One of the interesting aspects of any early stage innovation is that it is incredibly difficult to distinguish a breakthrough idea from a dud. At one point Twitter (TWTR) was considered a mere Internet curiosity, while the Segway was expected to revolutionize urban transportation. The proposed Bitcoin ETF is a classic case in point: If successful, it could make virtual currency trading more mainstream, which would be a breakthrough development. However, that success is currently not assured.
Nevertheless, the Bitcoin ETF is an important concept, so rather than speculating on its potential adoption, this article focuses on understanding the product itself. We address five fundamental questions about the proposed Bitcoin ETF:
- What is the asset underlying the ETF?
- Who is launching the ETF and what is the current status?
- How will the reference price / index level for the ETF be determined?
- What is the legal structure & expense ratio for the proposed product?
- What are the key risks associated with the product?
1. What is the asset underlying the ETF?
Bitcoin is a virtual currency that can be stored and traded electronically. It is stored in a digital wallet and can be traded using a downloadable software (Bitcoin client) or through a third party provider. It is important to distinguish Bitcoin from payment systems like Paypal (EBAY) or Apple Pay (AAPL), which are ways to transfer a traditional currency (such as the US Dollar) electronically.
An important reason for the adoption for Bitcoin is that it is decentralized i.e. there is no central Bitcoin issuing or monitoring authority. Instead, every time a Bitcoin transaction is initiated, it must be validated by a Bitcoin ‘miner.’ These miners are entities within the Bitcoin network that validate the transaction by solving a mathematical proof. Once the transaction is validated, the miner adds it to the record of previous Bitcoin transactions. This updated chain of completed Bitcoin transactions is called a Blockchain, which is publicly transmitted across the entire Bitcoin network. This system prevents double counting of existing Bitcoins and enables record keeping of all Bitcoin transactions.
In return for validating transactions, miners are rewarded with a transaction fee and new Bitcoins. So miners are effectively performing a dual function: they are validating transactions and facilitating the creation of new Bitcoins in a systematic manner. (A detailed explanation of Bitcoin mechanics is available on the Khan academy website)
The goal of the proposed ETF is to provide exposure to this asset and reflect Bitcoin price changes.
2. Who is launching the ETF and what is the current status?
The Winklevoss Bitcoin Trust is the first Bitcoin ETF to be filed with the SEC and is sponsored by Math-Based Asset Services, promoted by Tyler and Cameron Winklevoss. The first ETF application was filed on 1st July 2013 and has been revised four times with the last amendment filed on 1st July 2014. The latest amended registration statement states that if approved, the ETF will trade under the ticker COIN. (A complete list of tickers for US listed ETFs is available here)
The application is currently pending approval with the SEC, and it is still unclear how long that process could take. The ETF could also potentially compete with SecondMarket’s Bitcoin Investment Trust, which is currently available to accredited investors only and is seeking SEC approval to open to all investors. Coinfloor, a London based Bitcoin exchange, has also recently stated its plans to introduce a Bitcoin ETF to tap the European markets.
3. How will the reference price / index level for the ETF be determined?
According to the SEC filing, “the investment objective of the Trust is for the Shares to reflect the performance of the price of Bitcoins, as measured by Winkdex, less the expenses of the Trust’s operations.” The Winkdex is an exponential moving average calculated using volume-weighted prices of US Dollar denominated trade data from the three highest trading Bitcoin exchanges in the past 24 hour. By weighting transactions by volume and time, the formula gives greater weight both to higher volume transactions and more recent transactions. The calculation of Winkdex as of 4:00 p.m. New York time on each Evaluation Day will be used as the Winkdex spot price for the calculation of the Trust’s NAV.
4. What is the legal structure & expense ratio for the proposed product?
Two important determinants of tax rates for investors holding an ETF (or more accurately, an Exchange Traded Product) are the product’s legal structure and the nature of the underlying assets.
- Legal Structure: The Winklevoss Bitcoin Trust is structured as a Grantor Trust under the Securities Act of 1933. For federal income tax purposes, a share in the ETF is treated as a pro-rata share in the underlying asset itself. Therefore, the applicable tax rate will depend on how the underlying Bitcoin holding is classified for tax purposes.
- Treatment of underlying asset: The long-term capital gains rate for a Grantor Trust ETP is dependent on how the underlying asset is classified. Currently, grantor trust ETPs that hold physical metals such as gold are subject to the collectibles capital gains rate on long-term capital gains. Those that hold capital assets (e.g. stocks or bonds) are subject to regular long term capital gains, while those that hold currencies are subject to the ordinary income tax rate on long-term capital gains. On this issue of how Bitcoin will be treated, the ETF filing cites the IRS guidance issued on March 25, 2014. This notice (IRS Notice 2014-21) concludes that Bitcoin should be treated as property that is not currency for US federal income tax purposes and clarified that Bitcoin could be held as capital assets. (Note: Since this is a fluid area, potential investors in Bitcoin based investment products should consult with a tax expert).
The expense ratio for the proposed ETF has not been specified in the regulatory filing. We can expect this to be specified in the future, but as of this article being published, the expense ratio has not been determined.
As a point of reference, the table below compares the proposed Bitcoin ETF with the SPDR Gold ETF (GLD) and the BIT Fund.
||Proposed Bitcoin ETF
||All US Investors
||All US Investors
||Not mentioned in filing
||Math-Based Asset Services LLC
||World Gold Trust Services, LLC
||Alternative Currency Asset Management
||London PM Fix
||Volume weighted average price across the market
5. What are the key risks for the products?
The potential risks in the Bitcoin ETF can be categorized under two heads: those inherent in Bitcoin, and those that are specific to the proposed ETF.
Risks Inherent in Bitcoin
- Bitcoin network vulnerability: Virtual currencies do not have any physical existence, which makes them susceptible to online attacks. The recovery of lost Bitcoins could be difficult. The shutdown of Mt Gox, a Bitcoin exchange, exposed the Bitcoin network’s potential vulnerability.
- Reputational damage: In the past Bitcoin has allegedly been used to buy illegal goods and services. Such activity could potentially tarnish its reputation and credibility.
- Volatility in Bitcoin prices: As of October 29, 2014, Bitcoin was trading 70% lower than its all time high price. On 11% of days in the index’s history, the Bitcoin Price Index experienced changes of more than 10%. Such volatility can be potentially detrimental to ETF investors.
- Changes in the Bitcoin protocol: Disagreements within the core Bitcoin developer group or the creation of unauthorized variations in the protocol could cause confusion.
- Regulatory changes: Regulatory bodies may propose guidelines and laws impacting usage and tax implications.
- Unexpected changes in Bitcoin supply: The Bitcoin protocols have been developed so as to ensure there is no over-supply of Bitcoins, with the total maximum Bitcoin issuance expected to be capped at 21MM. However, there could be unexpected factors (such as future protocol changes) that impact the supply of Bitcoins, affecting their value.
Risk of trading Bitcoin ETF
- Ambiguity in cost: Important factors like expense ratio are still not fully determined and announced.
- Loss of private key required to access Bitcoin: The Bitcoin Trust will be responsible for the safekeeping of Bitcoin private keys for investors.
- Liquidity in underlying asset: Since ETFs utilize a create / redeem mechanism, ETF liquidity must be gauged by looking at the underlying asset’s liquidity rather than the ETF itself. Since Bitcoin is a new concept, it is hard to know how two-way flow will be impacted if there is an event that causes market stress in this asset. Poor liquidity in Bitcoin trading could potentially hamper the create/redeem activity by Authorized Participants in the ETF.
It is clear that Bitcoin and the proposed Bitcoin ETF product do carry significant risks, but also potential benefits. As we stated at the outset, it is difficult to assess upfront the potential success of any early stage innovation. If this product does get approved, ultimately the marketplace will decide if this product serves a useful need.
This article was co-authored by Aniket Ullal and Jania Kesarwani.
Aniket Ullal is the founder and CEO of First Bridge Data, a provider of independent ETF data and analytics to institutional clients. First Bridge is not affiliated with any ETF sponsor and does not promote or distribute any ETF products. Jania Kesarwani, FRM, previously worked as a research analyst with CRISIL, a subsidiary of S&P.
This article should not be considered investment or tax advice. Both the authors and First Bridge Data LLC shall not be liable for any actions or decisions made based on the information provided in this article. First Bridge Data LLC is not a registered investment advisor or broker, and does not recommend specific securities, funds, or investment strategies, nor does it advocate the purchase or sale of any individual investment vehicle.