Rob Behnke
January 29th, 2024
Bitcoin was originally intended to be an alternative to the traditional financial (TradFi) system. The genesis block of the Bitcoin blockchain included a newspaper reference that both timestamped the first block and pointed out the potential repercussions of financial institutions’ failures. Bitcoin was created as an alternative designed to overcome many of the limitations and challenges of the traditional financial system.
Fast forward to January 2024, and the U.S. Securities and Exchange Commission (SEC) has approved eleven companies’ applications to create a Bitcoin exchange-traded fund / product (ETF / ETP).
This approval came in the wake of an appeal by Grayscale after the SEC rejected its application for a spot Bitcoin ETF in 2022. In 2023, a ruling was made in Grayscale’s favor that the SEC’s rejection of spot Bitcoin ETFs while approving Bitcoin futures ETFs violated the Administrative Procedure Act and the Securities Exchange Act of 1934 by making decisions on an “arbitrary and capricious” basis. The SEC decided not to fight the appeal, opening the way for a new Bitcoin ETP.
The creation of Bitcoin ETPs represents a significant change in the relationship between Bitcoin and traditional assets markets as investors are now able to purchase and hold Bitcoin without managing it themselves. Instead, they can invest in an ETP that indirectly maps to ownership of real Bitcoin.
These new Bitcoin ETPs have their benefits for the crypto community and investors alike. However, they also have their downsides and introduce a range of new security risks for holders of the new asset.
Before diving into the details of the new Bitcoin offerings, it’s useful to know the difference between an ETF and an ETP.
An exchange-traded product (ETP) is a general term for assets that can be bought and sold on traditional financial markets like a stock.
Exchange-traded funds (ETFs) are a particular type of ETP that is designed to track the value of a particular pool of assets, such as stocks and bonds.
The use of an asset pool instead of a single asset is designed to help protect the overall ETF against fluctuations in the value of one of the assets in the pool.
This distinction is important because the new offerings approved by the SEC in January 2024 only include a single type of asset: Bitcoin. This means that they’re better described as a Bitcoin ETP than a Bitcoin ETF, which is why you might see both terms in use in media reports about the new offering. In practice, either term can be used to refer to these new types of assets.
The recently approved Bitcoin ETPs are spot ETPs. This means that the funds are backed by real Bitcoin that are held by the issuers of the ETP.
This differs from previous Bitcoin ETPs that didn’t directly hold Bitcoin as their underlying assets. These past ETPs typically held Bitcoin futures, which are derivatives rather than the actual asset. These futures were agreements to exchange assets at a fixed price at some point in the future.
The new Bitcoin ETPs bridge the gap between actual ownership of Bitcoin and the traditional stock market. Before these ETPs were approved, the only means of owning Bitcoin was to do so yourself. This could involve self-custody — maintaining and securing your own private keys — or relying on a cryptocurrency exchange like Binance or Coinbase to do so.
This differs significantly from the traditional stock market, in which investors hold stocks that represent fractional ownership of a company. These stocks don’t mean that the investors’ names are on deeds, contracts, etc., but it does give them voting rights and some control over the company if they own enough of its stock.
A Bitcoin ETP takes this concept of virtual ownership of an asset and applies it to Bitcoin. The ETP issuer is responsible for holding and securing the Bitcoin assets, but they technically “belong” to the investors who have bought shares in the ETP.
In theory, these issuers will directly hold the Bitcoin themselves. In reality, many approved issuers of the Bitcoin ETPs have contracted a custodian (like Coinbase) to manage the private keys for their Bitcoin assets.
The creation of Bitcoin ETPs created significant excitement in the crypto community. The reason for this is that it provides several benefits both to the existing community and to holders of the new asset.
Some of the most significant benefits of a Bitcoin ETF include:
Easier Access: Currently, buying and selling Bitcoin requires a certain level of technical know-how, including knowing where to go (various exchanges), creating an account, and managing your tokens. With an ETP, ownership of Bitcoin is integrated into traditional financial markets, making it easier to access and more like a traditional investment.
Regulatory Safety: One of the most significant challenges facing the cryptocurrency industry is the lack of modern, effective regulation. A Bitcoin ETP falls under the regulatory authority of the SEC and existing laws, providing investors with a greater degree of protection.
Simplified Personal Security: Owning Bitcoin directly places the responsibility for security — mainly protection of their private key — primarily on the user. With a Bitcoin ETP, the issuer owns the asset and is responsible for protecting it.
Increased Liquidity: By integrating Bitcoin into traditional markets, Bitcoin ETPs expand the pool of potential investors. This can help to increase Bitcoin’s liquidity and may help to stabilize the price of the asset over time.
Asset Diversification: Diversification is essential to protecting an asset portfolio against various shifts in financial markets. The price of Bitcoin is less tied to that of other assets, providing additional options for investors looking to diversify their portfolios.
A Bitcoin ETP has a range of potential benefits for its investors and the Bitcoin and cryptocurrency as a whole. These benefits are why the crypto community has been so excited about the potential for ETFs and the success of Grayscale’s appeal against the SEC’s ruling.
However, Bitcoin ETPs have their downsides as well, including significant security risks.
Some of the downsides of a Bitcoin ETP — but not the most significant one — include the following:
Indirect Asset Ownership: One of the main selling points of Bitcoin is that it gives people the opportunity to be their own bank, free of the potential for censorship, etc. With the Bitcoin ETP, investors are accessing Bitcoin through the ETP issuer, which reintroduces many of these downsides.
Limited Utility: Bitcoin is a currency, meaning that it can be used to purchase goods and services or be transferred directly to others. Bitcoin ETPs can’t be used to make purchases, and gifting shares to others is a more complex process than a direct transaction via the blockchain.
No Cross-Crypto Support: Cryptocurrency exchanges make it possible for crypto owners to exchange Bitcoin for other cryptocurrencies, unlocking additional investment opportunities. With a Bitcoin ETP, the fact that investors don’t own the Bitcoin that backs the ETP means that they are limited to investing only in Bitcoin with no potential to trade for other crypto assets.
Lack of Anonymity: Bitcoin also offers pseudo-anonymity since Bitcoin addresses are randomly generated and not linked to a user’s real-world identity unless they go through an exchange with know-your-customer (KYC) requirements. With an ETP, the issuer is required to collect a range of identifying information from investors before allowing them to purchase the product.
Exposure to Security Risks: Bitcoin ETPs require someone to own Bitcoin, meaning that investors are exposed to 51% attacks and other blockchain risks. They also lack visibility into the security controls used by the ETP issuer to protect the private keys that secure the Bitcoin that backs the funds.
Restricted Trading Windows: As a global, decentralized network, Bitcoin is active 24/7, and users can perform Bitcoin transactions at any time. With a Bitcoin ETP, investors are limited to the trading windows of the stock market. This means that investors can miss opportunities when Bitcoin’s price shifts outside of normal market hours (nights, weekends, etc.).
Increased Fees: The Bitcoin network has certain fees associated with performing transactions; however, it’s possible to interact directly with the network and cut out the middleman. With a Bitcoin ETP, the ETP issuer will have a certain fee on transactions, which is likely to be significantly higher than Bitcoin’s built-in fees.
Inaccurate Pricing: Bitcoin is a volatile asset, and Bitcoin ETPs are a new concept, which might mean that they will have limited adoption and liquidity. As a result, the price of a spot Bitcoin ETP might not accurately track the real-world price, and investors may struggle to make purchases and sales at their desired price points even if the “real” price of Bitcoin is at that point.
Lack of Control: With Bitcoin, it’s possible to “be your own bank”, exerting complete control over your cryptocurrency portfolio. With a Bitcoin ETP, the management strategy of the fund is determined by the fund manager, who might make different decisions than the investors would prefer.
While the downsides mentioned above are inconvenient, they are not the most significant concern regarding Bitcoin ETPs. This — as pointed out in a CoinDesk op-ed by Halborn’s COO David Schwed — is the centralization risk of the new Bitcoin ETP.
The SEC approved multiple different issuers to create Bitcoin ETPs. In theory, this would create a level of decentralization since the varying issuers would be in competition with one another. As with the network of independent miners in the Bitcoin blockchain, having a group of competing parties reduces the risk of fraud and various types of cyberattacks.
The centralization risk of the Bitcoin ETP exists one level deeper with the companies that these ETP issuers are trusting to manage their Bitcoin holdings. Instead of engaging in self-custody, many of the issuers are using a third-party service to manage their Bitcoin wallets, just like many Bitcoin users do. This creates significant security risks, especially when the majority of ETP issuers are using the same organization to do so.
Most of the recently approved issuers of crypto ETPs have announced that Coinbase will be the custodian of the Bitcoin holdings that back their spot Bitcoin ETP. As highlighted in Halborn COO David Schwed’s op-ed in CoinDesk, the fact that many issuers are relying on the same custodian introduces a few risks, including:
Cyberattacks: While Coinbase currently has an excellent security track record with no known hacks, this could change in the future. If the majority of Bitcoin ETPs are backed with crypto held by this company, a hack could be devastating.
Fraud: The fall of FTX — and numerous other incidents — underscore the threat of fraudulent or risky business operations in the crypto space. While Coinbase has shown no sign of such activities, fraudulent activity regarding Bitcoin ETPs could result in billions in losses.
Operational Disruptions: While Coinbase appears to be a healthy company, it could go out of business or be engaged in legal suits that disrupt its operations. If it is responsible for backing most Bitcoin ETPs, then a disruption of the company’s operations could have far-reaching consequences.
Many of these risks can be managed with improved regulation of custodians of crypto assets. However, regulations commonly lag behind technology in the crypto space.
The approval of new Bitcoin ETPs creates new investment opportunities in the crypto space. In addition to the ability to invest in Bitcoin futures, spot Bitcoin ETPs are now a possibility.
This creation of Bitcoin ETPs has numerous potential benefits for Bitcoin. In addition to helping to bring Bitcoin and cryptocurrency further into the mainstream, it also simplifies the process of investing in Bitcoin and can create additional liquidity in Bitcoin markets.
However, these ETPs also introduce security risks, especially the fact that the custodianship of issuers’ assets is largely centralized in a single company, Coinbase. Managing the risks of such custodianship — an inherently risky business — requires additional regulation and oversight.
To further explore the security risks of this centralized custodianship, check out our COO David’s op-ed in CoinDesk.