Not All Bitcoin ETFs Are Created Equal - What Investors Need To Know

In this article I delve into how traditional ETFs work and why some investors prefer using them instead of holding their own bitcoin directly. Later I explore some of the key differences in the available bitcoin ETFs on the Australian marketplace and why not all ETFs are created equal.

How does a traditional ETF work?

An ETF is a type of fund that typically performs two functions:

1. Directly holds the underlying asset that it represents
2. Tracks the price of the underlying asset with minimal slippage (the price at which you make the order for and the eventual price at which you buy/sell it).

Why would you want to buy via an ETF rather than just buy bitcoin directly?

The reason ETFs are useful is that with commodities like gold and oil, you get exposure to the price without having to deal with physical delivery and custody such as hoarding gold bars or barrels of oil in your basement. Similarly, with bitcoin you can learn to self-custody, but many investors want something that is safe and easy to buy and hold without having to worry about losing the keys to their bitcoin wallet or the crypto exchange collapsing.

How do some bitcoin ETFs differ from others?

Guidance released by ASIC in October 2021 outlined that companies looking to offer crypto asset related investment products to their clients would need to apply for a crypto asset authorisation under an Australian Financial Services License (AFSL). The guide further outlines reasoning why, stating that the issuers of these products need to ensure they have the appropriate insurance, pricing mechanisms and secure third-party custody standards to maximise investor protections and minimise risks of capital loss.

Importantly, some bitcoin ETFs have found a loophole where they don't need to adhere to the crypto asset authorisation AFSL because they don't hold bitcoin directly as part of their fund. These funds, often termed ‘feeder funds’ hold units in a separate fund based overseas in places like the United States.

Why create a feeder fund in the first place?

Some ETF issuers who have already established operations overseas have been able to bring their product to market faster and more cost effectively by offering customers access to units in another fund rather than going through ASICs crypto asset authorisatoin license required when offering the underlying bitcoin directly. Unfortunately, this also means that these funds are not held to the same price benchmarking, compliance and regulatory scrutiny for investor protections as funds that hold bitcoin directly. For example, should a fund encounter issues overseas, investors would be faced with having to deal with overseas companies and regulatory processes in order to recover funds.

What bitcoin ETFs actually hold the underlying bitcoin?

Monochrome is one of the few bitcoin ETF providers in Australia that holds the underlying bitcoin. In order to track the price of the underlying bitcoin more closely and to minimise slippage, Monochrome uses an independent CME CF benchmarking rate.  A benchmark rate is a way to determine the market price of bitcoin by aggregating live price data from the largest exchanges such as Coinbase, Gemini, BitStamp, Kraken, IBIT and LMAX. In many cases, you’ll find other bitcoin ETFs use and actually own their own benchmarking rates for bitcoin prices, which can lead to selection bias and potentially poorer price tracking performance.

For example, one of the most popular bitcoin ETF feeder funds has returned 0.32% less than its bitcoin price benchmark rate over the last month alone. Compare this to Monochrome where the return of the fund is just 0.0024% below the CME CF price benchmark over the month despite having near identical fund management fees to the feeder fund, the price slippage in holding the Monochrome ETF is >100x lower.

In summary, ETFs that adhere to and work within the guidelines provided by ASIC and the crypto asset authorisation guidelines appear to offer investors not only better returns by tracking the underlying performance of bitcoin more closely, but ultimately provide investors with greater protection through holding bitcoin directly. Investors should focus on increasing their awareness of the potential increased risks and performance differences when investing into a feeder fund compared to a true spot bitcoin ETF.