• Matthew Feargrieve

Bitcoin ETFs: Providing Public Access to a Bubble Asset?

Investment management consultant MATTHEW FEARGRIEVE explains how the Bitcoin price surge, combined with regulatory worries, is driving institutional interest in providing proxy access to cryptocurrencies through ETFs.


The parabolic curve in Bitcoin prices has undergone yet another flash crash, after soaring to nearly US$42,000, tumbling 28% to US$30,775.26 as investors pocketed profits from the long rally over Q4 2020, and as the UK's financial watchdog issued a clarion call to financial regulators worldwide about the unregulated nature of cryptoassets.


The growth of the world’s leading cryptocurrency over recent months has seen price hikes of more than 300% over 2020 (in comparison, the S&P 500 rose feebly by 18%). In less than a month, Bitcoin has doubled its value to break through US$40,000 (£29,500) for the first time since its inception.


Banks and investment firms are now cashing in, by offering proxy access to crypto via ETFs (exchange-traded funds). Institutional interest in Bitcoin and other cryptocurrencies is, in direct proportion to the buying frenzy, at an all-time-high; and, perhaps, its last.


BTCetc Bitcoin Exchange Traded Crypto (BTCE), a German product, has recorded average daily trading of around EUR57m in the first two weeks of January, according to data provided by Deutsche Börse, which also disclose trades above EUR30,000, which appear unlikely to have been placed by mere day traders or retail investors.


The sharp rise in trading in the securities highlights how investors are increasingly looking to gain exposure to or bet against cryptocurrencies on traditional markets rather than buying the digital currencies outright. The trading surge in BTCE, representing a sharp pick-up on the EUR15.5m daily average in December, comes following a tenfold rise in the price of Bitcoin since March 2020 to the January peak of US$42,000.


Elsewhere in Europe, VanEck and 21Shares are offering Bitcoin ETNs on Deutsche Börse. And the Swiss exchange currently boasts no less than thirty-four exchange traded crypto products provided by several issuers.


On the other side of the Atlantic, Grayscale’s Bitcoin Trust, which like its German counterpart tracks the price of the digital currency, has posted average daily turnover of almost US$1bn in the first two weeks of 2021, boosting its 2020 average by almost ten times. The inflows into Grayscale tell you all you need to know about the surge in interest in Bitcoin: the firm's AUM had increased from US$2bn in Q1 2020 to US$23bn by the end of the year.


Bitcoin ETFs and the Grayscale Systemic Risk


The SEC is expected to approve a Bitcoin ETF some time in 2021. Regulatory authorization would strengthen Bitcoin's investment case in the long term. There is an opinion in some quarters on Wall Street, however, that the introduction of such an ETF is likely to cause institutional players to withdrawn from Grayscale, thereby creating a near-term drag on Bitcoin prices.


This is because, unlike retail investors who typically buy Bitcoin directly using exchanges like Coinbase, institutional investors largely purchase stakes in Grayscale for regulatory reasons. The trust effectively holds a monopoly on institutional capital flowing into Bitcoin and therefore boasts a large premium to the cryptocurrency it tracks.


A typical trade for monetizing the premium involves borrowing Bitcoin, placing the tokens in the trust, and receiving shares with a six-month lockup period. Investors then hedge the stake by shorting Grayscale shares. Once the six-month lockup expires, a significant portion of the trust's investors could rush for the exits to pocket the premium, after having entered into this monetization trade in mid-2020. A Bitcoin ETF, by offering an alterative home to institutional allocations, would accelerate this movement, eroding Grayscale's prime mover status and prompting a rush to the exit by the trust's remaining clients.


These withdrawals, and a collapse of the Grayscale premium, would negatively impact Bitcoin prices, given the central importance of Grayscale in the still-young market infrastructure of the cryptocurrency.


Increased Interest in Bitcoin ETFs


ETF proxy access to crypto circumvents some of the regulatory concerns and counterparty risk involved in trading bitcoin and surely increases the appeal of cryptocurrency investments for both retail and institutional investors who can invest in the ETF without needing to set up specialised digital infrastructure or use an unregulated crypto platform.


Until recently, the SEC has turned its back on all crypto ETF proposals. Investors and the digital currency universe are hoping that a change in the SEC's top brass, together with the astounding change in Bitcoin's fortunes, could bolster the ETFs' prospects.


VanEck have been quick to capitalise on this turnaround, filing plans for a Bitcoin trust with the SEC. The rhetoric at VanEck is that the Bitcoin market has matured and is now operating at a level of efficiency and scale similar in material respects to established global equity, fixed income and commodity markets.


But many investors, big and small, will not be convinced by this argument.


Notwithstanding the uptick in insitutional allocations over 2020, cryptocurrency trading is still the preserve of mainly retail players, and more speculative firms including hedge funds, as opposed to traditional money managers like pension funds, which remain nervous about bitcoin’s extreme volatility.


Crypto Regulation on the Way


The crypto warning issued in January by the UK financial regulator, the FCA, that investors should be prepared to “lose all their money” when invested in risky cryptoassets, will not assist the speed to market of Bitcoin ETFs. The FCA's warning is the clearest indication to date by a national financial watchdog that the inflows into Bitcoin, and the wholly unregulated sphere in which crypto platforms operate, are of major concern. Regulation looms for crypto in 2021.


Christine Lagarde, president of the European Central Bank, has recently joined the doubters, calling on 13 January for global regulation of cryptocurrencies to help combat their use in “totally reprehensible money laundering activity”.


Bitcoin ETFs: Retail access to a short-lived Bubble?


So what are the risks of Bitcoin and other cryptocurrencies, and should you invest directly through an unregulated platform (like Coinbase, for example; and you can read all about my problems using their platform here) or via a regulated ETF?


The primary factor that prospective investors must keep clearly in mind is that Bitcoin, and other cryptocurrency, is not equivalent to cash. Money converted into cryptocurrency should be treated like money invested in any other investment product or asset: as capital at risk.


Investors should resist at all costs the temptation to view the parabolic curve in Bitcoin prices as a personal get-rich scheme. For two reasons. First, because prices might not get much higher, and you are likely buying at a peak. Secondly, Bitcoin is like any other risky asset, with investors caught up in a mindless buying frenzy, one which you should naturally be slow to join.


Do not be fooled by some market commentary into thinking that crypto now enjoys overall buy-in by traditional allocators. There is plenty of talk of mainstream houses piling into Bitcoin, but in fact the majority of investment houses have not matched expressions of interest with real action. For every institution apparently interested in, or buying, crypto, there are several that are staying away.


Crypto is a risky, highly speculative market. Bitcoin is hardly regulated anywhere in the world, and the money that retail consumers invest will likely not be compensated under government protection schemes (like the one in the UK, which the FCA warned this week would not protect crypto investors in the event of loss).


The narrative that persistently underpins Bitcoin is that it is a decentralised currency that is somehow liberated from central bank tampering. The reality is that it is an (alternative) asset that has profited from an environment of incredulity and that is naturally - and obviously - hardwired into the mainstream banking and financial system, a system that is still driven and operated by mainstream players. Just consider the susceptibility of Grayscale and Bitcoin prices to ETFs promoted by mainstream players like VanEck.


Can Bitcoin really be a Safe Haven Asset in 2021?


Coronavirus has played a part in Bitcoin's recent good fortunes. Crypto looks from a distance like an attractive alternative to currencies that may be devalued by the stimulus packages. The packages are needed but there are real concerns they may set inflationary forces in play. This also creates a new dimension of interest in Bitcoin, that of the cryptocurrency being a Safe Haven asset for 2021.


It is true that Bitcoin can, in theory, serve as a safe haven in such times of frenzy. Its rise in recent months has been driven primarily by concern over the sums that governments have thrown at the pandemic and the prospect of inflation that looms in their wake. To protect against the value of their investments being eroded by inflation, investors often like to hold a real asset (e.g. gold), to serve as a hedge.


Bitcoin could serve a similar role. Its supply is finite – only 21 million coins will ever exist. Unlike US dollars that can be printed, or gold that can be mined. Bitcoin is easier to transact than gold. In times of uncertainty, this gives it some – maybe purely notional- value.


Enter Goldman Sachs, who have reassured their clients that Bitcoin does not pose an existential threat to gold, (Bloomberg reports 18 Dec): “We do not see evidence that Bitcoin’s rally is cannibalizing gold’s bull market and believe the two can coexist“. Goldman did, however, admit that Bitcoin’s ongoing rally could steal some demand from gold investors: “Gold’s recent underperformance versus real rates and the dollar has left some investors concerned that Bitcoin is replacing gold as the inflation hedge of choice. While there is some substitution occurring, we do not see Bitcoin’s rising popularity as an existential threat to gold’s status as the currency of last resort“.


This, from Goldman Sachs, is clearly significant. The traditional move in markets as tumultuous as 2020’s would be to hedge against stock volatility with gold. This has proven an effective method in the past, but Bitcoin has ushered in a new era of digital currencies. As the leading cryptocurrency, Bitcoin has many of properties of a currency, but with some unique features that can make it a viable haven. You can read more about how Bitcoin stacks up against gold in my blog here.


For me personally, Bitcoin’s Safe Haven attributes are limited and should not be overstated. As for buying it now? Prices are too high, and in my view are unlikely to go much further. You would be buying at a peak that cannot be sustained for much longer, as the mainstays of traditional markets and mainstream assets begin to stabilise with vaccines and a Biden administration at the vanguard.


The inflow of monies from small consumers, and the imminent intervention of national regulators, will in my view contrive only to render Bitcoin a highly regulated Bubble. For many investors, big and small alike, Bitcoin is a risk asset that has Bubble written all over it. Bitcoin ETFs would merely provide a regulated way for retail consumers to lose their money.


You can read more of my 2021 outlook for Bitcoin and crypto in my investing blog here.


MATTHEW FEARGRIEVE is an investment management consultant. You can read his business blog here and see his Twitter feed here.