• Research

Jan 3, 2018

S3 Analytics: The Bitcoin ETFs are Coming

After declining several Bitcoin ETF applications in 2017 such as the Winklevoss Bitcoin Strategy ETF, SolidX Bitcoin Trust and VanEck Bitcoin Strategy ETF the SEC is now considering approval of several Bitcoin based ETFs which would trade on the CBOE, NYSE and NASDAQ exchanges. The new ETFs will differ from Grayscale Bitcoin Investment Trust (GBTC) in that their underlying asset will be CBOE and CME Bitcoin Futures contracts and not actual Bitcoins. SolidX which had filed previously to create its Bitcoin Trust ETF with the SEC in 2016 has not refilled its application.

Generating short Bitcoin exposure has been limited to shorting the GBTC ETF which has been hindered by the relatively small amount of shares available to borrow (less that $200 million) and expensive borrow costs (over 20% fee recently). The influx of new ETFs and the probability of significant institutional holdings should allow for an increased amount of short selling by traders who prefer not to transact in actual Bitcoins or futures contracts.

CBOE
• First Trust Bitcoin Strategy ETF
• First Trust Inverse Bitcoin Strategy ETF
• REX Bitcoin Strategy ETF
• REX Short Bitcoin Strategy ETF
• GraniteShares Bitcoin ETF
• GraniteShares Short Bitcoin ETF

NYSE
• ProShares Bitcoin ETF
• ProShares Short Bitcoin ETF

NASDAQ
• VanEck Vectors Bitcoin Strategy ETF

Bitcoin investors will eventually be able to own outright “physical” cryptocurrencies via the various cryptocurrency exchanges, trade both long and short Bitcoin futures contracts on the CBOE and CME exchanges and accumulate both long and short Bitcoin exposure via ETF contracts. The increased options of Bitcoin asset types will not only open Bitcoin investing opportunities to a much larger population of traders, investors and speculators, but also create the possibility of varied trading strategies.

Traders will now be able to short Bitcoin more efficiently and more cheaply via futures contracts and ETFs, which opens up arbitrage opportunities between asset classes and exchanges. If Bitcoin futures contracts or ETFs are overpriced, traders will be able to go long ”physical” Bitcoin and short the “mispriced” derivatives in anticipation of the outsized spread shrinking to “fair” levels and earning a relatively risk-free arbitrage profit (depending on execution cost and efficiency).

In addition to keeping a mindful eye on both arbitrage and algorithmic trend trading, investors of the new futures based ETFs will have to manage contango risk as the ETFs continuously roll their underlying futures assets into forward contractual months. Contango occurs when the cost of forward dated futures contracts are trading at a premium compared to the near dated futures contracts. On inception, futures contract based ETFs create their shares they buy $1 of futures contracts for each $1 of cryptocurrency shares they create. Over time, these original futures contracts will expire and need to be replaced with newer futures contracts. ETF creators do not wait till expiry, and risking unhedged exposure, to “roll” their futures positions but gradually sell their nearly expired futures contracts and replace them with longer dated futures contracts so as to minimize trading and price volatility. In periods of contango the price of the longer dated futures contract is more expensive than the nearer dated futures contracts, therefore selling $1 of nearly expired contracts worth 1.00 cryptocurrency will only buy $1 of longer dated futures contracts worth 0.99 cryptocurrency. Over time, this continued asset depletion due to the monthly futures “roll” will cause the ETF to hold fewer and fewer cryptocurrencies and therefore devalue the price of the ETF. This contango effect can be clearly seen in the various long VIX ETFs such as the iPath S&P 500 VIX Short-Term Futures ETN (VXX) which was down 73% in 2017 while the CBOE VIX Index was only down 21% for the year.

The emergence of futures, swap and ETF Bitcoin trading leads us to believe that Bitcoin options trading is not far behind. The ability to hedge out Bitcoin exposure via daily traded margianable exchange based futures and ETFs will allow option writers to offer Bitcoin puts and calls. Once the CBOE and CME futures contracts have a history of successful executions, settlements, trading volumes and pricing, option writers will have the capability to write OTC options offset with futures contracts or ETFs. Eventually, if the OTC options are successful and have sufficient trading volumes, listed options are sure to follow.

Traditional long Bitcoin investors and speculators will now have to worry about sophisticated trading strategies moving Bitcoin’s spot price as seen in the traditional foreign exchange markets. In addition to timing market trends and managing operational and settlement cryptocurrency risks, traders will have to be aware that Bitcoin price movements will be affected not only by “physical” Bitcoin demand but also by derivative and ETF market activity. 

Up until now, virtually all of Bitcoin trading has been long buying or long selling – the emergence of futures and ETF trading will add short selling and short covering into the mix. Short selling will add downward pressure in times of Bitcoin price weakness and short covering will add impetus to times of Bitcoin strength. Eventually the ability to short Bitcoin exposure will smooth out some of Bitcoin’s volatility but in its nascency volatility is bound to be exacerbated until pricing equilibriums are reached. 

Want deeper insight into the above analysis? Contact:
Ihor.Dusaniwsky@S3Partners.net
Managing Director Predictive Analytics, S3 Partners, LLC
The information herein (some of which has been obtained from third party sources without verification) is believed by S3 Partners, LLC ('S3 Partners') to be reliable and accurate. Neither S3 Partners nor any of its affiliates makes any representation as to the accuracy or completeness of the information herein or accepts liability arising from its use. Prior to making any decisions based on the information herein, you should determine, without reliance upon S3 Partners, the economic risks and merits, as well as the legal, tax, accounting and investment consequences, of such decision.


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