Russian doll of Cryptocurrency
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So Bitcoin has been around for a while, and it looks like it's here to stay for a while longer. More people around the world are giving into their FOMO and deciding to invest in BTC.
However, with Bitcoin's abstract nature, it's not evidently clear as to what one needs to do to purchase the cryptocurrency. Even for technically-minded people, Bitcoin has not been a straightforward investment to make.
And it’s not getting any easier, as new Bitcoin-based products become available - each with its own specifics and complexities.
At the moment, you can trade Bitcoin spot, futures, options, ETFs and options on those ETFs.
So what do you do when you just want to get some BTC exposure?
The US SEC regulator seems to suggest that the way forward is to invest in Bitcoin-linked ETFs. Just last month, ProShares launched the first Bitcoin ETF in the U.S., with more to follow. In two days after the launch, the fund’s AUM reached $1 billion.
Fantastic! Once again, ETFs open the markets for retail investors, giving a straightforward way to buy Bitcoin!
Well, there is only one catch.
These ETFs aren't made from fresh Bitcoin - instead, they're just Bitcoin-flavoured funds, made from concentrate. As such, investors don't receive direct exposure to BTC but rather through Bitcoin futures.
So what, who cares!? Futures or spot - it's still going to the moon, right?
Sure, why not. But the ticket to the moon via futures is going to be a little more expensive.
Futures do not track Bitcoin exactly and have additional costs compared to holding Bitcoin spot. And unfortunately, if you're in the US, that's the only route you have for now.
A reasonable suggestion might be - well, in that case, why not just open an ETF that invests in the spot market rather than futures? This would be a fairly straightforward product and give investors the direct exposure they seek.
Well, the SEC has been rejecting applications for Bitcoin spot ETFs so far, and none are available in the US.
They recently rejected a promising case for a spot ETF, citing “fraudulent and manipulative acts and practices” in Bitcoin markets. (Source:
Hence, futures-based ETFs is what we have.
So what's the problem then?
Caution! Not Compatible with Diamond Hands
Since the end of 2018, investors could purchase Bitcoin via cash-settled futures that started trading on the CME exchange. At 5 Bitcoins per contract, they were trading around $100k at the time.
However, the trouble with futures is that they don't always trade at the same level as the spot market. The difference between the two - called a basis - usually represents a cost of carry in traditional financial markets, but with Bitcoin, it has mostly to do with future expectations. As a result, futures are frequently priced at a premium to spot.
For example, at the time of writing in November 2021, Bitcoin was trading at $58,824, whereas the December CME future was priced at $59,615.
This represents a $791 premium or 1.34% over one month.
The issue is that as time goes by, this premium will eventually evaporate because the futures contract has to converge with spot at expiry:
Therefore, Bitcoin has to appreciate by at least 1.34% for the futures holder just to break even. Of course, given Bitcoin's volatility, it's not something that can't be done, but it still represents an additional headwind for the HODL'er.
And maybe it wouldn't have been such a problem if these were perpetual futures.
But CME futures have an expiration date, and you simply cannot HODL it forever. Once a contract expires, it will be cash-settled, and Bitcoin exposure will cease, effectively forcing paper hands.
If you want to keep playing, you have to "roll your exposure" and buy a new futures contract.
Also, at a premium.
And as you can see, this cost is a recurring problem.
If we were to plot a chart of Bitcoin futures against their expiries, it would look something like this:
The further the expiry, the more expensive the contract - a relationship called a contango. If we were to seek a constant Bitcoin exposure via futures, we would need to roll the expiring contract into next month.
Due to contango, every time we approach the expiry, we have to sell the cheaper futures and buy the more expensive one.
Buy high, sell low.
Over time, this adds up to an additional cost, usually termed a "contango bleed". Using current market data below, if we held November Bitcoin futures, it would expire at the end of the month. Selling November and buying December would cost us 1% on the roll, which is approximately 12% annualised.
However, this roll cost varies and can be lower or higher, depending on the futures term structure. Some estimate it can get to as low as 2.5% annually, while others have less optimistic forecasts:
Over time, this can add up to a significant underperformance compared to simply holding Bitcoin.
Don't believe me? Ask the volatility traders.
The concept of contango bleed is far too familiar to anyone trading VIX products, and there is nothing that demonstrates contango bleed better than a VXX fund.
VXX uses a similar strategy in that it holds VIX futures and rolls them as they expire. Given that VIX term structure is in contango most of the time, this results in a roll cost, which.... well... see for yourself:
Adjusting for reverse stock splits, since its launch in 2009, VXX lost 99.94% on contango bleed. Yes, VXX is based on a VIX index, which is a mean-reverting asset, but it still demonstrates what contango roll can do to a financial asset over long periods.
Buy High, Sell Low
So this leads us to the Bitcoin-linked ETF - BITO.
Despite being SEC-approved, the fund is actually a few levels away from physical (physical?) Bitcoin.
And even though it's supposed to track Bitcoin, it can't keep up with the cryptocurrency. Since its inception on 19 October 2021, it has already underperformed Bitcoin spot by around 2%.
And this is why the futures term structure is essential.
In order to obtain a consistent Bitcoin exposure for its investors, the BITO fund has to roll the contracts and pay the difference.
Add an expense ratio of 0.95% on top of that, and you got a substantial hurdle when investing in Bitcoin via BITO ETF.
At the moment, the fund greatly benefits from the TINA (There Is No Alternative) effect. But once a buy-and-hold Bitcoin spot ETF becomes available, it will be difficult for BITO to retain its 1 billion AUM.
Until then, it remains one of the few options in the US to gain Bitcoin exposure without a cryptocurrency wallet.
The key consideration is whether it’s worth the contango bleed.
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