The institutional investment case for bitcoin ETPs

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Like any truly disruptive technology still in its early years, bitcoin has been called many things – a revolutionary, a rebel, a safe haven, and a scam.

The institutional investment case for bitcoin ETPs

Bitcoin is ripe for institutional adoption, says Bradley Duke, co-Founder and CEO of ETC Group, a specialist issuer of crypto-backed ETPs.

While it maintains its critics, bitcoin continues marching into the mainstream, and an increasing number of investors are asking how they can deploy the world’s largest cryptocurrency within their portfolios to improve risk-adjusted performance.

To help shed some light on this, Bradley Duke, co-Founder and CEO of ETC Group, a specialist issuer of crypto-backed ETPs, recently shared his perspectives with an audience of investors on a webcast hosted by ETF Strategy and sponsored by turnkey ETP platform HANetf.

Duke began by providing an overview of bitcoin’s characteristics and the current state of the bitcoin market.

He noted bitcoin’s nature as a decentralized digital currency without a single administrator such as a central bank or government, allowing users to interact without the need for intermediaries.

Bitcoin relies on a technology called blockchain – a list of records (or blocks) that are linked by cryptography. Each block contains a timestamp, a cryptographic tag of the previous block, and transaction data.

Blockchain is highly secure, fast, and difficult to tamper with as changes must be validated by a majority of users within the system. This makes blockchain ideal for transferring sensitive data including contracts, shareholder details, medical records, and, of course, money.

While there are more than 2,000 cryptocurrencies in existence, bitcoin is by far the dominant player with the greatest acceptance by users and a $160bn market capitalization that represents roughly two-thirds of the entire cryptocurrency universe.

Similar to fiat currencies, bitcoin’s value is determined by supply and demand and founded on trust in the system. According to Duke, bitcoin meets the grade for a successful currency across the four criteria of scarcity, divisibility, utility, and transferability.

Bitcoin was designed with a maximum capacity of 21 million tokens. The current supply of bitcoin is around 18m tokens, and new bitcoin is added to the system as rewards for miners that process transactions in the blockchain. Due to regular “halvings” – technical events that cut the rate of new bitcoin supply in half every four years – bitcoin is only expected to reach its capacity around 2140. These halvings make it more difficult to mine tokens, raises the cost of mining, and increases the scarcity value of bitcoin.

A finite supply of 21m bitcoins is vastly smaller than the circulation of most global currencies; however, to address this imbalance, bitcoin is divisible up to eight decimal points. The smallest unit, equal to 0.00000001 bitcoin, is called a “Satoshi” after the mysterious creator(s) of bitcoin. This degree of divisibility enhances bitcoin’s function as a medium of exchange across all types of goods and services within an economy.

For a currency to be useful, it must also be easily transferred between participants in an economy. Cryptocurrency exchanges, wallets, ATMs, and other tools have been established to make bitcoin secure and easier to use.

Finally, no parties involved in a bitcoin transaction need to know or trust one another in order for the system to work properly. Complex checks and verifications maintain the blockchain ledger and the mining of more bitcoins. Bitcoin’s inability to be manipulated by individuals, governments, or central banks allows users to reliably trade in the cryptocurrency.

According to Duke, these characteristics have supported bitcoin as an increasingly mainstream means of payment. He notes a diverse group of businesses, retailers, and charities are now accepting payments in bitcoin including the likes of Microsoft, Etsy, Lush, Expedia, AT&T, Save the Children, Subway, Xbox, Playboy, and Lamborghini.

Source: ETC Group.

For Duke, the investment case for bitcoin is simple: diversification and high growth potential.

One of the most compelling arguments for a bitcoin allocation, according to Duke, is the cryptocurrency’s low correlation to widely held asset classes both in periods of market calm and turbulence. He noted that bitcoin’s independent behaviour means that it has the potential to be a powerful diversification tool in a multi-asset portfolio.

Duke also believes that bitcoin may serve as a long-term inflation hedge, particularly as central banks embark upon massive stimulus programs to combat the economic effects of Covid-19, as well as a hedge against future financial crises as the cryptocurrency primarily offers an alternative to the traditional banking sector.

Source: ETC Group.

On bitcoin’s growth potential, the cryptocurrency has certainly enjoyed impressive bull runs during its history including more than a 1,800% gain in 2017 when its price reached a peak of nearly $20,000 per token. It has also, however, been characterized by high volatility and periods of significant downturns.

Most recently, the price of a bitcoin token has been trading between $9,000 and $10,000 since the latest halving which occurred in May. Prior to this, the cryptocurrency had plunged from similar levels at the start of the year to below $5,000 in March following the wider Covid-19 market sell-off before recovering swiftly.

Duke was reluctant to comment on bitcoin’s short-term outlook, saying that immediate movements in volatile asset classes are hard to predict; however, he is ultimately bullish about the cryptocurrency’s long-term potential.

He noted that demand for bitcoin is expected to continue growing as cryptocurrencies become more widely used and accepted; however, by design, bitcoin has a finite supply. These dynamics will likely provide an ongoing tailwind to price performance.

Duke further noted that bitcoin’s next bull run could be a long one, particularly if it is driven by institutional adoption. He spoke of a ‘tipping point’ where bitcoin’s market capitalization will pass a threshold that will precipitate an influx of institutional capital, leading to increased adoption, greater acceptance, and a larger market size which, in turn, will drive further inflows in a virtuous circle.

Sensing an opportunity, Duke founded ETC Group with the intention of designing a bitcoin ETP that addresses key compliance issues currently facing institutional investors looking to enter the bitcoin market.

Following lengthy discussions with regulators, as well as collaboration with several blue-chip market makers, ETC Group unveiled its maiden product – the BTCetc Bitcoin Exchange Traded Crypto (BTCE GY) – on Deutsche Börse Xetra in June.

It became the first crypto-backed ETP to list in Germany after BaFin, the German financial regulator, announced in March that it officially recognized cryptocurrencies as financial instruments.

The ETP delivers exposure to bitcoin, is fully backed by actual investment in the cryptocurrency, and maintains the added oversight, security, and liquidity of an exchange-traded product.

Significantly, it is the first centrally cleared bitcoin product with Eurex Clearing acting as the central counterparty. This is the key feature expected to open the door to institutional investors which are typically prevented from trading non-centrally-cleared instruments – a restriction that precludes direct transactions in bitcoin itself or in any of the other bitcoin ETPs that are currently available.

Clearing through a central counterparty system, as opposed to bilateral settlement, reduces the counterparty risk that market participants are exposed to.

Other main advantages of the product, as with other bitcoin ETPs, is that less technologically savvy investors can gain exposure to the asset class without having to engage with the technical challenges of purchasing and storing bitcoin such as setting up a cryptocurrency wallet, managing cryptographic keys, or trading on unregulated crypto exchanges.

The ETP strictly follows KYC (Know Your Customer) and AML (Anti-Money Laundering) rules that prevent rotten actors from using the ETP for disreputable purposes.

It is MiFID-approved which qualifies the ETP as regulatory capital which can be shorted or used as collateral.

It is also the first ETP to allow investors to redeem their shares for bitcoin if they so wish – albeit with a fee of $2,500 if redeeming in bitcoin for an amount that is less than $250,000. Each share corresponds to 1/1000th of a bitcoin.

According to Duke, the ETP is backed by a world-class network of authorized participants and market makers with experience in trading on cryptocurrency exchanges. These partners help support liquidity in the product, allowing for trades of considerable sizes while maintaining relatively narrow spreads.

The ETP comes with an annual fee of 2.00% and is tradeable in euros. While the fee is somewhat high, Duke notes that this reflects the premium nature of the product and its careful design which, he hopes, will make it the go-to ETP for institutional investors seeking bitcoin exposure.