The Securities and Exchange Commission (SEC) greenlighting a futures-based exchange-traded fund for bitcoin has been a boon to holders of the cryptocurrency this week, with bitcoin hitting all-time highs just shy of $67,000 on news of the ETF’s clearance. But let’s be clear: It’s a horrible deal for investors in the fund itself.
Due to a common phenomenon in futures markets known as contango, the manager of the newly listed ProShares Bitcoin Strategy ETF looks likely to incur such significant costs that investors will earn a dramatically lower return than if they’d invested directly in bitcoin. The loss is so large it makes any concerns the SEC had about volatile, inconsistent reference prices for spot-market bitcoin ETFs seem trivial.
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In choosing the futures road to an ETF rather than approving a spot market-backed fund, the SEC seems to have chosen the easiest route from a regulator’s standpoint, given that the underlying contracts – the CME Group’s bitcoin futures – are themselves regulated by the Commodity Futures Trading Commission (CFTC).
If it had instead blessed one of the many spot market-backed ETF proposals submitted over the past eight years, it would have needed to approve the prices quoted by exchanges whose bitcoin listings aren’t regulated by either the SEC or the CFTC. Nevermind there are now sophisticated, trustworthy indexes – such as CoinDesk Indexes’ XBX index for bitcoin – that would serve that role perfectly well. It seems the SEC just couldn’t get beyond the global, unregulated world of bitcoin exchanges and the prices they produce. So it punted to a futures solution.
Yet, in choosing that path over the spot market and essentially approving contango-based losses, the SEC may be doing more harm to the small investors it is supposed to protect than they would incur from whatever uncertainty the spot market brings.
My colleagues David Morris and Omkar Godbole have already done a fine job explaining the challenges posed by contango, where the prices for longer-dated futures contracts are higher than the short-dated ones. (In essence, there’s a cost involved in the ETF manager having to “roll the contract” every month, because the manager will have to sell the lower-priced, expiring current-month contract and buy the higher-priced next-month contract. The greater the contango effect, the more a futures strategy will underperform the price of the underlying asset the futures contracts intend to track.)
But it wasn’t until I talked with another colleague, CoinDesk Indexes Managing Director Jodie Gunzberg, that I realized just how costly this phenomenon is for a bitcoin ETF. (She described the concept as “fatally flawed” in an appearance on CNBC.)
According to Gunzberg, the average “negative yield” per monthly roll on bitcoin futures for the past few years of its existence has been 2.29%. On an annualized basis, if investors held shares in a bitcoin futures fund that had rolled over every month for the past year, they’d have ended up with a cumulative cost of 28% relative to the spot market.
The monthly average negative yield for bitcoin futures is above the average contango cost incurred by crude oil futures, at 1.69% per month, and only slightly below that of unleaded gas, at 2.85%. It’s significantly higher than the monthly contango costs incurred on gold futures, which average at 0.23%.
For commodities, a great deal of the contango effect is explained by storage costs, which mount up over time and thus make longer-dated futures contracts more expensive. Those costs vary from commodity to commodity. Gas and oil are costly to store; gold is not. Hence the disparity in the average negative yield roll.
Yet, bitcoin, which according to Gunzberg’s analysis is in a state of contango 58% of the time, is even cheaper than gold to store. Storage is not a factor at all in its tendency toward contango, which is explained purely by hyper-bullish future price expectations. In fact, the absence of any storage problem makes managing bitcoin futures a very different – and arguably more difficult – proposition than for commodity futures.
Although the overall cost of storing commodities grows over time, the marginal cost of adding more storage time tends to decline the longer the commodity is held. That means the negative yield burden is often lower for longer-dated futures in contango. Savvy investors will offset their losses in shorter-dated contracts by buying the longer-dated ones.
But in the case of bitcoin, where there’s no real storage cost to speak of, that longer-term effect simply doesn’t occur.
“The price of bitcoin futures contracts is reflecting very purely the higher expected spot price in the future,” says Gunzberg. “And there is no convexity in the back end. It’s just straight up. You can’t even play those back-end contracts to your benefit. There is nowhere to hide.”
The other contango-related problem with a futures-backed ETF is that fund managers are forced to hold a large amount of cash to cover the roll payments over time, which creates an opportunity cost because those funds aren’t exposed to bitcoin’s gains. By contrast, spot market-backed ETFs can invest the bulk of their funds.
“Our ETF has 95% of funds under management invested directly in physical bitcoin,” says Alex Tapscott, managing director and head of digital assets at Toronto-based Ninepoint, one of four firms now managing spot market-backed ETFs north of the U.S. border.
None of this – not the comparatively better performance in either Canada or the bitcoin spot market – has deterred U.S. investors so far. It took just two days for the ProShares ETF to surpass $1 billion in assets under management, a record for any ETF.
Demand is so strong, Bloomberg reported, that ProShares is close to exceeding the Chicago Mercantile Exchange’s limit on the total number of contracts an entity can own. Bloomberg’s analysis found that, with a stash of 1,900 contracts in the current October month – just shy of the 2,000 limit for a single month – the fund has had to diversify into longer-dated contracts. It now holds 1,400 November contracts, but may have to go further out the curve into December if demand keeps up. Even then, the fund faces an absolute limit of 5,000 contracts
A decision by the CME to raise the front-end month limit to 4,000 from 2,000 starting in November could ease some of the pressure on ProShares. Meanwhile, competing bitcoin futures ETF from Valkyrie and VanEck will likely pick up some of the slack from pent-up investor demand and take the pressure off ProShare. But if investors respond negatively to the underperformance of their fund relative to bitcoin’s soaring spot price, the rush for the exits could become a stampede.
All of which raises the question: Why on earth did the SEC, with a mandate to protect small investors, take this route? It’s time for a proper, spot market-backed bitcoin ETF.