- The first US Bitcoin ETF imposes a heavy penalty on investors.
- Bitcoin futures prices are well above equilibrium.
- Bitcoin futures have significantly underperformed the cash market.
America's first Bitcoin ETF started trading on October 19. Strong pent-up investor interest was immediate. The Proshares Bitcoin Strategy ETF (NYSEARCA:BITO) jumped 4.8% the first day. The product tracks Bitcoin by buying futures contracts on the Chicago Mercantile Exchange (CME). Within 2 days, the fund absorbed $1 billion in assets. That's the fastest any ETF has reached that milestone.
At first glance, the concept of a Bitcoin ETF may seem appealing to its acolytes. An ETF security is quite liquid. The SEC often withholds approval of ETF concepts if it has doubts about liquidity or transparency. Futures contracts on the CME are closely regulated. Investors in the bitcoin ETFs need not worry about losing their passwords or theft from hackers.
However, the underlying structure of the bitcoin futures market does raise some red flags. This fund buys the front-month CME bitcoin futures rather than the crypto itself. As those contracts mature, the ETF exchanges its position for the next month's contract.
The problem is that very high buy-side interest pushes the prices of bitcoin futures contracts above a fair equilibrium price. The first bitcoin ETF already comprises one-third of the buy-side interest in next month's bitcoin futures contract. Sellers (shorts) of that same contract have to be compensated to take the other side of the trade. They simply demand a higher price.
These sellers are known as "carry traders". They lock in a profit by holding the actual bitcoin and selling it forward in the futures market. Today, they can lock in a handsome annualized return that varies from 5% to 15%. That's a great deal in today's zero interest world. “It can cost you a lot of money to roll your bitcoin futures,” said Francisco Blanch, an analyst at Bank of America. “There’s an element of traders taking advantage of it, and an investor potentially losing out.”
Consider a simplified example. Let's assume that today bitcoin trades at $60,000. Due to strong demand, the CME futures contract one month out trades at a 1% premium of $60,600. As the contract nears expiration, the futures price must converge to the cash price. The carry trader locks in a 1% profit. Do this for a year and one can obtain a 12% return with almost no risk.
Let's do a little algebra. If going long the cash bitcoin and shorting the futures contract locks in a 12% return, then shorting the cash market and going long the nearby futures contract produces a 12% loss. It's simply the offsetting transaction.
Long(Bitcoin) + Short(Bitcoin Futures) = 12%
- (Long(Bitcoin)) + Short(Bitcoin Futures)) = -12%
Short(Bitcoin) + Long(Bitcoin Futures) = -12%
Short(Bitcoin) + Long(Bitcoin) + Long(Bitcoin Futures) = Long(Bitcoin) - 12%
Long(Bitcoin Futures) = Long(Bitcoin) - 12%
That's right, futures market investors earn 12% less than cash investors in this scenario. Is this empirically the case? Yes! Solactive (a German provider of financial indices) calculates that the strategy of rolling the front-month bitcoin futures every month has returned about 13% less than the cash market so far in 2021. The cost of the roll yield does vary over time.
The WSJ has provided us with a chart the contrasts a strategy of monthly repositioning of front-month bitcoin futures against the underlying cash market. The cumulative underperformance since late 2017 is over 100% and the trend is accelerating. Recent demand dynamics are ominous.
It's notable that there are at least 8 additional ETFs being reviewed by the SEC for possible trade in the 4th quarter of 2021. This should cause investors to reconsider for a couple of reasons. Additional futures-based ETFs and their associated marketing campaigns will stimulate more buy-side interest in the Bitcoin futures market. That would push the roll yield further into negative territory and cost ETF investors even more money.
Secondly, there may be a better implementation of a Bitcoin ETF - perhaps one that professionally manages holdings in the Bitcoin cash market. I would never encourage anyone to hold Bitcoin but ... if you were going to do so, take a position in the cash market.
The structure of the Bitcoin futures market may evolve over time. The contracts themselves may multiply or become deeper. These developments would almost certainly benefit futures investors. Be warned, however. Commodity futures contracts can remain asymmetrical for extended periods of time - even for more traditional assets.
The United States Oil (NYSEARCA:USO) is the largest U.S.-traded oil ETF and primarily invests in near-term West Texas Intermediate (WTI) crude oil futures contracts. Since 2012, it has lagged the WTI spot market by a staggering 57%.
There is a great deal of debate about the long-term utility and value of bitcoin. It exhibits a high degree of price volatility and its implementation of blockchain technology is very energy-intensive. In my view, it will make bitcoin very difficult to scale as a medium of exchange.
This first version of a bitcoin ETF introduces structural disadvantages to investors that are substantial. Buyers will be penalized with a negative roll yield of roughly 10% a year plus a hefty 0.95% management fee. It seems like a very high entry barrier for a product that is already massively volatile.
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