“How does a Bitcoin ETF work?” Now this is a question we get a lot. And with good reason. There’s a lot of information out there about what Bitcoin ETFs are, but not a whole lot about the inner workings of the funds themselves.
For context, Purpose launched the first ever spot Bitcoin ETF in the world. Given our experience, we wanted to provide an inside look into how a spot crypto fund works. Note that in this article, we will use Bitcoin as an example; however, the principles can apply to other crypto-assets, including Ether (Purpose also launched the world’s first spot Ether ETF in the world). Although there are many detailed nuances in how funds operate, we will focus on the most important mechanics to provide readers with a strong foundational understanding of the processes and components necessary to run a spot crypto fund. So, let’s get into it. Things are about to get interesting (in a nerdy finance kind of way).
Key takeaways
- Spot Bitcoin ETF units represent actual underlying bitcoin held in custody on behalf of the ETF fund unitholders.
- The bitcoin bought by the fund is held in trust by institutional-grade custodians, who are regulated entities that specialize in safeguarding crypto assets.
- Bitcoin funds benefit from institutional trading relationships, which allows them to purchase Bitcoin at tighter spreads and with lower commissions than retail investors (i.e., it’s similar to the advantages of purchasing goods in bulk – you get economies of scale and typically better pricing).
- Spot crypto ETF units are compliant with securities regulations and can be traded using traditional brokerage accounts (including in registered vehicles, such as RRSPs/401ks), making them a user-friendly, low-risk method to access crypto.
The components of a spot Bitcoin ETF
At the highest level, this is how a spot Bitcoin ETF works:
- A buyer purchases units of the ETF on a publicly traded exchange.
- The ETF Provider uses the money received to purchase actual Bitcoin.
- This bitcoin is held safely in trust by regulated custodians on behalf of the Fund Provider, usually in cold storage wallets (akin to storing gold in a vault).
- When a seller wants to redeem their ETF units, the ETF Provider sells a corresponding amount of bitcoin in order to fund that redemption.
There are certainly nuances that exist within this framework; however, this provides an overview of the key elements. As we explore this more deeply, here are some terms and components/players within the ETF buying and selling process that are important to define and understand:
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ETF Provider/Fund Provider: This is the company that operates and manages the ETF.
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Buyers/Sellers: Individuals, family offices, or institutions that would like to buy or sell units of an ETF.
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Exchanges: Where units of a spot Bitcoin ETF are publicly traded. Examples of exchanges include the New York Stock Exchange, the Toronto Stock Exchange and the NASDAQ.
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Fund Administrator: A third-party organization to whom the ETF provider outsources some of its back-office tasks. Some of the most important things the fund administrator is responsible for are fund accounting, financial reporting, and net asset value calculations.
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Market Makers:
- Institutions that function as wholesaler buyers/sellers of ETF units. They will agree to buy or sell ETF units in bulk and at specific prices (by way of exchanges). This helps guarantee the liquidity of an ETF.
- Unlike regular buyers/sellers, Market Makers have also been authorized by the Fund Provider to create and redeem units of the ETF on their behalf.
- The partnership between a Market Maker and a Fund Provider ensures ETF units are liquid and always available to trade.
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Custodians: A third-party entity that holds the assets of the fund in trust. Custodians will also perform integral functions for the Fund Provider, including clearing and settlement of money transfers, managing compliance with Crypto Trading Counterparties, and providing an additional layer of security. Custodians are usually subject to regulatory standards; for example, any publicly traded fund in Canada must use a qualified custodian. There are a number of specific requirements, including being a regulated trust company, meeting certain operating and compliance standards, and holding a certain amount of capital on their balance sheet.
Part of the complexity of crypto ETFs is that in Canada, funds need a custodian that is domiciled in Canada. Currently, few firms meet all the requirements to be qualified custodians and also have the capability to store crypto assets safely. To solve this challenge, firms have partnered to meet these requirements. In Canada, this has resulted in a structure where in most cases, there is a Primary Custodian, which is a Canadian trust entity that meets all requirements to be a qualified custodian but that doesn’t have the technical infrastructure to store crypto assets, and a Sub-Custodian, which is typically a US-based entity that does have the infrastructure to store crypto assets.
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Crypto Trading Counterparties: Entities that trade bitcoin. These entities often only trade with institutional clients and are not available to retail investors. They can be considered wholesalers for buying/selling bitcoin.
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Hot/cold wallets: A hot wallet is a cryptocurrency wallet that is connected to the internet. A cold wallet is a cryptocurrency wallet that is not connected to the internet. The former is more convenient but less safe; the opposite is true for the latter. Think of a hot wallet as the cash you keep in your pocket. Think of a cold wallet as the gold you keep in your safe.
Right. We’ve got these definitions out of the way. Now let’s map out the life cycle of a spot Bitcoin ETF unit.
What happens when you buy a spot Bitcoin ETF unit?
The inner workings of an ETF can be complicated, even for industry professionals. With this in mind, we are going to break down what happens behind the scenes in parts. Note: we said “parts” and not “steps” here. Although we are presenting this information in a linear manner for ease of understanding, in practice, some parts of the unit-buying process are executed simultaneously or out of sequence.
Although this outline doesn’t go into every detail and nuance, it does provide a solid overview of the most important elements that occur when you buy a Bitcoin ETF unit.
Part one
Buyers looking to purchase a unit of a Bitcoin ETF will do so through an exchange.
Part two
The units that are bought and sold on exchanges are provided by Market Makers. Market Makers will determine the price they are willing to buy/sell to investors for. They will also work with the Fund Administrator and the ETF Provider to identify the number of units to be created or redeemed. This is based on the net trading flow of the day. For example, if three investors buy a total of 10,000 shares, and two investors sell a total of 5,000 shares, then the net flow would be 5,000 shares that are bought. Thus, the ETF Provider needs to create 5000 new shares for the fund.
Part three
Because the objective of the spot crypto ETF is to have each unit represent a real asset (in this case, Bitcoin), it is necessary for the Fund Provider to take the money they have received from buyers and use it to purchase actual Bitcoin, which they will then hold in trust.
For this to happen, the Fund Provider will communicate to Crypto Trading Counterparties about how much bitcoin they need to buy. When the Fund Provider and a Crypto Trading Counterparty have agreed to a bitcoin purchase price, the Fund Provider will execute the trade with the Crypto Trading Counterparty. This trade will be cleared and settled through the Sub-Custodian and the Primary Custodian (more on clearing and settlement in the segment below).
There. That’s it. That is a bird’s eye view of how fund units, cash, and bitcoin flow through a spot Bitcoin ETF. We’ll now dedicate a bit more time to going deeper into topics that arise.
How spot Bitcoin ETFs benefit from volume
Though nobody gets excited about the prospect of paying fees, it’s important to remember that because Bitcoin ETFs have institutional relationships, they are able to benefit from wholesale pricing, which is driven by tighter trading spreads and lower trading commissions. These savings can be passed on to investors, acting as an offset to fees.
As an example, here is a snapshot of how much bitcoin you would have received using some of Canada’s most popular crypto exchanges compared to how much bitcoin you would have received buying units of the Purpose Bitcoin ETF (BTCC).
Newton (no fees)
$10 000=.28625BTC
Bitbuy (after fees)
$10 000=.28290BTC
BTCC
$10 000 worth of shares=.2871BTC
All numbers as at June 14, 2023. Source:Newton.com, Bitbuy.com, Purposeinvest.com
Though these savings are not guaranteed every time units of a spot Bitcoin ETF are bought and sold, it is important for any investor to understand the full implications of dealing with an investment vehicle that can effectively leverage volume when compared to an individual.
A closer look at Bitcoin transactions and storage
There are a few very important things to understand when we look at the flow of Bitcoin in and out of a Bitcoin ETF. First, virtually all of the Bitcoin that is held by Crypto Custodians on behalf of the fund is held in offline crypto cold wallets (the safest way to store digital assets). Second, Crypto Custodians are regulated entities that hold the fund’s Bitcoin in trust, meaning they cannot use the fund’s Bitcoin for any other purpose. Third, Bitcoin is only moved to online hot wallets in order to execute trades, thereby severely mitigating risks of hacking.
If we zoom in further on the Bitcoin trading, settlement, and storage components of a spot Bitcoin ETF, we would see the breakdown as follows:
Understanding spot Bitcoin ETF fees
All ETFs have fees, and spot Bitcoin ETFs are no different. But let’s shine some more light on the fee structure of this type of ETF so you understand what’s going on behind the scenes.
First, let’s get familiar with two terms: 1) Management fee and 2) Management Expense Ratio (MER).
The former refers to the administrative fee the Fund Provider charges for operating the ETF. The MER refers to the combined cost of the management fee and operational costs associated with running the fund.
A management fee is easy to understand. It’s simply the amount a fund charges investors for managing and operating the fund. When we start talking about “operational costs,” there are many components to it.
We can outline some of the most common costs incurred when operating a Bitcoin ETF. Here are some examples:
- Sales taxes
- Accounting, auditing, and legal fees (A Fund Provider must pay fees for services that make sure finances are where they should be and do what they should be doing)
- Custodial services (Custodians charge a fee for storing and safekeeping the fund’s bitcoin)
- Investor servicing costs (Think of this as the infrastructure needed by a Fund Provider to offer client-facing services like support, informational content, sales, etc.)
The Fund Provider does not bill an investor for these fees, nor do they interact directly with an investor’s units to charge these fees. They deduct the fees from the assets held in the fund. In the case of a spot Bitcoin ETF, this means that some of the fund’s bitcoin will be sold to cover operating costs and management fees. In effect, this means that over time, and very incrementally, an investor’s unit will hold slightly less Bitcoin than when they first bought it.
Demystifying clearing and settlement
We mentioned clearing and settlement a couple of times above. And while most people have a vague idea of what that means, breaking it down further is a worthwhile exercise if you really want to understand how a spot Bitcoin ETF works.
So, let’s peel back the layers a bit more.
First off, let’s make sure we understand what clearing and settlement means. Clearing is the process of reconciling daily transactions.
Settlement is the finalization of these transactions. In the context of a spot Bitcoin ETF, settlement occurs when bitcoin is titled to the buyer and money is transferred to the seller.
Clearing and settlement for Bitcoin/cash looks something like this:
- The ETF Provider will agree upon terms to buy/sell crypto in bulk quantities with Crypto Trading Counterparties.
- The Sub-Custodian will be informed about the trades and will proceed to settle and clear these trades. This involves receiving the cash and crypto from each party, verifying that each party provided the appropriate amounts and then releasing the cash/crypto to the other party.
- This settlement and clearing process can take between minutes and one business day to occur.
- When the settlement process is complete, the transactions are final and irreversible.
The role of a trusted intermediary (Sub-Custodian in this case) in the clearing and settlements process ensures that no one pays for something and does not receive what they’ve bought.
Summing up
Spot Bitcoin ETFs can be a great way to get exposure to Bitcoin. They’re safe, regulated, accessible, and benefit from institutional-level buying power. And for many, they can be the right choice when deciding how to increase your portfolio’s exposure to digital assets. But that doesn’t mean understanding them isn’t important. Educating yourselves thoroughly on any given financial product is key to making the choices that most make sense for you and your financial goals.
Commissions, trailing commissions, management fees and expenses all may be associated with investment fund investments. The prospectus contains important detailed information about the investment fund. Please read the prospectus before investing. There is no assurance that any fund will achieve its investment objective, and its net asset value, yield, and investment return will fluctuate from time to time with market conditions. Investment funds are not guaranteed, their values change frequently, and past performance may not be repeated.
If the securities are purchased or sold on a stock exchange, you may pay more or receive less than the current net asset value. Investment funds are not guaranteed, their values change frequently and past performance may not be repeated.
This information is provided for illustrative and discussion purposes only. This material is not intended as a formal research report and should not be relied upon as a basis for making an investment decision. Historical trends do not imply, forecast or guarantee future results. Information is as of the date indicated and subject to change without notice. Nothing herein constitutes a prediction or projection of future events or future market behavior.