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U.S. First Bitcoin ETF “BITO” Mechanics

By Laxmikant Khanvilkar

Crypto markets are buzzing with the prospect of Spot-Bitcoin exchange traded fund (ETF) launch with several top U.S. financial giants approaching markets regulator – the Securities Exchange Commission (SEC) seeking approval. The agency has delayed its decision due mainly to concerns that the asset is predominantly traded on non-regulated exchanges. But it seems very soon it will have to surrender to the industry demand, market observers say.

Hence, it is time to know what the spot-BTC ETF is and how will it change the crypto-universe. Let’s first understand the first-ever U.S. BTC ETF called “BITO” existence and the change it has brought to crypto markets.

BITO’s launch & product structure

As per the Bank of International Settlements (BIS), the first US bitcoin (BTC) exchange-traded fund (ETF), “BITO”, started trading on 19 October 2021. The fund debuted as one of the most heavily traded ETFs in market history, attracting more than $1 billion in assets in the first few days.

Subsequently, the ETF accumulated a significant share of all short-term bitcoin futures contracts, reaching about one third of the underlying futures market just 10 days after its launch.

The futures-based structure of BITO differs from that of more traditional, non-futures-based equity ETFs and the possible implications for prices and risks.

BITO is the first SEC-approved bitcoin ETF, largely because the fund is based on futures contracts that are traded on the regulated Chicago Mercantile Exchange (CME).

As we know, a futures contract is a legal agreement to buy or sell a particular asset at a predetermined price at a specified time in the future. Such a contract allows investors to take positions without holding the underlying asset. Since holding that asset gives rise to cost of carry – which may be positive in the presence of storage costs or negative due to a convenience yield – the futures price is typically different from the asset’s spot price.

In case of BITO, the asset is bitcoin, and the cost of carry tends to be positive, thus implying that the futures price is generally above the spot price, and that the futures curve tends to be upward-sloping, which is longer dated futures are always expensive that the near-term futures.

To obtain bitcoin exposure, BITO enters into long positions in near-term (one-month) CME bitcoin futures contracts. As contract expiry draws near, the position is rolled over to next month or longer dated contract.

The rebalancing strategy of BITO can erode performance over time in a similar way to that seen in other commodity futures-based ETFs.

Effect on price

In general, a futures-based ETF is likely to affect prices in two main ways. The first effect works through flow rebalancing: when an ETF buys futures contracts in response to inflows, it pushes futures prices up, and vice versa for outflows. The second effect works through calendar rebalancing: as the ETF gradually sells futures contracts before expiration, their prices fall.

The price impact in the futures market can also spill over to spot prices through investors’ hedging behaviour, especially for assets with physical settlements of the futures contract and large storage costs.

The bitcoin ETF may amplify volatility in prices and create risks for investors if the fund is a large share of the futures market.

It is a known fact that futures-based ETFs can exacerbate price movements and create additional volatility when they have a large footprint in the underlying asset. This means the chances of incurring losses are high.

The trading by BITO could also spill over to fixed income markets through its holdings of cash equivalents. If the ETF were to liquidate these instruments in response to bitcoin depreciation or excessive outflows, that could put pressure on bond markets.

Currently, BITO is unlikely to cause such disruptions, as it holds mostly highly liquid short-term Treasuries, and it is small relative to the market for these instruments.

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