Deep Dive: Spot Bitcoin ETF: Shaping a $70-$140bn Landscape
US Bitcoin ETF Anticipation Drives Market Momentum: Critical US SEC deadline on January 10, 2024, following legal victory for Grayscale, and BlackRock's ETF application. Several countries, including Australia, Germany, Canada, and Brazil, have already granted approval for spot Bitcoin ETFs.
Institutional Investor Potential: Pending approval, US Bitcoin ETFs could transform digital currency investing for institutions and retail investors, addressing efficiency, accessibility, transparency, and custody limitations. Tagus Capital estimates attracting institutional allocations of at least $70-$140bn in the long-term.
Portfolio Optimisation: The portfolio diversification benefits of Bitcoin, with low to negative correlation to traditional assets, likely to drive demand for spot Bitcoin ETFs. Portfolio optimisation indicates a 4% allocation.
ETF Snowball Effect: Spot Ethereum ETF applications, delayed by the SEC until May 2024, are poised to experience a notable surge in interest following any successful spot Bitcoin approval. Combining BTC and ETH, they collectively represent over 70% of the total cryptocurrency market capitalisation.
Optimism of Spot Bitcoin ETF Approvals: The momentum in Bitcoin and the broader cryptocurrency market since October 2023 has been significantly fuelled by the anticipation of spot Bitcoin exchange-traded fund (ETF) approvals in the US. This heightened expectation is also reflected in the sizeable premium on Bitcoin CME futures contracts, especially as the market awaits the final statutory deadline on January 10, 2024, set by the US Securities and Exchange Commission (SEC) for the ARK/21Shares' spot Bitcoin ETF application.
Following the SEC's decision in October not to appeal an August court ruling that mandated a review of Grayscale's Bitcoin ETF application, there has been a noticeable shift in regulatory dynamics in favour of the industry. Since then, there have been frantic discussions and meetings with SEC officials and Bitcoin ETF applicants. The question remains: will Bitcoin ETFs finally receive approval in early 2024, and what is already factored into the market?
Source: BlackRock, US Court of Appeals D.C. Circuit, Depository Trust and Clearing Corporation, Tagus Capital.
Bitcoin ETF Timetable:Despite the SEC's historical denials for a decade regarding spot Bitcoin ETFs, recent legal victories, like Grayscale Investments' success and BlackRock’s spot Bitcoin ETF application, signal a shift in sentiment. BlackRock's entry with the iShares Spot Bitcoin ETF on June 15, 2023, is significant. As the largest asset manager in traditional finance (TradFi) with a 575-1 SEC ETF approval rate, BlackRock's move increases the chances of the SEC approving the first spot Bitcoin ETF. This has spurred other financial institutions like Fidelity and Franklin Templeton to submit their applications and collaborate with the SEC for refinements.
By December 21, there have been 25 meetings between BlackRock and the SEC (File No. SR-NASDAQ-2023-016) regarding its iShares Bitcoin ETF application, with six occurring in just over one month, starting on November 20. Similarly, Grayscale has had seven meetings with the SEC (File No. SR-NYSEARCA-2021-90), five in a just over a single month. The intensified discussions raise the odds of a more favourable regulatory outcome, potentially paving the way for broader acceptance of Bitcoin.
Source: SEC.gov, Tagus Capital.
A court ruling favouring Grayscale (GBTC Fund) against the SEC on August 29, is also significant. The U.S. Court of Appeals for the District of Columbia Circuit instructed the SEC to review Grayscale Investments' application for a spot Bitcoin ETF. The court found the SEC's denial of Grayscale's proposal, which it rejected on June 29, 2022, arbitrary and capricious, emphasising the importance of consistent treatment for similar cases. Notably, the SEC opted not to appeal this ruling. The market fluctuations related to BlackRock's ETF ticker (IBTC) listing on the Depository Trust and Clearing Corporation (DTCC) website on 24 October, its removal on October 25, and subsequent reinstatement have indicated that a significant portion of recent trading activity has been closely linked to monitoring ETF-related developments. Although the inclusion of IBTC on the DTCC's website happened in August, the attention garnered in October have left sustainable expectations about the prospects of ETF approval, with some market participants viewing it as a standard procedure signalling potential SEC approval.
In December the SEC instructed several companies, including BlackRock, Grayscale Investments, and ARK Investments/21 Shares, to submit final changes to their filings by December 29, with warnings that missing this deadline would exclude them from potential spot Bitcoin ETF approvals in early January. The SEC is scheduled to make a decision on ARK and 21 Shares' joint proposal by January 10. While various other final deadlines, including BlackRock's iShares are set for later, the regulatory body might choose to grant approval for multiple Bitcoin ETF applications by January 10 or defer all decisions. The SEC's recent regulatory signals suggest an increasing willingness to greenlight specific spot Bitcoin ETF proposals, with a heightened emphasis on addressing issues related to fraud and market manipulation. Changes to technical details, including cash redemptions, have been made by issuers like BlackRock and ARK/21 Shares and the SEC very recently held meetings with the major exchanges, Nasdaq, CBOE, and NYSE.
Institutional Prepositioning and High Odds Factored: The market has, to a large degree, factored in the potential Bitcoin approval outcome leading to potentially volatile reactionary price swings. Leveraged positions, particularly among institutional investors, are evident in the recent rise in CME Bitcoin futures premiums compared to a more modest contango, where the forward price is higher than the spot price, prior to October (Tagus Bytes: 4 Jan 2023). Polymarket's decentralised trading platform consistently reflects elevated probabilities, as the contract for "Bitcoin ETF approved by Jan 15" is currently trading at around 80 cents, indicating an 80% likelihood of approval. This represents a substantial increase from the approximately 50% probability observed at the start of December. Nevertheless, beyond any fluctuations associated with potential announcements, there are sustained benefits expected to gradually accrue for Bitcoin.
Inflows Due to Institutional Shift: The SEC's potential approval of spot Bitcoin ETFs opens the doors to digital-currency investing for institutional and retail investors. Major financial players like BlackRock, Fidelity, and Invesco, currently in the process of applying to enter the spot Bitcoin ETF market, have the potential to transform it into a $100bn industry. This move is viewed as a redemption opportunity for the cryptocurrency sector after the crisis caused by the FTX implosion in 2022. Wealth managers and financial advisers are fielding inquiries about Bitcoin ETFs, expecting institutions to allocate a portion of their portfolios, including pensions, to this new investment vehicle due to the transparency, liquidity offered by ETFs, and the crucial diversification benefits of Bitcoin. Pending SEC approval of spot bitcoin ETFs, companies may even add them to US retirement savers 401(k) options. Much like the improved efficiency seen in stock and bond ETFs, Bitcoin ETFs offer convenience, efficiency, and transparency for both institutional and retail investors. Importantly, this widens access to Bitcoin for a broader investor audience, overcoming limitations related to custody and brokerage.
Spot Bitcoin ETFs have already been approved by several countries outside the US, e.g., Australia, Germany, Canada, and Brazil, whilst others such as Hong Kong and the UAE are in the process of their own ETF and El Salvador’s ETF is planning going one step further with a BTC-in BTC-out ETF, allowing for full BTC ownership. Net inflows to global crypto ETFs have already surged to $1.6bn this past year and all related exchange trade products total over $50bn in assets. There is scope for some cannibalisation of flows given the existence of exchange trade products related to ETFs. The US, led by $1.7bn ProShares Bitcoin Strategy ETF (futures-based and convertible to a spot ETF upon approval) and the $27bn Grayscale Bitcoin Trust BTC (a passive Bitcoin investment available in shares), is preparing for potential conversion to a spot ETF. This change in Bitcoin status might lead to a recycling of Bitcoin flows rather than new inflows. That said, there is still significant potential for new inflows. Moreover, there are indications of building of demand for spot Bitcoin ETF. Investors during 2023 acquired a significant number of Grayscale Bitcoin Trust (GBTC) shares, i.e. around $2.5bn, at a considerable discount to net asset value (NAV) in likely anticipation of SEC approval for the trust's conversion to an exchange-traded fund (ETF).
A more precise evaluation of sustained flows into spot Bitcoin ETFs can be achieved by considering the rising preference for cost-effective investment options in the existing US ETF asset market. Based on a conservative 1-2% of the $7trn ETF assets under management in the US redirected into Bitcoin, Tagus Capital estimate the potential to inject $70-$140bn into Bitcoin, comprising between 8-17% of its current market capitalisation. Diversification benefits and portfolio optimisation, as outlined below, indicate that an increased allocation of 4% to Bitcoin could be optimal for an existing traditional asset portfolio. This may lead to potentially greater inflows in the longer term, particularly with the introduction of additional Bitcoin ETFs worldwide. Moreover, rather than just a reallocation of existing total assets under management (AUM) of US based ETFs this could increase the overall AUM given other attributes, such as ‘store of value’.
Source: Investment Company Institute, BlackRock, Tagus Capital. *Note: estimate.
Gold ETF precedent: The initial gold ETF, Gold Bullion Securities, debuted on the Australian Securities Exchange in March 2003, and the United States saw the launch of a gold-backed ETF via SPDR Gold Shares (GLD) in November 2004. The introduction of gold ETFs transformed gold investment, offering a simpler and more cost-effective way to invest without physical ownership. The first US gold ETF in 2004, coincided with a lengthy surge in gold prices through to a cycle high in 2011.The gold price, having been on a decline since 1980, saw a consistent increase after central bank selling ceased and VAT was eliminated on physical gold purchases. Subsequently, with the introduction of the first gold ETF in 2004, prices surged from around $450 to over $1,820 by 2011, representing around 300% increase. Various macroeconomic factors also contributed, such as dollar depreciation, central banks augmenting gold holdings, and economic growth in India and China, underscored the demand for gold as a 'store of value' and well as its broader adoption through ETFs.
Similarly, the approval of a Bitcoin ETF would mark a significant step toward broader acceptance of Bitcoin as a legitimate investment asset. This increased accessibility may boost demand and contribute to an upward trend in Bitcoin's value. However, differences in dynamics, regulations, and investor profiles between gold and Bitcoin markets mean that historical patterns may not fully predict the impact of a Bitcoin spot ETF and macro conditions are also likely to be pivotal too (Tagus Bytes, 22 Dec, 2023). The parallels between gold and Bitcoin may be strengthened further as both serve as ‘stores of value’, particularly with the accessibility of ETFs. The past year highlighted Bitcoin's safe-haven characteristics, often referred to as "digital gold," during periods of heightened inflation and risk aversion, such as the Silicon Valley bank crises in March 2023. This indicates a potential case for an even higher portfolio allocation than the recommended 4% suggested by optimal portfolio theory. Notably, Bitcoin's correlation attributes point to enhanced diversification advantages even related to gold.
Source: Auronum, YahooFinance, Tagus Capital.
Diversification Benefits of Bitcoin to Fuel ETF Demand: Bitcoin offers a compelling chance for diversification (Kim, 2020) in portfolio asset allocation, given its distinct characteristics in contrast to traditional asset classes. Its low to negative correlation with other asset classes (Bianchi and Babiak, 2022) and its independent asset class (Sifat, 2021) will only be enhanced by spot ETFs. The significance of correlation in portfolio diversification is widely recognised in traditional finance. Portfolio theory states that superior risk-adjusted returns can be achieved by including assets with weak correlations in the investment portfolio (Markowitz 1952). Portfolio allocation strategies considering Sharpe ratios and efficient frontiers, suggest a diversified traditional finance portfolio should allocate between 1% to up to 6% in Bitcoin (Liu and Tsyvinski, 2020). Portfolio optimisation techniques by Tagus Capital, indicates a 4% allocation to Bitcoin as an alternative asset class in a traditional 60/40% equity/bond portfolio to enhance diversification, improving risk-adjusted returns. Significantly, Bitcoin exhibits comparable or even superior diversification attributes compared to gold when considering correlation with other traditional asset classes.
Correlation Matrix (2023)*
Source: Tagus Capital, YahooFinance, StatMuse, S&P Global. *Note: Correlation coefficients for 2023 based on daily returns (%).
Spot Bitcoin ETFs Pose Challenges for Futures Products: Given the potential for SEC approval for spot Bitcoin ETFs, the outlook of existing Bitcoin futures ETFs, such as ProShares Bitcoin Strategy ETF (BITO), is uncertain. The ProShares BITO, currently standing at $1.7bn, tracks Bitcoin through futures. If spot Bitcoin ETFs are approved, they are expected to offer a cheaper alternative for investors to gain exposure to Bitcoin, potentially overshadowing the appeal of futures-based products. While some believe both types of ETFs can coexist, others anticipate a decline in interest in futures ETFs once spot Bitcoin ETFs become available. Fees are expected to be a key differentiator among these similar products, potentially driving down costs for investors.
Implications for Web3/Blockchain: The potential approval of spot Bitcoin ETFs has broader implications for the blockchain and Web3, ranging from increased institutional participation to regulatory validation and market infrastructure development. If approved, it could lead to increased liquidity and trading activity in the cryptocurrency markets. This, in turn, may impact the valuation of various blockchain projects and tokens, known as Alt+coins, as there is a strong association to the dynamics of Bitcoin, other crypto currencies, and blockchain-based initiatives. As blockchain technology continues to evolve, regulatory frameworks may develop to include decentralised applications, smart contracts, and token offerings.
