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Bitcoin ETF Revolution: How to Invest in Digital Gold Through the Securities Market?
Dive into the financial mechanisms and market dynamics shaping this investment frontier.
Po-Hsiang Lee
May 03, 2024 • Estimated Reading Time: 7 minutes
Table of Contents
The first "block" of Bitcoin was created in January 2009, generating an initial 50 bitcoins.
After almost 16 years, the U.S. Securities and Exchange Commission (SEC) finally approved the Bitcoin ETF which became available for trading on January 11, 2024.
Investors outside the US cannot yet invest in Bitcoin ETFs, but understanding its mechanisms prepares them for future participation.
This article will sequentially explain:
The advantages and disadvantages of Bitcoin ETFs compared to current exchange trading
The financial mechanisms behind it
How Authorized Participants (APs) and Market Makers (MMs) help issuers maintain price stability
The ETFs currently issued
How to predict prices through ETF capital flows
Advantages and Disadvantages of Bitcoin ETFs
Advantages:
Convenience: Investors can buy Bitcoin directly through their existing securities accounts, avoiding the extended issues of storage and custody.
Liquidity: Purchasing assets directly using traditional USD can boost participation and significantly enhance liquidity.
Quality: BlackRock's extensive experience in creating traditional ETFs ensures high-quality offerings.
Disadvantages:
Price Volatility: The inherent price volatility of Bitcoin leads to significant fluctuations in the ETF's price.
Higher Costs: Investing in a Bitcoin ETF incurs additional management fees, affecting returns.
For those interested, you can view BlackRock's promotional advertisement.
Financial Mechanisms of Bitcoin ETF
Three main roles: the fund issuer, Authorized Participants (AP), and Market Makers (MM).
Starting with the relationship between the fund issuer (ex: BlackRock) and investors. It's divided into three parts: share division, ownership transfer, and arbitrage mechanism.
Initially, the fund issuer purchases a certain amount of Bitcoin, stored in a cryptocurrency wallet. The total value of these bitcoins corresponds to the Net Asset Value (NAV) of the fund, meaning each share represents a specific proportion of Bitcoin.
Ownership Transfer
Once these shares are listed on the stock exchange, investors can buy or sell them. The ownership of the shares is transferred to the investor upon purchase.
Arbitrage Mechanism
To ensure the ETF's Bitcoin does not deviate from market prices, an "arbitrage mechanism" is utilized.
When there's a discrepancy between the price of the ETF and the price of the underlying Bitcoin (NAV), the other two market participants, Authorized Participants (AP) and Market Makers (MM), collaborate with the fund issuer for arbitrage, aligning the ETF's price with its NAV.
Price differences between markets are inevitable, but they cannot be allowed to expand indefinitely, confusing or disadvantaging investors.
Next, we discuss how Authorized Participants (AP) and Market Makers (MM) operate in primary and secondary markets to help the fund issuer control the ideal quotation behind the scenes.
In the primary market, Authorized Participants (APs) are typically large financial institutions such as banks.
The primary market involves direct sales of stocks or bonds by corporations to investors to raise capital. The characteristic of this market is fixed prices but low transaction frequency, generally occurring before listing.
When there's a difference between the ETF's price and its NAV, APs arbitrage this discrepancy to align the ETF's price with its NAV.
The process involves APs exchanging real Bitcoin with the issuer for ETF certificates (creation) and vice versa (redemption).
For example, if the cost of beef noodles in Taipei's night market becomes too high (from 100 to 200 TWD per bowl), other vendors might invest in eastern ranches to increase beef production, resulting in:
Earning from the price difference
Increasing beef production, thus reducing the cost of beef, aligning it with a reasonable price (e.g., 150 TWD)
The principle is similar. When the ETF's price significantly exceeds the real value of the underlying Bitcoin, APs can buy Bitcoin with USD and exchange it with the issuer for ETF certificates, not only making a profit from the price difference but also stabilizing the ETF's price closer to the market's average Bitcoin price.
Market Makers (MM)
In the secondary market, MMs act more like retailers (with APs resembling wholesalers), directly trading with retail investors.
The secondary market involves trading already issued stocks or bonds, with individual and institutional investors as the main participants. Its characteristics include fluctuating prices and high transaction frequency, generally occurring after listing.
Similarly, when there's a discrepancy between the ETF's price and its NAV, MMs also arbitrage this difference to align the ETF's price with its NAV.
MMs can negotiate wholesale prices with APs, allowing them to purchase large quantities of shares at better prices than individual investors.
Continuing the beef noodle example, if a night market beef noodle costs 300 TWD, but its beef cost is 200 TWD per bowl. If we negotiate with the beef supplier to purchase more at 160 TWD per pound:
Increases its profit margin from 100 to 140 TWD
Can choose to either increase its profit or sell at a lower price to attract more customers
Thus, it gains some control over pricing
However, in the financial market, pricing is transparent, so your buying and selling prices are immediately known, essentially revealing your profit as half the bid-ask spread.
Therefore, MMs in the financial market act more like controllers of the bid-ask spread, ensuring it's not too wide while still leaving room for profit.
Finally, let's explore the current ETFs and how ETF data can be used to estimate ETF prices.
Current Spot Bitcoin ETFs
As shown below, there are currently 11 spot Bitcoin ETFs on the market.
The Expense Ratio indicates the management fee rate of the ETF. Specific transaction fees depend on which securities exchange investors purchase from.
Unsurprisingly, Grayscale's GBTC and BlackRock's IBIT dominate the market in terms of assets under management.
Capital Flows
For net capital flows (all ETFs), you can also check Coinglass.
Green bars indicate capital inflows into the ETF, while red bars indicate capital outflows.
It's intuitive to observe that when capital flows into the ETF, Bitcoin's price generally rises; conversely, when capital flows out, Bitcoin's price tends to fall.
Over the past nearly 16 years, Bitcoin has evolved from an innovative digital currency concept into a widely recognized investment asset. The latest development is the official approval and listing of Bitcoin ETFs in the United States.
This marks a new phase in Bitcoin investment, where investors can directly invest in Bitcoin through traditional securities accounts, enjoying greater convenience and liquidity while facing higher price volatility and costs.
The operation of Bitcoin ETFs involves various financial mechanisms and market participants, including fund issuers, Authorized Participants, and Market Makers. They maintain the consistency of ETF prices with the actual value of Bitcoin through creation and redemption mechanisms and market arbitrage.
These mechanisms' effective operation is crucial for maintaining market stability and transparency. For investors, understanding these basic principles and market dynamics will aid in making more informed investment decisions.
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This article is solely for educational purposes and does not constitute investment advice. Investors should be aware that all investments carry risks.