Bitcoin ETF breaks records and US becomes leader in miningThe Node Ahead #2
October 26, 2021
Bitcoin hit new all-time highs last week but, if you have been following us for a while, this shouldn’t come as much of a surprise. In our last newsletter, we highlighted the supply squeeze that has been building for the past several months which meant it was just a matter of time until we started pushing to higher prices. That's the beautiful thing about blockchain – it’s all there in the on-chain data. As of writing this, there hasn’t been much structural change on the supply side (we will keep watching and provide a more detailed update in the next newsletter) but ETFs, pension funds, and PIMCO all recently announced they have begun investing, meaning this is likely just the start of this bull run. Get ready for a wild Q4!
Before moving on, we did want to highlight a recent article for everyone – this piece written by Avik Roy (the President of the Foundation for Research on Equal Opportunity), is an extremely articulate writeup on why the US should embrace bitcoin. A highly recommended read.
With that, let's jump into it.
Back to the Futures
Eight years ago, the first Bitcoin ETF application was filed by the Winkelvoss twins; it was promptly rejected. In 2018, they filed for a second time and were once again rejected. Over the years, at least 12 more proposals have crossed the SEC’s desk, all of which were denied. Then on Friday, October 15, the SEC approved the first ever bitcoin futures ETF and on Tuesday October 19th, the ProShares ETF began trading under the ticker BITO.
There is so much to unpack here, so let’s tackle this piece by piece starting with why this matters.
The reason a bitcoin ETF has been long sought after comes down to accessibility; there are unique technical and compliance challenges when investing in cryptoassets for many institutions and financial advisors. While anyone can open a Coinbase account, customers can’t hold bitcoin in their Schwab account or trade it on traditional platforms. However, the ETF vehicle gives investors a way to gain exposure to bitcoin through an ordinary brokerage account without having to hold the cryptocurrency directly. Packaging bitcoin up as an ETF means organizations such as Schwab or any institution managing 401ks can easily access the asset class. Now clients can give their friendly neighborhood financial advisor a call and say they want some bitcoin!
There is just one caveat: the BITO ETF is for bitcoin futures, not actual bitcoin. Futures contracts are agreements to buy the asset at a predetermined price at a specified time in the future. It is not an investment in the asset itself or at the current price of the asset. In fact, while a spot priced ETF would closely track the price of bitcoin, this futures-based ETF is much more likely to have a premium or discount to the current price of bitcoin.
Would a spot priced ETF be better? Absolutely. Should most retail investors buy bitcoin directly rather than through a futures ETF? 100% yes. But as GBTC proved in the past, and what BITO is proving once again, convenience matters. If a futures-based ETF allows more people to access the asset class, that's a positive development. Furthermore, this is another step towards the SEC’s acceptance of crypto which could lead to spot priced ETFs and Ethereum ETFs in the future. Because of that, the futures ETF is better than nothing.
Which leads us to the next question, why did the SEC prefer a futures-based ETF over a spot-based ETF? The official reason SEC Chairman Gary Gensler has provided is that he and the SEC believe that a futures-based product provides “significant investor protections” that a spot-based product does not. The SEC apparently prefers futures to spot because the SEC is concerned about a potential lack of liquidity and the risk of price manipulation on spot exchanges. In contrast, the futures ETF can be governed under the Investment Companies Act of 1940, giving the Commodities and Futures Trading Commission (CFTC) additional control and oversight. To approve a spot ETF, the SEC has insisted that they need to see a “regulated market of size” to lead price discovery just like for other commodity ETFs. The gold market isn’t regulated, but the regulated futures market leads discovery. Thus, the same standard should hold true for bitcoin.
There is just one small problem with Gensler’s rationale: bitcoin has already met this standard. As the market has grown to over $1 trillion, so too has the trading ecosystem which now includes both large spot trading platforms and a large, regulated futures market run by the CME Group. In fact, Bitwise recently released a research study showing that the CME bitcoin futures market leads the bitcoin spot market in a consistent and statistically significant manner. So, bitcoin already satisfies the SEC’s stated criteria for a spot-based ETF.
Moreover, a futures-based ETF has several disadvantages for retail investors compared to a spot-based ETF.
- Retail investors are likely to pay a premium compared to buying bitcoin directly should they choose to invest in BITO. The price of Bitcoin futures soared the last couple of weeks as news about the futures-based ETF came to market. This has led to a scenario where the spread between the spot price of Bitcoin and BTC futures is the widest it has been in five months.
- Additional fees and costs. The BITO ETF can’t hold bitcoin, so when the futures contract comes due it must roll over the contract. That could cost over 5-10% per year plus another 1-2% in standard fees.
- The futures-based ETF has a limit on the number of contracts it’s allowed to purchase. If demand keeps up at the current pace, the fund could blow past that limit soon. If that happens, CME Group would need to petition the CFTC to raise the legal limits or ProShares may be forced to buy longer-dated contracts thus furthering the spread between the futures price and spot price. In all fairness, as more futures-based ETFs come to market (which they are expected to do), they could soak up some of the excess demand. However, the SEC could have prevented this issue by approving multiple futures-based ETFs at once, rather than giving ProShares a first mover advantage simply because they filed first.
- Finally, Canadian regulators earlier this year approved ETFs that hold bitcoin directly. The first one launched in February from Purpose Investments on the Toronto Stock Exchange and there have been no indications or evidence of price manipulation.
So how in the world is a futures-based ETF providing “significant investor protection”? The answer is it’s not. Regardless, the futures-based ETF is here and, as previously stated, it’s still a net positive development. So positive in fact that the BITO is breaking records.
It turns out there was apparently a lot of pent-up demand for an ETF (even if it’s an inferior product to a spot-based product). In the first day alone, BITO surpassed over $1 billion in trading volume making it the second largest ETF debut of all time. On day 2, BITO’s surpassed $1.1 billion in assets making it the fastest ETF to ever reach that mark and breaking GLD’s 18-year-old record of 3 days. Given bitcoin is often considered digital gold, this seems rather fitting. Furthermore, open interest in CME futures contracts has increased by $3.95B over the course of October representing 265% growth since the end of September (see chart below). Regardless, the availability of a bitcoin ETF is clearly bringing in more investors into the space and will likely facilitate greater education about the industry.
That's a lot of new capital coming into the market. And if you read our last newsletter, you would know this influx of new capital caused by the US government’s approval of the ETF is coming precisely at a time when the illiquid supply of bitcoin is at an all-time high. We find ourselves in a situation in which large pools of capital that are looking for inflation-hedge assets are getting access to an inflation hedge asset that is currently highly illiquid. Limited supply, huge demand. No wonder we saw bitcoin hit new all-time highs.
What is so funny about the whole situation is that this is now the second time the US government will be at least partly responsible for a significant upward movement in bitcoin’s price. In May of last year, the government decided to print trillions of dollars at the same time bitcoin was experiencing its third halving event. Simultaneously, the US government said there was “unlimited” amounts of capital and bitcoin was cutting its daily supply issuance in half. This caused a number of high-profile investors such as Paul Tudor Jones and Stanley Druckenmiller, to turn to bitcoin. One might start to think that the US government could be bitcoin’s greatest PR agency.
But wait, this ETF isn’t buying bitcoin, so why would it impact the spot price of bitcoin? Well first, as alluded to earlier, Bitwise has shown that CME futures lead bitcoin spot price. However, that's not all. Remember that spread between the futures price and the spot price mentioned earlier? Well, that leads to an arbitrage opportunity for hedge funds which is likely to lead to an increase in bitcoin buying.
By selling the futures contract and buying spot bitcoin, hedge funds can capture the spread, thus profiting with very little risk. This is known as the “Basis Trade” or “Cash and Carry” trade. This is great for hedge funds who can take advantage of this trade, not so great for retail investors who end up paying higher prices than they would if there was a spot priced ETF. In the past this spread has gotten as high as 35-40% and that was before the ETF. It will be very interesting to watch how the spread reacts over the coming .
Shameless plug alert: this is in part why we created Onramp, to provide financial advisors with the ability to access the crypto industry without having to go through sub-optimal products such as a futures ETF. By giving financial advisors the tools they need (including buying, selling, and storing actual bitcoin directly), financial advisors can offer a better product and experience using Onramp than financial advisors whose only avenue to buy bitcoin is BITO or GBTC. And it's not just the ability to conveniently buy or sell the asset. The self sovereignty of holding your own keys, moving capital from one person to another without an intermediary, earning yield through staking and lending, and the ability to see crypto holistically as part of a larger portfolio, these are the key fundamentals that most people are ignoring by focusing on an ETF as “THE” solution.
Why it matters: There is growing demand from clients to own cryptoassets, but they also want help managing it. They’re not financial experts – that’s why they hired a financial advisor in the first place. Like any other investment, cryptoassets touch every aspect of the financial planning process – tax planning, estate planning, and so on. While a bitcoin ETF unlocks all the tools and resources that financial advisors already have at their disposal, they need to understand the unique nuances of this asset class in order to provide the best advice to their clients.
We’re number one! We’re number one!
One of the few systemic risks with Bitcoin has been the concentration of mining power in China. China has historically been the leading country in terms of aggregate mining power contributed to the Bitcoin network. At its peak earlier this year, roughly 71% of all computing power on the Bitcoin network came from Chinese miners according to estimates by Cambridge Bitcoin Electricity Consumption Index (CBECI). By comparison, the US had roughly 10.5% in January 2021.
This was a concern because Bitcoin’s blockchain works on a consensus mechanism such that a majority of the network must agree in order to validate a block. Should any one actor control at least 51% of the computing power, they would be capable of influencing which transactions were validated thus undermining the entire system. There were numerous different mining operations previously located in China, and while none of them controlled a majority of the computing power by themselves, there was always a fear that the Chinese government would one day confiscate all these independent miners and take control of the Bitcoin network for itself.
Thankfully, China decided to do the exact opposite. Earlier this year, China announced it was making bitcoin mining illegal. In response, miners, who had invested millions of dollars into mining equipment, shut down their mining rigs, packed up their equipment and moved to friendlier jurisdictions (more on where they moved in a moment). In July of this year, we saw a 48% drop in computing power on the network.
As we have covered in the past, Bitcoin has a predictable and inelastic supply issuance schedule. Should computing power on the network increase, the difficulty to mine bitcoin increases to maintain a constant block time of approximately 10 minutes. Should computing power on the network drop, no problem, the difficulty adjustment mechanism kicks in, making it easier to mine bitcoin. With this adjustment, Bitcoin continued working at its normal pace, verifying blocks on average every 10 minutes.
Since then, miners previously located in China have started to come back online in new geographies.
Before we talk about where the computing power relocated to, let’s pause and acknowledge how incredible the past several months have been. Half of the industry’s production was shut down by one of the most powerful countries in the world and five months later, it’s as if nothing ever happened. Bitcoin didn't experience a single fraudulent transaction, no hacks, not even a moment of downtime. Usage of bitcoin hasn’t stopped – it has accelerated. This is exactly why no government will ever be able to kill the bitcoin network. We witnessed one of the largest, most powerful countries in the world where nearly three quarters of the network’s computing power resided, do everything they could to kill the Bitcoin network and it accomplished nothing. Just imagine what would happen to the computer industry if China banned the production of semiconductors and electronics or if the Middle East banned the production of oil. The whole world would come to a screeching halt.
Furthermore, one of the few systematic risks to bitcoin has now been eliminated. Hash rate has returned but it's more distributed throughout the world. No longer does the threat of Chinese influence on the network exist. Not only was bitcoin not hurt by China’s ban, bitcoin emerged stronger, more decentralized and more secure.
The biggest winner of all has been the United States. The US was already seeing its share of the network power increase in recent years thanks to significant investment in US based mining operations. The US’s share of hash rate on the network grew from 3.4% to 10.5% from January 2020 to January 2021. Then, in the middle of 2021, the China ban sent miners relocating to a variety of jurisdictions with the US widely considered the premiere destination. As a result, the US is now holding the largest share of hash rate on bitcoin’s network (35.4%) compared to any other country.
So, why is the US so attractive? For one, the US has strong property rights and relatively friendly regulation (or lack thereof) towards crypto mining. Thus, it’s very unlikely we would ever see a confiscation or complete dismantling of the industry like we saw in China. The US also has an abundance of energy and it’s relatively cheap compared to most other geographies around the world. Finally, the US has the largest, deepest capital markets to support a huge infrastructure buildout. The vast majority of new ASICs (machines used to mine bitcoin) that have been bought recently have been purchased by US companies meaning the most aggressive build out is happening in the US.
The state that is by far leading the charge in that buildout is Texas. As Nic Carter pointed out in a presentation he gave at the Texas Blockchain Summit, Texas has several attractive characteristics for bitcoin miners. The state has a deregulated grid with real time pricing, policymakers such as Greg Abbott and Ted Cruz who are strong advocates for crypto mining, and most importantly, significant excess renewable energy. West Texas is one of the best locations in the country for wind power. West Texas is also a premiere location for solar energy. Both technologies have intermittent power with limited up time and thus on their own, these technologies have a hard time sustaining power generation. However, West Texas has a combination of both and as a result, roughly 30% of Texas’ grid is powered by renewable energy.
There is just one problem. West Texas is…how do we put this nicely…sparsely populated. Most of the demand for electricity is in the southeastern part of Texas (Austin, Dallas, Houston) which, if you ever have tried to drive across the state, you know is a long way away. This is important because electricity doesn't travel well. In fact, West Texas has 32 GW worth of generation (mostly from wind and solar), but only 5 GW worth of local demand. Furthermore, only 12 GW can be exported to southeast Texas through high-voltage transmission. In other words, West Texas produces much more energy than it can use or transfer to other parts of Texas. And that's before the quantity of renewable energy is expected to increase significantly in coming years from more infrastructure buildout that is currently happening. Thus, the region creates a ton of clean, excess capacity that goes to waste. Or it did until now. Bitcoin miners can set up shop precisely where all this excess capacity resides and take advantage of this otherwise wasted energy. Now these renewable producers have a second “buyer” of this power other than the Texas power grid which is improving the economics of these renewable businesses.
There is one more reason Texas is attractive, and that is the fact that oil mining is kind of a big deal in Texas. Methane gas is a byproduct of extracting oil from the ground and is considered nothing more than a waste product. Oil rigs have no use for it, and most operations are not connected to any pipelines to take the gas away. However, methane is extremely bad for the environment. Rather than release it directly into the air, they burn it (aka flaring) which creates a lot of CO2. This isn’t great for the environment but it’s better than venting directly into the atmosphere. It’s also worth noting that not 100% of the methane gets burned using this method, some still leaks into the air, especially on windy days.
However, bitcoin miners have developed methods for funneling that methane to a generator that converts all of it to electricity and uses it to mine bitcoin. This is a dramatic improvement over the status quo, both for the environment (preventing toxic emissions from being released into the environment) and economically speaking (oil miners get additional revenue on an asset they would otherwise let go to waste).
Hence, the US is a very attractive place to relocate to and invest in bitcoin mining. The Chinese ban has proven to be an incredibly positive development for the security of the network and an economic boon to the US. We are now the largest contributor to the bitcoin network, and we at Onramp do not expect that trend to change anytime soon.
Why this matters: Bitcoin’s network has been significantly derisked over the last 6 months. Also, there are a number of US, publicly traded bitcoin mining operations which might be an interesting way to get indirect exposure to the asset class on behalf of clients.
In Other News
Fixed-income titan Pimco is starting to embrace cryptocurrencies.
On their Q3 earnings call Morgan Stanley’s CEO James Gorman said “I don't think crypto is a fad. I don't think it's going to go away.”
Houston Firefighters' Relief and Retirement Fund Announces Bitcoin Purchase.
State Street’s Digital Unit is seeing triple-digit growth.
Mastercard says any bank or merchant on its network will soon be able to embed crypto into their products, meaning crypto wallets, credit cards and loyalty programs where points can be earned can be swapped for bitcoin.
Walmart Inc. has started a pilot program in which shoppers can buy Bitcoin at Coinstar kiosks in some of its U.S. stores.
Bitcoin mining is reshaping the energy sector for the better.
A new report claims that companies including Disney, video game publisher Electronic Arts and Robinhood Markets are expected to benefit from non-fungible tokens (NFTs).
Lord Philip Hammond, the UK’s former Chancellor of the Exchequer, has warned that the nation’s finance sector is at risk of falling behind global rivals unless regulators do more to help firms embrace digital assets.
Premium on bitcoin futures has doubled this month as investors expect the SEC will approve the first futures-based bitcoin ETF.
Visa is launching an NFT program to support digital artists.
Sotheby’s launches curated NFT platform called Sotheby’s Metaverse.
OFAC released crypto-specific guidance on navigating U.S. sanctions in which the agency expects virtual currency operators to shoulder the same responsibility for avoiding sanctions violations as other financial institutions.
Coinbase unveils lobbying push for a brand-new US regulator focused on digital assets.
The Associated Press launches NFT collection to sell pieces of history.
Grayscale files with SEC to convert Its Bitcoin Trust into an ETF.