A little over a week ago, the world’s first Bitcoin-linked ETF hit the markets with ProShares’
Bitcoin Futures ETF, ticker BITO.
As a big believer in Bitcoin myself, I think this is something to be excited about for
many reasons.
However, that doesn’t necessarily mean I would ever want to invest in this kind of
product.
In this video, we’re taking a closer look at the Bitcoin Futures ETF and how it actually
works.
This starts with understanding Bitcoin futures themselves, which are the core investment
of the ETF.
After reviewing futures, we’ll take a look at how the ProShares Bitcoin Futures ETF uses
them in their strategy.
Ultimately, the use of Bitcoin futures in this ETF has some major problems, which investors
have to be aware of.
Please watch at least until I cover these issues, because they will dramatically impact
the performance of this Bitcoin futures ETF, and any that come after it, potentially causing
massive losses.
Finally, we’ll discuss whether the BITO ETF has a place in an investment portfolio
despite the risks involved.
This will involve a comparison to other methods of Bitcoin exposure, just so you know all
of the available options.
Stay tuned and I’ll cover everything you need to know.
First things first, we need to understand futures contracts and how they work with Bitcoin.
If you’re familiar with call options, futures contracts are a lot like that, except they
apply to commodities and other assets outside of stocks.
Essentially, when you buy a futures contract, you are buying the right to purchase an asset
at a certain price in the future.
So for a quick example, if you enter into a Bitcoin futures contract at $60,000, you
would be eligible to purchase Bitcoin at $60,000 in the future.
If the price of Bitcoin goes higher than $60,000, you’ve made a nice profit because you’ve
secured your purchase at a lower price.
However, there are some very important differences between buying call options and entering into
futures contracts.
Let’s break down how a futures contract works with Bitcoin, and keep in mind, this
will all be based on the Chicago Mercantile Exchange, or CME, because that’s where the
BITO ETF is trading Bitcoin Futures.
For starters, one Bitcoin futures contract represents the obligation to buy or sell 5
Bitcoin.
This is similar to how call options represent 100 shares of a stock.
So a $60,000 Bitcoin futures contract is actually worth $300,000, because it represents 5 Bitcoin
in a single contract.
Next, Bitcoin futures are cash settled.
With call options and some other futures contracts, once the contract expires, you might have
to deliver the shares or commodity to the party who owns the contract.
But with Bitcoin futures, the contract is settled by paying the equivalent dollar amount.
This means that no Bitcoin is ever transacted as a result of the futures contract, and this
is why the BITO ETF never actually gets its hands on any Bitcoin.
In order to purchase or enter into a futures contract, you have to make an initial margin
deposit.
This is typically a percentage of the value of the contract.
That means the margin requirement will fluctuate with the price of the contract.
At the time of writing, a Bitcoin futures contract requires an initial margin of $128,320.
The current price of a Bitcoin futures contract is $62,945, multiplied by 5 Bitcoin is $314,725.
This means that the initial margin is approximately 40% of the value of the Bitcoin futures contract.
And this is how much it would cost to enter into the contract.
As you might’ve noticed, this means you can enter into a contract and gain exposure
to 5 Bitcoin at a lower cost of purchasing them outright at $62,945 each.
This means that Bitcoin futures are a leveraged product.
If the price goes up, you will earn substantially greater returns because you had to invest
a fraction of the cost of 5 Bitcoin.
Conversely, if the price goes down, you could lose money a lot faster than if you just purchased
Bitcoin directly.
Because of this risk, there are also minimum margin requirements.
In order to maintain your futures position, you have to stay above a certain level of
margin.
And like we said, the margin level will fluctuate with the price of the futures contract.
If you drop below this margin requirement, you will have to either invest more money
to bring your margin back up to the initial level, or the broker will liquidate your contract
and you could lose your investment.
With Bitcoin futures, the minimum margin requirement is $116,660, which is approximately 37% of
the value of the contract, and doesn’t leave much room for volatility on the downside.
These levels are set particularly high for Bitcoin futures because of the volatility
of Bitcoin.
Finally, the price of Bitcoin futures, as in the cash settlement that would be paid
at contract expiration, is determined by something called the Bitcoin Reference Rate.
This is a CME tool that collects pricing data from various cryptocurrency exchanges, weighted
by volume and other factors, and then calculates a “reference” price for Bitcoin once per
day.
But the trading price of futures contracts will fluctuate based on market activity.
So with an understanding of Bitcoin futures, we can take a closer look at the BITO ETF
to understand how they look in practice.
Again, many fund providers have applied to bring a Bitcoin ETF to market, but ProShares
is the first to receive approval, and many more are expected to follow.
If we take a look at their website, we see right away that the fund does not actually
invest in Bitcoin, and that the performance of Bitcoin futures is expected to differ from
the “spot” price of Bitcoin - which is what we just learned from dissecting Bitcoin
futures as an investment.
Their strategy is fairly straightforward.
The BITO ETF will purchase Bitcoin futures contracts to gain direct exposure to Bitcoin.
However, there are a few very important details revealed in their prospectus documents.
First, they will focus on front-month Bitcoin futures contracts.
As shown here, these are contracts with the shortest time until expiration.
These should track the price of Bitcoin more closely than longer-term contracts, but it
also means that if Bitcoin drops in price, there is less time for prices to recover and
deliver a profit.
At the time of writing, BITO has all of its assets in October and November futures contracts,
verifying that they’re sticking to the shortest-terms possible.
Next, instead of letting these contracts expire and collecting a cash settlement, they trade
it into a similar futures contract for the next month.
This is a process known as rolling, and as explained here, it does come with some risks.
The main risk is something called contango, which is when the longer-term contract is
priced higher than the shorter-term contract, which is often the case.
As a result, BITO may be routinely trading their current futures contracts for a low
price, then paying a small premium to trade into the next available expiration date.
The reason for doing this is that they maintain constant exposure to Bitcoin.
If they exercised and waited for the cash settlement to purchase new futures contracts,
there may be some delay between the two, which could result in missing out on market movements,
for better or for worse.
To summarize the BITO strategy, they take all of their assets and invest them into short-term
Bitcoin futures contracts from CME.
This should track the price of Bitcoin fairly well, but it does have some risk.
Instead of exercising and collecting cash settlements, BITO rolls their contracts into
the next month whenever the time comes, which maintains constant exposure to Bitcoin, but
could come at a cost of slightly lower returns.
Plus, as we learned from CME’s futures contracts, the strategy has a 40% initial margin requirement,
which means it’s a fairly leveraged investment.
And this is one of the most fascinating things to me, because I read dozens of articles on
this ETF and not a single one mentioned the impact of leverage on this portfolio.
It’s a 2 1/2-to-1 leverage ratio, which is significantly riskier than just holding
Bitcoin outright.
It could appreciate twice as fast, and conversely, crash twice as hard.
And this leads us into some of the major problems with the BITO ETF.
The use of Bitcoin futures has some severe implications for investors, especially because
people have flocked to this fund within the first few days of trading.
Specifically, I want to focus on two problems: the limits placed on futures contracts and
the poorly publicized use of leverage.
As we covered, BITO uses a front-month futures strategy, so they’re going to place the
bulk of their assets in the futures contracts with the nearest expiration date.
However, ETFs are limited to holding a maximum of 2,000 front-month contracts.
Within two days of trading, BITO was already at 1,900 contracts.
This is fine if they never exceed demand for 2,000 contracts, but at the rate they’ve
been going, it’s a real possibility that they will.
When they hit that 2,000 contract limit, they’ll be forced to purchase contracts with expiration
dates further in the future.
These will be more expensive, and will track Bitcoin’s price less accurately, both of
which will restrict the fund’s performance.
They also highlight an alternative strategy in their prospectus - if they reach the limit,
they may just invest in Bitcoin-related stocks, such as Bitcoin mining companies or crypto
exchanges.
This would produce a more indirect exposure to Bitcoin, which is not what investors are
buying into this fund for.
Additionally, there’s a total limit of 5,000 Bitcoin futures contracts, regardless of expiration
date.
If BITO accumulates enough assets to own that many contracts, they won’t legally be able
to purchase any additional contracts, which could force them to further branch out from
a futures strategy.
The second problem, as mentioned, is the poorly publicized use of leverage, and all of the
potential loss that could come from it.
Again, I dug through the fund literature and many different articles and found practically
no mention of leverage and its effect on the fund.
However, we know for sure the investments are leveraged because of the nature of Bitcoin
futures contracts.
I finally found confirmation of this deep in the prospectus documents, in reference
to the risk associated with derivatives, of which futures contracts are a type of.
It says these can be aggressive and can bring more risk than investing directly into the
underlying asset.
And specifically, because they require limited initial investment, as we discovered with
the initial margin requirements, the use of derivatives can create losses greater than
the funds initially invested.
This means that if the price of Bitcoin drops enough, a futures contract could drop even
further, bringing the investment of a futures contract to 0, or potentially even in the
negatives.
Given the nature of Bitcoin, and the use of futures in this fund, I feel that the BITO
ETF is almost guaranteed to experience massive loss at some point in its lifespan.
Let me illustrate how this could occur.
Prior to exceeding their futures contract limit, we know that BITO would hold entirely
short-term Bitcoin futures contracts.
Most of these would expire within one month, although they may have a few that spread into
the next month giving them up to two months before expiration.
We also know that they only put in 40% (2.5:1) of the contract value to enter these contracts.
When Bitcoin goes up, things are great, because the returns on these contracts are over twice
the returns of Bitcoin.
Here’s an example using our numbers from earlier.
A Bitcoin futures contract costs $62,945 and comes with a margin requirement of #128,320.
If Bitcoin goes up $5,000 to $67,945, the margin invested appreciates $25,000 - 5k per
Bitcoin represented in the contract.
That brings the total to $153,320, or a 19% return.
In comparison, Bitcoin only appreciated 8%.
But things aren’t as great when prices go down.
Using our same example, let’s say Bitcoin loses $5,000, and it’s now sitting at $57,945.
The value of the margin is reduced by the same $25,000, again 5k per Bitcoin, down to
$103,320.
This is a negative 19% return, but that’s not the only problem here.
Because we are now below that minimum margin requirement of $116,660, we need to put in
another $25,000 of cash to get us back to that initial margin requirement we started
with just to maintain our position.
So not only have we lost money, but now we have to put even more cash back into it.
So the BITO ETF could do great when Bitcoin is going up, but when it’s going down, it
could set off a costly chain of events.
The value of their margin tied up in futures contracts will plummet, requiring huge investments
of cash just to maintain their exposure.
If Bitcoin bounces back they may recover, but there’s no telling if this will happen
before their short-term expiration dates.
This would leave them to trade into their next futures contract, again trading at lower
prices for more expensive contracts.
Any volatile moves to either the upside or the downside obviously means more risk for
investors, but it also means that this product may not track Bitcoin very efficiently.
And because Bitcoin has historically experienced 30 to 90% drops in value every few years,
BITO could be an incredibly risky way to gain exposure to Bitcoin.
So does BITO have a place in a portfolio?
I can’t say what’s right for you, but I think the only scenario I would hold this
ETF in is if I was looking for a retirement-fund friendly Bitcoin product and if I had incredibly
high risk tolerance in that portfolio.
The only reason this ETF is such big news is that it’s the first Bitcoin-linked fund
that can be put into other investment funds, retirement funds and other regulated investment
portfolios.
The only product we had previously was the Grayscale Bitcoin Trust, ticker GBTC, but
it doesn’t meet all the requirements for every investment application.
I also have some other issues with GBTC, such as high expense fees and the frequent discount
or premium pricing.
However, GBTC does give you direct exposure to Bitcoin because they actually buy and hold
Bitcoin.
This is something BITO fails to deliver, and it’s not subject to the massive risks of
leverage.
So even though I did not give GBTC a favorable review in my previous video, I would actually
choose it over BITO because of everything we looked at today.
There’s also the weird middle area of investing into companies that are indirectly exposed
to Bitcoin, from Coinbase, a crypto exchange, to crypto mining companies like Marathon,
or even companies like Square that hold some of their cash Bitcoin.
This is still what I’m doing within my Roth IRA because I don’t have access to GBTC,
I don’t like BITO enough, and I still want some tax-sheltered Bitcoin exposure.
The downside is that this just doesn’t deliver the exact returns of Bitcoin.
For all these reasons, I believe the best way to gain exposure to Bitcoin is still just
to buy it directly on an exchange.
Until an ETF comes along that actually buys and holds Bitcoin, it just makes the most
sense.
There’s no leverage, unless you want it, there’s lower fees, your returns are 100%
tied to Bitcoin and you can even earn interest on your crypto balances for greater returns.
But I’d love to hear your thoughts on the Bitcoin Futures ETF, so leave me a comment
and let me know if you’re buying BITO or any of the alternatives.
And if you’re interested in the cheapest way to buy Bitcoin with the highest possible
returns, check out this video on the exact method I use.
I’ll see you in the next video.