Understanding the difference between spot Bitcoin ETFs and Physical Bitcoin ETPs

Following the highly anticipated launch of spot bitcoin exchange-traded funds in the US at the start of January, the term ‘ETF’ has become synonymous with investments tracking the price of bitcoin. However, physical bitcoin exchange-traded products (ETP), which serve the same purpose, have been trading on the European markets since 2019. This article explains how ETFs and ETPs differ despite both offering retail investors the opportunity to add bitcoin exposure to their portfolios.

What are ETPs?

Before exploring the differences between these products, let’s quickly recap how ETPs work and how they benefit investors.   

ETP is an umbrella term used to describe ETFs, exchange-traded commodities (ETCs) and exchange-traded notes (ETNs). An ETP is an investment vehicle that tracks the performance of an underlying asset such as a share, commodity or cryptocurrency, or a basket of assets. They trade on mainstream exchanges like shares, meaning they’re easily accessible and can be held in portfolios, a major benefit for investors who don’t want to buy crypto directly through a decentralised exchange.  

There are two types of ETPs. ‘Spot’ or physical products, the subject of this article, hold the underlying asset, while synthetic ETPs use derivatives- rather complex financial instruments- to replicate its performance. As a result, synthetic products are less transparent and harder to understand.

Providers of spot and physical products store the underlying assets with a custodian, an independent financial institution responsible for the safety of the assets. In addition to offering peace of mind to investors, custodians also play a role in the ‘settlement’ of trades (more on this process below).

Spot Bitcoin ETFs

The Winklevoss twins, founders of the Gemini crypto exchange, were one of the first providers to attempt to launch an ETF tracking bitcoin in 2013. But efforts gathered momentum in the summer of 2023 when 11 financial institutions, including powerhouses like BlackRock and Fidelity, submitted applications to the Securities and Exchange Commission (SEC) to launch spot bitcoin ETFs in the US. The SEC eventually approved the applications in January 2024, and investors poured nearly $2 billion into these products in the first three days of trading.

ETFs are structured as investment companies, trusts that invest pooled capital on behalf of investors. They’re open-ended funds, so they can create new shares to meet demand.

While the products approved by the SEC use various custodians, BlackRock chose Coinbase Prime, the institutional arm of the well-known crypto exchange which serves over 13,000 clients. Its in-house custodian, the Coinbase Custody Trust Company, is licensed to operate as a fiduciary in the state of New York. The underlying bitcoin is stored in the Coinbase Vault, a cold storage solution (meaning it isn’t connected to the internet) combining physical security, consensus computation and strict process controls. Deloitte, a ‘big four’ accounting firm, audits Coinbase’s custody solution. Fidelity stores its bitcoin with Fidelity Digital Assets, a subsidiary regulated by the New York Department of Financial Services.

Physical Bitcoin ETPs

Physical bitcoin ETPs differ from spot ETFs in the way they’re structured. Most of these products are ETCs, which were originally designed to provide access to the commodity market, but their remit has since expanded to currencies and crypto. ETCs are bankruptcy-remote special purpose vehicles (SPV). An SPV is a subsidiary, a separate company from the provider with its own balance sheet, and the appointment of a trustee to manage the underlying assets minimises the risk of bankruptcy. The SPV issues debt securities backed by physical bitcoin held by a custodian.

The majority of physical bitcoin ETPs are listed on European exchanges, including the CoinShares Physical Bitcoin ETP, which launched in 2021 and trades on the Nasdaq Stockholm. Its underlying bitcoin is stored by Komainu, a digital asset custodian founded in 2018 by Japanese bank Nomura, crypto security company Ledger and CoinShares. Komainu’s institutional-grade custody solution stores assets onchain and protects them using hardware security module vaults (physical storage) and cryptographically secured multi-party computation wallets. Komainu is regulated by the Jersey Financial Services Commission and the Dubai Virtual Assets Regulatory Authority. Registered Certified Public Accountant the Network Firm provides proof of reserves for CoinShares products.

Comparison between Spot Bitcoin ETFs and Physical Bitcoin ETPs

ETFs and ETPs have two fundamental characteristics in common- they track the performance of bitcoin, and they buy and hold the underlying asset. But there are several differences worth noting.

• Regional preferences explain why ETF is used in the US and ETP in Europe. Likewise, ‘spot’ and physical refer to products priced for the immediate custody of the underlying asset by the vehicle, as opposed to a bitcoin future, which involves settling a trade at a fixed price on a date in the future. 

• ‘Settling’ a trade refers to how providers buy and sell the bitcoin backing the products they issue. ETFs settle in cash, which means the provider buys the underlying bitcoin using fiat currency, the standard approach in traditional financial markets. However, ETPs settle in bitcoin, which accelerates the process, lowers counterparty risk, and reduces trading costs so providers can charge lower fees. 

• ETFs are subject to the EU’s Undertakings for Collective Investment in Transferable Securities (UCITS) regulation because they’re typically funds holding diversified portfolios. ETCs aren’t classified as funds, so they can track a single underlying asset like bitcoin, and they don’t fall under the UCITS framework.  

• As the SEC approved spot bitcoin ETFs, they’re only available on the US markets, and they’re supervised by US financial authorities. But the US hasn’t introduced crypto legislation yet, so the SEC and Commodity Futures Trading Commission have to apply existing laws to an asset class that shares little in common with traditional assets. Conversely, the EU’s Markets in Crypto Assets regulation came into force in June 2023. 

Conclusion

ETP is an umbrella term used to describe a range of investment products, including ETFs, that track the performance of an underlying asset- bitcoin in the case of this article. Spot or physical ETFs buy and hold the bitcoin, whereas synthetic products use derivatives to replicate its performance. 

The SEC approved the introduction of spot bitcoin ETFs in the US at the start of 2024, but physical ETPs have been trading in Europe since 2019.  While both products serve the same purpose, they also differ in several ways, such as the terminology they use, the way the provider settles trades for the underlying bitcoin, and the regulations to which they must adhere.