After 10 years of refusals, US regulators for the first time approved the launch of exchange-traded funds (ETFs) that directly invest in Bitcoin. The new funds, backed by fund managers such as BlackRock and Fidelity Investments, are expected to attract more investors (both retail and institutional) to Bitcoin, and the need to purchase Bitcoin as an underlying asset for fund shares will provide a significant influx of capital to the crypto market.

The US has allowed ETFs for Bitcoin for the first time. What does it mean

In many ways, Bitcoin ETFs are similar to gold ETFs, which first emerged in the early 2000s and have become a popular way to invest in the precious metal. Instead of purchasing physical gold bars, investors can purchase shares of such a fund through their broker in the same way they would purchase any securities or other assets. Likewise, new Bitcoin spot ETFs should make it easier to invest in the cryptocurrency. There is no need to deal with wallets, remember keys, or create an account on a cryptocurrency exchange - you can simply use the same brokerage account.

What does "spot" ETF mean?
The term “spot” means that the fund actually holds Bitcoin, and not some kind of derivative instrument tied to its rate. The ETF's share price should rise and fall in line with the price fluctuations of Bitcoin in the cryptocurrency markets.

In 2021, the US Securities and Exchange Commission (SEC) approved several ETFs that allow investing in Bitcoin futures, but for years refused to allow the launch of spot ETFs. The agency took the position that the Bitcoin spot market is highly susceptible to market manipulation.

The situation changed after Grayscale, one of the future issuers, sued the SEC in 2022, challenging the refusal to launch Bitcoin spot funds while approving futures funds and won in court in August 2023, which then forced the SEC to allow spot funds Bitcoin ETF.

How the new ETFs work
Essentially, spot Bitcoin ETFs are trusts that manage reserves of Bitcoin and issue shares (units). Market-making firms constantly buy and sell shares of these ETFs, picking up on tiny discrepancies between the current share price and what its price should be based on the value of Bitcoin. By doing so, these market makers help the ETF track the market price of Bitcoin.

Who are the market makers of the crypto market. Why are they needed and how do they earn money?

Some of these market makers also act as so-called authorized participants—companies that help ensure that the number of shares available expands and contracts in response to investor demand. Banks can also play such a role. The list of authorized participants in the new Bitcoin ETFs includes financial market heavyweights Jane Street Capital and Virtu Financial, as well as the US brokerage arm of JPMorgan Chase.

If a group of investors buys shares of an ETF after noticing an increase in demand, authorized participants contribute funds to the fund (trust). In response, the fund issues new baskets of shares and delivers them to authorized participants. This expands the supply of ETF shares. At the same time, the fund replenishes its bitcoin reserves, so that its pool of bitcoins under management grows as new investors join it.

Spot ETF issuers have managed more than 3% of Bitcoin's supply

When investors, on the other hand, dump Bitcoin ETF shares, the reverse process occurs. Authorized participants bring shares to the trust to redeem them for cash, thereby reducing the supply of those shares. And the fund reduces the number of bitcoins in its reserves.

Who Buys and Sells Bitcoin for ETFs
Many of the new ETFs are forced to rely on third parties to handle the actual purchases or sales of Bitcoin as needed. As a rule, these are trading firms that specialize in buying and selling large quantities of cryptocurrencies.

Initially, Bitcoin fund managers insisted on a different model for working with Bitcoin. Under this model, authorized participants would contribute bitcoins to the fund when shares were created or be paid in bitcoins when shares were redeemed. ETF managers believed that this model was simpler and more efficient than the model that was eventually adopted, in which the creation and redemption of shares were carried out in cash.

However, the in-kind buyback model has become a source of concern for regulators and a sticking point in negotiations between issuers and the SEC in late 2023. Concerns were related to the fact that authorized participants are registered broker-dealers in the US stock market, and laws do not allow broker-dealers to deal in cryptocurrencies.

BlackRock made a concession to the SEC and updated its application for a Bitcoin ETF

By December, all management companies that planned to launch spot Bitcoin ETFs were forced to switch to a monetary model in which authorized participants do not need to touch Bitcoin. The beneficiaries of this decision are highly regulated Wall Street firms (such as banks), which are now more likely to act as authorized participants for Bitcoin spot funds.

In addition, BlackRock has had over-the-counter (OTC) cryptocurrency purchase channels since August 2022 and its own private trust in partnership with the Coinbase exchange. Fidelity also has similar resources: the company has had its own OTC desk and cryptocurrency platform Fidelity Crypto for several years.

How do issuing companies make money?
Companies attract potential investors by the fees they will charge for their services. The commission from BlackRock, Fidelity and VanEck will be 0.25%. Invesco, which has filed to create a Bitcoin ETF with Mike Novogratz's Galaxy Digital, said it intends to waive the 0.59% fee for the first six months of the fund's operation. Valkyrie's fund will have a slightly higher fee of 0.8%. An ETF from Grayscale stands out among others, which charges a commission of 1.5%, which is noticeably higher than other participants.

How are bitcoins stored?
The documentation for each of the Bitcoin spot ETFs lists the possibility of security breaches as one of the potential risks of the funds' operating process. To ensure the safety of assets, issuing companies rely on third-party custodians, which is standard practice in the ETF market. For example, gold exchange-traded funds typically partner with banks that have vaults to store the physical metal.

Most new Bitcoin funds have chosen the cryptocurrency storage service from the largest crypto exchange in the United States, Coinbase, as a custodian. When one of these funds purchases bitcoins, the coins are sent to a special wallet controlled by Coinbase. Custodians typically store keys to crypto assets in what is known as cold storage, an offline infrastructure not connected to the internet, to ensure their security. It's the digital equivalent of a gold vault.