What is a Bitcoin ETF, and How Does It Work?

A Bitcoin ETF is like any other ETF. So, in order to understand what a Bitcoin ETF is, let’s first understand what an ETF is.

ETF is an acronym that stands for Exchange Traded Fund. Exchange-Traded Funds have only been around since the 1990s and were created to combine the benefits of stocks and index funds.

Any given ETF trades like a stock. That is, traders can buy and sell shares of an ETF as often as they want during trading hours on an exchange. This is in stark contrast to index funds, which can only be traded once per day during market hours.

Any given ETF also represents diversification. This is also true of any index fund. Index funds represent diversified groupings of stocks chosen to mimic the return of a financial index, for example, the S&P 500 or the SSE Composite Index. An ETF might mimic the entire value chain of companies within, say, electric vehicles. This is in stark contrast to stocks, which represent only a single company.

So, the first ETFs were created several decades ago to combine the best of two worlds: The traceability of stocks, and the diversified nature of index funds. This directly relates to Bitcoin ETFs because issues of tradability and diversification are currently hampering Bitcoin’s adoption.

Before launching into an explanation of how a Bitcoin ETF works, an important note: There currently are no Bitcoin ETFs listed on U.S. exchanges. The U.S. Securities and Exchange Commission (SEC) has denied Bitcoin ETF applications dating back several years. The SEC has issued denials because Bitcoin trades on unregulated exchanges, and it also cites concerns regarding volatility among others.

Nevertheless, calls for regulatory approval of a Bitcoin ETF are increasing. Polling indicates that investors are in favor of allowing the investment vehicle. The volume of Bitcoin ETF applications should only continue to increase as the cryptocurrency itself has become mainstream. In fact, the SEC is currently evaluating 8 such applications for Bitcoin ETFs. It is simply a matter of time before a Bitcoin ETF is approved by the SEC and listed on a U.S. exchange. This will counter some of the negative price pressure Bitcoin faced in light of Turkey’s recent crypto decision

With that note aside, let’s jump back into the dual issues of tradability and diversification, and how exactly a Bitcoin ETF solves them.

Any Bitcoin ETF that receives SEC approval will trade on a stock exchange. That is, it will be an exchange traded fund. This is important because Bitcoin ETFs will ease the friction that currently afflicts Bitcoin. Investors who want to own Bitcoin have to purchase it from cryptocurrency exchanges. For a vast swath of investors these exchanges simply represent too great an unknown. Storage issues and security concerns only exacerbate the problem. The net effect is that investors who might otherwise invest in Bitcoin don’t.

Knock down those barriers to entry, and a whole new class of investors suddenly floods into Bitcoin. Make Bitcoin act like an ETF, and it suddenly becomes more accessible to smaller retail investors whose trepidation regarding crypto exchanges may have previously prevented a Bitcoin purchase. Perhaps more important, from a sheer volume perspective, is the counterpart to those retail investors. Make Bitcoin act like an ETF, and institutional investors can now trade much more easily in the cryptocurrency. The recent Coinbase IPO makes all of these possibilities that much more tangible.

Since institutional investors make up the vast amount of trading volume in markets, Bitcoin will suddenly become a much more important part of the financial landscape once the ETFs are approved.

Make Bitcoin act like an ETF, and it suddenly moves out of the exotic world of cryptocurrency and into the much more familiar world of stocks and exchanges.

A Bitcoin ETF leads to diversification. This might seem inherently contradictory. After all, ETFs and index funds represent a basket of stocks, commodities, or other assets. A Bitcoin ETF simply contains Bitcoin. So, where is the diversification?

Really here, diversification is about the degree of integration of Bitcoin into traditional financial markets. A Bitcoin ETF is a quantum leap forward for Bitcoin as an asset because it moves Bitcoin into the world of stock exchanges and not only cryptocurrency exchanges.

Bitcoin ETFs also diversify Bitcoin in another important way. Currently, investors can’t short Bitcoin. Owners can sell Bitcoin if they anticipate that its price may decline. But in such a case the seller gets no financial benefit beyond avoiding the loss by getting out at the right time. They can’t profit from correctly anticipating a decline in Bitcoin and placing a bet on that decline. However, a Bitcoin ETF can be shorted just as all ETFs can be shorted. Overall, one thing is clear: Bitcoin ETFs provide powerful benefits for the cryptocurrency.

Bitcoin ETFs share the fundamental characteristics of all exchange traded funds. They work, look, and act like all ETFs. The important thing to note is that Bitcoin ETFs fundamentally change Bitcoin and its relationship to markets and finance. Make no mistake about it, Bitcoin ETFs represent a milestone in the cryptocurrency’s evolution.

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