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Exchange-Traded Funds (ETFs) play a crucial role in financial markets and the concept of ETFs has been a buzzword in the cryptocurrency market, particularly with the launch of Bitcoin spot and Ethereum ETFs. In this blog, we will start with the fundamentals of ETFs—their issuers, history, and primary use cases—before exploring the introduction of crypto ETFs, their regulatory journey, their connection to underlying assets like Bitcoin, and how fund inflows and outflows influence both ETF share prices and the value of the underlying cryptocurrencies.
About ETFs
The first Exchange-Traded Fund (ETF) was introduced in Canada in 1990 with an instrument known as Index Participation Units, which traded on the Toronto Stock Exchange. In the United States, the first widely successful ETF was the SPDR S&P 500 ETF, launched in January 1993. Today, it remains one of the largest and most actively traded ETFs globally.
An Exchange-Traded Fund (ETF) is a pooled investment fund, somewhat similar to a mutual fund, but with one major difference: it trades on a stock exchange throughout the day, just like a regular stock. Each ETF holds a basket of underlying assets (which can be stocks, bonds, commodities, or even cryptocurrencies) and aims to replicate or track the performance of that basket. Typically, large asset management firms or fund sponsors issue ETFs. Examples include:
- State Street Global Advisors (creator of the SPDR family of ETFs).
- BlackRock (iShares).
- The Vanguard Group.
- Invesco, and others.
How & Why ETFs are Used?
- Diversification: Instead of picking individual stocks or bonds, you can invest in an ETF that instantly gives you a slice of hundreds (or even thousands) of holdings as a basket.
- Low Cost: Many ETFs track popular indices (like the S&P 500) with expense ratios sometimes as low as 0.03% per year. (i.e. if you invest $10,000, then the fund will be getting $3)
- Liquidity: ETFs can be bought and sold quickly on an exchange, often with little bid-ask difference for the well-known funds which results in high trading volume & low transaction cost.
- Targeted Exposure: There are ETFs for nearly every niche or sector (technology, healthcare, REITs, commodities, single-country, and so forth).
- Tax Efficiency (especially in the U.S.): Since most creations and redemptions occur in-kind (swapping baskets of assets for ETF shares), there tends to be fewer taxable capital gain distributions relative to many traditional mutual funds.
Crypto ETFs
The Winklevoss twins, Facebook fame guys who sued Mark, filed for a Bitcoin ETF around 2013–2014 and that application was eventually denied by the SEC, citing concerns such as market manipulation, custody, and the unregulated nature of crypto exchanges.
It was in 2023-24, when big names like Fidelity, BlackRock, VanEck, Invesco, WisdomTree, Ark Invest (Cathie Wood’s firm), and Bitwise filed their applications and the SEC finally approved these ETFs, i.e., in January 2024 – The SEC officially approved 11 Spot Bitcoin ETFs (including products by BlackRock, Fidelity, Ark, and others) and they began trading shortly afterward.
About Spot Crypto ETFs
A spot cryptocurrency ETF directly holds the underlying digital assets in a custodian’s wallet, rather than gaining exposure through futures contracts. As previously mentioned, an ETF is designed to track the performance of its underlying assets, providing investors with a convenient way to gain exposure. Thus, in the case of a spot Bitcoin ETF, investors benefit from real-time (“spot”) price movements of Bitcoin, with potentially fewer pricing distortions compared to a futures-based ETF, which relies on derivative contracts rather than direct ownership of the cryptocurrency.
However, from the SEC’s perspective, direct Bitcoin holdings raised more concerns about:
- Proper custody (ensuring the fund’s Bitcoin is safe from hacking or theft),
- Ensuring no large-scale manipulation from unregulated offshore exchanges.
A spot Bitcoin ETF is structured so that the fund sponsor directly purchases and holds Bitcoin on behalf of investors. These Bitcoin holdings are then entrusted to a custodian, which could be a major crypto exchange with institutional-grade security (e.g., Coinbase Custody) or a specialized trust company. To mitigate hacking risks, a significant portion of the Bitcoin is typically stored in cold storage (offline).
Liquidity and Tracking Efficiency
Some spot Bitcoin ETFs, such as FBTC and IBIT, offer higher liquidity, meaning they have tighter bid-ask spreads and more accurately track Bitcoin’s price. Conversely, lower-liquidity ETFs may experience larger tracking errors, as limited trading activity can lead to price discrepancies between the ETF and the underlying asset.
The Role of Authorized Participants (APs)
Like traditional equity ETFs, crypto ETFs rely on authorized participants (APs)—institutional firms that have agreements with the ETF issuer to create or redeem “creation units” in large blocks, typically 25,000 or 50,000 ETF shares at a time.
- Creation Process: If demand for ETF shares increases, pushing the ETF’s price above its net asset value (NAV) (i.e., the value of the underlying Bitcoin), APs purchase Bitcoin from the open market and deliver it to the ETF sponsor in exchange for newly created ETF shares. They can then sell these shares to investors, bringing the ETF price back in line with Bitcoin’s market price.
- Redemption Process: If demand weakens and the ETF price falls below its NAV, APs can buyback ETF shares, return them to the sponsor, and receive an equivalent amount of Bitcoin. They may then sell this Bitcoin in the open market if they choose, which helps stabilize the ETF price.
This creation and redemption mechanism ensures that the ETF closely tracks the price of Bitcoin while maintaining liquidity and minimizing discrepancies between the ETF price and the underlying asset.
How Does Inflows and Outflows Affect the Price of an ETF?
When the first U.S. spot Bitcoin ETFs launched in January 2024, they saw a combined trading volume of $4–5 billion on day one, with net inflows exceeding $1 billion in the first week. However, as the broader crypto market experienced short-term corrections later in Q1 2024, some ETFs faced daily outflows of tens or even hundreds of millions of dollars.
Impact of Inflows
Inflows occur when more investors buy into the ETF, leading to increased demand for ETF shares. This triggers authorized participants (APs) to purchase more Bitcoin on behalf of the ETF sponsor, which in turn can push Bitcoin’s spot price higher.
Example:
If a large institutional investor allocates $100 million into a spot Bitcoin ETF, that capital flows to the ETF sponsor. The sponsor, through APs, purchases $100 million worth of Bitcoin in the open market. This additional buying pressure can drive Bitcoin’s price upward.
Impact of Outflows
Outflows occur when investors sell or redeem their ETF shares. This can force the ETF sponsor to offload Bitcoin holdings to meet redemptions. If large amounts of BTC enter the market, it can create an oversupply, contributing to downward price pressure.
Example:
If institutional investors redeem a significant number of ETF shares, the ETF sponsor must return BTC to APs, who may then sell it on the open market. This selling activity can weigh on Bitcoin’s price.
ETF-Driven Market Movements
Before the introduction of spot Bitcoin ETFs, institutional investors had limited avenues to gain exposure to Bitcoin. The launch of these ETFs has led to significant capital inflows, playing a key role in Bitcoin’s price movements.
For instance, Bitcoin surged from ~ $51K to ~ $105K, coinciding with the rising trading volume of IBIT and other ETFs. This confirms that ETF-driven buying pressure is a major factor behind Bitcoin’s rally.
Key Takeaways
- More ETF demand → More Bitcoin purchases → Price appreciation
- More ETF redemptions → More Bitcoin selling → Potential price declines
The spot Bitcoin ETF market has introduced a new layer of institutional demand that can significantly influence Bitcoin’s price dynamics.
Closing Thoughts
ETFs have transformed the investment landscape by providing efficient, diversified, and liquid exposure to various asset classes. Since their introduction in Canada in 1990 and the United States in 1993, ETFs have grown into one of the most widely used investment vehicles globally. Investing in a crypto ETF, whether for Bitcoin or Ethereum, offers a simplified approach to gaining exposure to cryptocurrency price movements without directly managing digital wallets or private keys.
Based on the recent market developments it can be concluded that ETF fund flows play a crucial role in driving demand for the underlying assets and have a direct impact on the price of these assets in the following way:
- More ETF demand → More Bitcoin purchases → Price appreciation
- More ETF redemptions → More Bitcoin selling → Potential price declines
