What Is a Spot Bitcoin ETF?

A spot bitcoin exchange-traded fund (ETF) is an investment vehicle that allows ordinary investors exposure to the price moves of bitcoin in their regular brokerage accounts. Unlike bitcoin futures ETFs, a spot bitcoin ETF invests directly in bitcoins as the underlying asset, not derivatives contracts based on their prices.

Spot bitcoin ETFs offer a regulated and accessible way for mainstream investors to invest in the digital currency. However, expenses like management fees and brokerage commissions still apply, though these are offset by not having the costs in time and exchange fees to buy and hold bitcoins directly.

How Spot Bitcoin ETFs Work

Spot bitcoin ETFs securely hold bitcoins in a secure digital vault, which registered custodians manage. The purpose of this kind of ETF is to mirror the price of bitcoins in the crypto market. To get started, the ETF buys bitcoins from other holders or through authorized cryptocurrency exchanges. The tokens are then stored in a digital wallet, often using several layers of security, including cold or offline storage, to reduce risks like hacking.

Spot bitcoin ETFs and derivatives-based bitcoin ETFs differ in how they are structured and how much exposure they offer to bitcoin’s price changes. Spot bitcoin ETFs directly hold bitcoins, but derivatives-based bitcoin ETFs use financial instruments like futures contracts to replicate bitcoin’s prices.

Spot bitcoin ETFs thus have direct ownership of bitcoins. This exposure is more intuitive for investors, making spot bitcoin ETFs more straightforward for those investing in bitcoin. Spot bitcoin ETFs can thus be more transparent since each share of the ETF corresponds to a specific number of bitcoins held.

By contrast, derivatives-based ETFs can be more opaque for investors, given that their value is derived indirectly from futures contracts, which can be influenced by various market factors beyond bitcoin’s spot price.

Pros and Cons of Spot Bitcoin ETFs

Pros

Below are the advantages investors are thought to have from spot bitcoin ETFs:

• Convenience: A major benefit of spot bitcoin ETFs is their accessibility to a broader range of investors. Spot bitcoin ETFs substantially lower the barriers to entry into the crypto market. Investors are excused from managing wallets with bitcoins, navigating online crypto exchanges, or grappling with private and public keys. Removing these technical hurdles simplifies asset management, making it a more attractive proposition for those accustomed to traditional investments.
• Liquidity: Spot bitcoin ETFs make buying and selling bitcoins easier through familiar brokerage accounts. The process mirrors trading traditional stocks or ETFs, providing an intuitive transition for mainstream investors.
• Regulatory oversight: When you purchase your own bitcoins, you might be doing so without the backing of clear, standardized regulations. Spot bitcoin ETFs are subject to rules that ensure transparency and protect investors.
• Tax implications: In certain jurisdictions, spot bitcoin ETFs could have tax benefits compared with holding cryptocurrencies directly. The tax treatment of ETFs is long-established, and investors can know going in what their tax obligations will be.

Cons

Like all investment vehicles, spot bitcoin ETFs are not without risk:

• Crypto volatility: The most obvious is the market volatility of bitcoin prices, which could lead to significant financial loss. While the ETF structure can mitigate some of the complexities associated with crypto by taking care of ownership and storage, it doesn't insulate you against the inherent risks of the cryptocurrency market.
• Regulatory uncertainty: Another risk involves the lack of a clear regulatory framework to protect investors. Until more comprehensive oversight and standards are established, there remains a great deal of uncertainty about how risks like fraud, manipulation, and loss of assets will be treated. Cryptocurrency markets are still evolving, and future regulations could affect the performance of bitcoin ETFs. Changes in tax laws, for example, could make crypto less attractive for investment purposes.
• Security risks: The number of coins that spot bitcoin ETFs would have to hold to be viable would make them attractive targets for cybercriminals. Bitcoin and other cryptocurrencies rely on digital keys and internet-based storage and transfer. While ETF managers use multilayered security protections like cold storage and encryption, no system is impenetrable. Successful major breaches at spot bitcoin ETFs could result in the theft of thousands or even millions worth of bitcoins. Unlike cash in a bank, stolen bitcoins can quickly be transferred anonymously and are almost impossible to retrieve. While rare, such cyber thefts have affected some cryptocurrency exchanges and holders, and an incident like this for a spot bitcoin ETF would severely damage investor confidence and fund stability.
• Management fees: While investing in spot bitcoin ETFs would save you the time and costs of exchanging and securing bitcoins yourself, these ETFs do charge management fees or expense ratios to cover operational costs, diminishing your returns over time. These fees can be higher than traditional equity ETFs because the ETF must also pay fees for exchanging and securing bitcoins.
• Tracking error: While spot bitcoin ETFs try to mirror the performance of bitcoin closely, tracking error differences between the ETF share cost and the value of bitcoin can occur. Reasons for this might include liquidity in the market, delayed rebalancing of the fund's holdings, and management fees.

The Future of Spot Bitcoin ETFs

As of October 2023, regulators had yet to approve a spot bitcoin ETF. The U.S. Securities and Exchange Commission (SEC) has been reluctant to approve any spot bitcoin ETF applications, citing concerns over market manipulation, fraud, custody, and investor protection. However, the SEC recently decided not to appeal a court ruling that rejecting a spot bitcoin ETF proposal by Grayscale, a leading digital asset manager, was wrong. This decision has raised expectations that the SEC will reconsider Grayscale’s application, as well as other pending applications by major industry players such as BlackRock, Valkyrie, WisdomTree, Ark Invest, and 21Shares, among others.

Analysts say there’s a strong chance of approval for spot bitcoin ETFs in 2024 based on recent modifications to the prospectuses submitted by Ark Invest and 21Shares. These modifications indicate that the SEC and the fund sponsors are in active discussions and negotiations, which is generally a positive sign for future approval.

Could Spot Bitcoin ETFs Affect the Price of Bitcoin?

A spot bitcoin ETF does not directly affect the price of bitcoins, but it can indirectly affect their price in several ways:

• Increased adoption: A spot bitcoin ETF will likely attract significant investment inflows from mainstream investors who want exposure to bitcoins within their brokerage accounts. As demand rises, this influx of new investors and capital could boost bitcoin prices.
• Market validation: The approval and launch of a spot bitcoin ETF would further validate bitcoins in the mainstream financial system. This perceived legitimacy could bolster confidence in bitcoins and drive prices higher.
• Trading activity: A spot bitcoin ETF could create more avenues for active trading of bitcoin exposure by hedge funds, day traders, and other speculators. This could lead to greater trading volume and volatility.
• Reduced premiums: Some argue that a spot bitcoin ETF would reduce the premium institutional investors pay to acquire bitcoins through trusts and private funds. Lowering this premium could depress bitcoin prices at the margin.

The Bottom Line

Spot bitcoin ETFs represent a significant evolution in cryptocurrency, offering a regulated and simplified way to gain exposure to bitcoin's prices. By potentially enhancing market liquidity, aiding in better price discovery, and attracting more institutional participation, spot bitcoin ETFs could play a pivotal role in stabilizing and boosting bitcoin adoption. However, the ripple effects of increased demand and speculative trading could also lead to worries about an overvaluation of the currency.