Why Invest Through ETPs
8 min read
- Finance
In the early days, investors could only gain exposure to crypto by purchasing it directly through an exchange like Binance or Coinbase and then storing it in a digital wallet, which required a certain amount of technical expertise. But it became more accessible in 2015 when exchange-traded products (ETPs) tracking bitcoin and ether started trading on mainstream exchanges, allowing investors to hold this emerging asset class in their portfolios for the first time.
To inform decisions about the most suitable way to invest in crypto, this article explains how these exchanges and ETPs work and explores the advantages and disadvantages of each approach.
Crypto Exchanges
Centralised exchanges (CEXs), like their mainstream equivalents, are run by a central authority that serves as an intermediary, matching trades between buyers and sellers using what’s known as an order book system. Many rely on entities called market makers to provide liquidity by ensuring supply and demand for each asset, which helps keep spreads (the cost of executing a transaction) low. Binance and Coinbase, the largest crypto exchanges by trading volume, are centralised.
Decentralised exchanges (DEXs) are built on blockchain technology so they don’t rely on a central authority. They facilitate crypto-to-crypto trades directly between buyers and sellers using smart contracts, programs that automatically execute when certain preconditions are met. Liquidity usually comes from liquidity pools, smart contracts that lock up tokens for each traded pair and pay the holders a share of the DEX’s transaction fees. These fees may fluctuate because they have to factor in gas fees charged by the underlying protocol for processing transactions. Some of the most popular DEXs, including Uniswap and Sushiswap, run on the Ethereum blockchain.
To store crypto purchased on an exchange, users can choose between custodial or self-custody wallets. The main difference is what happens to the user’s private key, which authorises transactions. When using custodial wallets, the type offered by centralised exchanges, users hand over responsibility for managing their private keys and assets to a third party. In contrast, self-custody wallets put users in control of their private keys and assets. There are two kinds of self-custody wallets:
Hot wallets, such as browser-based MetaMask and mobile wallets, connect to the internet, so they’re convenient but also vulnerable to breaches.
Cold wallets are physical devices that are offline, so they’re considered the safest way to store crypto.
Crypto Exchange-Traded Products
ETPs track the performance of an underlying asset, such as indices, commodities or crypto, so investors don’t have to hold it directly. They’re typically structured as passive investments, which keeps fees to a minimum, and they trade on mainstream exchanges like shares.
ETP is an umbrella term for a range of products including exchange-traded funds (ETFs), exchange-traded commodities and exchange-traded notes. They come in two forms- physical ETPs buy and hold the underlying asset, whereas synthetic ETPs use complex financial instruments called derivatives to replicate the performance of the underlying asset. Most crypto products are physical due to their simplicity, transparency and lack of counterparty risk.
Several entities are involved in listing and managing ETPs:
The product provider sets up a subsidiary in a special purpose vehicle, which ringfences the underlying assets, to issue the product.
A trustee safeguards the assets and ensures the provider manages the ETP according to its terms and conditions.
A custodian holds the assets.
An administrator helps the provider manage the day-to-day operations of the ETP.
Authorised participants create and redeem shares in the ETP by buying and selling the underlying asset, ensuring liquidity.
When an investor places a buy order, the exchange checks if it has any available shares. If not, it asks the authorised participant to create new shares. Once the authorised participant has purchased the asset and sent it to the custodian, the provider issues the share to the investor via the exchange.
The launch of spot bitcoin ETFs in the US at the start of 2024, following approval by the Securities and Exchange Commission, was a major milestone for the crypto markets (followed by spot ether ETFs in July). However, CoinShares launched the world’s first bitcoin ETP back in 2015 and has expanded the product range in the intervening years. It now offers exposure to a variety of cryptos, indices tracking the top 10 coins and smart contract platforms by market cap, and staked ETPs which distribute rewards paid by ‘proof of stake’ consensus mechanisms.
More than 200 crypto ETPs are available to EU investors, with assets under management (AUM) totalling $12,6 billion, according to data provider etfbook. But Bloomberg expects global AUM to grow to $120 billion by 2028, with US spot ETFs serving as one of the biggest catalysts.
Some issuers, including CoinShares, structure physical ETPs so the profits and losses experienced by investors with an unrestricted tax liability are treated more favorably as capital gains rather than income. While the government charges a 25% tax on capital gains, investors don’t need to pay it on investments held for more than a year, and even then it only applies to returns exceeding €600 per year.
Comprehensive Risk-Benefit Analysis
Trading on crypto exchanges involves significant risks, as many are either underregulated or unregulated. For instance, Mt. Gox was one of the earliest exchanges to gain traction, but it suffered multiple breaches over several years, which only came to light in 2014. Hackers stole nearly 750,000 bitcoin, and another 100,000 went missing, worth a total of $460 million at the time. More recently, leading exchange FTX collapsed in November 2022 after it emerged that it used customer funds to prop up trading firm and sister company Alameda Research. Investors rushed to withdraw their funds from FTX, forcing it to declare bankruptcy within a week. While creditors of both exchanges may be repaid, the process takes time - 10 years and counting in the case of Mt. Gox.
Storing crypto is also complex, regardless of what type of wallet a user chooses. Relying on a custodial wallet could be a costly mistake, as described above, and the holdings can’t contribute to an investor’s overall returns. Self-custody wallets shift the burden to the user, but they require technical expertise and come with cybersecurity risks too. Furthermore, the user must safely store the seed phrase issued when signing up for a self-custody wallet. If they lose it, they can’t recover the funds held in the account.
ETPs are a much easier way to gain exposure to crypto because they trade on mainstream exchanges. Not only are they more accessible, but they can sit in an investor’s portfolio alongside traditional assets like shares and bonds, so they contribute to overall performance. Crypto ETPs are also more secure because an independent custodian stores the underlying assets. Finally, they’re subject to the same regulations as mainstream products and the rules governing exchanges. Providers must meet strict requirements covering accounting procedures, transparency and disclosure enforced by the EU’s financial authorities.
Conclusion
To gain exposure to crypto, investors can trade on an exchange or purchase an ETP. Which option is right depends on various factors, including risk tolerance, technical expertise and regulatory protection. This article aims to provide a balanced perspective so investors can make an informed decision, but it ultimately comes down to which is more important: the direct market access provided by exchanges or the peace of mind and familiarity of an ETP.
Published onOct 16th, 2024
