Demystifying Bitcoin: a closer look at cryptocurrency ETFs

Let's peel back some of the mystery around the recent news propelling Bitcoin into the spotlight - the new crypto exchange traded funds (ETFs).

Cryptocurrency is digital money secured by a specific type of public ledger called blockchain. Without a governing body, a public digital ledger transparently records peer-to-peer transactions. Bitcoin, launched in 2009, became the first widely adopted cryptocurrency. Because the number of coins is limited, Bitcoin has become a tempting speculative investment.

Bitcoin as an ETF

On January 10th 2024, the U.S. Securities and Exchange Commission (SEC) marked a significant milestone in the cryptocurrency world with the approval of 11 spot Bitcoin ETFs. This includes offerings from fund titans BlackRock and Fidelity. This move is set to potentially transform the landscape of cryptocurrency investing and open new opportunities for traders.

To understand the impact of this development, it is essential to grasp what spot ETFs are. A spot ETF is a type of fund that directly tracks the current, or "spot," price of an asset—in this case, Bitcoin (BTC). Unlike futures-based ETFs, which are tied to contracts betting on the future price of an asset, spot ETFs are backed by the actual price of the asset itself.

This means that when you invest in a spot Bitcoin ETF, the fund purchases actual Bitcoin, and the value of your investment fluctuates with the real-time price of Bitcoin in the market. These Bitcoins are held by a custodian. Coinbase is the custodian for eight of the 11 spot Bitcoin ETFs.

The introduction of spot Bitcoin ETFs is a game-changer because it provides a bridge between the traditional financial world and the burgeoning crypto market. For traders, this means easier access to Bitcoin investments without the complexities and security concerns of managing a digital wallet or trading on a cryptocurrency exchange.

One of the most significant advantages of these ETFs is the potential for increased liquidity and price stability. As more institutional and retail investors gain exposure to Bitcoin through these funds, trading volumes are expected to rise. This could lead to a more stabilized market with less price volatility, which is beneficial for traders who seek to capitalize on incremental price movements.

This price stability resulting from greater market participation could be a disadvantage to traders who benefit from regular and dramatic Bitcoin price movements. Moreover, spot Bitcoin ETFs could also lead to broader adoption and acceptance of Bitcoin as a legitimate asset class. With the SEC's stamp of approval, investor confidence in Bitcoin could grow, potentially leading to increased demand and, consequently, higher prices.

This parallels the journey of gold ETFs, which increased gold demand substantially and reduced volatility long-term.

How the ETF is different from other Bitcoin derivative products

Bitcoin ETFs make investing in Bitcoin much more accessible to casual traders and retail investors. While futures contracts based on the price of Bitcoin require oversight of settlement dates and delivery complexities, an ETF trades like a stock. It simply tracks an underlying index price - in this case, Bitcoin spot price.

So the Bitcoin ETF offers simple exposure tied to Bitcoin's price swings without needing to directly buy crypto from an exchange or wallet and take on the hassles of storage and security. You can buy and sell the ETF seamlessly like stocks from a standard brokerage account.

The ETF format opens the door to mainstream investments funds, retirement accounts like 401ks, and amateur stock dabblers - not just specialized futures traders. This instantly widens the pool of potential Bitcoin investors dramatically.

However, holding such a volatile asset in an ETF format might be a shock to ETF investors who typically benefit from the performance of entire markets as opposed to individual assets. Since the ETF tracks the performance of a single asset, the ETF also doesn’t offer the diversification inherent in broad-market ETF products. The Bitcoin ETF will behave like a commodity ETF.

The launch of Bitcoin ETFs coincides with another important moment for Bitcoin prices: halving day.

Bitcoin halving day

Bitcoin mining is how new coins are created and verified transactions are added to the blockchain ledger. Miners compete to solve complex math puzzles and earn rewards for each block added. Originally, successful Bitcoin miners were rewarded 50 BTC per block, an incentive for mining activity. However, Bitcoin has a hard cap of 21 million total coins that can exist.

To ensure controlled supply until the cap is reached, mining rewards decrease by 50% every 210,000 blocks mined. This pre-set halving of mining rewards happens approximately every four years, with the next halving day estimated to be in April 2024.

When halving days reduce the supply of new Bitcoins flowing in, simple economics kicks in. All else being equal, when supply drops but demand keeps growing, prices tend to rise. The anticipation of this can spur speculative investing leading up to the halving day.

Even without the ETF news, Bitcoin’s next “halving day” in April 2024 suggests this built-in increasing scarcity could drive prices up in the coming years.

Of course, cryptocurrencies still come with plenty of risk and uncertainty. But the possibility of more investors and financial giants embracing Bitcoin and its derivatives indicates prices could continue climbing.