The first exchange-traded fund (ETF) of bitcoin, known as BITO, began operating on October 19, 2021. To date, the launch of this investment vehicle has been a total success. The fund debuted as one of the most traded ETFs in the history of the market, attracting more than 1 billion dollars in the first days. In addition, in the following sessions, the ETF accumulated a significant part of all short-term bitcoin futures contracts, reaching approximately a third of the futures market in just ten days of life, a movement that has raised some concerns. What risks does this trend imply? Can it affect other markets?
The Bank for International Settlements, BiS for its acronym in English, has dedicated a box this week to explain the operation of this ETF and the risks involved. From the BiS they assure that “the structure based on BITO futures is different from that of the more traditional stock ETFs, which are usually based on futures (they usually have real positions in the assets that replicate or similar)”.
This can create significant risks for investors and for other markets where BITO accumulates much of its liquidity. However, to better understand these risks, BiS experts believe that it is necessary to explain the operation of this type of ETF in detail.
First, a futures contract is a legal agreement to buy or sell an asset at a predetermined price at a specific time in the future. Such a contract allows investors to take positions without having the underlying asset (many times it is possible to take leveraged positions, that is, a much greater exposure to the contributed capital).
In addition, since holding that asset generates a ‘storage’ cost (which is sometimes positive because the asset generates a return), the futures price often differs slightly (depends on the underlying asset) from the asset’s spot price. In the particular case of BITO, the asset is bitcoin and the cost tends to be positive, which implies that the futures price is generally above the spot price, and that the futures curve tends to have an upward slope (long term)So long-term futures contracts are more expensive than short-term ones.
To get exposure to bitcoin, BITO goes long (bet bitcoin is going to go up) with short-term bitcoin futures contracts (one month normally). As contracts approach expiration, the fund gradually sells them and buys new futures contracts, a strategy known in financial jargon as rollover. In addition, BITO keeps a part of its funds in liquidity or very safe assets and liquids like Treasury bills.
When the price of bitcoin rises, BITO uses the profits it makes to expand its liquidity (increases its holdings of cash, Treasury bills, promissory notes …). On the contrary, when the price of bitcoin falls, BITO uses part of its liquidity to offset losses with futures contracts. This structure is different from traditional ETFs of bonds or stocks, that simply have bonds and stocks, but is similar to the structure of the ETF of commodities or on the VIX.
After releasing these details, the BiS economists address the main issue and point out the ways in which this ETF can generate great risks for investors and certain markets. “In general, A futures-based ETF can affect prices in two main ways. The first effect works through the rebalancing of flows: when an ETF buys futures contracts to satisfy new inflows (investors entering the ETF), it drives up futures prices, while the opposite occurs with exits. ”
The second effect works through the balance or calendar balance: as the ETF sells futures contracts before they expire, their prices fall. At the same time, as the ETF buys longer-term futures contracts, the prices of those particular futures rise. “This predictable behavior of the ETF can also lead to ‘early execution’ incentives, motivating investors to buy longer-term bitcoin futures before the ETF enters those contracts.”
It also affects the price of bitcoin
In addition, BiS experts assure that the impact of prices in the futures market can also extend to spot prices (the price of constant and sound bitcoin at the moment) through the hedging behavior of investors, especially for assets with physical settlements of the futures contract and large storage costs. A recent prominent example was the drop in oil spot prices to negative territory in April 2020. “Futures-based ETFs likely contributed to rising storage costs and subsequent declines in spot prices.” , argue the BiS experts.
Thus, the economists of the Bank for International Settlements conclude that “The bitcoin ETF can amplify price volatility and create risks for investors if the fund takes (as it is) a large part of the futures market. Experience suggests that futures-based ETFs can exacerbate price movements and create additional volatility when they have a large presence in the underlying asset, “these experts warn.
Impact on markets
An example of how these types of ETFs can distort the markets could be observed in February 2018, a month in which the stock markets experienced strong volatility caused in part by these investment vehicles that exacerbated fear among investors. “The great activity and the large volume of operations in ETFs destabilized the prices of VIX futures and contributed to triggering this volatility index in February 2018,” according to the economists of the Bank for International Settlements.
“This led to losses for investors and the subsequent expulsion of the largest inverse ETF from the VIX,” the report said. An inverse ETF tries to replicate the opposite move that of its underlying asset. For example, if the Ibex 35 falls 10% in the year, your inverse ETF should rise 10% in the same period.
Possible collateral damage
Another risk is the impact that the ETF can have on bitcoin in other markets. The financial connection between some markets and others is intense, since, for example, mutual funds or ETFs have almost all their liquidity in money market assets considered as safe. Imagine a scenario in which participants in the funds and ETF investors want their money back out of fear. These investment vehicles will be forced to undo their positions in these safe assets (to meet repayments), generating downward pressure on their prices.
This is reflected in the BiS box that explains that “BITO trading could also have repercussions on the fixed income markets through its liquidity positions. If the ETF were to liquidate these instruments, for example in the face of the depreciation of bitcoin or excessive outflows of your participants, that could put pressure on the bond markets. At present, BITO is unlikely to cause such disruptions as it holds mostly highly liquid short-term Treasuries and is small relative to the market for these instruments. “