Original Title: "In-depth Understanding of the Current Situation and Potential of Cryptocurrency ETPs Before the Launch of Bitcoin Spot ETF"

Original Author: Diana Biggs, Partner at 1kx

Translated by: Luffy, Foresight News

Exchange traded products (ETPs) provide a convenient, regulated, and low-cost way for retail and institutional investors to access a range of underlying investments, including cryptocurrencies.

Since Sweden launched its first Bitcoin tracking product in 2015, cryptocurrency ETPs have developed from Europe to all over the world. At the end of 2020, there were only 17 cryptocurrency ETP products, but now there are about 180. As more and more traditional financial institutions join the ranks of native cryptocurrency companies, ETPs not only play a role in expanding investment opportunities for investors in cryptocurrencies, but also promote the overall acceptance of cryptocurrencies in the global financial market.

This article provides an overview of the cryptocurrency ETP, including the currently available product types, operating models, regions, and our focus areas in this rapidly developing field.

Overview of Cryptocurrency ETP

What is the cryptocurrency ETP?

Exchange Traded Products (ETPs) are a type of financial product that are bought and sold on regulated stock exchanges during normal trading hours. They track the returns of underlying benchmarks, assets, or investment portfolios.

ETP is mainly divided into three types: Exchange Traded Funds (ETFs), Exchange Traded Notes (ETNs), and Exchange Traded Commodities (ETCs). ETFs are investment funds, while ETNs and ETCs are debt securities. ETCs track physical commodities such as gold and oil, while ETNs are used for all other types of financial instruments. Since the creation of the first ETF in 1993, which is now thirty years ago, ETPs have evolved from tracking products in the stock market to become one of the most innovative investment product categories, providing investors with a range of innovative underlying assets investment opportunities.

Attention: Although "ETP" is the general term for such products, the term "ETP" is sometimes used to refer to debt securities exchange-traded products.

Especially in the past 20 years, ETP has continued to grow, with 11,859 products and 23,931 listings from 718 providers in 63 countries/regions and 81 exchanges worldwide. Among them, ETF has the largest share, about 10.747 trillion US dollars, accounting for 98% of the total ETP assets of 109.9 trillion US dollars (data from ETFGI, the end of November 2023). OW Consulting predicts that the growth of ETFs will accelerate in the coming years, with the market growing at a rate of 13% to 18% per year from 2022 to 2027.

Source: ETFGI

The convenience and accessibility of ETP make it a popular tool for opening up new asset classes (including cryptocurrencies) and investment strategies to investors.

The first Bitcoin ETP was launched on the Nasdaq Stockholm by XBT Provider (later acquired by Coinshares) in 2015. The market grew relatively slowly until the second half of 2020, when the number of products from both new native cryptocurrency entrants and traditional issuers began to grow strongly, a trend that continues to this day. In February 2021, Canada's Purpose Investment launched Purpose Bitcoin on the Toronto Stock Exchange, becoming the world's first Bitcoin ETF. Although cryptocurrency ETPs constructed in the form of debt securities still far outnumber and outweigh cryptocurrency ETFs in terms of assets under management, we expect this to begin to change, especially with the opening of the US spot ETF market.

Source: ETFGI

The number of cryptocurrency products has steadily increased, especially in the past three years. According to data from ETFGI, as of November 2023, there are 176 cryptocurrency ETFs and ETPs. Assets invested in these products grew by 120% in the first 11 months of 2023, from $5.79 billion at the end of 2022 to $12.73 billion at the end of November 2023.

Why choose cryptocurrency ETP?

The idea of the cryptocurrency ETP seems counterintuitive to those in the native cryptocurrency field: ETP introduces intermediaries, while the goal of cryptocurrency technology is to eliminate intermediaries. However, as an easily understandable and regulated investment product, ETP provides more opportunities for investors who may not have access to this asset class for various reasons. For example, retail investors may lack the tools, time, risk tolerance, and expertise to invest directly in cryptocurrencies. ETP, as a structure of traditional securities, is open to institutional investors who may be limited to investing in these types of instruments or avoiding direct holdings of cryptocurrencies for regulatory, compliance, technical, or other reasons.

Compared to directly purchasing cryptocurrencies, ETPs have potential drawbacks and considerations (not all investors may consider these as drawbacks). These include much higher fees for cryptocurrency ETPs compared to other ETPs (although these fees have decreased with increased competition), limited trading access times compared to traditional exchanges and the 24/7 cryptocurrency market, counterparty and exchange rate risks, and settlement times.

Note: Examples of geographical restrictions include European cryptocurrency ETPs, which are often not registered under the 1933 US Securities Act and therefore cannot be offered to US investors; the UK FCA prohibits the sale of cryptocurrency ETPs to retail investors.

Product Structure

Broadly speaking, cryptocurrency ETPs are divided into two product categories and types: ETFs and ETPs, as well as physical assets and synthetic assets.

Encryption Currency ETF Structure

The structure of ETF is a fund, and the holding amount of ETF is fund shares. Usually, the fund is legally separated from its issuing entity through a trust, investment company, or limited partnership to ensure that investors' holdings are protected in the event of the parent company/issuer's bankruptcy. ETFs typically need to comply with additional rules and transparency requirements, depending on their jurisdiction; for example, ETFs registered in the EU and sold to EU investors typically need to comply with UCITS (Undertakings for Collective Investment in Transferable Securities) regulations, which bring diversification requirements, such as a limit of 10% on the proportion of a single asset to the total fund amount.

Currently, most cryptocurrency ETFs are either spot or futures products. Spot ETFs have direct ownership of the underlying cryptocurrency assets and are guaranteed by independent custodians. For futures ETFs, the issuer does not hold the underlying cryptocurrency, but instead purchases futures contracts on the assets. Therefore, these products do not directly track the spot price of the underlying assets and are generally considered to bring greater complexity and cost, with lower transparency and intuitiveness for investors.

Encryption Currency ETP Structure

The cryptocurrency ETP (in this case, the term refers to products other than ETFs) is structured as a debt security. Although their structural requirements are not as strict as ETFs, their disclosure requirements are very similar.

Physical encrypted currency ETP is a guaranteed debt contract, which is 100% supported by the amount of underlying encrypted currency it tracks. The encrypted assets are purchased and held by independent third-party custodians under the supervision and control of designated trustees. The trustees represent the rights and interests of ETP holders and are responsible for organizing redemption in the event of the issuer's bankruptcy.

Synthetic ETP is an unsecured debt contract, which means that the issuer does not need to hold the underlying assets that the product is tracking, but instead uses derivatives and swaps to track the assets (the exact structure and terms may vary). Therefore, Synthetic ETPs carry greater counterparty risk, as there is no legal requirement for the product to be fully supported by underlying physical assets. XBT Provider (and Valour) are two cryptocurrency ETP issuers that offer synthetic products.

Index Provider

Index providers are responsible for creating, designing, calculating, and maintaining the indices and benchmarks that ETPs track, providing transparency and reliability for issuers and investors. In some jurisdictions, index providers are regulated. For example, in the EU, there is the European Benchmark Regulation (BMR). Index providers active in the cryptocurrency ETP space include MarketVector Indexes, CF Benchmarks (acquired by Kraken in 2019), Vinter (a cryptocurrency native index provider), Bloomberg, and Compass.

Exchanges and Multilateral Trading Facilities (MTFs)

The willingness of exchanges and MTFs to list cryptocurrency ETPs depends first on the approval of the issuer's prospectus by local regulations and regulatory authorities. After that, it becomes a business decision for the exchanges and MTFs, with the outcome depending on the issuer and product eligibility requirements. This typically involves an evaluation of parameters such as the liquidity, compliance, publicly available pricing information, and risk mitigation of the underlying assets. The rules for which types of products can be listed vary by trading venue, for example, Xetra in Germany only lists asset-backed ETPs, while the six Swiss exchanges have specific rules for eligible cryptocurrency underlying assets.

Trustee

The trustee is responsible for protecting assets and representing the interests of ETP holders or investors. Their specific roles and responsibilities may vary depending on the specific structure and legal arrangements of the ETP. Trustees active in cryptocurrency ETPs include Law Debenture Trust Corporation, Apex Corporate Trust Services, Bankhaus von der Heydt, and Griffin Trust.

Administrator

Administrators support the overall operation and management of ETP. Their services may include accounting, regulatory compliance, financial reporting, and shareholder services. Administrators active in the crypto ETP space include Deutsche Bank, JTC Fund Solutions, CIBC Mellon Global Securities Services, Theorem Fund Services, NAV Consulting, Formidium, and BNY Mellon.

Other Service Providers

Other service providers that may play a role in the ETP plan and product lifecycle include, but are not limited to, payment agents (responsible for registering new ETP units and obtaining ISINs from local agencies), transfer agents (used to maintain records of shareholders and other responsibilities), calculation agents (used to calculate the net asset value of underlying assets), and registrars (used to maintain shareholder records). Depending on the product type, issuer, and jurisdiction, these different roles and responsibilities may overlap or be undertaken by different parties.

About fee explanation

ETP charges management fees, also known as expense ratios or underwriting fees, to cover the costs of managing and operating the product. This fee is calculated annually as a percentage of the holdings and deducted daily or periodically from the net asset value. Many early cryptocurrency ETPs were able to charge fees as high as 2.5%, while typical ETP fees range from 0.05% to 0.75%. When alternatives charge as low as 0%, cryptocurrency ETPs charge 2.5% of AUM, which demonstrates the stickiness and first-mover advantage of these products.

We expect that fees will become a key differentiating factor for new products in the future, as is currently reflected in US spot ETFs. The first companies to disclose fees are Invesco and Galaxy, which waive fees for the first six months and the first $5 billion in assets, while Fidelity offers a fee of 0.39%. As of January 8th, announcements from other issuers confirm that the fee war has indeed begun:

Source: James Seyffart, January 8, 2024

Region

Europe

Cryptocurrency ETP originated in Europe, and the first Bitcoin product was launched in Sweden in 2015, which was an ETP that tracks synthetic assets issued by XBT Provider. In Europe, the issuer of cryptocurrency ETP benefits from a single market, because once the ETP prospectus is approved by a regulatory authority in one European country, the product can also be listed in other member states (referred to as a "passport" prospectus). The SFSA in Sweden is still a popular choice for approving cryptocurrency ETP prospectuses in Europe. Germany is another jurisdiction that has approved cryptocurrency ETP prospectuses, and cryptocurrency ETPs have good accessibility in various trading venues, such as leading exchange groups such as Deutsche Boerse and Boerse Stuttgart Group.

ETP is still the dominant product type in Europe, and the lack of true cryptocurrency ETFs in Europe is largely due to the UCITS (Undertakings for Collective Investment in Transferable Securities) regulations. Overall, most European ETFs comply with UCITS regulations in order to benefit from the pan-European passport, which allows these ETFs to be sold to retail investors in other EU member states in addition to the country of registration. However, UCITS rules and requirements are currently incompatible with single-asset tracking products such as Bitcoin ETFs. For example, UCITS diversification requirements include that no single asset may exceed 10% of the fund, and the underlying asset must be a qualified financial instrument. In June 2023, the European Commission tasked the European Securities and Markets Authority (ESMA) with investigating whether UCITS rules need to be updated and focusing on cryptocurrency assets. However, the purpose of this move seems to be to determine whether more rules and investor protection are needed, rather than expanding the types of qualified products. The deadline for ESMA's opinion is October 31, 2024.

Switzerland

In 2016, Switzerland became the second jurisdiction, after Sweden, to approve and launch an ETP for cryptocurrency. Bank Vontobel launched a Bitcoin-tracking ETP on SIX Swiss Exchange. Subsequently, the world's first cryptocurrency index product was launched in Switzerland in November 2018. This is a physically-backed basket ETP consisting of Bitcoin, Ethereum, Ripple, and Litecoin, issued by 21Shares. SIX Swiss Exchange has specific rules for cryptocurrency underlying assets, including "the cryptocurrency must be one of the 15 largest cryptocurrencies measured by market capitalization in USD when applying for temporary trading permission," and according to our research, the cryptocurrency is widely used as an underlying asset in products traded on all global exchanges. BX Swiss, the Swiss stock exchange, also allows products with cryptocurrency as underlying assets, with the requirement that the underlying asset must be one of the top 50 cryptocurrencies by market capitalization.

England

In October 2020, the Financial Conduct Authority (FCA) in the UK banned the sale, marketing, and distribution of any cryptocurrency derivatives to retail investors. Many cryptocurrency ETPs are listed on the Aquis Exchange in the UK, but are only available for purchase by professional investors.

Canada

Canada is the first country to approve a Bitcoin ETF, with the first product launched by Purpose Investments on the Toronto Stock Exchange (TSX) in February 2021, followed closely by an Ethereum ETF. In October 2023, 3iQ launched a staked Ethereum ETF, with staking rewards included in the fund, which is the first of its kind in North America. Other Canadian cryptocurrency ETF issuers include Fidelity Investments Canada, CI Global Asset Management (CI GAM) in partnership with Galaxy, and Evolve Funds.

Brazil

Brazil follows closely behind Canada. The Brazilian Securities and Exchange Commission (CVM) approved the first Bitcoin ETF in Latin America in March 2021. The issuers of the Brazilian cryptocurrency ETF include Hashdex and QR Capital, both of which are cryptocurrency asset management companies, as well as Itaú Asset Management, which is partnering with Galaxy.

美国

translates to

United States

in English.

So far, only cryptocurrency futures ETFs have been approved by the SEC and made available to investors. ProShares launched the first Bitcoin futures ETF on October 19, 2021, becoming one of the largest funds in history in terms of trading volume, attracting over $1 billion in funds in the first few days of trading.

Source: Bloomberg, from Eric Balchunas, Senior ETF Analyst at Bloomberg

Two years later, on October 2, 2023, ProShares, VanEck, and Bitwise launched the first batch of Ethereum futures ETFs in the United States. Futures products typically require investors to have more knowledge and come with additional costs as well as the risk of tracking errors and performance declines due to frequent rebalancing. In fact, the underlying futures contracts are traded on the Chicago Mercantile Exchange (CME) and are regulated by the commodity exchange. This is a popular explanation for why futures ETFs were approved before spot products.

The first US Bitcoin ETF application was submitted by the Winklevoss brothers in July 2013 and was subsequently submitted multiple times over the following years, ultimately being rejected. Ten years later on June 15, 2023, the world's largest asset management company, BlackRock, submitted an application for the iShares Bitcoin Trust. The influence of the BlackRock brand and its outstanding track record (according to Eric Balchunas, senior ETF analyst at Bloomberg, BlackRock has been rejected only once out of 575 ETF products) changed the game and helped make the US Bitcoin spot ETF one of the most anticipated products ever.

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