Should you Invest in a Bitcoin ETF Holding Bitcoin Futures Contracts?
What Does Any of this Mean?
An ETF (Exchange Traded Fund) is a collection of securities (stocks, bonds, whatever) that can be conveniently traded at a regulated, price-establishing exchange. Like a stock, the ETF will have a market established price. The advantage being that you do not have to invest in each individual security, you just efficiently invest in the single ETF. There are over 1000 ETF’s being actively traded in the U.S., representing all sorts of investment strategies. As ETF’s are regulated by the SEC, you can invest in them directly via a brokerage account, or even as part of a retirement account such as an IRA.
The first Bitcoin focused ETF (ProShares Bitcoin Strategy ETF) recently began trading, rising 5% in its debut, with about $981 million of shares being exchanged over the session, making it the second-most highly traded ETF debut ever. What is interesting is that this ETF does not hold any Bitcoins, rather, it exclusively holds Bitcoin futures contracts, making it possible for regulated institutions to gain exposure to bitcoin, albeit indirect, as we shall see…
In their own words, ProShare’s goal of this ETF is to “provide investment results that generally correspond to the performance of Bitcoin.” They will attempt to achieve this result via managed exposure to Bitcoin futures contracts, a complication made necessary by the SEC.
In order to gauge whether or not this ETF is a good investment, let’s first understand what a “futures contract” is, and why they exist.
Consider the case of Farmer Bob, the corn grower. Bob purchases his seed and fertilizer in the Spring (at a fixed cost), pays his employees all Summer (another fixed cost), but receives all of his income at harvest in the Fall, when he must sell all of his corn before Winter, as he has no means of storage.
Bob’s problem is that the price of corn is very dependent on the net harvest each Fall, the amount of corn produced by Bob and all the other corn farmers. Plus, the demand for corn at that time. While Bob’s expenses are known and fixed, his income is an unpredictable variable.
For any given year, Farmer Bob may make or lose money, a stressful situation for most.
Will also assume that for any given year, Farmer Bob will produce between 900–1100 bushels of corn, depending on weather, etc.
Disclaimer: I have no idea what a bushel is, or if corn is measured in it.
While Farmer Bob might be the type who prefers to roll the dice, and be either hammered by an unusually low price, or pleasantly surprised by a high price, this would be the exception. Most of us prefer not to gamble, that an assurance of a modest profit is better the random roll of the dice.
Now consider the case of Alice, the cornbread maker. A major expense for her bread-making business is the cost of the corn, and it is difficult for her to run an efficient business if her expenses are too volatile. Alice would like to lock in a price for her corn well before she takes delivery, not be subject to last minute price fluctuations.
All that is needed is an agreement between Bob and Alice.
Assume that for the last decade the price of corn has fluctuated between $100 and $200 per bushel. While Farmer Bob prefers the higher $200 price, given an average harvest of 1000 bushels, his break-even price is $135. On the other side, while Alice prefers a low price of $100, her break-even price is $155.
Neither party is aware of the other’s break-even price, but this implies that there is room for negotiation, that both parties would accept a price in the range of $140 — $150, where both can be modestly and predictably profitable.
It will be assumed that after negotiations in the Spring, they mutually agree to a “futures contract,” that six months from now, after the harvest, Alice will purchase 500 bushels of corn from Bob for $145, a net purchase of $72,500.
An agreement has been reached; a legal contract is in place.
By committing to selling about half of his harvest for a known price, Bob has mitigated his risk for that year. Less downside if the harvest price is lower than average, at the expense of less profit if the price is higher.
Alice had also mitigated her risk, as she has now acquired the right to purchase the corn she requires at a known price, one that guarantees a modest profit for her business.
Then the funny thing happens. Just as how loans become a tradable financial asset independent of loaner and borrower (as described in my book), this “futures contract” becomes a tradable financial asset, independent of Bob and Alice.
Because random dude Charlie, with cash to spare, thinks that the price of corn will in fact be $160 at the harvest. He is so confident that his forecast is true that Charlie is willing to purchase some of the futures contracts from Alice, at $150 per bushel. While Alice may not be willing to sell the whole contract, why not sell some of it for a quick profit? The result being that Alice keeps a futures contract for 400 bushels at $145, while Charlie has a futures contract for 100 bushels, still at $145.
Charlie writes Alice a check for $15,000, and Alice makes a quick profit of $500, ($150 — $145) x 100.
If Charlie is correct, come harvest, he will purchase 100 bushels from Bob at $145, and then immediately sell them on the market for $160, netting himself a $1,500 profit for this sale, and a $1,000 ROI if one remembers that he purchased the contract from Alice at $150 per bushel.
But what is the market price is in fact $140? Well, Charlie probably loses money, as he is contractually required to purchase 100 bushels, before the expiration date, from Bob at $145. So unless he has a place to store this corn, he will have to sell it at a loss.
Note that Farmer Bob is unaffected by Charlie’s speculation, as there are still commitments in place for a net purchase of 500 bushels of his corn for $145.
But hold on, along comes another random speculative person Denise, who in the Spring is equally convinced that come harvest the price of corn will instead be $135! How can she profit if her dire forecast is correct?
Similar to shorting stock, Denise enters into a side agreement with Alice, “borrowing” 100 bushels worth of the futures contract from Alice, to be returned to Alice just prior to the harvest. Alice receives an interest payment in exchange for this financial asset “loan”.
Denise immedialty sell these 100 bushels of futures contract to Charlie for $150.
Come close to harvest, Denise is correct, the market established price for corn is dropping, no bottom in sight. Hoping to minimize his losses, Charlies agrees to sell the 100 bushels of futures contracts back to Denise for $135, who in turns returns them to Alice.
Denise nets a quick profit of $1,500, Charlies loses his shorts, and Bob and Alice could care less.
And the opposite would more or less be true if the price of corn were to be higher than expected…
In reality, there would be much more than two speculative traders involved, because that would be required for the futures contracts market to be deep and liquid, desirable traits for any exchange. And there would more than one farmer and one baker locking in future prices, hedging, or limiting, their exposure to future price volatility.
The important point is to understand that the price established at the corn futures contracts market is not the same as the price established for the corn itself, as these are two separate exchanges. The price of corn is determined solely by the supply and demand for corn itself, while the futures price reflects the expectation of the future price of corn, a balance between the bull and bear speculators.
This is not a silly game of risk-taking. The benefit of the futures contracts market is to allow Bob and Alice, the “hedgers”, to shield themselves from price volatility, a kind of insurance. While the “speculators” provide the liquidity to make this possible.
And back to Bitcoin.
Why would one invest in a Bitcoin ETF that attempts to match the performance of Bitcoin, rather than simply purchasing Bitcoin itself? And will this ETF accurately track the price of Bitcoin, or will it be subject to “tracking error?” Unfortunately, explaining how an ETF composed of futures tracks an underlying asset is beyond the scope of this paper, and perhaps beyond the scope of me!
Personally, I would just buy the Bitcoin, enjoy a linear, 1:1 return as Bitcoin increases, and the opposite if it goes down. No leveraging involved.
One possible reason to buy into this ETF is that many do not want to be bothered with understanding how to purchase Bitcoin at a cyber-currency exchange, and how to safely store that Bitcoin on a hardware wallet. Too much work.
Another reason is that many may want to have Bitcoin exposure in their retirement accounts, this ETF makes it possible. I get that.
Does this ETF directly increase the price of Bitcoin? Not really, as it is neither selling nor purchasing Bitcoin. However, my guess is that such ETF’s will add legitimacy to Bitcoin, thus encouraging others to buy and store it directly, hopefully storing it in a hardware wallet.
No doubt that other Bitcoin ETF’s will follow, some that are bearish, some that are bullish, and some that will allow you to leverage your bets for spectacular gains or losses. I will personally pass on those.
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