Bitcoin ETF intensifies risks for investors and may be a threat to other markets, according to BiS

The first bitcoin exchange-traded fund (ETF), known as BITO, To date, the launch of this investment vehicle has been a total success. The fund debuted as one of the most traded ETFs in market history, attracting more than $1 billion in the first few days. Furthermore, in the following sessions, the ETF amassed a significant portion of all short-term bitcoin futures contracts, reaching roughly a third of the futures market in just ten days of life, a move 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 explaining how this ETF works and the risks involved. From the BiS they assure that it 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 they replicate or similar).

This can create significant risks for investors and for other markets in which BITO accumulates much of its liquidity. However, to better understand these risks, the BiS experts believe that it is necessary to explain in detail how these types of ETFs work.

First, to buy or sell an asset at a predetermined price at a specific time in the future. This contract allows investors to take positions without having the underlying asset (many times leveraged positions can be taken, that is, a much greater exposure to the contributed capital).

Also, because holding that asset incurs a ‘storage’ cost (which is sometimes positive because the asset generates a return), the futures price typically differs slightly (depending 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, so that long-term futures contracts are more expensive than short-term ones.

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This is how BIT works

To gain exposure to bitcoin, BITO goes long (bets bitcoin will go up) with short-term (typically one month) bitcoin futures contracts. As contracts near expiration, the fund gradually sells them off and buys new futures contracts, a strategy known in financial jargon as rollover. In addition, BITO keeps a portion of its funds in liquidity or very safe and liquid assets such as 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…). Conversely, when the bitcoin price drops, BITO uses some of its liquidity to offset losses with futures contracts. bond or stock, which simply has bonds and stocks, but is similar in structure to commodity or VIX ETFs.

After revealing these details, the BiS economists go to the heart of the matter 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 flow rebalancing: when an ETF buys futures contracts to satisfy new inflows (investors entering the ETF), drives up futures prices, while the opposite is true for outflows.”

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-dated futures contracts, the prices of those particular futures rise. “This predictable behavior of the ETF can also lead to ‘early run’ incentives, motivating investors to buy longer-dated bitcoin futures before the ETF enters those contracts.”

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It also affects the price of bitcoin

In addition, BiS experts say that the impact of prices in the futures market can also extend to spot prices (the price of hard-earned bitcoin at the moment) through the hedging behavior of investors, especially for assets with physical futures contract settlements and large storage costs. A recent example highlighted in April 2020. “Futures-based ETFs likely contributed to the rise in storage costs and subsequent decline in spot prices,” BiS experts argue.

Thus, economists at the Bank for International Settlements conclude that “the bitcoin ETF can amplify price volatility and create risks for investors if the fund captures (as it is doing) a large part of the futures market.” suggests that futures-based ETFs can exacerbate price movements and create additional volatility when they have a large presence in the underlying asset.”

Impact on the markets

An example of how this type of ETFs can distort the markets could be seen in February 2018, the month in which it was caused in part by these investment vehicles that exacerbated fear among investors. “The high activity and high volume of operations in ETFs destabilized the prices of the VIX futures and contributed to triggering that volatility index in February 2018”, according to economists at the Bank for International Settlements.

“This led to investor losses and the subsequent expulsion of the largest inverse ETF from the VIX,” the report said. An inverse ETF attempts to replicate the opposite movement 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.

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Possible collateral damage

Another risk is the impact that the ETF may have on bitcoin in other markets. The financial connection between some markets and others is intense, since, for example, investment funds or ETFs have almost all their liquidity in money market assets considered safe. Imagine a scenario where fund owners and ETF investors want their money back out of fear. These investment vehicles would be forced to unwind their positions in these safe assets (to meet redemptions), generating downward pressure on their prices.

This is reflected in the BiS box that explains that “the trading of BITO 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 that could put pressure on bond markets.BITO is unlikely to cause such disruptions at present, as it owns mostly highly liquid short-dated Treasuries and is small relative to the market for these. instruments”.

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