Rob Behnke
March 12th, 2024
In January 2024, the Securities and Exchange Commission (SEC) approved the creation of Bitcoin spot exchange-traded funds (ETFs). Unlike previous Bitcoin ETFs — which were based on Bitcoin derivatives — spot Bitcoin ETFs allow investors to directly invest in Bitcoin. The issuer of the Bitcoin ETF is responsible for purchasing and holding the Bitcoin needed to back the ETFs that they offer on the stock market.
This new approach to Bitcoin investment, which opened up opportunities for new investors, had a dramatic impact on the cryptocurrency space. Within the first month, billions of dollars were invested in these ETFs, exceeding many analysts’ expectations. As a result, Bitcoin’s value increased to all-time highs, shortly in advance of its next halving (which also typically drives price increases).
Like any investment — whether in cryptocurrency or traditional stocks — investing in Bitcoin ETFs has its risks and the need to implement security best practices. Understanding which risks and security requirements apply to the ETF issuer vs. the buyer is essential to safe investment.
Ten companies created spot Bitcoin ETFs in the wake of the SEC’s ruling. One of the main benefits of Bitcoin ETFs is that it eliminates the need for buyers to directly own and manage their own Bitcoin. Instead, the Bitcoin ETF issuer manages a store of Bitcoin equivalent to the amount of investment held by their fund.
Some of the security risks and requirements that this different approach to crypto ownership transfers to the Bitcoin ETF issuer include:
Bitcoin Custody: Bitcoin ETF issuers need to hold the Bitcoin required to back their exchange offerings. In many cases, these issuers have decided to use a custodial provider, such as Coinbase, to manage their private keys. However, the issuer is responsible for protecting their account with the custodian against account takeovers via compromised passwords, phishing, etc.
Regulatory Compliance: The crypto regulatory space in the US is complex. While Bitcoin ETFs have been authorized, issuers also need to ensure that they are compliant with applicable regulations.
Investor Education: Issuers also have the responsibility of educating investors about the potential risks of investing in their funds. For example, they should explain how a Bitcoin ETF differs from purchasing cryptocurrency directly and the associated market risks.
In general, since spot Bitcoin ETFs are pegged to the price of Bitcoin, ETF issuers are not exposed to the potential risks of Bitcoin’s volatile price. However, they are responsible for ensuring that their fund remains backed by the appropriate amount of Bitcoin.
Investing in a Bitcoin ETF rather than buying the cryptocurrency directly shields buyers from some of the risks and technical challenges associated with managing their own Bitcoin wallets.
However, not all security risks are taken on by the ETF issuers. Some security risks that ETF buyers need to accept or manage themselves include the following:
Selecting an ETF Issuer: The SEC’s decision allowed ten organizations to create Bitcoin ETF offerings, each of which has its own unique set of fees and features. When choosing to invest in Bitcoin via a spot ETF, it’s important for investors to perform their own due diligence on Bitcoin ETF issuers to select the one that is the best fit for them and their risk appetite.
Supply Chain Risks: In addition to potential security risks associated with the ETF issuer, a Bitcoin ETF investor must also consider the risks associated with that issuer’s partners and suppliers. For example, many ETF issuers have chosen to use the same custodial provider — Coinbase — creating centralization risks in the space.
Account Security: Bitcoin ETFs make it possible for investors to indirectly hold Bitcoin via a traditional investment account, treating it like any other stock or ETF. This eliminates the need for buyers to manage and secure their own wallets and private keys, a significant challenge for many investors. However, users are still responsible for securing their accounts with their investment account provider to protect against unauthorized buying and selling on their behalf.
Price Volatility: The value of spot Bitcoin ETFs is directly tied to the real-world value of Bitcoin, just like if an investor bought Bitcoin directly. This means that Bitcoin ETF investors accept the risk that the value of their investment will decrease, just like with any other investment.
Liquidity Risk: Bitcoin ETFs may have limited liquidity, especially at times when the price of the asset is increasing or dropping rapidly. This means that ETF investors may struggle to perform buys or sells at their desired times and price points.
Counterparty Risk: With a Bitcoin ETF, an investor is trusting the ETF issuer’s management of the ETF. If the issuer mismanages the ETF, then investors may lose money.
Regulatory Risks: The regulatory landscape for Bitcoin and cryptocurrency in general is still in a state of flux, and regulatory changes may impact the viability and value of Bitcoin ETFs. While spot Bitcoin ETFs have been explicitly approved by the SEC — making it unlikely that they will become illegal again — changes to the rules may affect the ability to invest, or opening up the door to spot ETFs for other cryptocurrencies may dilute the investor pool and the ETF value.
Investing in a Bitcoin ETF exposes investors to many of the same risks as buying Bitcoin directly but eliminates the challenge of securing private keys. However, Bitcoin ETF investors still have security responsibilities and also accept additional risks by choosing indirect ownership of their cryptocurrency.
The introduction of spot Bitcoin ETFs has significant implications for the cryptocurrency space and investors outside of it. In the past, the technological and regulatory challenges of owning Bitcoin directly put many investors off, steering them toward other asset classes. With the ability to treat investing in Bitcoin like investing in any other stock, interest has exploded, bringing new capital and interest into the space.
However, any type of investment carries security risks and responsibilities. While buying Bitcoin via an ETF transfers some security responsibility to the issuer, buyers also need to be aware of the security risks and responsibilities that they are taking on as well.