Bitcoin ETFs are everywhere. Yet, most crypto enthusiasts don’t understand their workings. Admittedly, it’s not that straightforward, but that's okay because we're here to demystify it all. The goal is to demystify Bitcoin ETFs. Our goal?
This means we’ll have to explore the two predominant models used for processing the transactions: in-kind and in-cash. They determine the movement of bitcoin and cash throughout the transaction. You’ll be able to understand the Spot Bitcoin ETFs and their nuances by understanding the two models.
Think of it as an easy crash course.
What is a Bitcoin ETF?
A Bitcoin ETF is an Exchange-Traded Fund listed on traditional stock exchanges like the New York Stock Exchange or Nasdaq. Instead of buying Bitcoin directly on crypto exchanges, one purchases shares in a Bitcoin-related fund. You can get exposure to Bitcoin through these ETFs without holding the currency directly.
ETFs are available in two different types. We have two types of ETFs. The benefit is that they provide direct exposure. Some examples of spot Bitcoin ETFs available in the United States include the Grayscale Bitcoin Trust and the BlackRock iShares Bitcoin Trust ETF.
Futures-based Bitcoin ETFs are another type. They do not invest directly in Bitcoin, but rather buy Bitcoin Futures Contracts traded at platforms like the Chicago Mercantile Exchange. These funds track the performance of futures contracts. They have existed since October 2021. While these are all worth noting, the article’s focus will be on Spot BTC exchange-traded funds.
Bitcoin ETFs Terms You Should Know
Understanding the terms below will help you better understand what we are talking about.
ETF IssuerThe issuer is responsible for overseeing the ETF’s operation, managing its underlying assets and making sure that it adheres to the ETF’s investment goals and regulatory requirements. BlackRock would be the issuer in the above example.
Broker-Dealer: A market-making broker-dealer ensures there’s enough liquidity in the market. By quoting BTC buy and sell price, they facilitate the trading process. It is necessary to have brokers-dealers in order to make sure that buyers and sellers are available so the market can be stable and prices are discovered.
Transfer AgentIt is an entity that transfers assets from the ETF Issuer to the Authorised Participant. Transfer agent is responsible for ensuring that securities are exchanged between an authorised participant, and ETF issuer in a timely and accurate manner. The transfer agent could handle the administrative aspects of the redemption process such as processing orders for redemption, keeping records and communicating with the ETF Issuer and authorised participants.
Authorised participant (AP),: An authorised participant is an entity that can secure and sell Bitcoin as needed, ensuring there’s always enough liquidity. In the cash redemption model, the authorised participants are responsible for creating and redeeming baskets in the ETF and transferring money from and to its administrator. The in-kind redemption model allows them to facilitate the exchange ETF share for the ETF’s underlying assets. In the in-kind model, they facilitate the exchange of ETFs shares for assets that are held by ETFs.
Prime BrokerPrime brokers are the link between market makers and ETFs, providing liquidity and accessing the necessary Bitcoin liquidity. These brokers facilitate the transaction, which includes buying ETFs and selling Bitcoin. In addition, prime brokers manage all risks related to large transactions. This includes market, counterparty, operational, and other risks. The prime brokers provide detailed reports and oversee the settlement process. Prime brokers oversee the whole process. While Bitcoin’s custodians are responsible for Bitcoin, they also work closely with them to make sure Bitcoin is moved securely.
We can now move on to the methods that were mentioned at the start of this article.
Cash versus in-Kind: A Comparison
If you recall, before the Spot Bitcoin ETF was approved there was a fair bit of back and forth between applicants and the Securities and Exchange Commission (SEC). The main point of disagreement was the practicalities of purchasing and selling Bitcoin-based ETFs. Specifically, the debate was over the mechanisms for ‘creation’ (when new ETF shares are issued) and ‘redemption’ (when existing ETF shares are redeemed). The two different mechanisms are called ‘in-kind’ or ‘in-cash’ redemption models and determine how authorised participants (APs) can exchange ETF shares for the underlying Bitcoin or cash.
When comparing the ‘In Kind’ and ‘In Cash’ redemption models for ETFs, various differences come to light. When comparing the “In Kind” and “In Cash” redemption models for ETFs, various differences are revealed. "In-Kind Redemption" APs are able to redeem ETFs by receiving directly the underlying assets (typically Bitcoin) instead of money. The process involves sending a portfolio of matching securities to an ETF, which then generates ETF shares using this portfolio. This avoids immediate cash sales. Tax efficiency, liquidity preservation, avoiding market impact, creation/redemption flexibilities, and transparency are all benefits. Nevertheless, it is important to take into account factors such as logistical challenges, custody issues, and the feasibility of extreme market conditions.
In the meantime, the "In Cash Redemption" model, APs receive cash equivalent to the ETF's net asset value when redeeming shares. ETFs sell their underlying assets to the public market in order to raise the cash. Some situations where cash redemption may be preferable include: liquidity concerns, tax considerations; operational simplicity; extreme market volatility and AP preference for convenience.
Understanding the significance of these models is important as they impact the ETF's overall cost structure. While most ETFs utilise in-kind redemptions due to tax efficiency and liquidity benefits, the SEC prefers cash redemptions for the Bitcoin ETFs, which may stem from oversight and transparency concerns. There is also the question of how hard it would be for arbitrageurs to make a profit from the in-cash variant – something I talked about in a Q&A a few weeks ago.
Obviously, this simplified overview isn’t very ‘simple’. So let’s go over the process step-by-step using BlackRock’s flow chart in the following section to get a better handle on it.
Step 1: MM BD orders a redemption via AP as a result of ETF’s dislocation from NAV
This scenario begins with a broker placing a redemption request. This order allows investors to exchange their ETF shares back to the issuer in return for the underlying asset, which in this case is Bitcoin. A redemption order is a request from an investor to the fund manager that he sell his shares or units and return them to him.
APs execute this order when the ETF's market price significantly deviates from its NAV to restore balance. By creating or redeeming the shares, they align the ETF’s market value with its underlying true value (NAV). The process maintains arbitrage opportunities
ETF issuer must approve redemption order
This is the step where the issuer approves the request for redemption and then takes all the steps necessary to complete it.
The issuer's approval is essential because it ensures that the redemption process is conducted in accordance with the rules and regulations governing the ETF. This confirms whether the ETF has sufficient assets to satisfy the redemption request.
Step 3: MM-BD buys ETF shares via Listing Exchange
MM-BD acquires ETF shares at this time directly from the stock exchange, where ETFs are listed. The MM-BD purchases them directly from market participants selling the ETF shares on exchange. The ETFs are traded more easily as a result of this action, which adds to market liquidity.
Step 4 – MMBD transfers ETF shares directly to the Transfer Agent
Market makers deliver the shares to ETF transfer agents so that they can keep track of the shareholders and manage share redemption and issuance. The market maker will check the ETF to ensure that it is in line with its investment strategy. Essentially, the goal is to ensure that redemptions are executed as smoothly as possible between participants.
Step 5: ETF issuer instructs Bitcoin Custodian to release Bitcoin to MM-Crypto via transfer through Prime Broker.
In this part, the ETF issuesr provides instructions to the Bitcoin custody, which holds bitcoins in the name of the ETF. Upon receipt of an instruction from the ETF issuer, the Bitcoin Custodian will verify the legitimacy and compliance requirements.
The bitcoins are released if everything is correct. These bitcoins released are transferred to MM Crypto. The transfer is made through a prime brokerage, which acts as an intermediary, allowing the assets to be moved seamlessly and ensuring prompt delivery.
MM-Crypto can create ETF shares if they are in demand or do arbitrage, buying and selling ETF share based upon market conditions. Market makers can also maintain liquidity by purchasing or selling ETF shares.
Step 6: Unwind Bitcoin positions with MM-Crypto
Unwinding in this context means that MM-Crypto may sell some of their Bitcoin holdings for one of many reasons. MM Crypto may be motivated by profit taking, selling Bitcoins bought at a low price, to lock in the profits. Unwinding may also be a way to manage risk, since MM Crypto might want to decrease its exposure to Bitcoin, due to the volatility of the market or for other reasons. Regulation compliance could also be a factor, as internal or regulatory policies may require MM-Crypto to reduce exposure to specific assets.
The In-Kind model is similar to Steps 1 to 3.
First, the three steps are identical for the cash redemption and the kind redemption models. The MM-BD must place the redemption through the authorised participants and once the ETF issuer has approved the order, the MM-BD will buy the ETF shares on the listed exchange. This is step 4.
Step 4: ETF Issuer directs Bitcoin custodians that they should remove Bitcoins from cold storage so that it can be purchased.
ETFs typically follow a structure to instruct the Bitcoin custodian on how to remove Bitcoin from cold storage to sell. Communication is first initiated between ETF issuers and Bitcoin custodians to verify and authorize each other. If Bitcoin is required to be sold to redeem in cash, then the ETF issuer will provide the custodian with detailed instructions. This instruction specifies the amount of Bitcoin that is being transferred (e.g. to a cryptocurrency trade) and its timing.
A number of security measures have been implemented to protect Bitcoins, including the use of multi-signature authentication and approval. After retrieving Bitcoin from the cold storage system, the custodian initiates a blockchain transaction and waits for the confirmation. Transparency and compliance are ensured by maintaining detailed records, such as timestamps and transaction hashes. Post-transfer verification ensures the successful movement of Bitcoin to the specified destination, with updates made to the ETF's records accordingly.
Step 5: ETF issuer trades with MM Crypto to buy Bitcoin and sell it for USD.
This step involves the exchange of Bitcoins for US Dollars by the seller.
By providing Bitcoin bids, the market maker can help to facilitate the liquidity of the market and allow the ETF issuer execute the sell order in a timely manner.
This trade enables the ETF issuer to convert their Bitcoin assets into fiat currency (USD), which can then be used for various purposes such as covering expenses, meeting redemption requests, or rebalancing the ETF's portfolio. A market maker may benefit from buying Bitcoins at an advantageous price, then selling them at a higher value later, or simply by fulfilling their function as a facilitator of trades.
Step 6: MM-Crypto delivers cash to the Transfer Agent.
The MM Crypto delivers the cash to transfer agents to fulfill their obligations to settle a trade involving creation or redemption ETF shares. The cash can be used for the purchase of new shares or the receipt of proceeds from shares redeemed, depending on what the transaction is.
Step 7: Bitcoin Custodian delivers Bitcoin to MM-Crypto Via transfer through Prime broker.
In this step, the custodian verifies the investor's eligibility and authorises the transfer of the corresponding amount of Bitcoin to MM-Crypto. In order to fulfill the redemption, the Custodian takes the Bitcoin specified amount out of cold storage wallets. They then work together with Prime Brokers in order to make the transfer.
Communication is key to ensuring coordination. Subsequently, the custodian transfers the authorised Bitcoin amount directly to MM-Crypto's designated wallet address via the Bitcoin blockchain. MM Crypto confirms the transaction by checking the Bitcoin blockchain. Prime Broker ensures that the settlement is correct, including any fees and costs.
Step 8: MM-BD delivers shares to the Transfer Agent via AP.
Following an investor's decision to redeem ETF shares, the MM-BD initiates the redemption order via the AP, who facilitates communication between the ETF issuer and the investor. Upon the approval of the order for redemption, MM-BD works with the AP.
The MM will deliver the ETF to the Transfer Agent who keeps the official records of ownership. Parallel to this, the ETF’s issuer directs the Bitcoin Custodians to transfer an equivalent amount of Bitcoins to MM crypto. MM-crypto then closes the short position and completes the redemption after receiving the Bitcoin. It offers cost-efficiency, transparency, and it shifts the execution risks onto the market maker. It eliminates issuer finance and lowers trading event operational risk.
Step 9: ETF Issuer instructs Cash Custodian via AP to release the cash to MM – BD.
In this step, the ETF issuer directs the cash custodian, responsible for managing the ETF's cash holdings, to release the required cash amount to the MM-BD. Afterwards, the MM-BD receives the money from the Custodian via the AP. The MM-Crypto then delivers Bitcoins to the ETF through the AP. The final step of the redemption is to transfer assets from one party to another.
Step 10: MM Crypto can unwind Bitcoin positions.
Unwinding Bitcoin refers to MM Crypto potentially selling Bitcoin for any number of reasons.
How Bitcoin ETFs Work: Closing Thoughts & Insights
It’s clear that ETF transactions require more than just pressing a button in your app to convert $USDT into Bitcoin. But, at least now you'll have a solid understanding of Spot Bitcoin ETFs and how they function. You’ll also understand why there was so much ‘back-and-forth’ between regulators and applicants before the approvals were finalised.
In-kind models are simpler and less complicated. They result in lower fees, less work, and more challenges for applicants. However, it's important to recognise that the SEC's requirement for cash redemption models stems from regulatory considerations, transparency, and oversight. The transition from in-kind to cash redemption models underscores the intricate regulatory landscape surrounding Bitcoin ETFs and emphasises the SEC's cautious stance toward cryptocurrency investments.
With all that said, let's not forget that Spot Bitcoin ETFs were designed for individuals who are entirely unfamiliar with the crypto space and have no interest in delving into the inner workings of traditional finance. We often forget that the two ways to invest in Bitcoin are confusing for those who do not understand the crypto space. It’s nice to walk into a big institution, tell them you want to invest some Bitcoin, and then leave while they take care of it.
Common Questions
What is an ETF for Bitcoin?
Exchange-Traded Funds or Bitcoin ETFs are investment vehicles that trade on traditional stock markets. This allows investors to invest in Bitcoin without actually owning it.
What are two types of Bitcoin ETFs available?
Bitcoin ETFs come in two types. Spot Bitcoin ETFs hold Bitcoins themselves, while futures-based Bitcoins ETFs invest in Bitcoin contracts.
What is the role of key players in Bitcoin ETF transactions
The ETF issuer is one of the key participants. Other participants are broker-dealers and transfer agents.
How does the model of in-kind redemption work?
The in-kind model allows participants to redeem ETFs by receiving their underlying assets directly, usually Bitcoin. In this process, a matching security portfolio is transferred to the ETF’s issuer. They then create new ETFs shares from that portfolio.
What are the in-cash redemption options?
When redeeming ETF shares, authorized participants will receive cash equal to the ETF net asset value. In order to raise the cash required, the ETF issuer must sell its underlying assets (typically Bitcoin) on the open markets.