Bitcoin Future ETFs
TL;DR:
Recently the SEC approved trading of bitcoin future ETFs. These ETFs charge premium for:
1/ The volatility of BTC and, 2/ The custody of your coins
My opinion is that this premium isn't worth at all. Obligatory this is not financial advice.
Let's take a deeper dive into how all of this works.
First, what is a future? You can think of a future as a wrapper around some "thing". It can be corn, stocks, or bitcoin. A future gives you the right to buy this "thing" at a given price at a certain date in the future.
So say you just bought some corn futures. You have the right to purchase 100 tons of corn at $150/ton in Nov 2022.
First off, why would you do this? Imagine you are a multi-billion food production company.
You want certainty around the price of key ingredients in the case something happens (e.g. natural disaster). As such you are willing to pay a premium for that certainty.
Note: these derivative products are the one of the reasons why McDonald's chicken nuggets exist!
Anyways, a year passes and it is Nov 2022. The issuer and seller scramble to actually deliver the 100 tons of corn.
Storing and moving 100 tons of corn is not free but it's okay since they've baked these costs into the price of the future (that you bought a year ago).
Ok so, back to BTC ETFs. What does owning BTC, and more broadly digital currency, even mean?
Cryptocurrency ownership resides around a public and private key. These keys are super long sequences of characters (not human readable).
The public key represents an address that can be used to receive bitcoin. Each public key has a corresponding private key. The private key allows you to do whatever with the BTC thats associated with the address (public key). You can think of a public key as a username, and the private key as a password.
This is where the saying: "not your keys, not your coins" comes from. If someone has your keys, they *can* take all of your BTC. It doesn't mean they will, but they can.
Now, the hard problem around custody is: you want to keep your private key secure but you also want it to be accessible if you want to move around your cryptocurrency.
So do you write them down? Someone could come into your house and take them.
Do you store them online? Someone can install a key logger into your computer
Do you encrypt the shit out of them? Maybe, but you could forget how to decrypt them.
This represents the trade-off between security and accessibility around custody. Custodying your keys certainly requires work, just like delivering and storing corn is work.
Now, back to the recently approved BTC future ETFs. First off, what's an ETF? I'm glad you asked!
An ETF, similar to a future, is also a wrapper around some "thing".
The purpose of an ETF is to track the price of this "thing". If this "thing" increases in price, the ETF should do the same. Ditto if this "thing" decreases. The simplest way to replicate an ETF is to hold the underlying asset. In this case that would be BTC. Oh but wait! Remember BTC custody being a hard problem?
The SEC doesn't want to deal with the regulatory complexity around custody of cryptocurrency. If an ETF issuer custodies their own coins, what happens if they get hacked or forget their seed phrase? It'd be devastating if the SEC stamped self-custody crypto ETFs and then the ETF issuer lost everything.
* Ironically this would probably be bullish for crypto in confirming the view that our financial system should be decentralized lol
So what's another way to form an ETF around bitcoin ? Currently, there are bitcoin futures issued on SEC regulated derivative exchanges. A simple example of how a BTC future might work is: someone buys a BTC, then they put up cash proportional, as collateral, to the current cost of BTC.
They are now able to issue/sell a BTC future - whoever buys this future will have the right to buy a BTC at some prior specified price and prior specified date. As BTC fluctuates in price, the seller/issuer will deposit/withdraw the collateral (deposited cash) proportionally. Remember BTC is volatile as fuck, so there is non-zero risk in doing so.
Imagine BTC going up 10x, the issuer will need to keep enough cash on hand to up the collateral comparably or risk liquidation. While BTC just blew up 10x, custody solution still need to be in place. The 10x is also giving hackers/fraudsters 10x more incentive. Just as the issuer of corn futures needs to worry about the corn crops, the custodian of BTC needs to make sure the keys are both secured, yet accessible. The futures ETFs ultimately are trying to replicate the ownership of BTC. This seems like a low of work for ownership of an asset that you can buy outright.
Unlike corn, BTC isn't tangible. BTCs are literally bytes (so is your Chase bank account balance!) on a computer. If humans had perfect memory like computers do, one way to custody our keys is by simply memorizing them. There's still the challenge of entering your keys securely to transaction, but that's a problem for another day. Today, we have reputable, publicly traded companies that can securely custody your coins such as Coinbase or Square.
You can buy BTC on these platforms and not pay exorbitant premiums to keep your bytes away from malicious actors. Although transaction fees can be quite high. There's the common critique on whether these platforms are trustworthy - that there is a chance you lose access to your account or they ban you from their platform. Even accounting for this risk, I'd argue that the average person custodying their own keys is riskier than using Coinbase.
Caveat: the only case where the ETF could be worth/necessary is owning BTC in a tax advantaged account, but even then other options exists like Greyscale $GBTC. Also, obligatory, this and the above is *absolutely* not financial advice.
Let's zoom out on all of this - having to jump through the different regulatory hoops to construct an ETF that tracks the price of bitcoin - and ask: why does it have to be so complicated? It's the lack of seamless synchronization between the different financial systems. Financial institutions don't even interface well within the same country! Let's not get started on traditional financial institutions and crypto
In the long term, the question then becomes:
How can we keep our traditional financial system in sync with the different, decentralized public ledgers that are bitcoin, ethereum, etc?
My view on this is that they will all eventually converge.
There will be multiple rails for processing transactions, similar to Visa vs. MasterCard vs. American Express, with one settlement layer that serves as our universal source of truth around financial transactions and contracts. So far that settlement layer/ source of truth exists as the transactions that occur across the different, disparate financial institutions all duct-taped together.
That duct-tape is a chaotic mix of the laws, regulation and audits that the SEC, ECB, etc. has put together. It is also the barely interoperable, dust filled communication protocols that goes on between these institutions to process transactions. It's the millions of human operators that have to double check the data and spreadsheets being output by half century old mainframe. And just as duct-tape loses its stickiness, this legacy system makes mistakes.
A common criticism is that there isn't regulation or support on a decentralized financial system.
That can still be there. You can have the equivalent of FDIC insurance on a particular set of rails at the price of higher transaction fees or KYC.
I won't get into the details of how this manifests, but a general paradigm in software is: building the first instance is difficult, the second instance less difficult and eventually some company builds out a generalized solution which makes it extremely easy: look at AWS for compute/servers or Stripe/PayPal for payments.
This applies to spinning out decentralized blockchains too! Once the generalized solution is set up you can focus on your core value prop - in this case coming up with different policies or rule that make you favorable for a specific niche of users.
We already see this playing out with the Polkadot and Kusama ecosystem. The overarching idea (multiple rails vs. one settlement layer) is the separation of execution (processing on multiple rails) with consensus (truth).
This is already happening with the multiple rails such as AVAX, Optimism and Ethereum as the settlement layer. All of this said, I'm not suggesting there will ever be one settlement layer or one dominant execution layer.
Maximalism, the belief that "one winner *perpetually* takes all", seems quite silly if you look at historical trends around business and governance. The most relevant quote that comes to mind is: "there are only two ways to make money in business: One is to bundle; the other is unbundle". Likewise, there will be constant evolution in this space. As these ideas are built out, we'll look back and laugh at the complexity that are future based BTC ETFs.
But for now, these ETFs utilize a clever mechanism and they definitely affirm the belief that BTC, and more broadly cryptocurrency, are legitimate and here to stay.