Oct 26, 2021
Bitcoin — ETF — Good or Bad?
Let’s start with the good. A Bitcoin ETF can be purchased and held in a Roth IRA for Bitcoin exposure that will not be taxed. Companies that aren’t allowed to hold BTC might be able to have Bitcoin exposure through an ETF. Companies that don’t know how to secure their own private keys could benefit from an ETF.
Ok, now let’s talk about the bad. The bad mostly stems from the ETF being based on Bitcoin futures, not a spot ETF, and being cash-settled, not physical delivery. Note that physical delivery (if it was allowed) would just require digitally signing the transfer of BTC on-chain which doesn’t require trucks, warehouses, etc.
I needed a crash course in futures, so I took one. Here are the nuts-and-bolts enough to understand the problem.
- Futures are contracts (just promises) for a specific amount of something delivered at a specific time. In this case Bitcoin, each month.
- These are cash-settled futures, it is just the promise to deliver an amount of cash that could buy real Bitcoin. BTC is not being delivered.
- People can either buy a promise now to get enough cash to buy bitcoin on a settlement date in the future, or they can sell now, get the cash, and promise to deliver enough cash to buy bitcoin on a settlement date in the future. The first is a bet that bitcoin will go up, and the second is a bet that bitcoin will go down. In neither case does any bitcoin change hands.
- The ETF is layered on top of this cash-settled Bitcoin futures market which means that the price is determined by the futures contract price. The futures contracts have to be settled between the futures markets participants and rolled from month to month.
So, I asked myself what this has to do with Bitcoin. The answer is not much. It is a side bet played with dollars. Does it track BTC? Yes, it should. Does it allow you to hedge a real bitcoin position and lock in gains if timed right? Yes. But it also increases the supply of exposure to BTC, therefore, changing Bitcoin’s market dynamics. When supply goes up and the demand stays the same, the price goes down. So, why did the price of BTC go up significantly on Tuesday October 19, 2021 when BITO began trading. Because of the news of an ETF being approved and going live, not because of Bitcoin cash-settled futures being bought or sold.
Thankfully, there is a cap on the number of futures allowed. In fact, that cap was nearly reached on day one of 2000 contracts for CME, and the cap was increased for next month’s futures to 4000. If that pattern continues, it adds more supply (of BTC exposure, not of real BTC).
So what’s the harm? Just extra supply. Imagine if Michael Saylor decided to use BITO ETF instead of real BTC to keep his company’s dollars from being ravaged by inflation. Same BTC exposure, but it wouldn’t be locking up 114,042 real BTC. For this reason, it may very well keep BTC price lower.
In learning about futures, I immediately recognized the value of being able hedge commodity prices like oil, gold, wheat, etc., and the benefits that would give to drillers, miners, and farmers. It allows the crowd-sourced and money-where-your-mouth-is wisdom to be collected and distributed in near real-time. If prices are higher a few months or years out, the farmer, miner, or driller can lock in that higher price and begin producing more for delivery.
And then I found this from yesterday October 20, 2021. https://finance.yahoo.com/news/happens-world-key-metal-exchange-141118223.html An article about copper where the supplies are running dangerously low. That should cause the copper futures to skyrocket in price so that copper mines can sell a copper futures contract for a large amount of cash and use the cash to ramp up copper mining like crazy, deliver the copper thereby fixing the copper shortage. Markets at work — it’s a beautiful thing. Is that what happened? NOPE! If this article is accurate, some financial eggheads called an emergency meeting and decided that instead of those that promised to deliver copper having to actually deliver copper, they just pay a financial fee and defer delivery. Otherwise, they said, the price of copper futures could go too high. WTH!?!
This is where the financial markets tear loose from reality. Of course the price dropped on the manipulated copper futures market after the “emergency” rule change. Why would you want a long copper futures contract if it doesn’t really represent future copper delivery? A physically settled BTC futures ETF would carry the same risk of arbitrary rule changes. At least in the case of copper, the extreme price increase incentivizes additional mining and refining of copper resulting in additional supply. The supply and rate of BTC issuance are already known, so the futures market, even if physically settled, can’t increase supply.
I see this manipulation of natural markets all the time. When there is a supply shortage, of say, gasoline, during an impending hurricane, a trucker shortage, or a pipeline rupture, the responses are completely wrong. If the prices are raised significantly by the market participants, there are claims of gouging, and investigations and prosecutions begin. The right thing to do is to allow the price to rise significantly until supply and demand match. Raising prices will increase supply and decrease demand. It automatically causes each individual to weigh the need for more fuel. “Maybe I just need enough to get out of the hurricane zone where fuel isn’t in short supply instead of filling up my tank and six extra 5 gal gas cans because I waited six hours in line.” It also causes additional supply to materialize as entrepreneurial individuals will bring in cans of $4.00/gal gas to where they can sell it for $16/gal. Price should be used as a signal. The right price for gasoline might be $4 in normal times to make sure it can be drilled, piped, refined, and delivered on a regular basis. But in an emergency, there isn’t enough supply so the price should rise enough to send the signal for more supply and less demand until the two match. The government response usually favors those early in line at the expense (potentially fatal) of those who arrive later, while also suppressing the signal for additional supply. The LME is destroying the signal of a copper supply imbalance, and we can watch the consequences unfold. Grab your popcorn.
Soapbox rant finished.
Back to the ETF. Because the ETF is based on futures, and they have a roll-over cost month after month, it’s better to just buy Bitcoin and hold it yourself. If you still want to trade some counter-party risk for convenience, keep it in Coinbase, or some other exchange that will hold it for you. Unless you’re buying for an entity that can’t hold BTC directly, or you want the BTC price exposure in a tax-advantaged account like a 401K or Roth IRA, then you should just hold Bitcoin directly.
I was worried about the futures price separating from the real market price, but the reference rate comes from a combination of live markets. https://www.cmegroup.com/trading/cryptocurrency-indices/cf-bitcoin-reference-rate.html
I learned about the underlying Bitcoin futures market because I wanted to understand the risks that these new cash-settled futures-based ETFs pose to Bitcoin. I don’t want the manipulation present in the fiat markets to adversely impact the bitcoin market. I’m convinced that except for creating some extra supply that might be used instead of those market participants using real on-chain BTC, thereby lowering the demand for real BTC, the cash-settled futures-based ETF is pretty innocuous.
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