What is BITO ETF? How do futures ETFs work?

BITO ETF (ProShares Bitcoin Strategy ETF) made headlines on Tuesday October 19 as the first U.S. bitcoin futures ETF to hit the U.S. markets. This set the stage for a perfect storm of pending Bitcoin ETFs, waiting for regulators' nod to flood the markets. BITO's launch witnessed roaring demand, attracting $570 million in assets under management on its first day of trading. By the end of Day 2, ProShares' product exceeded the billion-dollar mark and closed with $1.1 billion in AUM.  

Let’s start with the basics, how do futures ETFs work?

First, we need to define what is a futures contract. A futures contract is a legally binding agreement to buy or sell a standardized asset at an agreed-upon price on a specific date or during a specific month. This transaction is facilitated through a futures exchange (e.g., CME Group). The fact the futures contracts are standardized, ensures quality and quantity of the product for all participants. As a result this eliminates counterparty risks, making these instruments indispensable to commodity producers, consumers, traders and investors.

An example of how futures contracts work:

Let's say Simon buys a December gold futures contract, he is then committed to buying 100 troy ounces (3.1 kg) from the agreed price upon the December expiration, regardless of what will the market price be at that time. Candy, the seller, is also agreeing to sell those 100 troy ounces of gold at the agreed-upon price. Unless either trades their contract to another buyer or seller by that date, then the original seller will deliver 100 troy ounces of gold to the original buyer.

In principle, futures contracts are either physically settled or cash settled. In case of physical settlement, the holder of the contract will either have to take the commodity from the exchange or produce the commodity. In Simon's case, he would receive the 100 troy ounces of Gold from Candy and become the new owner.

However, cash settlement does not involve any delivery of asset, but just net cash is settled on contract expiration. So, if Simon wants to settle the contract in cash, he will have to pay the difference between the spot price of the contract as of the settlement date and the Futures price pre-decided. He will not be required to take physical ownership of the gold.

Retail traders and asset managers are not interested in delivering or receiving the underlying asset. A retail trader will unlikely stack 1,000 barrels of oil in his backyard, but they may be interested in booking a profit on the price moves of oil. Futures contracts can be traded purely for profit, as long as the trade is closed before expiration.

How Bitcoin futures work?

Bitcoin futures enable investors to gain exposure to Bitcoin without the need of owning physical bitcoin, which is considered a hassle by many. They are similar to any commodity or stock index futures contract in that they allow investors to speculate on Bitcoin's future price. The Chicago Mercantile Exchange (CME) offers monthly contracts for cash settlement. That means that an investor takes cash instead of physical delivery of bitcoin upon settlement of the contract.

The futures contracts are based on the CME CF Bitcoin Reference Rate (BRR), which serves as a once-a-day reference rate of the U.S. dollar price of bitcoin. The BRR aggregates the trade flow of major bitcoin spot exchanges during a one-hour calculation window into the U.S. dollar price of one bitcoin as of 4 p.m. London Time.

Why are Bitcoin futures ETFs approved, and Physical Bitcoin ETFs are not?

Companies have been trying to release the first U.S. bitcoin ETF since 2013 (Winklevoss Bitcoin Trust), but the U.S. Securities and Exchange Commission (SEC) has been wary of approving ETFs that track Bitcoin’s spot market due to its fear of price manipulation within the crypto space and excess volatility. The regulator said it feels investors are safer when they invest in Bitcoin futures ETF over the regular Bitcoin ETFs.

However, if approved, the physically backed Bitcoin ETFs would mimic the spot price of the underlying asset, Bitcoin. This allows investors to buy into the currency without going through the overcomplicated process of trading bitcoin itself. Like Bitcoin futures ETF, holders of the Physical Bitcoin ETF won't be directly invested in bitcoin itself, they will not have to worry about the storage and security procedures required of cryptocurrency investors.

As U.S. investors await SEC's decision on physically backed Bitcoin ETFs, multiple Canadian Bitcoin ETFs have been made available to the public since February 2021, including Purpose Bitcoin ETF, CI Galaxy Bitcoin ETF and Ninepoint Bitcoin ETF.

BITO - the first U.S Bitcoin futures ETF

The ProShares Bitcoin Strategy ETF (BITO) invests in cash-settled, Bitcoin futures contracts, which means the fund does not own any physical Bitcoin. It currently holds

CME Bitcoin November 2021 Futures (BTCX1) and CME Bitcoin October 2021 Futures (BTCV1) along with other liquid assets (Cash and Treasury bills). When those futures contracts mature, the ETF will buy up contracts for the next month.

For an annual fee of 0.95%, investors can buy this ETF and eliminate the need for an account at a cryptocurrency exchange, crypto wallets and other hassles of owning a physical bitcoin.   

The downsides of BITO and other Bitcoin Futures ETFs

The downside is that BITO and other Bitcoin Futures ETFs are suboptimal investment solutions compared to trading the underlying cryptocurrency. Price tracking errors and administration fees that arise of rolling out expiring contracts and into the current contract, are some of the concerns that spot ETFs are virtually free of. It is also suggested that if BITO continues to spread its holdings over-longer dated contracts, it risks distancing itself from the actual Bitcoin price, or what is called "contago".

So, should you buy a Bitcoin Futures ETF? 

Well, there are certainly pros and cons of owning Bitcoin futures ETFs and our job at Trackinsight is to give you a little bit of context before you go into full "FOMO" mode. As an investor, you should always know what you are getting into. Whether it's BITO or something else, it is best practice to read the prospectus, latest reports and above all, compare with similar products.

Keep reading:

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• The impact of Bitcoin on ETFs and latest thematic updates

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