To BITO or Not to BITO (or Perhaps XBTF)?

To BITO or not to BITO. Lately, that has been the question for investors. The transformation of cryptocurrencies (blockchain technology, really) from its militant Crypto Anarchist Manifesto days to the current sh*tcoin environment making headlines and occasional millionaires seems to have happened rather quickly but in reality, has taken well over a decade. While the noise around meme coins is a bit of a distraction, cryptocurrencies have come into their own being used as unofficial and official currencies in countries such as Venezuela and El Salvador over the past few years. Further, despite outright bans in countries like China and to a certain extent, Russia major coins like Bitcoin and Ether (built on the Etherium Blockchain) are becoming a regular part of asset allocation discussions advisors are having with their clients. Indeed, there is at least one group whose sole focus is helping advisors navigate the crypto space. All this to say that what once was pure crypto-anarchist hopefulness and Bitcoin Pizza Day novelty is now being treated as a legitimate investment if not an entirely new asset class. In January 2020, the CME launched the first bitcoin futures contracts, and about 22 months later ETF issuer ProShares received their effectiveness notice from the SEC and the 95 basis point ProShares Bitcoin Strategy ETF started trading. Not to be outdone, today marks the launch of the 65 basis point Van Eck Bitcoin Strategy ETF (XBTF). What's in the Box? In order to understand what these funds are and what they do, you need to understand what the funds invest in. SPOILER ALERT: these funds do not, I repeat, DO NOT invest in Bitcoin. They do, however, invest in Bitcoin futures. Bear with me as I attempt a crash course of sorts on Bitcoin futures. Characteristics of future contracts structure and trading play heavily into setting expectations for BITO and XBTF investors. As I said, bear with me. There's some high water we need to wade through here... To value and calculate a settlement price on a futures contract, the market needs a reference price. Natural Gas has Henry Hub transactions, Crude Oil has West Texas Intermediate transactions, E-mini S&P 500 contracts have 1/5 the S&P 500 Index. So what about Bitcoin futures? As Bitcoin trading is unregulated, global and a 24/7 market, CME created its own reference in the CME CF Bitcoin Reference Rate (BRR) and the CME CF Bitcoin Real-Time Index (BRTI). Pricing sources for this index include the following venues (including 24-hour market share as of 4:00 pm 11/15): Coinbase (45.87%), Kraken (16.77%), Bitstamp (10.71%), Gemini (4.20%), and ItBit (0.76%). The rationale for using these venues is that they represent the leading edge in aligning with existing regulated venue practices, at least in the eyes of the CME and the SEC. There has been some criticism of this methodology. The first objection is that using only these venues does not capture the full scope of activity in the marketplace (78.37% by this count). I would counter that equity indexes generally rely on prices sourced from the primary listing venue only and ignore everything that trades UTP. This reflects longstanding industry practice. The other complaint is that Bitcoin price discovery is based on all market activity and not just these approved venues. Any bad practices or outright fraud will find its way into the global Bitcoin price and these venues' price data regardless. The only counter I have is that the more market share these venues attract the less likely that scenario is to play out. Further, the more market share these venues capture the more other venues will begin to adopt similar rules to be able to compete effectively. Time will tell how this plays out. Now that we know what the futures contracts follow let's take a look at the contract specs. These contracts are cash-settled, which means that if you hold a contract to expiration, you will not receive or need to deliver any Bitcoin, just the dollar difference between what you paid and the settlement value of the contract. No crazy stories of tractor-trailers full of bitcoin wallets being dumped on anyone's driveway with these futures. One contract represents notional exposure of five Bitcoins. What this means is the price quoted for this contract gets multiplied by five to arrive at the cost of purchasing the contract. The futures curve includes the current month, the next six months, and the current and subsequent years' December contracts (don't ask me, futures folks get weird with their calendars). Position limits come into play as well with a 4,000 contract limit for holders of the current month contract and a 2,000 contract limit on any subsequent future months. Currently, BITO has positions in both November and December contracts so it seems like the fund already has run into some position limit issues, which exacerbates an issue I'll talk about next. In an effort to protect contract holders the CME has set some price volatility triggers: a 10% price move triggers a temporary trading halt and a 30% move indicates the contract has traded limit up or limit down and traders need to come back tomorrow if they want to trade that contract. Expiration Is Such a Drag -- On Returns Finally, on to the funds. As I said earlier these funds invest in Bitcoin Futures. Futures have an expiration date. If you want to have a continuous futures exposure you need to roll your position from the current expiring month into the next available month. Futures prices are composed of two elements. The first is the future expected spot price of the underlying and the second is what is known as the cost of carry. With physical futures (Oil, Gas, Corn, Gold, etc) this is the actual estimated cost to store the commodity until contract expiration. With financial futures the risk-free rate is generally used. I can only assume that a combination of risk-free rate and electricity/hardware costs play into Bitcoin cost of carry but I honestly don't know. Because most markets generally expect future spot prices to be higher than current spot prices (in addition to cost of carry) almost all futures curves are upward sloping to the right. For market participants (hedgers), this represents the cost of doing business. For passive investors (speculators) this represents a drag on returns known as negative roll yield. Here's how it plays out: I own 100 November contracts currently priced at $63,880 (500 BTC notional exposure) Assuming today is expiration I need to roll to the December contract priced at $64,505 I only have $63,880 to buy something valued at $64,505 (99.03% of 100%) Given my available funds, I can only buy 99 December contracts (495 BTC notional exposure) In doing the roll, I have effectively given myself a 1% haircut in terms of notional exposure Doing this repeatedly over time creates increasingly larger tracking error to spot Remember the issue of position limits and how the fund had to reach further out the curve to complete its first roll? Following my example, the January contracts are currently priced at $64,785 which represents a larger 1.40% haircut. In addition to the natural shape of the curve dealing you a blow, don't forget that these funds (like all futures-based fund) broadcast to the market exactly what it is going to do and when it is going to do it. This is known to professional traders as easy pickings. We saw some evidence of this in BITO's first roll in October where price action on the November (and some December) contracts created some unusual distortions in the overall shape of the curve on the day of the roll. So, HODL BITO, XBTF? Because of the issues I've outlined I would not recommend these funds to anyone who fancies themselves a HODLR. If you are looking to get long-term exposure to Bitcoin or any other crypto asset I would recommend opening an account at any one of the venues mentioned above and initiate a position. All of them can set you up with at least a hot wallet and many offer custody services as well so you don't end up another lost private key sob story. Further, given the SEC's position on approving a physical bitcoin ETF, a -type crypto product doesn't seem to be in our collective future any time soon. Having said this, if you are a market maker, veteran futures trader, or someone who wants to trade around Bitcoin volatility then these products are for you.

To BITO or Not to BITO (or Perhaps XBTF)?

What once was pure novelty is now being treated as a legitimate investment, if not an entirely new asset class. But how do the new Bitcoin ETFs stack up?

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