By Joshua Bryant
•
27 Mar, 2024
On January 10th, the US Securities and Exchange Commission approved the first US-listed Bitcoin exchange-traded funds (ETFs). Eleven applications were approved, including those from BlackRock, Fidelity, Invesco and VanEck. This much anticipated regulatory greenlight provided a new way for investors to gain exposure to Bitcoin price movement. Since the ETF approval in January, Bitcoin’s price has surged 50% to new all time highs. Bitcoin ETFs are a convenient method of tracking Bitcoin’s price in your portfolio. But are they the best option for investing in Bitcoin? The answer to that question turns on trust. Who do you trust to hold your investment? Will you trust a corporate third party to hold Bitcoin on your behalf? As Seinfeld said to the car rental agent, anyone can take the reservation, but it’s the holding of the reservation that really matters. In purchasing a share of a Bitcoin ETF, you are not purchasing native Bitcoin. You are purchasing contractual rights as a beneficial owner of a security. In this blog we will explore the risks associated with investing in a securitized version of Bitcoin rather than native Bitcoin. What control do you have over the underlying Bitcoin? Will you be able to sell or access that Bitcoin? What are the risks of holding Bitcoin through intermediaries? How much transparency is offered in regards to your Bitcoin investment? We will answer these questions as we explore the topics of asset custody, counterparty risk and financial transparency. One of the foundational attributes of Bitcoin is the ability to take custody of your own Bitcoin. Bitcoin is a digital bearer asset and only those with the private key to the Bitcoin wallet can move the Bitcoin in that wallet. When purchasing a share in a Bitcoin ETF, the investor does not hold the Bitcoin private keys. Bitcoin ETF investors cannot send the Bitcoin to a different wallet address on the Bitcoin network. They can only sell their shares of the Bitcoin ETF to another buyer of the shares. To illustrate this point, the Blackrock Bitcoin ETF ( iShares Bitcoin Trust ) partners with Coinbase as the custodian to hold the Bitcoin that belongs to the fund. As custodian, Coinbase holds the private keys to the Bitcoin on behalf of their client Blackrock. The iShares Bitcoin Trust ETF investor does not legally own the underlying Bitcoin, does not hold the private keys and cannot access that Bitcoin. The investor must trust both Blackrock and Coinbase as intermediaries to hold the underlying Bitcoin on their behalf. For Bitcoin investors seeking financial sovereignty and permissionless access to their wealth, self custody of their Bitcoins is non-negotiable. Native Bitcoin is independent from the existing financial system in that Bitcoin transactions can be settled without the approval of a bank, exchange or government. Securitized Bitcoin ETFs integrate native Bitcoin into the financial system, as ETF shares can only be exchanged for fiat currencies and the underlying native Bitcoin is controlled by the custodian. ETF investors are completely dependent on the contractual obligations of multiple corporate third parties. Native Bitcoin holders are not dependent on a corporate or institutional third party to honor a contract or secure the asset. A second issue to consider is the counterparty risk associated with investing in a Bitcoin EFT. I learned at a young age that “there is no free lunch” . Everything in life comes at a cost to someone. If you sign up for a free brokerage account and purchase a Bitcoin ETF with no commission, you should ask yourself how the Broker Dealer and ETF issuer are being compensated. They are not providing their products and services for free. There are many ways that Wall Street firms generate profits from the funds and assets they manage. Securities lending is one example where counterparty risk is introduced in order to generate a return from client invested assets. As defined in a paper on Blackrock iShares ETFs , “Securities lending is a well-established practice whereby investment vehicles such as ETFs make loans of stocks or bonds to seek an incremental increase in returns for fund shareholders… While not without risk, securities lending seeks to benefit the fund.” The document goes on to describe how the underlying stocks and bonds of the ETF are lent out to other financial institutions, typically to hedge against market risks, facilitate a short sale, or to use as collateral in another transaction. Blackrock iShares ETFs receive 81-82% of the income generated from securities lending, with the remainder of the income retained by a Blackrock affiliate. This lending of the underlying assets introduces counterparty risk, primarily borrower default risk and collateral reinvestment risk. Blackrock is able to loan out the underlying assets, because they are legal owners of the underlying assets. While there is no evidence that Blackrock is lending out the Bitcoin in their new Bitcoin ETF product, lending is clearly a part of their business model with other ETFs. It demonstrates that ETF investors are accepting a level of institutional counterparty risk when they purchase shares in an ETF. While price movement is easy to comprehend, counterparty risk is less obvious and more difficult to measure, especially as a main street investor. There have been too many instances of loss when Bitcoin is lent out by financial intermediaries. As a Bitcoin investor, why expose your Bitcoin to counterparty risk when you can hold the Bitcoin outright with no institutional counterparty risk? A third area for consideration is the transparency of the financial institutions who are your counterparties. Transparency builds trust, and we look for third party institutions with high levels of transparency. Many crypto custodians now offer “Proof of Reserves”, a process whereby crypto custodians demonstrate their solvency and prove that all user balances are backed 1:1 with assets held on the Bitcoin blockchain. This provides a level of confidence that the custodian holds the amount of Bitcoin they claim to custody on behalf of their clients. While it is simple to prove Bitcoin proof of reserves on the blockchain, it is not as easy to verify the number of outstanding shares of a security trading in the markets. The main street investor is a beneficial owner of the ETF share, and so is their Broker Dealer. The legal owner of the shares is the Depository Trust Corporation (DTC) registered in the name of Cede & Co as nominee for the DTC. As stated in the Blackrock iShares Bitcoin Trust Prospectus , “DTC will act as securities depository for the Shares…Beneficial ownership of the Shares will be limited to DTC Participants, Indirect Participants and persons holding interests through DTC Participants and Indirect Participants. Owners of beneficial interests in the Shares will be shown on, and the transfer of ownership will be effected only through, records maintained by DTC , with respect to DTC Participants; the records of DTC Participants , with respect to Indirect Participants; and the records of Indirect Participants , with respect to beneficial owners that are not DTC Participants or Indirect Participants.” In contrast to the transparency of the Bitcoin blockchain, ownership records maintained by the DTC, Participants and Indirect Participants are not transparent. There is no way for the retail investor to verify that the beneficial ownership they hold in a security can be mapped 1:1 from the private ledger of their Broker Dealer (DTC Participant) to the private ledger of the DTC and then to the corresponding Bitcoin custodial wallet held at Coinbase. There is no way to verify that all ETF shares in circulation across all DTC Participants and Indirect Participants equals the number of shares registered in the name of Cede & Co., the nominee for DTC. There is no way to see if higher priority claims have been made against the ETF shares by another market participant through a lending arrangement. There is no way to see if the ETF shares have been posted as collateral for a loan by a market participant. In short, retail investors must trust multiple levels of institutional financial intermediaries without transparency. Bitcoin ETFs introduce multiple levels of custodial risk, lack of transparency and provide no ownership or control of the underlying Bitcoin. In our view, there is no substitute for holding native Bitcoin on-chain in a private wallet. For smaller amounts of Bitcoin, we recommend an exchange account with a full reserve custodian who can provide proof of reserves. Remember, “Not your keys, not your coins” . Bitcoin private keys should be closely held, either in self-custody or through a collaborative custody solution with a trusted advisor.
