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This article comes from Fidelity Digital Assets and is translated by Chain Catcher. To date, much of the discussion in the institutional investor community has focused on “Why Bitcoin?” If one does come to the conclusion that Bitcoin is suitable for their portfolio, the next logical question is usually “how” to invest in Bitcoin. In this article, we will discuss the merits of different investment avenues, including third-party custody, passive single-asset funds, futures contracts, and actively managed funds. A core feature of Bitcoin (and digital assets more broadly) is that holders are able to self-custody their assets and have true ownership, eliminating the need to trust an intermediary to exercise control over the assets. However, many institutions with fiduciary duties face regulatory and operational constraints that prevent them from directly custodying these assets. Furthermore, as it currently stands, self-custody requires strong security and risk management processes that some institutions may not be willing to undertake or may not have the time and resources to perfect. In line with this reality, the number of channels for investing in Bitcoin has increased significantly as institutional interest in the asset has grown. In this article, we focus on the benefits and challenges of multi-channel investing that institutional investors may consider after deciding to allocate to the asset class. 1. Spot Trading and Custody Much of Bitcoin's early infrastructure was built to meet trivial transaction needs, and there were fewer options for strong, secure institutional custody solutions. Historically, the lack of institutional-grade solutions has been a barrier for institutional investors to invest in Bitcoin. In recent years, this challenge has been addressed head-on, with several digital asset native service providers launching institutional-focused custody to protect customer assets from loss and theft and help them meet regulatory and fiduciary obligations.
Today, the benefits of gaining Bitcoin exposure through working with a third-party custodian include the maturity of custody solutions, the relatively low cost of maintaining spot exposure through a custody room, and the potential capital efficiency benefits of holding the underlying Bitcoin. As a result, spot trading and custody are the most common channels for exposure. In our 2019-2020 Institutional Investor Survey, we found that approximately 60% of respondents with digital asset exposure hold the underlying asset. Below we outline the benefits and considerations that investors need to be aware of when considering gaining spot Bitcoin exposure.
1. Potential Benefits 1) Institutional-grade trading and custody In recent years, the Bitcoin landscape has matured significantly with the introduction of integrated trade execution and custody solutions built specifically for institutional clients, which are designed to facilitate the acquisition, long-term storage and protection of Bitcoin by large, regulated investors. Today, digital asset custody operates under a robust operational and regulatory framework. Many custodians undergo regular operational and security (e.g., SOC) audits, following the standards of any traditional service provider. They may also hold a state trust charter or a national bank charter.
Meeting these criteria, along with other requirements set forth in the Investment Advisers Act of 1940, has led some regulated entities to interpret certain Bitcoin custodians as qualified custodians. This is important for investors such as registered funds, which must hold investment securities that belong to companies that are qualified custodians. Note that Bitcoin is not classified as a security, but it is still important to appropriately match the characteristics of qualified custodian status.
2) Low-Cost Spot Bitcoin ExposureAnother advantage is that it is one of the more cost-efficient ways to acquire the asset due to relatively low total fees (trade execution and custody costs) compared to most of the other ways we have discussed. Annual custody fees and fee schedules vary from one provider to another, but most providers have less than 50 basis points per total assets under custody. Depending on the provider, custody rates may also scale as the total assets on the platform grow. Trade execution costs include trading fees as well as the drawdown that investors may experience, especially when building large positions.
In a hypothetical test, assuming a price of $50,000 per Bitcoin, Coin Metrics estimates that a $5 million order executed in one day would have a total transaction cost (transaction fees plus slippage) of 0.175% (higher transaction costs but lower slippage). A $1 billion order executed in about two weeks would cost 0.225% (higher latency but lower transaction costs). 3) Opportunities to Improve Capital Efficiency In addition to self-custody, depositing physical Bitcoin with a custodian is the most direct way to establish exposure to the asset class. A key advantage of exposure to physical Bitcoin is capital efficiency. As Bitcoin becomes more widely accepted as an investable asset, borrowers may increasingly use Bitcoin as collateral to obtain liquidity while maintaining their positions. Lenders may see the value of Bitcoin as collateral because it has certain attractive characteristics, namely high liquidity, borderlessness, fast final settlement, and real-time dynamic prices. 2. Notes
1) Technical Due Diligence Given the relatively more technical nature of digital asset custody, investors may not feel equipped to properly communicate with due diligence service providers. For example, they may struggle to understand the differences between hardware security modules (HSMs) and multi-party computing (MPC) models used to protect assets, or understand the pros and cons of integrated custody versus segregated custody, among other issues. Therefore, due to technical knowledge and experience gaps, some institutions may prefer tools that allow them to outsource service provider assessments.
2) Decentralized Liquidity Liquidity in digital asset markets is decentralized. Digital assets like Bitcoin are traded on multiple exchanges around the world, with varying volumes, transparency, security, and regulatory status. This is in stark contrast to traditional capital markets, where trading occurs on a single exchange and is legally required to provide customers with the National Best Bid and Offer (NBBO), or the best obtainable buy (minimum) and sell (maximum) price. Bitcoin exchanges are not subject to such requirements and, given the level of fragmentation, are unlikely to guarantee “best execution” across all platforms.
However, a growing number of institutional service providers are launching integrated execution services and smart order routing solutions, which will allow clients to fund a single account and access multiple liquidity providers in an attempt to achieve better price execution and improve capital efficiency.
3) Lack of integration with traditional assets Institutional investors are largely unable to access Bitcoin through the same accounts or platforms they use to access traditional asset classes, creating a fragmented experience and operational challenges (such as taxes and reporting) in managing risk exposure to different asset classes. For investors, being able to integrate Bitcoin assets into traditional portfolios and view these assets in a single interface would be a win. This might be less of a concern if traditional banks and custodians began to offer digital assets alongside traditional assets by building, purchasing, or partnering with sub-custodians. Factors supporting this trend include interest from institutional clients and potential clients, regulatory support from key agencies such as the OCC, and competitive pressure. 2. Private placement of passive funds Private placements of passive funds provide another channel for qualified institutional investors to gain long-only Bitcoin exposure. Passive funds are popular because they abstract the complexity of Bitcoin trading and custody and present the asset to investors in a familiar structure. The cost of convenience is that the fund charges investors a management fee in addition to the trading and custody fees. This fee is not only used for the fund manager and operations, but also for the costs incurred by the fund through its selected custodian.
1. Potential Benefits
1) Convenience and readability Passive Bitcoin funds used by recognized institutional investors offer a convenient fund structure. Generally, allocators of the fund can provide physical assets or fiat assets and allow the fund to execute trades on their behalf. Fund managers, who may be more capable of analyzing the prospects of service providers, are also responsible for due diligence and the selection of custody and trading partners. Therefore, allocators must have a high degree of trust in the fund management company in order to make appropriate decisions related to security, counterparty risk, etc. Passive funds can also provide simplified and easy-to-read tax and reporting benefits.
2) Accounting at Fair Value More and more corporate finance teams are making balance sheet allocations to Bitcoin. One challenge that companies face when investing directly in Bitcoin is the accounting treatment of the allocation. On the financial statements of public companies, direct investments in Bitcoin are treated as an indefinite-lived intangible asset. As a result, the investment is written down to the lowest trading price of Bitcoin in each accounting period, which poses a potential adverse impact on GAAP results - the current market value of each accounting period is not reflected in the financial statements. By establishing Bitcoin exposure through a passive fund, companies can achieve preferred accounting treatment because Bitcoin may be classified as an "equity investment" and valued at market value in each fiscal period, as well as other potential tax and accounting benefits.
2. Notes Passive funds typically charge an annual management fee of 50 to 200 basis points, in addition to costs associated with trade execution, custody and/or fund management. Therefore, given that fund managers do not offer significant advantages in buying and holding Bitcoin, private placements are a relatively more expensive way to invest. However, the entry of multiple new players into the passive fund space is creating healthy competition and putting downward pressure on fees.
Investors should also evaluate the differences in redemption frequency and redemption mechanisms among passive Bitcoin funds. Investors should determine whether the fund allows redemptions on a daily, weekly, or other frequency. In addition, they should understand whether redemptions can be made for physical Bitcoin, cash, or shares on the secondary market, as we discuss below. 3. Publicly traded stocks Investors can also gain exposure to potential price movements of Bitcoin through publicly traded shares. For example, Grayscale Bitcoin Investment Trust (GBTC) offers investors an opportunity to gain exposure to Bitcoin through an open-ended private trust. The trust issues shares that trade as securities on the open market. These shares represent ownership of the trust, whose sole purpose is to hold Bitcoin and track its fundamental price movements.
While the secondary market shares are open to both retail and institutional investors, accredited investors can also participate in daily targeted allotments at net asset value (NAV) and sell shares in the secondary market after a six-month lock-up period.
The main benefit of gaining exposure to Bitcoin through publicly traded stocks is that investors do not need to deal with the logistics associated with safekeeping, transferring, and accepting Bitcoin. They can access exposure as easily and conveniently as any other publicly traded security.
Unlike private passive funds, publicly traded Bitcoin exposure not only requires paying a relatively high 2% management fee, but the secondary market may also trade at a premium or discount due to the lack of redemption mechanisms, asynchronous trading hours, and poor liquidity between the secondary market and traditional Bitcoin exchanges. In the past, GBTC has closed at twice the price of Bitcoin's base price. Since reaching a high of 137% in late 2017, GBTC's premium has recently been discounted to net asset value. As competition for similarly structured products heats up, products like GBTC may find it difficult to obtain the premiums they once did. 4. Bitcoin Futures Investors can also use Bitcoin futures to establish long exposure, hedge spot exposure, or establish risk-neutral Bitcoin exposure. Bitcoin futures come in all shapes and sizes, from highly regulated products offered on familiar platforms to less regulated products offering significant leverage on overseas platforms.
1. Regulated cash-settled futures 1) Potential Benefits
Cash-settled Bitcoin futures offered by Commodity Futures Trading Commission-regulated platforms such as CME have become one of the most prominent products catering to institutional interests. CME's cash-settled futures attract financial institutions because they are traded on the same platform as futures contracts for other assets. They are regulated by the same agency (CFTC) that oversees traditional commodity contracts, creating a familiar playing field.
Another advantage of trading on CME is that the exchange already has connections with Futures Commission Merchants (FCMs), which institutions use to obtain and clear other futures contracts. There are more than two dozen FCMs that support Bitcoin futures settlement, including E*Trade, Macquarie, TD Ameritrade, and Wedbush, among others. Since FCMs are already integrated, it is easy for them to trade the new cash-settled products offered on the platform. The fact that futures are cash-settled adds another convenience factor, as exchanges, FCMs, and customers do not have to worry about custody issues when physical delivery is made.
2) Note: The settlement price of spot futures depends on the spot price index. Platforms that provide cash settlement futures must refer to a group of exchanges that are large, regulated, and not subject to price manipulation.
Additionally, cash-settled Bitcoin futures are typically traded in contango compared to spot, meaning that futures trade at a premium to spot, and longer-dated futures trade at a higher premium than shorter-dated futures. As a result, holding Bitcoin long-term through futures can be a relatively expensive option, depending on the level of contango. Maintaining long-term exposure to Bitcoin through cash-settled futures also requires rolling contracts before expiration, which adds transaction costs on top of the contango.
Generally speaking, futures contracts trade at a premium to account for the storage costs of holding the underlying asset (physical commodities such as gold or oil). Therefore, Bitcoin futures may trade at a premium to offset custody costs. A more likely explanation is that institutions facing regulatory or operational restrictions on obtaining spot Bitcoin are willing to pay a premium to obtain Bitcoin futures.
While this premium may be a disadvantage for players taking long positions, it can also be a feature for traders looking to lock in risk-neutral rolling gains by going long spot Bitcoin (or shorter-dated futures) and shorting longer-dated futures.
2. Regulated physically settled futures 1) Potential Benefits Physically settled futures deliver Bitcoin to the contract buyer upon expiration (if the contract is not rolled over), which is attractive to institutions that ultimately want to invest in the underlying asset, especially if the contract is offered by a regulated institution. In addition, stakeholders do not have to worry about potential manipulation of the spot exchange at settlement, as they might with cash-settled futures.
2) Notes Regulated physically settled futures (volume and open interest) have not yet received the same adoption as regulated cash settled futures. This may be because FCMs are reluctant to support these contracts to avoid clearing and settling physical Bitcoin trades. This is a barrier for institutions whose counterparties may not support these contracts. 5. Active Trading Funds Investors may also find value in gaining exposure to Bitcoin through actively managed vehicles. As a transparent, liquid, volatile asset that trades 24 hours a day, Bitcoin offers active managers an attractive opportunity to generate "alpha" above regular price action. While Bitcoin's inability to adapt to traditional active management has caused institutional investors to abandon active management strategies, Bitcoin offers a unique set of tools that investors can use to assess its fundamentals.
Specifically, market participants have access to data that allows for deeper analysis of Bitcoin than any other traditional asset. Just as government statistical agencies publish a country’s demographic and economic data, or public companies publish quarterly financial statements that disclose growth rates and earnings, Bitcoin provides a real-time global ledger that publishes data about network activity and internal economics.
Actively managed Bitcoin vehicles are often structured in the form of hedge funds. Expenses typically include management fees (1-2%) and carried interest (10-20%). Lock-up periods are longer than other venture capital vehicles, typically 1 to 3 years, with redemptions quarterly. Strategies vary, including neutral/hedged and arbitrage strategies. For investors seeking quality Bitcoin exposure, actively managed strategies may be the best path. 6. Exchange Traded Funds (ETFs) To date, multiple Bitcoin ETF applications have been approved internationally, including in Canada and Brazil. However, the U.S. Securities and Exchange Commission (SEC) has not approved a Bitcoin ETF application. Although the SEC previously raised a series of questions when rejecting Bitcoin applications, the maturity and institutionalization of Bitcoin custody and trading has led to a new round of Bitcoin ETF applications in the United States.
1. Potential benefits of ETFs
1) Redemption Mechanism A publicly traded trust is a security that usually trades at a premium or discount because the shares of a private placement have a 6 to 12 month maturity period during which they must be locked, creating a disconnect between supply and demand in the secondary market. On the other hand, Bitcoin ETFs can be redeemed and created in real time by authorized participants, whose role is to arbitrage ETF shares when the value of shares in the secondary market deviates from the net asset value (NAV) of the fund's holdings in real time.
2) Approved Products Certain fiduciaries, such as registered investment advisors, desire regulated products that address operational constraints they may face (e.g., products that simplify reporting and trading on behalf of many clients). As we have discussed, one of the best options currently is over-the-counter publicly traded trusts that typically deviate from net asset value. However, certain firms may only be authorized or prefer to trade securities on national exchanges with strict reporting requirements, thereby providing more visibility and transparency. A Bitcoin ETF approved by the U.S. Securities and Exchange Commission (SEC) and traded on a national exchange would provide greater protection and transparency than currently available tools.
3) Ease of use In addition, a Bitcoin ETF will allow retail and institutional investors to obtain Bitcoin through a low-cost security package, the share price may be close to the net asset value for the reasons mentioned above, and it can be obtained through traditional brokerage platforms and financial institutions without having to deal with digital asset exchanges and wallets. Greater transparency and ease of use can attract more investment from retail and institutional investors.
An ETF would provide a tool for more conservative retail investors who are uncomfortable or concerned about the availability of recently vetted digital asset service providers, while institutional investors may have similar concerns or be limited in the options currently available to them to acquire Bitcoin. 2) Potential challenges to ETF approval
The SEC raised multiple questions about the previously submitted Bitcoin ETF application, including concerns about Bitcoin custody, Bitcoin market manipulation and regulation, and whether there is a sizable Bitcoin market regulated in the U.S. The digital asset space is advancing rapidly, so these issues are worth re-evaluating.
1) Bitcoin Custody The safe custody and trading of Bitcoin has always been a key concern for regulators. In recent years, the necessary time has been provided to establish high-quality, sound and secure digital asset custody suitable for institutional participation. Institutions now have a variety of reputable custodians to choose from, and these custodians are demonstrating, iterating and improving their security and robustness every day.
2) Manipulation, surveillance, and scale of the Bitcoin market Bitcoin trading is extremely fragmented, as exchanges trade around the world every moment, but lack the interconnectivity experienced by traditional markets. The development of mature trading venues in spot and derivatives markets has helped establish a reliable, regulated, and sizable market. As the space continues to grow, we are seeing improvements in pricing efficiency as large traditional market makers have begun to see the space as worthy of their participation.
The SEC has yet to comment on a growing number of ETF filings. When the time comes, decisions could provide more clarity on whether the regulator believes these previously flagged concerns have been adequately addressed. VII. Conclusion As a truly anonymous asset, Bitcoin’s custodial structure presents unique challenges for entrusted asset managers. This provides a variety of investment vehicles for allocators to consider leveraging to gain exposure to Bitcoin. Each option has its own unique trade-offs in terms of custody, cost and operational burden, as well as other characteristics to consider.
Over time, these products have become cheaper, easier to use, and increasingly efficient. If regulators eventually approve a more traditional investment product, such as an exchange-traded fund, it could lead to a more competitive landscape that could greatly benefit end investors.
"The lack of regulatory clarity and the suboptimal nature of some existing investment vehicles create barriers to investment that prevent certain potential investors from owning these assets. For those who are able to analyze the various trade-offs associated with currently available exposure channels and potentially configure them, the current situation offers an opportunity to stay one step ahead of their peers." |
