Bitcoin spot ETF is about to be approved. Here is a guide to the operation mechanism of Bitcoin spot ETF

With the SEC’s Jan. 10, 2023 deadline approaching for a ruling on Ark21’s ETF application, fund issuers are scrambling to amend their S-1 filings to finalize fees and authorized participant identities.

Most people in the cryptocurrency space believe that the SEC will approve all 13 applications to avoid creating a single dominant player.

Once the ETF is approved, the marketing war for Bitcoin is expected to begin as ETF issuers compete for market share.

On Christmas morning in 2023, John Reed Stark, former head of Internet enforcement at the SEC, tweeted that “Based on my 20 years of experience at the SEC, it seems likely that the SEC will approve several Bitcoin spot ETFs,” following a series of recent meetings between applicants and the SEC. Just a few weeks ago, he commented that a 90% chance of approval was “absolute nonsense.”

Only time will tell whether the expected $1 billion to $2.4 billion will flow into the ETF if it is approved.

1. How does Bitcoin ETF work?

ETFs (Exchange Traded Funds) hold a “basket” of assets such as stocks, bonds, commodities, and soon Bitcoin.

The first Bitcoin ETF application was filed by the Winklevoss Bitcoin Trust back in 2013, but it was rejected along with dozens of other applications over the years.

The SEC is “reexamining” the Bitcoin ETF following an August 2023 ruling that the SEC’s rejection of Grayscale’s initial application was unfair.

All of the dozen or so applications submitted proposed the establishment of a grantor trust, where Bitcoin would be stored by custodians such as Coinbase, similar to how physical assets such as gold are stored in vaults in gold ETFs. The trust would issue shares representing the “beneficiary rights” to the assets (BTC) protected by the custodian.

Under the contract, APs are the only parties that can interact directly with the ETF issuer when creating and redeeming shares through a “creation and redemption” process.

For example……

Retail investors (like you and me) use our brokerage accounts to place buy orders to purchase a specified amount of a particular Bitcoin ETF (IBIT, HODL) on the secondary market through the listing exchange (NASDAQ). The broker (JP Morgan, Robinhood) will place redemption orders on the primary market with Authorized Participants (APs, also known as institutional investors or market makers, such as Jane Street, Wintermute, BlueSky, etc.) who are "approved" (authorized and contracted) to trade predetermined assets (physical delivery of Bitcoin) or "cash flow generation" (cash delivery) in exchange for a certain number of ETF shares directly from the issuer (Blackrock, Ark21, Grayscale).

2. How do authorized participants make money?

An Authorized Participant (AP) is a market maker approved by the ETF issuer (BlackRock, Ark21, etc.) whose role in the investment process is to create and redeem ETF shares.

There are two ways for AP to make money: one is when the market maker sells the product to a broker (JaneStreet) who sells the product, and the other is when it sells to a broker representing retail clients (Morgan Stanley).

APs can execute trades (even after the market closes), create / redeem ETF shares through buy and sell orders to bridge the trading gap between the ETF price and the Net Asset Value (NAV), and provide liquidity in the market.

Since APs create and redeem shares, the number of ETF shares available to the public is uncertain.

The AP monitors the exchanges where you and I buy ETF shares, and the AP deploys arbitrage strategies to buy (create) or sell (redeem) ETF shares to the ETF issuer / provider.

( 1 ) If the Bitcoin ETF trades at a premium

If the market price (MP) is higher than the net asset value (NAV), then the AP can purchase new shares from the ETF issuer in the primary market (at a discount). Typically, the AP will short the ETF shares and buy Bitcoin (BTC) from the exchange. The AP will execute a " creation " transaction with the ETF issuer, purchasing the newly "created" shares at a lower NAV. These lower-priced (newly created) shares are effectively a short cover when they are sold to you and me in the secondary market. The supply shock caused by the new shares usually causes the ETF share price to fall, closer to the ETF's NAV, resulting in a profitable short trade/arbitrage opportunity for the AP.

The two most common delivery methods between APs and ETF issuers are:

Physical delivery: AP purchases Bitcoin (BTC), or uses its own BTC to trade the underlying asset (BTC) with the ETF issuer to create new shares. Stock transactions are not subject to capital gains tax because no cash is involved in the transaction process.

Cash settlement: AP sells BTC/other assets for cash, or uses cash on hand to trade with ETF issuers to create new shares. Capital gains tax will be levied when buying and selling assets or stocks using cash settlement.

( 2 ) If the Bitcoin ETF trades at a discount

If the market price (MP) is lower than the NAV, the AP can purchase ETF shares in the secondary market and then trade the shares with the ETF issuer in the primary market in exchange for the ETF's underlying asset (Bitcoin). This process is called redemption.

As redemptions reduce the supply of shares on the secondary market, the discount will become smaller and the stock price will move more in line with its net asset value.

Physical delivery: When the AP redeems “in kind” (ETF shares for Bitcoin), the ETF issuer does not need to pay capital gains tax because there is no sale involved (but an exchange). This cost savings can help keep retail investors’ fee costs low because the ETF issuer realizes the low cost and then passes it on to retail investors.

Cash settlement: When an AP redeems shares for cash, the AP’s cash exchange usually requires a transaction fee to offset the ETF issuer’s cost of liquidating assets (BTC) from its portfolio. Since redemptions will result in a reduction in the supply of shares on the secondary market, the discount will be smaller and the stock price will move closer to the net asset value.

Below are two more specific examples that illustrate the role of AP in ETF investing.

Example 1: Bitcoin ETF stock creation (investment in ETF):

A retail investor wants to invest (buy) $10,000 worth of a particular Bitcoin ETF, say IBIT. If the spot price of BTC:USD is $40,000 and the Bitcoin ETF IBIT is trading at $40,010 on the market, AP receives an order from the investor's broker to trade (buy) $10,000 worth of IBIT at the fair value of the ETF ($40,010). IBIT is trading at a $ 10 premium to its NAV, so AP makes a profit of $2.50 because $10,000 is equivalent to 0.25 Bitcoin, given that Bitcoin (the underlying asset) in our example is trading at $40,000 (BTC:USD).

AP’s profit is not the entire $10 difference between ETF spot and BTC spot, but rather (0.25 x $10) = $2.50.

Example 2: Bitcoin ETF stock redemption ( ETF liquidation):

When the ETF is trading at $39,990 and the ETF’s NAV is $40,000 (spot price BTC:USD $40,000), the retail investor wants to sell his $10,000 position.

In this example, the ETF is trading at a discount. The AP (market maker) will open a trade, simultaneously buying $10,000 worth of Bitcoin ETF shares (IBIT) and selling $10,000 worth of BTC (0.025 BTC) on an exchange where the BTC:USD is trading at $40,000, thereby netting $2.50 (0.025 x $10 = $2.50).

These numbers may not sound like much, but you have to factor in the volume. APs are the middlemen between brokers and ETF issuers, just as brokers are the middlemen between retail investors (you and me) and APs.

ETF issuers profit from fees paid by APs, which are passed through the chain to brokers and ultimately to retail investors like you and me.

APs make profits through arbitrage and by charging brokers fees.

Brokers make money by charging fees or commissions, and if the AP is charged $7 in fees/commissions to make a trade, then a $1,000 trade would only buy $993 worth of ETFs.

3. Cash delivery and physical delivery

Physical redemption is a standard procedure for ETFs. The SEC (U.S. Securities and Exchange Commission) prefers cash settlement for Bitcoin ETFs, which has attracted issuers such as Ark21 and Black Rock to a certain extent.

Black Rock recently amended its S-1 filing to prioritize cash delivery while retaining the option for physical delivery in an ongoing creation/redemption process.

AP and ETF issuer deliver to create new shares, involving two delivery methods:

· Physical delivery: The AP delivers the underlying asset (Bitcoin) to the ETF issuer. Bitcoin can be purchased on the market or from the AP's current Bitcoin holdings. In turn, when the AP redeems shares from the ETF issuer (BlackRock, Ark21, etc.), the issuer can also pay the AP in Bitcoin. Physical delivery benefits APs with strategic Bitcoin reserves, which typically cost less than the current BTC:USD spot price.

Cash settlement (“cash flow creation”): Cash settlement is like “prepayment” and adds costs (fees and taxes), which will be passed on to retail investors, making buying Bitcoin more attractive than buying ETFs. These costs include the bid-ask spread, the operational costs involved in calculating, executing, and accounting for Bitcoin market transactions. This may make small APs concerned and tilt their investment balance towards large banks with trillions of dollars on their balance sheets. The following flowchart is from a recent document from Blackrock.

Due to deposit restrictions, banks cannot hold Bitcoin until 2025, at which time guidelines from the Basel Committee on Banking Supervision (BCBS) may allow holding no more than 2% of reserves in cryptocurrencies.

Cash redemptions require the AP to sell its ETF shares, which will incur capital gains taxes, and return the cash value to the ETF issuer, rather than exchanging the ETF shares for Bitcoin (BTC) tax-free.

The SEC’s decision to adopt cash settlement may have been motivated by pressure from banks, or they may not want brokers to handle Bitcoin transactions because there is no FDIC or SIPC insurance to compensate for losses caused by theft or mismanagement of deposits held in hot or cold wallets.

4. Cash flow creation and the big problem with Bitcoin

Let’s assume that 1 Bitcoin (BTC) = 1000 shares of the ETF. If the spot price of Bitcoin is $45,000, then the spot price for a retail investor to buy 1 share of the ETF (listed on NASDAQ) would be $45 per share.

Cash flow creation requires the issuer to receive cash from the AP when the AP wants to buy (create) new shares of the ETF to fulfill a trade order. Note that the AP is the broker that executes trades on behalf of retail investors (you and me) on behalf of the broker dealer (BD), and neither the SEC nor FINRA has approved these brokers to trade spot Bitcoin assets.

In the cash flow creation model, the issuer will maintain a real-time price quote that the AP needs to pay to create 1,000 shares of the ETF. The AP then trades with the issuer to create 1,000 new shares at the issuer's quote.

There is a time delay between receiving cash and trading in Bitcoin, which creates a price difference. The longer the delay, the greater the risk to the issuer.

If the price of Bitcoin rises during that delay, the issuer will have to spend more money to buy Bitcoin than it received from the AP . The issuer has a negative cash balance, which directly reduces the fund's NAV and thus reduces performance, and investors may choose ETFs based on performance.

If the issuer is able to purchase Bitcoin at a lower price than what they received from the AP, they will have a positive cash balance and a higher net asset value.

This situation will incentivize ETF issuers to price and quote above market prices to create better performance by maintaining neutral or positive cash balances.

The ETF issuer’s traders will be responsible for purchasing Bitcoin at the lowest possible average price using multiple exchanges (e.g. Coinbase, Kraken) and/or market makers (e.g. Jane Street, Wintermute) to reduce their expense ratio.

Different ETFs may use different trading strategies and liquidity sources, which may affect ETF prices and fees.

For example: ARK21 is waiving its 0.25% fee on the first $1 billion of inflows for six months. BlackRock is offering a 0.2% fee for the first $5 billion of new capital for six months.

Retail investors will be watching this closely, and issuers that trade more efficiently could end up being the big winners.

5. Several questions about Bitcoin ETF

ETF issuers may have been accumulating Bitcoin over the past few months in anticipation of physical delivery. Coincidentally or not, ArkInvest has been unwinding its positions recently, possibly in preparation for cash delivery. Blackrock committed $10 million to its Ishares Bitcoin Trust on January 3, 2024.

If the Bitcoin ETF application (S-1 & 19b-4) is rejected again, we may see a lengthy court battle. Equally worrying, Blackrock warned: "Any enforcement action by the SEC or state securities regulators alleging that Bitcoin is a security, or a court ruling on the same, is expected to have an immediate and material adverse effect on the trading value of Bitcoin and the (spot Bitcoin ETF) shares." (Remember Ripple?)

The SEC’s deadline for accepting filing amendments for consideration in the first round of decisions is Friday, Dec. 29, 2023. BlackRock elaborated on the issue of cash versus in-kind redemptions in its most recent amendment.

I expect that if a (only) cash redemption model is required, we will at least need more information on why the SEC prefers "cash". Is it just to protect investors?

If applicants have to liquidate the Bitcoin they have been quietly accumulating at very low cost for years, how much tax revenue will be collected? Are those “unidentified” whales still absorbing liquidity now?

Are traders “selling the news,” or are ETFs already pricing in a bull run that ends in 2023?

What percentage of assets will financial advisors allocate to Bitcoin via ETFs?

Will ETF leadership reduce volatility over time?

Is it cheaper to hold Bitcoin in an ETF or on an exchange?

When will the first sovereign wealth fund to hold a large amount of Bitcoin through an ETF appear?

( 1 ) Can I short the Bitcoin ETF ?

Shorting a Bitcoin ETF is different from an inverse Bitcoin ETF. Depending on your investment decision, you can open a long or short position in your brokerage account. The price of a Bitcoin spot ETF will be closely tied to the Bitcoin spot price, as APs can create and redeem shares through the ETF issuer. If you believe that the price of Bitcoin (BTC) will fall, you can open a short position in your brokerage account for the ETF shares. If the price of Bitcoin rises, the price of the ETF shares will also rise, creating a loss on the trade. One way to hedge is if you hold Bitcoin (BTC) in a separate exchange account (or cold storage), you may be forced to sell Bitcoin to cover the loss.

( 2 ) Should I buy a Bitcoin spot ETF or buy Bitcoin directly from an exchange?

There are many different opinions on whether a Bitcoin ETF is a boon or a bane for cryptocurrencies.

We can't predict the future or time the market accurately, and I can't give financial advice. Talk to a professional and do your own research.

After Coinbase was appointed as the custodian of BlackRock iShares Bitcoin Trust, my confidence in Coinbase has increased. BlackRock must have chosen the best.

Bitcoin still has a long way to go. Depending on your personal preference, you can build a dollar cost averaging strategy to repeatedly buy ETF shares or Bitcoin (BTC).

Personally, I would buy low with our DCA bot to ensure minimal OTC trading to limit UTXO volume, especially in a high fee environment. Also, the number of parties required to create/redeem ETF shares seems much more complex than storing Bitcoin in a cold wallet or even an exchange.