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For several years, investors seeking crypto exposure had to risk purchasing it on an exchange. When the first crypto exchange-traded funds (ETFs) eventually launched in 2021, they were backed by futures that track the price of bitcoin at an agreed point in the future. Investors had to wait until early 2024 for the Securities and Exchange Commission (SEC) to approve products replicating the spot price of bitcoin.
This article provides a brief history of crypto ETFs before explaining how they work and exploring their advantages and risks.
Crypto ETFs - how did we get here?
The early days of the crypto markets were regularly compared with the Wild West, given the lack of regulation. One of the first exchanges to gain traction was Mt. Gox, but it suffered a major security breach which came to light in 2014. Nearly 750,000 btc had been stolen over several years, while another 100,000 btc went missing, worth a total of $460 million at the time. Mt. Gox eventually went into liquidation, and it finally started repaying creditors in 2024.
Other exchanges have endured. Coinbase launched in 2012 and quickly gained users with its customer-friendly interface. It was the first crypto exchange to go public in 2021. Kraken opened a year later, after founder Jesse Powell had visited the Mt Gox office and decided he could offer a more secure platform. Kraken also offered a trading facility.
While crypto became more accessible, it was still out of reach to many. The only mainstream option was the Grayscale Bitcoin Trust (GBTC), which started trading in 2013. Accredited investors could buy shares of GBTC, which was structured as a private trust, but they had to hold them for a minimum of six months before selling on the secondary market. Even then, retail investors occasionally had to pay a premium (when shares in a trust trade above its net asset value), unlike well-known products such as SPDR S&P 500 ETF Trust or SPDR Gold Shares.
The first crypto ETF, ProShares Bitcoin Strategy ETF (BITO), came to market in October 2021. BITO tracks bitcoin futures, a type of derivative that commits the holder to buy or sell the underlying asset at a future date for an agreed price. Its launch represented the SEC’s earliest endorsement of a mainstream crypto product, but BITO didn’t offer exposure to bitcoin’s spot price, at which the underlying asset trades for immediate settlement.
The SEC finally approved 11 spot bitcoin ETFs at the start of 2024 issued by providers including some of the biggest players in the financial industry, such as BlackRock and Fidelity. The appetite for these products became immediately clear as they received nearly $2 billion of inflows within the first three days of trading. The SEC subsequently approved spot ETFs tracking ether, Ethereum’s native token, in July 2024.
How do Crypto Trusts/ETFs work?
Crypto ETFs work like any other ETF by tracking the performance of an underlying digital asset or basket of assets. They trade on traditional exchanges like shares, so investors can hold them in a portfolio or retirement account alongside mainstream assets. This also means their returns contribute to the portfolio’s overall performance.
While synthetic ETFs aim to replicate the performance of the underlying crypto with derivatives, spot ETFs purchase it on behalf of investors. They store the crypto with a digital custodian, an independent financial institution that assumes responsibility for its safekeeping. Custodians typically hold crypto in what’s known as a ‘cold’ wallet, which remains offline, as opposed to a ‘hot’ wallet, which is connected to the internet. Cold wallets are highly secure because they’re practically immune to hackers or malware.
On occasion, ETFs experience tracking errors, where the product’s price deviates from the value of the underlying crypto, for instance if liquidity (how easily traders can buy and sell an asset) drops. If this happens, entities known as authorised participants (APs) can create or redeem shares in an ETF to realign it with the spot crypto price. APs, typically large financial institutions, make a profit from the difference between these two prices (a trading strategy called arbitrage).
Benefits and risks
Crypto ETFs offer investors a range of benefits:
Peace of mind- as mentioned above, the SEC, the government agency responsible for supervising the financial markets, regulates these products. They must meet the same reporting and disclosure requirements as other ETFs.
Transparency- spot ETFs are particularly easy to understand. They buy and hold the underlying asset rather than relying on complex derivatives like synthetic products.
Availability- investors can purchase crypto ETFs through the channels they use for mainstream assets, such as banks and brokers, instead of buying directly via unregulated or underregulated exchanges.
Low cost- crypto ETFs are passive investments, so they‘re cheaper than actively managed funds. The spot bitcoin ETFs launched earlier this year charge competitive fees, as low as 0.25%, as they seek to capture market share.
However, there are risks too:
Volatility- as a young asset class, crypto prices fluctuate for several reasons, primarily because investor sentiment can be easily influenced by news items, regulatory developments and cyberattacks.
Limited trading- even though the crypto markets never close, ETFs are subject to the trading hours set by exchanges. Investors can only trade between 9am and 4.30pm Eastern time.
Tracking error- in addition to a drop in liquidity, tracking errors can occur in a variety of scenarios, for example due to the impact of management fees charged by the issuer or discrepancies due to the difference between ETF trading times and the 24/7 crypto market.
Counterparty risk- the issuer could fail to meet their obligations (this risk is higher with synthetic ETFs) or experience disruption due to technical glitches or cyberattacks.
Conclusion
Access to crypto assets has evolved over the years, from the ‘Wild West’ of the early days, encapsulated by the Mt Gox hack in 2014, to the launch of publicly listed exchanges and the approval of a range of ETFs, most recently spot bitcoin and ether products.
Crypto ETFs allow investors to gain exposure to the underlying asset without having to purchase it directly. They store the crypto with custodians, who typically keep it in ‘cold’ or offline wallets. If tracking errors occur, authorised participants trade the product’s shares to correct it.
Crypto ETFs offer investors the following benefits:
Peace of mind
Transparency
Availability
Low cost
However, investors also need to be aware of the risks:
Volatility
Limited trading hours
Tracking errors
Counterparty risk
To add a crypto ETF to your portfolio, simply open a brokerage account or IRA, fund the account, then select the product and execute the trade.
