Bitcoin & Ethereum Spot ETF Guide

written by Michael Blake, Oct. 15^th 2023

OVERVIEW

This report seeks to act as a comprehensive guide for all of the pertinent information related to designing, filing for, and operating a Bitcoin / Ethereum Spot ETF. Major topics that will be discussed are:

· Background and Market Landscape

· SEC ETF Filing Process

· Required Application Information

· ETF Economics

·  Combined BTC/ETH ETF Considerations

· Closing Remarks

BACKGROUND and MARKET LANDSCAPE

The digital asset industry has long been obsessed with the idea of a Bitcoin Spot ETF being approved by the U.S. Securities Exchange Commission. The first ever attempt was made by the Winklevoss twins a decade ago in 2013, and was ultimately rejected by the SEC in 2017.

Since then, a number of futures-based Bitcoin ETFs, like the ProShares Bitcoin Strategy ETF (Ticker: BITO), have been approved by the SEC and are actively trading on U.S. exchanges. These products however, have yet to gain the mainstream adoption many had hoped for with the largest currently holding $1.1B in assets under management, and the rest holding less than $100M.

Potential reasons futures-based ETFs have struggled are because of the potential risks and additional costs associated with actively rolling futures contracts on a continuous. Another reason may just be investors are more comfortable with a Spot ETF that actually holds actual underlying crypto assets.

Fast forward to October 2023, and the SEC is now actively reviewing almost a dozen Bitcoin Spot ETF applications from traditional financial giants like BlackRock and Fidelity, and also from tech-focused funds like Cathie Wood’s ARK Invest. The full list of active applications and upcoming decision dates can be seen below:

Switching gears for just a moment to the second largest cryptocurrency by market cap, Ethereum has also been making news headlines as investment managers are exploring Ethereum Spot ETFs as well. On Oct. 2nd, Grayscale Investments in conjunction with NYSEArca, filed for approval from the SEC to convert the Grayscale Ethereum Trust (ETHE) to a Spot Ethereum ETF. The Grayscale Ethereum trust is the largest ether investment product in the world with almost $5 billion in assets under management. ARK Invest, in partnership with 21Shares, also just filed for their own Spot Ethereum ETF on Sept. 6th.

Although the SEC has recently delayed decisions on multiple Spot ETF applications, the pressure is beginning to mount against SEC-Chairman Gary Gensler to change course. On Sept. 27 ^th , four key congressional leaders publicly addressed Gensler in an open letter, asking him to “immediately” approve Spot Bitcoin ETFs. They also referenced the landmark Grayscale case from August, which ruled that the SEC incorrectly rejected Grayscale Investment’s listing of a bitcoin exchange-traded fund.

So why exactly is the digital asset industry so excited about the potential approval of a Bitcoin or Ethereum Spot ETF?

Steven Schoenfield, former managing director at BlackRock and current CEO of MarketVector Indexes, recently told crowds at the Digital Asset Summit in London that the impending approval of a Spot Bitcoin ETF could bring $200 billion to Bitcoin investment products in the short-term. He also said it was promising that the SEC was not outright rejecting the ETF filings, but only delaying them. “Instead of completely rejecting the whole list, they've asked for comments, which is a marginal but significant improvement in the dialogue,” Shoenfield said, referencing BlackRock’s application. “There's also the Grayscale lawsuit, which the SEC lost, which means they're most likely going to have to allow the Grayscale Bitcoin Trust to be converted into an ETF.”

With the current crypto bear market approaching its two-year anniversary, many industry participants are hoping a Spot ETF approval could be the catalyst to launch the next crypto bull run. It’s obvious why digital asset investors are so excited about a potential Spot ETF, but let’s discuss why asset managers are equally excited about the opportunity.

Although customer demand is a big factor in bringing these investment products to market, they also represent a massive new revenue opportunity for asset managers. Let’s use the SPDR Gold Shares ETF (Ticker: GLD) as a comparable given the common classification of Bitcoin as “digital gold”. GLD is managed by State Street Global Advisors, and is the largest ETF holding physical gold bullions with $52.5B in assets under management according to Yahoo Finance. If we take the AUM of the fund, and multiply it by the fund’s annual expense ratio of 0.40%, we get a staggering revenue figure of $208M.

The recent BTC and ETH Spot ETF filings from ARK Invest both indicate intended annual expense ratios of 0.95%. If these funds are able to attract $10B in AUM (just 1.8% of Bitcoin’s total market cap at the time of writing) they would unlock a $95M annual revenue opportunity for ARK.

SEC FILING PROCESS

So, now that we’ve established Bitcoin/Ethereum Spot ETFs are an extremely lucrative opportunity for both crypto investors and asset managers, what does the process look like for actually getting an ETF created and approved by the Securities and Exchange Commission?

Given the regulatory landscape around digital assets is constantly evolving, it's essential to consult legal experts and stay up to date with the latest guidelines. Below is a general breakdown of the key steps to getting a Spot Bitcoin/Ethereum ETF approved:

1. Preliminary Planning:

Determine the structure and objectives of the BTC/ETH Spot ETF, including its investment strategy, tracking methodology, target market, and potential risks.

2. Engage Service Providers that will Help Operate the ETF:

Launching and operating a BTC/ETH Spot ETF will involve various service providers, each with specific responsibilities. In order to streamline the approval process as much as possible, it is important to engage these stakeholders early and get their buy-in. A detailed breakdown of the different service providers can be found in the next section ‘Required Application Information’.

3. Creation of the ETF Prospectus:

Prepare a detailed ETF prospectus that includes essential information about the ETF including its objectives, business model, risk factors, fees, and other relevant details.

4. Form S-1 Filing with the SEC:

The Form S-1 Filing expands upon the ETF Prospectus, presenting comprehensive information about the desired ETF to the Securities and Exchange Commission. This filing also initiates the formal regulatory review process.

Typically, ETF applications require a Form N-1A, however in the case of a Bitcoin or Ethereum Spot ETF, the Form S-1 is used for the following reasons:

· Nature of the Asset: Bitcoin is not a traditional security like stocks or bonds; it's a digital asset or commodity. Therefore, ETFs that intend to hold physical Bitcoin must register with the SEC using the S-1 form, which is designed for securities offerings, including commodities.

· Commodity-Based ETFs: ETFs that primarily hold commodities, such as physical gold, silver, or Bitcoin, fall under the regulatory oversight of the SEC and the Commodity Futures Trading Commission (CFTC). The S-1 filing ensures compliance with both sets of regulations.

· Disclosure Requirements: The S-1 form allows issuers to provide detailed disclosures about how they intend to acquire, hold, and secure physical Bitcoin, which is essential for investors and regulators to understand the fund's operations.

· Unique Characteristics: Bitcoin Spot ETFs have unique characteristics compared to traditional securities-based ETFs, and the S-1 filing process allows issuers to address these nuances in their disclosures.

5. SEC Review:

The SEC will review the S-1 filing for compliance with federal securities laws and regulatory requirements. This review process can take several months, and the SEC may issue comments or requests for additional information during the review. The SEC may also decide to formally postpone their approval decision, as they have recently done with ARK Invest, BlackRock, and others. On average the review process takes 4-6 months.

6. Amendments and Clarifications:

Applicants will need to respond to any comments or requests for clarifications from the SEC promptly. This back-and-forth communication with the SEC can extend the review process. In the past, the SEC has cited issues around Spot Bitcoin ETFs such as:

• Lack of reliable pricing data & transparency: BlackRock has taken a massive step in addressing this concern by entering into a Surveillance-Sharing Agreement with Coinbase. SSA’s allow for the sharing of information about market trading activity, clearing activity, and customer identification, allowing for little possibility of market manipulation.

• Concerns regarding asset custody: by partnering with a custody partner like Coinbase, BlackRock and others can point to a highly-regulated institution that has demonstrated robust and consistent controls for securely holding crypto assets

• Market Maturity: this concern has slowly lost weight given that Bitcoin has transcended into a global macro asset held by numerous institutions and governments around the world.

7. SEC Approval (hopefully):

Although it hasn’t happened yet, many industry experts and analysts are hopeful that a Spot BTC/ETH approval is likely sometime between Oct. 2023 and Mar. 2024. Once the SEC is satisfied with the filing and all regulatory requirements are met, they will issue a notice of effectiveness, granting approval for the launch of a Spot ETF.

8. Listing on an Exchange:

After receiving SEC approval, asset managers will need to work directly with a stock exchange to list their ETF for trading. It is best to initiate these conversations before filing the Form S-1 with the SEC so asset managers can make their ETFs available for trading directly after approval. 

9. Ongoing Reporting and Compliance:

Asset managers will be responsible for maintaining ongoing compliance with SEC regulations, including regular filings and disclosures. They will also need to provide investors with updated information on the performance of the ETF through periodic reports and communications.

ETF filing timelines can vary based on a variety of factors including ETF complexity, regulatory changes, and the efficiency of the SEC review process. As mentioned previously, it’s crucial to consult legal and financial experts with expertise in cryptocurrency ETFs to navigate the current environment.

Another option that could be attractive to asset managers is hiring an outside consultant to run the filing process on their behalf. Goldman Sachs just recently announced their own ETF Accelerator program and the first funds through the program just launched on Oct. 5th.

REQUIRED APPLICATION INFORMATION

As mentioned, the Form S-1 filing officially kicks off the ETF review process with the Securities and Exchange Commission. The S-1’s for the iShares Bitcoin Trust (BlackRock ETF) and the ARK21Shares Bitcoin ETF were 102 and 88 pages long respectively. The following is not an exhaustive list of required information, but highlights the major components consistent across both company’s filings:

· Overview of the Trust – breakdown of how the Trust will function, where it intends to trade, high level objectives, and summary information regarding topics explained more thoroughly in the rest of the Form S-1.

· Overview of Underlying Asset(s) – In the case of the Bitcoin Spot ETFs, this section provides a comprehensive description of the Bitcoin Network, its decentralized and sovereign properties, BTC’s supply/demand mechanics, market expectations for adoption, merchants/institutions/governments currently using bitcoin, BTC mining mechanics, and the permanent, cryptographic ledger system of BTC.

· Trust’s Investment Objectives - to seek to track the performance of Bitcoin, as measured by the ‘Index’, adjusted for the Trust’s expenses and other liabilities. To provide investors with a way to purchase and sell shares through traditional securities brokerage accounts and avoid the complexities of handling bitcoin directly (e.g., managing wallets and public and private keys themselves, or interfacing with a trading platform), which some investors may not prefer or may find unfamiliar.

· Asset Valuation Methodology – BlackRock and ARK Invest both reference “The CME CF Bitcoin Reference Rate - New York Variant”, also referred to as the ‘Index’. It is the rate in which bitcoin futures contracts are cash-settled in U.S. dollars at the CME.

· Trust Share Price Information - the current market price per share of the ETF will be published continuously as trades occur throughout each trading day on the consolidated tape by market data vendors.

· Trust’s Legal Structure – BlackRock and ARK Invest both elected to classify their ETF as a Delaware statutory trust.

· Trust’s Fees and Expenses – see ‘Business Models, Fees and Expenses’ section below

· Net Asset Value - the total assets of the Trust including, but not limited to, all bitcoin and cash, less total liabilities of the Trust, each determined on the basis of generally accepted accounting principles.

· Authorized Participants - Baskets may be created or redeemed only by Authorized Participants. Each Authorized Participant must be a registered broker-dealer, a participant in DTC, have entered into an agreement with the Sponsor and the Trustee (the “Authorized Participant Agreement”), and be in a position to transfer bitcoin to, and take delivery of bitcoin from, the Bitcoin Custodian through one or more accounts.

· Seed Investor / Initial Authorized Participant – Undisclosed by BlackRock and ARK Invest, this entity will take delivery of the “Seed Creation Baskets” at a previously agreed upon price, which will equate to a specific dollar amount of Bitcoin. This entity may offer all of the Shares comprising the Seed Creation Baskets to the public and will be indemnified by the Trust and Sponsor against liabilities under the Securities Act.

· Plan for Distribution - the Trust issues Shares in Baskets to Authorized Participants in exchange for deposits of bitcoin on a continuous basis. Shareholders who decide to buy or sell Shares of the Trust will place their trade orders through their brokers and will incur customary brokerage commissions and charges. The Shares are expected to be listed for trading, subject to notice of issuance, on the Exchange under a ticker symbol to be announced prior to commencement of trading.

· Federal Tax Considerations - owners of Shares will be treated, for U.S. federal income tax purposes, as if they owned a corresponding share of the assets of the Trust. They will also be viewed as if they directly received a corresponding share of any income of the Trust, or as if they had incurred a corresponding share of the expenses of the Trust. Consequently, each sale of bitcoin by the Trust will constitute a taxable event to the Shareholders.

· Use of Proceeds - Proceeds received by the Trust from the issuance of Baskets consist of Bitcoin. Such deposits are held by the Custodian on behalf of the Trust until:

· Emerging Growth Company – this is an important designation made by ARK and BlackRock that classifies their ETFs as Emerging Growth Companies under the Jumpstart Our Business Startups Act of 2012 (the “JOBS Act”).

· Principal Investment Risks – a full breakdown of risks from ARK’s application can be found here: ARK Comprehensive Risk Analysis

Service Providers:

Sponsor - arranges for the creation of the Trust and is responsible for the ongoing registration of the Shares for their public offering in the United States and the listing of Shares on the Exchange. For BlackRock, the Sponsor is iShares Shares Delaware Trust Sponsor LLC (an indirect BlackRock subsidiary), and for the ARK ETF the Sponsor is crypto market-maker 21Shares US LLC.

Trustee / Sub-Adviser – primarily responsible for the day-to-day supervision, investment strategy, and making investment decisions for the Trust. This role is filled by BlackRock Fund Advisors and ARK Investment Management LLC respectively.

Administrator – Both companies have elected to use The Bank of New York Mellon act as their Trust Administrator. BNYM will provide necessary administrative, tax and accounting services and financial reporting for the maintenance and operations of the Trust, including valuing the Trust’s Bitcoin, calculating the NAV per Share of the Trust, the NAV of the Trust, and supplying pricing information to the Sponsor for the Trust’s website.

Transfer Agent – For Ark Invest, BNYM will also act as the Transfer Agent, and will:

§  (1) facilitate the issuance and redemption of Shares of the Trust

§  (2) respond to correspondence by Trust Shareholders and others relating to its duties

§  (3) maintain Shareholder accounts

§  (4) makes periodic reports to the Trust

Custodian - a third-party limited purpose trust company that is subject to extensive regulation and has among the longest track records in the industry of providing custodial services for digital asset private keys. Both companies have selected Coinbase Custody Trust Company, LLC as their Bitcoin custodian.

 Marketing Agent – responsible for reviewing and approving the marketing materials prepared by the Sponsor for compliance with applicable SEC and Financial Industry Regulatory Authority (“FINRA”) advertising laws, rules, and regulations.

ETF ECONOMICS

Below is a simple model showing the potential economics of operating (not investing in) a crypto Spot ETF, assuming assets under management of $100M and an expense ratio of 0.95% (mgmt. fee indicated in ARK’s S-1 filing).

A deeper dive into the costs of running an ETF can be found here: Costs of Running an ETF.

COMBINED BTC/ETH SPOT ETF CONSIDERATIONS

As noted earlier, there are almost a dozen Bitcoin Spot ETFs and two Ethereum Spot ETFs currently under review by the Securities and Exchange Commission. A bulk approval approach by the SEC seems increasingly likely, and this would effectively neutralize any one company benefiting from a first-mover advantage.

So, how can an asset manager differentiate their offering and attract substantial liquidity in this environment?

One way would be to launch a Spot ETF that holds both Bitcoin and Ethereum simultaneously.

A side-by-side comparison of ARK’s separate Spot BTC and ETH ETF applications reveals there are many structural similarities. The same service providers, business models, fees, and expenses are all used. This implies there may not be significant extra work involved in combining the two assets into the same ETF.

The key difference, however, lies in the unique risk profiles of the two assets. Given the Bitcoin and Ethereum networks function in fundamentally different ways (Proof-of-Work vs. Proof-of-Stake), the mechanics of each asset would need to be clearly defined in an inclusive filing.

Additionally, given the prices of the two assets have performed wildly different over the last few years, means the expected performance of the ETF would also be impacted. This could make the combined Spot ETF more (or less) attractive to specific investors depending on their preferences.

A combined ETF may not be a competitive advantage for long though, as Valkyrie Funds recently announced they are converting their Bitcoin Futures ETF (NASDAQ: BTF) into a first-of-its-kind dual Bitcoin and Ethereum Futures ETF, effective Oct. 3rd. The ETF currently has $24.97M of net assets and carries an expense ratio of 0.95% according to Yahoo Finance.

With traditional investment giants and digital asset native companies embracing the ETF model at an alarming rate, asset managers will need to start getting creative in order to differentiate their offerings. Other than becoming the cheapest option, asset managers could consider other strategies like:

· Leveraging existing business relationships/connections to secure substantial liquidity ahead of their ETF filing/launch

· Creating Spot ETFs that include smaller market cap crypto assets that have also gained substantial attention from institutional investors. Ones that come to mind are Chainlink and Solana.

· Marketing ETFs to investors in crypto hubs outside of the U.S. (such as the United Arab Emirates, Singapore, and wealthier European nations). Securing Seed Investment from these regions could also be a strong competitive advantage.

CLOSING REMARKS

Finally, although the SEC hasn’t yet formally approved a Spot Bitcoin or Ethereum ETF, recent sentiment from applicants, industry analysts, and even lawmakers, has shifted towards potential approvals coming sometime between Oct. 2023 and Mar. 2024.

Digital asset enthusiasts believe these approvals could be the much-needed catalyst to ignite the next crypto bull run and bring an end to the two year-long crypto winter. Traditional investment managers are just as excited about these new Spot ETFs given the massive revenue opportunities they represent.

To asset managers considering submitting their own crypto ETF applications, this is your sign to take the leap and become pioneers helping lead the future of the digital asset industry!

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