If you buy shares of an S&P 500 index exchange-traded fund, what does the fund do with your money? There is a technical answer about in-kind creation and authorized participants that I am going to ignore here1 to just say: The fund takes your money and uses it to buy shares of the 500ish stocks in the S&P 500. If you slice open the S&P 500 ETF, you will find a bunch of stocks. It owns stocks. When you own shares of the S&P 500 ETF, you own a portion of the big pot of stocks that it owns.
If you buy shares of a Bitcoin ETF, what does the fund do with your money? Again I will ignore technical creation mechanics. Also of course this is a trick question, you cannot (in the U.S.) buy shares of a Bitcoin ETF, Bitcoin ETFs do not exist. But soon they will, Bloomberg’s Katie Greifeld, Vildana Hajric and Benjamin Bain report:
The Securities and Exchange Commission is poised to allow the first U.S. Bitcoin futures exchange-traded fund to begin trading in a watershed moment for the cryptocurrency industry, according to people familiar with the matter.
The regulator isn’t likely to block the products from starting to trade next week, said the people, who asked not to be named while discussing the decision. Unlike Bitcoin ETF applications that the regulator has previously rejected, the proposals by ProShares and Invesco Ltd. are based on futures contracts and were filed under mutual fund rules that SEC Chairman Gary Gensler has said provide “significant investor protections.”
So what will the Bitcoin ETF do with your money? The answer is2:
1. It will put about 30% of the money into a collateral account at a U.S. registered commodity futures exchange, to collateralize positions in cash-settled Bitcoin futures. The futures exchange will presumably hold the collateral in bank accounts or Treasury bills or whatever.
2. It will put about 70% of the money into money-market securities, Treasury bills or high-grade commercial paper or whatever.
Basically if you slice open the Bitcoin ETF you will find a bunch of (U.S. dollar) cash equivalents. Plus a cash-settled bet with a futures exchange that the price of Bitcoin will go up. If Bitcoin goes up, the ETF will get more cash to plop into money-market securities. If Bitcoin goes down, the ETF will have to sell some of those securities to hand over some cash. If Bitcoin doubles, the ETF’s cash will more or less double; if Bitcoin goes to zero, the ETF’s cash will more or less disappear.
The ETF holds a synthetic Bitcoin: cash, plus a derivative to make that cash go up and down with the price of Bitcoin. Somebody is manufacturing that synthetic Bitcoin for the ETF. Probably that someone is an arbitrage trader on the futures exchange, and probably the main ingredient it is using to manufacture the synthetic Bitcoin is a real Bitcoin.3 The trade is roughly:
1. The arbitrageur gets together $60,000 and buys one Bitcoin on a Bitcoin exchange, keeping it in custody on the exchange or in the arbitrageur’s own Bitcoin wallet.
2. The arbitrageur sells one cash-settled Bitcoin future on a registered futures exchange, posting $20,000 of collateral with the exchange to ensure that it will pay up on the bet.4
3. If the price of Bitcoin goes up, the arbitrageur has to put more cash into the futures exchange to margin its position. The value of the Bitcoin it holds goes up, but that doesn’t necessarily generate any cash; it’s not going to sell the Bitcoin.
4. If the price of Bitcoin goes down, the arbitrageur gets some cash out of the futures exchange. The value of the Bitcoin it holds goes down, but that doesn’t necessarily cost it any cash; it’s not going to sell the Bitcoin.
If you put $60,000 into a Bitcoin ETF, it will post about $20,000 at the futures exchange to collateralize one synthetic Bitcoin, and will keep the other $40,000 in cash earning a bit of interest. Meanwhile the person selling it the synthetic Bitcoin has to put up about $80,000 to (1) buy the actual Bitcoin and (2) post margin at the futures exchange itself. That $80,000 isn’t free; you have to pay the arbitrageur for the use of its balance sheet.
Also, the person selling the synthetic Bitcoin has to keep custody of the real Bitcoin it uses to manufacture the synthetic Bitcoin. This is a problem that has become easier over time, but it is still not entirely trivial; there is a lot more high-stakes remembering of passwords in the Bitcoin world than there is in the traditional financial system. This also costs money.