreads for increased transaction costs. On average, the NASDAQ trades about $200 billion daily, compared to about $1 billion on OTC markets.

The aforementioned ETF applicants have their eye on the prize of the immense investor base that major US exchanges provide access to.

Closed end funds do not allow investors to redeem shares back to the issuer at par value (although some make tender offers or buyback in the open market). Divesting of shares usually only happens in the secondary markets where the price may be more volatile than the NAV.
Loss of certain regulatory protections afforded to SEC registered issuers under the Securities Act of 1933. OTC Trusts and the later discussed private placements are exempt from registration under the Securities Act. Therefore, there are no or limited reporting requirements about shareholders actions, management activities and asset composition. Companies like Grayscale have progressed in this regard by gaining status as a Reporting Company pursuant to Form 10 Registration Statement with the SEC.

Exchange Traded Notes (ETN)

ETNs are non-equity, unsecured debt obligations issued by financial sponsors that are designed to track the return of an index or underlying asset such as a commodity or currency. Investors can buy certificates from the sponsor directly as well as indirectly from secondary markets on exchanges. The proceeds from new investors are used to 1) buy the underlying bitcoin, 2) enter into derivatives contracts and/or 3) enter into swap agreements with counterparties that provide price exposure. The certificate is essentially like a debt obligation where the fund makes a guarantee to the investor (in addition to their counterparties, lenders, etc) to make them whole on the certificate. Unlike the closed-end structure of a trust, ETNs are open ended to allow for the redemption of shares. You may also see category of Exchange Traded Products (ETP) but most of the digital asset offerings are structure as debt obligations. Even the SEC had an issue with the ambiguous ETP label when Coinshares’ bitcoin and ether Tracker One funds were suspended¹³ from trading on US markets.

Private Placements (PP)

Outside of Grayscale’s GBTC fund, bitcoin investment products in the United States are largely limited to accredited investors in Private Placements (PPs), namely under the 506(c) exemption¹⁴ from SEC registration. The typical bitcoin investor, tech forward Millennials do not always fall into these traditional, some say archaic constructs for measuring if an individual is financially “sophisticated”, according to the SEC. There is a proposed rule change¹⁵ to include individuals who passed a securities license exam, but this still lacks diversity and inclusion for millions of Americans.

PPs are considered non-exempt securities (usually requiring registration) but they are done mainly through a Regulation D exempt transaction. While many rules and conditions exist for Reg D, the overarching oversight is to only sell to accredited investors and to submit very basic information to the SEC about the offering and issuers. In 2012, the Obama administration passed the Jobs Act that separated Reg D into two different offering exemptions:

506(b) allows issuers to sell to a maximum of 35 self-verified non-accredited “sophisticated” investors who had a prior relationship with the issuer (presumably to discourage solicitation) and disclose a ton of financial and other information. Issuers are not permitted to use websites, social media or any public marketing of the offering.

The SEC’s vague “sophisticated” interpretation requirement that investors ”must have sufficient knowledge and experience in financial and business matters” might be the most ambiguous and malleable securities regulation since they started writing rules over 100 years ago.

506(c) offerings can only be sold to accredited investors but the burden of verifying accredited investor status is put on the issuer, what Emma Channing of Consensys Digital Securities calls “…the real sting in the tail”. If a single non-accredited investor slips through, the SEC will require Form 10 registration for a public security or be held in breach of offering an unregistered, un-exempt security. The substantial benefit of the 506(c) exemption is the ability to make public solicitations of the offering, a highly impactful consideration in a world of mass digital communication.

ETFs, ETNs and OTC unrestricted trust shares can all be held in tax-advantaged accounts such as IRAs and other retirement funds. Private placements, restricted shares or units of funds commonly offered through the 506(c) exemption do not qualify for tax-advantaged accounts.

OVERVIEW OF BITCOIN FUNDS

Grayscale Investments GBTC

Grayscale Investments is the largest asset manager of bitcoin and digital assets in the world. With $3.4 billion of assets under management (as of June 26, 2020), the Grayscale Bitcoin Trust (GBTC) is larger than the next investment product by a 5x multiple. Led by Barry Silbert, founder of the acquisitive Digital Currency Group conglomerate, Grayscale’s entrance into bitcoin asset management in 2013 provided a first-mover advantage.

GBTC is one of the largest US traded securities on OTC Markets with $761 billion traded in April 2020 alone, edging out names like Fannie Mae, Freddie Mac and foreign issuer ADRs such as Heineken and Adidas. Although issuers with shares traded on OTC markets have reporting requirements¹² such as financial statements prepared “by persons with sufficient financial skills” (i.e. unaudited), Grayscale recently¹⁶ registered GBTC with the SEC as a Reporting Company, requiring much more stringent and transparent reporting disclosures.

GBTC is still not accessible on major US exchanges like NYSE or NASDAQ, which limits certain institutional investors (insurance companies, pension funds) from investing in its public quotation. The upgraded reporting status shows that Grayscale is moving in the right direction to broadening the investor base.

GBTC trades in the secondary market at a price higher than the NAV of the underlying bitcoin holdings, mainly due to the lack of a redemption feature. Over the last five years of existence, the average premium was 39%, traded as high as 132% and as low at -0.34% but rarely at par or 0%. GBTC is often used by hedge funds due to the arbitrage opportunity¹⁷ to buy the primary issuance at par value and sell it to the public market for a premium six months later — if the premium still exists.

Coinshares’ Bitcoin Tracker One COINXBT

COINXBT is the first synthetic tracking investment product to be approved by regulators and listed on a major exchange. The fund was listed on Nasdaq OMX in Stockholm in May 2015. CoinShares is considered the leading digital asset fund sponsor in Europe. The firm is led by Daniel Masters, a former energy trader, venture capitalist and digital asset evangelist.

The fund’s premium or discount to NAV varies slightly but tends to stay closer to zero due to 1) the open-end redemption feature and 2) the market making function of affiliated companies. These market makers have certain levers such as negative inventory to bring the price close to the NAV. The continued discussion around trade-offs applies here as COINXBT may not be 100% backed by physical custody, the narrow trading range to NAV provides an efficient investment vehicle for bitcoin.

In addition to being available for OTC trading, shares of COINXBT are putable to the issuer, meaning an investor can always sell their shares back. This process can happen in 40 days at the minimum after written notice before month-end and eventual payout 10 days after the following month. There is also a 2% exit fee deducted from the NAV. Again, trade-offs.

3iQ’s The Bitcoin Fund QBTC

QBTC is the first asset backed bitcoin fund to be approved by regulators and listed on a major exchange. The fund was listed on the Toronto Stock Exchange in April 2020 (Ticker: QBTC_U) after a long legal battle with Canadian provincial securities regulators. The company is led by Fred Pye, a seasoned asset manager who brought gold and commodity listed products to Canada in the 1980’s. QBTC offers investment units in the trust (similar to shares) via Class A units for all investors, Class B and Class F units for investment managers or institutional accounts who integrate an additional fee structure. Primary unit issuances come with a 5.5% fee on A units and 3.5% fee on F units to pay the distribution agents. Units sold in the primary market are limited to QIBs, but anyone with a brokerage account that has access to Toronto Stock Exchange (Fidelity, Charles) is able to source shares on the secondary market. From the United States, there are additional commissions and fees associated with the transaction.

QBTC is similar to GBTC — not just in the name but in the trust legal structure and unrestricted share trading. Where it differs is in 1) increased issuance regulatory oversight and 2) major exchange traded. QBTC is approved by the Ontario Securities Commission, a regulatory achievement that only Coinshares can also claim. 3iQ is both sponsor and trustee of QBTC. This dual mandate may add an additional level of fiduciary duty and direct legal liability to 3iQ’s management and business practices.

Bitwise Investments Bitcoin Fund

With diverse management roots in both technology and finance, Bitwise is one of the more publicized digital asset managers and applicants of the bitcoin ETF. An in-depth presentation¹⁸ to the SEC on exchange volume, custody options and digital asset market dynamics asserted Bitwise’s thought leadership to many market practitioners. Although they are better known for the Bitwise 10 Crypto Index, both as a private placement and the forthcoming OTC listing (pending FINRA’s approval of their Form 211¹¹), Bitwise offers a bitcoin private placement via the Reg D, 506(c) exemption for SEC registration.

Accredited Investors contribute cash or bitcoin into the fund in exchange for units in the LLC on a weekly basis. Annual management fees are 1.5% but decrease to 1.0% for subscriptions of $1 million or greater. Units can only be acquired through the sponsor and do not trade on secondary markets. The LLC fund structure provides management with certain liability indemnification and exclusive control not found in the trust structure. It also allows investors to buy and sell the fund units at par value.

Honorable Mentions

Van Eck’s SolidX Bitcoin Trust 144A Shares¹⁹ trade under ticker XBTCZ on a private OTC market only available to QIBs. The open-end trust is the only DTC eligible security but the rich 2.9% annual fee and limited access may be contributing to AUM of less than $1 million.
Wilshire Phoenix recently filed an S-1²⁰ for the Bitcoin Commodity Trust. The issuer seeks to differentiate from GBTC by offering monthly redemptions, DTC custody and a low 0.90% management fee. Wilshire Phoenix is using the “Emerging Growth Company” qualification²¹ under the Jobs Act legislation to lessen registration requirements for disclosure, reporting and audits.
Previously known as Amun, 21 Shares offers a bitcoin ETP that trades on the Swiss SIX exchange. The shares have fairly low liquidity and are not available in the United States.
ETC Group recently launched the Bitcoin Exchange Traded Crypto (BTCetc) fund on Deutsche Borse’s main XETRA exchange.
Better known for their venture fund investments, Pantera Capital launched a bitcoin fund way back in 2013. The fund is based on the Cayman Islands and also includes bitcoin cash as a result of a fork of bitcoin in August of 2017.

Conclusion

Bottom line — getting investment exposure to bitcoin is hard, if not impossible for many financial advisors. Bitcoin custody relies on complicated technology and multi-level security protocols. Financial advisors are not able to manage private keys or even open exchange accounts on behalf of clients. A bitcoin ETF has the opportunity to unlock billions of managed capital in the United States. The SEC Chairman, Jay Clayton’s term ends in June, 2021. Unless something topsy turvy²² happens in the interim, it is unlikely we will see an ETF under Chairman Clayton’s rule.

Financial advisors who believe in the investment catalysts of bitcoin will have to “run the gauntlet” of complicated, if not impassible compliance stipulations. Advisor’s have to balance their risk appetite and fiduciary duty to clients with the compelling investment attributes of bitcoin.

“In Bitcoin’s first decade, investment advisors could get away with zero allocation. But in a world in which a hard-money asset like Bitcoin may prove to be one of the best defenses against infinite money printing, Financial Advisors have to ask themselves whether their clients can afford to wait for the perfect product.” — Andy Edstrom (CFA), Financial Advisor and author of “Why Buy Bitcoin”²³.

About the Author

Tom Lombardi has over two decades of experience in investment banking, principal investing and emerging technologies, most recently focused on bitcoin. He is an adjunct professor of finance at Pepperdine University, teaching Digital Asset Finance to MBA students. He was formerly the Head of Growth for the Enterprise Ethereum Alliance, working with global companies on how to embrace blockchain technology. Tom started his career as an investment banking analyst with Bank of America. After graduating from the Graziadio Business School at Pepperdine University, Tom worked at West Partners, a $500 million private equity firm.

Tom is an avid student of securities laws and financial regulations, particularly related to digital assets. He holds Series 63, 65 and SIE active securities licenses. Tom lives in Santa Monica with his wife and two young boys.

https://twitter.com/tomlombardi
https://www.linkedin.com/in/tom-lombardi/

Tom regularly conducts presentations with wealth management firms to educate financial professionals about the thesis and opportunity for allocating client assets to bitcoin. Feel free to reach out to schedule a session.

References

A big thanks to the following people who contributed to this paper: Arnold, Marissa and the team @ Grayscale, Townsend Lansing @ CoinShares, Matt Hougan @ Bitwise, Fred Pye @ 3iQ, Emma Channing @Consensys and Andy Edstrom @ WESCAP Group.

[1] Schwab Report: “Self-Directed 401(k) Balances Hold Steady; Millennials Allocate More to ETFs and Cash Than Gen X, Boomers”

[2] McKinsey Digital: Paper — “On the cusp of change: North American wealth management in 2030”

[3] Bitwise: Paper — “The Case for Bitcoin in an Institutional Portfolio”

[4] Paul Tudor Jones: “May 2020 BVI Letter — Macro Outlook” (posted by CoinDesk)

[5] Renaissance Technologies: Form ADV — disclosure of bitcoin investment

[6] The Block: “Buy some bitcoin ahead of the halving, says Jefferies’ head of equity strategy in new note”

[7] JP Morgan: “Blockchain, digital currency and cryptocurrency:
Moving into the mainstream?”

[8] Fidelity Digital Assets: Survey — “Growing Number of Institutional Investors Believe That Digital Assets Should Be A Part Of Their Investment Portfolios”

[9] Morningstar: “A Look at the Road to Asset Parity Between Passive and Active U.S. Funds”

[10] Hester Peirce: Filing — Dissenting Statement of Hester M. Peirce in Response to Release №34–88284; File No. SR-NYSEArca-2019–39

[11] FINRA: Form 211

[12] OTC Markets: Reporting Requirements

[13] SEC: Public Statement Statement on Order of Suspension of Trading of Certain Bitcoin/Ether Tracking Certificates (CoinShares)

[14] SEC: Rule 506 of Regulation D

[15] SEC: Amending the “Accredited Investor” Definition

[16] Grayscale Investments : Press Release — Grayscale Bitcoin Trust Becomes SEC Reporting Company

[17] Keegan Toci: Paper — “GBTC: Arbitraging Regulators and Retail Investors Since 2015”

[18] Bitwise: Presentation to the U.S. Securities and Exchange Commission

[19] Van Eck: SolidX Bitcoin Trust 144A Shares

[20] Wilshire Phoenix: Form S-1 Registration Statement for the Bitcoin Commodity Trust

[21] Wilshire Phoenix: SEC’s “emerging growth company,” as defined in Section 2(a)(19) of the Securities Act

[22] NY Times: “Jay Clayton, Low-Profile Regulator, Is Catapulted Into a Political Fight”

[23] Andy Edstrom: “Why Buy Bitcoin” book

Disclaimer: This content is provided for informational purposes only, and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisers as to those matters. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services.