What RIAs need to know about Bitcoin Futures ETFs
Head of Flourish
Director of Business Development at Flourish,
former VP of Commodities Structuring at Barclays
October 21, 2021
Gaining exposure to bitcoin through a Futures ETF comes with significant drawbacks. Here’s what advisors need to know.:
Estimated reading time: 10 minutes
Gaining exposure to bitcoin through a Bitcoin Futures ETF comes with significant drawbacks in comparison to direct ownership:
- There is a significant risk that a Bitcoin Futures ETF will underperform direct bitcoin ownership because of the high premium at which futures trade relative to the current price of bitcoin
- The bitcoin futures market is small compared to other established futures markets, which may result in even greater underperformance due to the market impact of a Bitcoin Futures ETF
- The tax treatment of a Bitcoin Futures ETF is substantially different from that of direct ownership
Direct ownership of bitcoin is a more efficient way of gaining exposure to this new asset class compared to a Bitcoin Futures ETF. With tens of millions of Americans already investing directly, advisors should carefully consider whether a significantly less efficient form of access makes sense for their clients—particularly with the emergence of direct ownership solutions built for RIAs.
On Friday, October 15, the SEC approved the first Bitcoin Futures ETF,1 coinciding with the price of bitcoin exceeding $60,000 for the second time in history. While the approval of a Bitcoin Futures ETF is an important moment for the cryptocurrency industry, we believe that futures are an inefficient way for advisors and their clients to gain exposure to bitcoin—particularly with the introduction of more efficient direct ownership solutions built for RIAs, such as Flourish Crypto.2
All else equal, advisors virtually always prefer direct ownership of any asset class over indirect ownership through futures. After all, it is unheard of for an advisor to invest in an S&P 500 futures fund if they are looking for exposure to the S&P 500—and bitcoin is no different.
When do futures make sense? Investors might reasonably prefer to access commodities like crude oil or lean hogs via futures, since the alternative of renting an oil tanker or a pig farm is likely out of the question. As a fully digital asset, however, bitcoin falls squarely in the category of assets that can be held directly.
Here’s what advisors need to know about Bitcoin Futures ETFs.
How will a Bitcoin Futures ETF work?
A futures contract is an agreement traded on an exchange to buy or sell assets (such as commodities or shares) at a fixed price, to be paid for and delivered at a later date.3 For every futures contract buyer there must be a futures contract seller.
A futures ETF does not take possession of the underlying asset; instead the ETF purchases and holds a number of futures contracts. Since all futures contracts eventually expire, in order to maintain price exposure, the ETF must periodically sell futures contracts before expiration (or hold them to expiration) and simultaneously replace the sold (or expired) contracts by buying new contracts that have a longer dated expiration. This process is commonly referred to as “rolling.”
A Bitcoin Futures ETF uses cash-settled bitcoin futures to gain exposure to bitcoin. The first approved Bitcoin Futures ETFs will purchase futures contracts traded on the Chicago Mercantile Exchange (CME); the fund “does not invest directly in bitcoin.”1
What are potential drawbacks of a Bitcoin Futures ETF?
1) Underperformance due to contango
Using futures to gain bitcoin exposure can lead to significant underperformance compared with holding bitcoin directly. This underperformance is often attributed to “contango,” which occurs when the price of futures contracts is higher than the current price of the underlying asset.4 To illustrate this simply, if futures are in contango, an investor will lose money if they hold a futures contract to expiration and the underlying asset doesn’t sufficiently increase in price by the time the contract expires. Contango is particularly common with anticipated future price increases and limited capacity.
Bitcoin futures are currently in contango. If this condition persists, when a bitcoin ETF buys a bitcoin future, it will be buying at a price that is higher than the then-current price of bitcoin (known as the “spot price”). As the futures contract approaches expiration, the futures price will generally converge towards the bitcoin spot price until, at expiration, it is equal to the price of bitcoin at the time of expiration. This drop in price is called “negative roll yield,” and can result in negative performance relative to the performance of the underlying asset itself; in fact, it can even result in the strategy losing money even when the underlying spot price has increased. As noted by SEC staff, “a rise in Bitcoin prices may not result in a similar increase in the value of a fund holding positions in Bitcoin futures contracts.”5
This risk isn’t just hypothetical. As of October 15, 2021, the October 2021 futures contract settled 3.4% higher than the spot bitcoin price,6 meaning an investor who purchased that contract would lose 3.4% in 17 days if they held the contract to expiration and the price of bitcoin did not change. A fund that invests primarily in front-month bitcoin futures contracts (i.e., contracts with the shortest time to maturity) must roll its futures position to the next contract every month, so this negative roll yield can add up throughout the year (if the same underlying conditions persist). While it is impossible to predict how both spot and futures pricing may change going forward, it is readily apparent that premiums of this magnitude can create a significant drag on returns to a futures investment strategy going forward in comparison to spot ownership.
If a Bitcoin Futures ETF increases demand for futures even further, the premium on futures prices could increase further, which could increase this negative drag.
It is theoretically possible for futures to experience “backwardation,” where the futures price of an asset is lower than current price of the asset. With that said, it is unusual for backwardation to persist for assets that are relatively easy to hold directly, such as gold and bitcoin.7
2) Uncertain impact of the small futures market size
The futures market for bitcoin is new and far smaller than other established futures markets, which may negatively impact returns.
The total market size (or open interest) of bitcoin futures trading on the CME is approximately $4 billion.8 In contrast, the comparable number is $85 billion for CME gold futures and $185 billion for CME crude oil futures. If the demand for bitcoin futures increases significantly—which could occur as a result of new Bitcoin Futures ETFs—the small bitcoin futures market may have trouble supporting the new buyers. Following the logic of supply and demand, this increased demand could cause the price of bitcoin futures to rise even more relative to the price of bitcoin, increasing contango further and resulting in more negative roll yield.
3) Tax Treatment
The tax treatment of direct bitcoin ownership is straightforward; bitcoin is subject to standard capital gains tax. While most retail exchanges do not provide clients with simple tax reporting, direct ownership solutions built for advisors, such as Flourish Crypto, are emerging that provide clients with 1099s.
The tax treatment of a Bitcoin Futures ETF is significantly different. The fund’s taxable income consists of 40% short term capital gains or losses and 60% long term capital gains or losses, with unrealized gains and losses marked to market each year.9 Further, these losses are “trapped” within the fund until the fund experiences future gains.
Investors should consult with a tax professional to make sure they understand the impact of the tax treatment of futures in comparison to direct ownership.
Why might a Bitcoin Futures ETF increase demand for futures?
For every buyer of a futures contract, there must be another market participant who is a seller. Before the launch of the ETF, bitcoin futures already traded at a significant premium, reflecting the fact that there was already higher overall demand for futures than participants willing to sell at or closer to the spot price.
The introduction of the ETF could meaningfully increase demand for futures. As investors buy the bitcoin futures ETF, the ETF in turn must purchase bitcoin futures, regardless of the magnitude of the premium. It values immediacy and liquidity, as it "seeks to remain fully invested at all times...without regard to market conditions, trends, or direction."1
While the price of Bitcoin Futures ETF will vary by fund, the first ETF approved by the SEC has an expense ratio of 0.95%—higher than some direct ownership solutions.
5) Lack of exposure to the crypto ecosystem
Gaining exposure to bitcoin through a Futures ETF means the investor will have no direct exposure to the cryptocurrency ecosystem, with no way to exchange the position for actual bitcoin at any point in the future.
To provide one small example: a Bitcoin Futures ETF will trade during normal market hours, while bitcoin can be traded 24/7 through the emerging crypto ecosystem. In addition, as powerful new use cases emerge, ranging from lending cryptocurrencies to generate yield to entirely new forms of digital ownership, investors in a futures-tracking ETF will be shut out.
We believe that cryptocurrencies have the potential to change the financial world, with exciting new applications emerging every day. Investors in a Bitcoin Futures ETF will not have “option value” to participate in this exciting new world.
What are potential benefits of a Bitcoin Futures ETF?
Despite meaningful drawbacks, there are certain benefits of a Bitcoin Futures ETF that advisors should keep in mind.
A Bitcoin Futures ETF can be traded through traditional custodians, and therefore can be easily used by advisors. Some of the above drawbacks can be considered a “convenience” premium.
2) Investor protections
Due to its evolving regulatory nature, the cryptocurrency community often lacks the same investor protections that can be found in traditional financial products. Shares of a Bitcoin Futures ETF are “securities” under the U.S. securities laws and would be eligible for protection by the Securities Investor Protection Corporation (SIPC) when held through a SIPC-member brokerage firm. Further, the ETF itself is subject to the requirements of the Investment Company Act of 1940 (or the “‘40 Act”). In recent commentary, SEC Chairman Gensler noted that he looked forward to staff review of Bitcoin Futures ETFs because “when combined with the other federal securities laws, the ’40 Act provides significant investor protections for mutual funds and ETFs.”10
3) Important signal of growing regulatory acceptance of BTC
While a Bitcoin Futures ETF is very different from direct ownership of bitcoin, including in areas of investor protection and disclosure, approval of these ETFs may signal increasing regulatory acceptance of Bitcoin.
Summing it up
Approval of a Bitcoin Futures ETF is an important moment for the cryptocurrency industry, and may be an appropriate investment for certain investors. But for advisors looking for bitcoin investing solutions, we believe there are better ways to access this asset class.
One of the biggest benefits of a Bitcoin Futures ETF is convenience, which we wholeheartedly agree is important. That’s why we are working to help advisors bring bitcoin into their practice like any other asset class, with direct custodial integrations and connections with providers like Orion, Tamarac and eMoney, digital statements and 1099’s, and the flexibility advisors need around features like trading and discretion.
Tens of millions of Americans are already investing directly in bitcoin through retail exchanges, benefitting from the lack of tracking error, tax efficiency, and exposure to the cryptocurrency ecosystems. Through Flourish Crypto,2 we are working to bring the same experience to advisors within a simple, beautiful, modern experience, helping advisors to compete and grow their practices.