Point, click, bitcoin?

Meltem Demirors
May 14 · 13 min read

For millennia, humans have been building innovative financial products to pool and distribute risk, provide diversification, and make it easier for average investors to participate in new markets with the help of a manager.

You can’t talk about bitcoin for ten minutes without having someone bemoan the lack of a bitcoin ETF. In this live episode, we talk about the history of pooled investment vehicles, why they’ve grown exponentially over the last two decades, and why US firms are so fascinated by making bitcoin, which is already quite friendly to retail, more accessible for institutions.

Listen to Episode 20

i’m sorry but Pirates of the Carribbean is never *not* funny

The Silk Road and The Beginnings of Investment Pools

The year is 750 AD. It is the golden age of the silk road (like, the trade route, not the black market). Muslim merchants traveling the trade route needed a way to finance their growing trade business. Combining elements of a loan and a partnership, the qirad was created as an informal agreement between two parties — one who had capital, and the other who put in labor. Over time, qirad agreements evolved to accommodate multiple investors in a single venture, and was passed on to children similar to a trust.

Fast forward to 1100, the Europeans are looking for new ways to finance increasingly risky and expensive ventures across the unknown oceans and to unknown ports. They called the contract commenda. The commenda contract became extremely popular with Venetian merchants, and for good reason.

While fortunes could be made at sea, ships were frequently lost and there was no guarantee that a merchant would return home from a voyage. The commenda enabled passive investment (no work needed), allowed for partial or fractional financing and facilitated investment in numerous ventures, and thereby enabled a new system for sharing profit and loss.

In addition to their unique investment partnerships, commenda were known for their liquidity. Investors could easily buy and sell whole (or partial) positions in a merchant’s voyage, which was a true innovation. Now speculative investing could be done in the town square, as news about voyages reached port.

Fast forward to 1774. A Dutch financier Abraham van Ketwich created a new pooled investment vehicle called, Eendragt Maakt Magt (Unity Creates Strength). The prospectus required that the portfolio would be diversified at all times. The 2,000 shares of Eendragt Maakt Magt were subdivided into 20 ‘classes’, and the capital of each class was to be invested in a portfolio of 50 bonds. Each class was to consist of at least 20 to 25 different securities, to contain no more than two or three of a particular security. So — this vehicle, the Eendragt Maakt Magt was an equal-weighted index fund designed to offer investors a broad, diversified exposure across ’20 classes’ of bonds.

The cost was 0.20% or 20 basis points of the total return, and the fund promised there would be no “active management” and safe custody, which in those days meant storing the stock paperwork in an “iron chest with three differently working locks”. If any investment decisions were made, the chest would have to be unlocked by three separate authorities.

The road leading to pooled investment products can be traced back over a thousand years. For millennia, humans have been building innovative financial products to pool and distribute risk, provide diversification, and make it easier for average investors to participate in new markets with the help of a manager.

Why Bitcoin ETF

To understand, we have to go a few steps back, and then a few steps forward:

  • What pooled investment vehicles are and how they work
  • Why funds have grown exponentially over the last two decades
  • How GLD re-shaped the Gold market
  • What people actually mean when they talk about a bitcoin ETF
  • What a bitcoin product might look like and whether or not it actually matters

Let’s dive in…

So What Are Pooled Investment Vehicles?

As its name suggests, a pooled investment vehicle (PIV), sometimes called a pooled fund, is an investment fund raised by pooling small investments from a large number of individuals. We’ll touch on the three most common types — REITs, mutual funds, and ETPs.

Pooled investment vehicles are sometimes organized as standalone companies, and in other cases they are arranged and managed as entities within a larger business, such as a brokerage house.

When someone participates in a pooled investment vehicle, their investment is managed by a team of professional fund managers.

Unless you are an expert in the financial markets or are extremely confident in your own ability to devise a winning investment strategy, this professional management can be a benefit in that it allows you — with only a small outlay of your own capital — to tap into the experience and knowledge of a team of investment professionals whose fees and reputation depend in part on how well they manage your fund.

Let’s talk about the most popular investment schemes

  • REITs , or a real estate investment trusts, which are pools money from investors (individuals as well as institutions) and purchases real estate — a large portfolio of properties. Tax benefits to investors and allow passive investors to get exposure to baskets of real estate. Real estate has created the majority of wealth in our world.
  • Mutual Funds, a pooled investment vehicle, where professional fund managers raise capital from many individuals and institutions, aggregate this capital into a single large fund, and then use the fund to purchase and manage a portfolio of investments. Mutual funds can be closed ended or open ended, and can have a variety of different features.
  • Exchange Traded Products, or ETPs, are comprised of two types of products, ETNs and ETFs. An ETF, or Exchange Traded Fund, represents an investment fund (a portfolio of securities) that tries to track a specific index. Sample ETFs include:
  • the S&P 500 ($SPY), which tracks the return of the top 500 publicly traded US stocks
  • the Vanguard Information Technology ETF ($VGT), which holds 300 tech stocks including blue chip stocks and smaller companies
  • Vanguard Short Term Corporate Bond ETF ($VCSH) which buys investment grade corporate debt from big-name companies
  • Invesco Preferred ETF (PGX) which purchases preferred stock, a kind of hybrid share class with bond-like features
  • If you’re me, Direxion’s $NUGT AND $DUST — triple levered gold miners bull and bear. For example, DUST, the bear product, is 80% short an index of gold miners, and applies 3x leverage, so if the index moves down 1%, the product returns 3% to investors.
  • And there are lots of more esoteric ETFs that hold private equity, bank notes, active strategies, and more!

A Quick Take on ETFs

Unlike mutual funds, ETFs aren’t sold directly to regular investors. Instead, they use banks and brokerage firms as middlemen. These large traders don’t transact in cash. They make an ETF bigger or smaller by adding portfolio stocks to it, or by taking them out. They call this activity “creating” and “redeeming” ETF shares. (All this is invisible to small investors, who just buy ETFs from brokers.)

All of these features rely on a specific “in-kind” creation and redemption principle: new shares can continuously be created by depositing a portfolio of stocks that closely approximates the holdings of the fund and similarly, investors can redeem outstanding ETF shares and receive the basket portfolio in return. Holdings are transparent since fund portfolios are disclosed at the end of the trading day.

Unlike mutual funds, ETFs are listed on an exchange and can be traded intraday. Issuers and exchanges set forth the diversification opportunities they provide to all types of investors at a lower cost, but also highlight their tax efficiency, transparency and low management fees.

Most importantly — ETFs typically take a passive investment approach, which means that rather than actively making decisions about which investments are more likely to succeed than others, they simply track predetermined indexes.

Now one thing that’s overlooked is the tax advantages associated with ETFs. Unlike mutual funds, ETFs almost never have to declare taxable distributions of capital gains that can add to your tax bill. That lets you decide when you want to realize any gains in the value of your ETF shares by selling them.

Just last month, a change is being discussed to minimize these tax benefits. Typically, when you sell a stock for more than you paid, you owe tax on the gain. But thanks to a quirk in a Nixon-era tax law, funds can avoid that tax if they use the stock to pay off a withdrawing fund investor. This is called a heartbeat trade — and it happens when banks pump billions into an ETF to help the fund avoid tax gains.

A fund manager asks a friendly bank to create extra withdrawals by rapidly pumping assets in and out. In fact, in 2018, State Street reaped $64B in capital gains tax savings by using this method.

Just as wealthy merchants along the Silk Road and wealthy Venetians used pooled investment schemes to provide diversification of returns and lower risk, today’s investors use pooled investment vehicles for a variety of reasons.

Sizing the ETF Market

ETFs are a relatively “new thing” in the world of finance. In less than 25 years, exchange-traded funds (ETFs) have become one of the most popular investment vehicles for both institutional and individual investors.

ETFs are in fact so popular that many brokerages offer their customers free trading in a limited number of ETFs. Many ETFs are now competing on fees, and Fidelity has even explored rolling out no-fee products to accrue more AUM. Why?

For institutions, aggregating positions gives them power and control. Owning 20 to 30% of a stock makes that institution a power player. In the world of asset management, it’s all about AUM (assets under management) and charging fees on that AUM.

At the end of 2010, assets under management in U.S. ETFs reached $1.0 trillion, which was invested across more than 1,100 ETFs, according to ETF.com. One of the most significant drivers of ETF growth has been the shift from traditional commission-based financial advice models to fee-based structures. Many financial advisors have embraced ETFs as a flexible, low-cost way to implement and rebalance diversified allocation models for their clients, and clients in turn have increasingly turned away from relying on advisory services, instead opting to diversify their portfolios through these products that are easy to buy and sell.

To give you a small sample — 2017 was a record year for ETF cash flows — $460 billion flowed into U.S.-listed ETFs, with more than $100 billion going to fixed income (interest yielding ETFs.) The current assets under management in US ETFs is a staggering $3.4 trillion!

Using an ETF to Buy an Ounce of Gold

Now one ETF that’s important to highlight is the SPDR Gold ETF, or $GLD, which is managed and marketed by State Street. For a few years, the fund was the second-largest exchange-traded fund in the world, and it was briefly the largest.

The fund allows individuals to track gold bullion prices — and the idea behind its appeal is that this gold fund could be cheaper than the cost of shipping, storing and insuring physical gold on your own given expenses are just 0.40 percent (or 40 basis points) in annual fees, or $40 each year on every $10,000 invested.

Each share of GLD is intended to track the price of a tenth of an ounce of gold. The ETF price roughly in line with the gold price, although the prices can deviate during each day.

As of March 31, 2019, $GKD had 24.5M ounces of vaulted gold in its custody, representing an asset value of $32B and earning State Street $128M in fees annually. SPDR Gold Shares is one of the top ten largest holders of gold in the world.

The gold bullion is stored as London Good Delivery gold bars and held in a vault in London and by several other custodians worldwide. The ETF has been criticized for its lack of transparency and lack of redeemability, as well as claims it may not be 1:1 backed.

Now the reason the GLD ETF matters is this:

  • Before the ETF, the price per ounce of gold was $332. At the peak of gold mania, it reached $1,600. Given gold is naturally scarce (until we mine asteroids), the idea was more captive demand for gold via an ETF would constrain market supply.
  • Investing in gold was fairly inaccesible to retail investors prior to the ETF — investors had to buy coins or bars and find a way to store them. It was largely a market for specialists, like investment managers. The introduction of the ETF made investing in gold as simple as point, click, gold — and enabled people to buy and sell gold on a daily basis.
  • Gold ETFs rival bank holdings of gold. Effectively, a bunch of circulating gold supply has been locked up and taken off the market. In fact, only three entities hold more gold than physical gold ETFs — the US, Germany, and the IMF.
  • The introduction of gold ETFs has created a more liquid market for gold.

Now this doesn’t come without problems. Some of the key challenges of a physically backed ETF that is matched with the underlying are:

  • Sponsors of these gold ETFs are beginning to move the market and impact the global market for gold.
  • Tellingly, the introduction of gold ETFs shifted investment away from gold mining companies, and more of the value has accrued in the asset itself than the companies focused on finding, acquiring, extracting, and processing gold. Gold companies have had a hard time out-perfoming the price of gold.
  • The largest source of demand for gold is still pure physical, in the form of bars and coins. About 25% of global demand for gold comes in the form of ETFs.
  • Lastly, the redeemability of gold is problematic. There are many blockchain projects (like Tradewind Markets, started by the team behind IEX) which aim to resolve the 1:1 relationship between a share of a gold product and a physical ounce of gold.

Many people will tell you gold’s success as an investable asset was largely fueled by the GLD ETF and the rise of pooled investment vehicles. However, they miss one important element. The World Gold Council.

The World Gold Council, which can be found at gold.org, is the market development organization for the gold industry. Its sole purpose is to stimulate and sustain demand for gold, provide industry leadership, and be the global authority on the gold market. It’s a membership organization

Just last year, they teamed up with State Street to launch another Gold ETF, this one offering 1/100 of an ounce of gold per share (as opposed to the $GLD product launched in 2004 which holds 1/10 ounce per share) and the very low fee of 0.18% to attract more investors.

What a Bitcoin ETF Actually Means

When new ETFs are created, they have a benchmark or index to follow, like the S&P 500 which is the most widely followed by institutional investors . One such index could be bitcoin.

ETFs have been huge for bringing historically institutional assets to retail…But crypto has the OPPOSITE problem, it’s very friendly to retail but NOT friendly to institutions.

When we talk about a bitcoin ETF — what we really mean is we want to make it easy for people to get bitcoin.

To create a bitcoin ETF, an AP would buy bitcoin in the open market and use to create shares. These shares, representing 1/10 or 1/100 of a bitcoin, could be easily traded in a normal portfolio — no private keys or Coinbase account required — by all sorts of investors looking to speculate on the price of bitcoin.

Bitcoin is friendly to retail but NOT to institutions. An ETF is basically putting a regulated, controlled product wrapper around bitcoin to repackage itand distribute it to a broader audience.

BTC is a digital currency maintained by a decentralized network of nodes. The whole point of Bitcoin is to allow people to serve as their own banks, without the intervention of centralized parties like banks or governments — which prompts this question: Why would we want to put Bitcoin in an ETF in the first place?

Unlike gold or oil, BTC is a digital asset that can be purchased easily on a number of exchanges and transferred to a digital wallet. While a Bitcoin ETF might usher in wider investment from institutional investors, it’s unlikely that a Bitcoin ETF will intrinsically have a large impact on the market.

Now, when ETFs were first being created, they required a virtual warehouse to store the stocks, and State Street was the firm that was willing to be a trustee and custody agent .The real threat to bitcoin is centralized custodial models that aggregate coins in the hands of a few institutions. In our very attempts to make bitcoin an asset class, we are arguably destroying the very features that make it valuable.

According to CoinShares research, here’s who controls large volumes of bitcoin today:

The recent Binance hack impacted 7,000 BTC or 0.03% of all bitcoin in circulation. This is a teeny tiny number compared to some of these others, and already people were discussing a possible miner-led block re-org and claiming it was “genius.” That’s the craziest thing I’ve ever heard.

Now let’s imagine what would happen if, say, a Xapo got hacked. With at least 7%, if not more, of every bitcoin ever mined being stored in Xapo’s vaults, a hack of Xapo might actually be enough to force a block re-org, much like Ethereum did after fully 15% of all Ether ever mined were re-appropriated (I refuse to say stolen) by the DAO hacker.

The more that bitcoin flows into these controlled, regulated, institutionally owned pockets, the more we cede control of these coins to their managers. We are creating the most perfect choke point for regulators to come after.

In my view, the real key to making bitcoin more accessible is not by wrapping it in a 30 year old Wall St created wrapper, but by creating a new product wrapper that preserves the very features that make bitcoin so appealing.

These products must be redeemable for bitcoin, and preferably, enable users to hold their own private keys. Anything less is a direct affront to bitcoin.

Tune in to the podcast to hear the rest!

What Grinds My Gears

Welcome to What Grinds My Gears, a podcast about the world of cryptocurrency. Each week, we delve into one big idea, and examine through a broader financial, political, and cultural lens to learn from the past, understand the present, and explore the future.

Meltem Demirors

Written by

making benevolent mischief. building products @coinshares. investing, advising, lurking in trollbox. teaching at MIT & Oxford.

What Grinds My Gears

Welcome to What Grinds My Gears, a podcast about the world of cryptocurrency. Each week, we delve into one big idea, and examine through a broader financial, political, and cultural lens to learn from the past, understand the present, and explore the future.

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