Here’s How the New Bitcoin ETFs Will Work

Crypto enthusiasts hope the new funds—backed by asset managers such as BlackRock and Fidelity Investments—will draw more mainstream investors into bitcoin.. REUTERS/Benoit Tessier//File Photo (REUTERS)
Crypto enthusiasts hope the new funds—backed by asset managers such as BlackRock and Fidelity Investments—will draw more mainstream investors into bitcoin.. REUTERS/Benoit Tessier//File Photo (REUTERS)

Summary

Similar to gold ETFs, the new funds will hold bitcoins in a digital vault.

Regulators have given the green light to the first U.S. exchange-traded funds that directly hold bitcoin. Crypto enthusiasts hope the new funds—backed by asset managers such as BlackRock and Fidelity Investments—will draw more mainstream investors into bitcoin.

In many ways, the new ETFs are similar to the gold ETFs that emerged in the early 2000s and became a popular way to invest in the precious metal. Instead of buying physical bars of gold, investors could buy shares in a gold fund through their brokerage, just like buying stocks.

Similarly, the new spot bitcoin ETFs are designed to make it easier to buy bitcoin. You won’t need to set up a digital wallet and memorize your keys, and you won’t need to create an account at a crypto exchange. You can just use the same brokerage account that you might already use to trade stocks, bonds and other ETFs.

First things first: What is a “spot" bitcoin ETF?

It is a fund that holds bitcoin for investors. The term “spot" simply means that it holds actual bitcoin, rather than a derivative tied to the price of bitcoin. The price of the ETF’s shares should rise and fall in line with the fluctuations of bitcoin’s price in the cryptocurrency markets.

Wait, haven’t bitcoin ETFs been available for a few years? What exactly is new here?

In 2021, the Securities and Exchange Commission opened the door to ETFs that hold bitcoin futures—a type of derivative that tracks the price of the digital currency. But the SEC resisted allowing spot bitcoin ETFs that hold actual bitcoins. The agency justified its stance by arguing that the spot bitcoin market was susceptible to market manipulation.

Advocates for crypto investing said it was illogical to allow bitcoin futures-based ETFs but not spot bitcoin ETFs. One fund manager sued the agency, winning a court ruling in August that pressured the SEC to allow spot bitcoin ETFs.

How do the new bitcoin ETFs work?

Under the surface, the new bitcoin ETFs are trusts that manage pools of bitcoin and issue shares. BlackRock’s bitcoin ETF, for instance, is the Delaware-based iShares Bitcoin Trust.

Electronic-trading firms known as market makers are constantly buying and selling the shares of ETFs. By capturing tiny discrepancies between the price of the ETF shares and what their price should be, based on the value of bitcoin, market makers help ensure the ETF tracks the price of bitcoin.

Some of these market makers are also “authorized participants"—firms that help make sure the quantity of available shares expands and contracts with investor demand. Banks can also play such a role. Authorized participants for the new bitcoin ETFs include electronic trading giants Jane Street Capital and Virtu Financial and the U.S. brokerage arm of JPMorgan Chase.

Suppose a stampede of investors buys shares of the bitcoin ETF. Seeing the upswell in demand, the authorized participants deliver cash to the trust. In return, the trust creates new baskets of shares and delivers them to the authorized participants. This expands the supply of ETF shares. Meanwhile, the trust adds to its bitcoin holdings, so its pool of bitcoin grows as more investors jump in.

In the opposite scenario—when investors dump their bitcoin ETF shares—the process happens in reverse. The authorized participants bring shares to the trust to redeem them for cash, shrinking the supply of shares. And the trust reduces the size of its bitcoin holdings.

Who actually buys and sells the bitcoin for the ETF?

Many of the new ETFs will rely on third parties to buy and sell bitcoin when needed. These are typically trading firms with desks that specialize in buying and selling large blocks of cryptocurrencies.

Initially, the asset managers behind the new bitcoin ETFs pushed for a different model for handling bitcoin. Under this “in-kind" model, the authorized participants would deliver bitcoin to the trust when they create shares, or get paid in bitcoin when they redeem shares. Some ETF executives say the in-kind model is simpler and more efficient than the model that ended up getting adopted, in which creations and redemptions are handled in cash.

But the in-kind model raised regulatory concerns that became a focus of talks with the SEC late last year, the ETF executives said. The concerns stemmed from the fact that authorized participants are registered broker-dealers in the U.S. stock market, and regulations don’t explicitly allow broker-dealers to handle crypto.

By December, all the asset managers seeking to launch bitcoin ETFs switched to a cash model, in which authorized participants don’t need to touch bitcoin, regulatory filings show. One winner from that decision: tightly regulated Wall Street firms such as banks, which are now more likely to act as authorized participants for the new breed of bitcoin ETFs.

What will it cost me to invest in a bitcoin ETF?

The asset managers backing the ETF will collect an annual fee. These range from as low as 0.2% from Bitwise to 1.5% from Grayscale Investments; several are offering an initial period of zero fees to attract investors.

Could the bitcoin held by these new ETFs be hacked?

There is always a danger that bitcoin can get stolen by hackers. All of the new bitcoin ETFs list security breaches as a potential risk in the fine print of their regulatory filings. And the hack of the SEC’s X account this week, prematurely trumpeting the approval of bitcoin ETFs, shows that shenanigans persist in the crypto market.

To ensure their assets are safe, the new bitcoin ETFs rely on third-party custodians—a standard practice in the ETF world. For instance, gold ETFs typically partner with banks that have vaults for storing physical gold.

Most of the new bitcoin ETFs have selected Coinbase as their custodian. So when one of these funds acquires bitcoin, the coins are parked in a special account at Coinbase. Such custodians generally hold the keys to crypto assets in “cold storage"—offline locations, not connected to the internet—to keep them secure. It is the digital equivalent of a gold vault.

Write to Alexander Osipovich at alexo@wsj.com

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