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How do spot Bitcoin ETFs work?

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What is a Spot Bitcoin ETF?

A spot Bitcoin ETF is an exchange traded fund that directly hold Bitcoin instead of derivatives. Their value fluctuates with the price of Bitcoin in the spot market.

Before you decide if spot Bitcoin ETFs are a viable investment vehicle for you, you might be curious about how these spot Bitcoin ETFs work.

Here’s a quick summary of:

How do spot Bitcoin ETFs work?

Function like Gold ETFs

Like Gold ETFs, the manager of Bitcoin ETFs buys and holds the actual Bitcoin with a custodian who will store the asset.

For a list of Bitcoin ETFs and their custodian, refer to our compilation of the Best Bitcoin ETFs.

Buys and Sells like Mutual Funds

Unlike most ETFs, Bitcoin ETFs are currently required to carry out cash redemptions instead of in kind redemptions. In this aspect, they are more akin to mutual funds.

Here’s how in-kind redemption works:

Source: BlackRock
  • When you buy a share of an ETF, your order is received by Money Maker (MM)
  • The MM will consolidate everyone’s orders then pass the cash to the authorised participant (AP) who will buy the underlying securities.
  • AP then passes the underlying securities to the ETF sponsor who then wraps everything up and issues ETF shares based on the securities they receive.
  • And you get your ETF shares assigned to you based on your order.

As you can probably tell, if the AP buys and sells underlying securities every time someone makes a trade on the ETF, it would be time consuming and would also incur quite a bit of fees.

So, in general, the AP will only create or redeem shares in bulk – aka Creation/Redemption Units of at least 25,000 ETF shares or 50,000 ETF shares depending on the structure of the ETF.

When smaller trades are made that doesn’t warrant bulk creation or redemption of shares, redemption are done in-kind. The underlying asset are not being sold to return cash to the investor.

In contrast, cash redemption requires that all underlying assets be sold for cash. Grayscale highlights that this could result in wider bid-ask spreads and lower liquidity. Here’s BlackRock’s illustration showing how much more complicated the process is:

Source: BlackRock

How will this affect retail investors?

Since our trading volume is low, the structure of the Bitcoin ETFs will not affect our trades significantly.

The impact of cash redemption method would be felt later when larger institutions and money funds come into the picture. The actual impact on the Bitcoin ETF remains to be seen, but we might see a greater tracking error in the future.

Another area for concern is that the cash redemption may have tax implications that could erode your returns. Currently, the consensus is that Bitcoin ETFs will be taxed in accordance to other ETFs. However, you should keep an eye for any new development in the coming months.

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