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DAS London Preview: ETFs

One of the selling points of crypto as a new financial system has always been “atomic settlement.” In decentralized finance, money and assets are exchanged at the exact moment a trade is agreed, and this seems like an improvement on traditional finance where money and assets are generally exchanged only two business days after the fact. 

TradFi’s T+2 settlement may look like an anachronistic holdover from the days of physical delivery, when a seller needed sufficient time to find their paper certificates and give them to a courier who would traipse across town for delivery to the buyer in return for a physical check for the courier to deliver back to the seller.

But stocks were “dematerialized" decades ago, so why does it still take two days to deliver them?

There are reasons. 

A seller may need time to recall shares they loaned out, or their shares may be scattered among hundreds or thousands of individual accounts that take time to reconcile, or they may be selling short before taking the time to secure a borrow, or they may sell short in the morning and buy back in the afternoon without bothering to borrow at all.

Thanks to T+2 settlement, no one has to worry about any of these things. Investment managers can sell stock the very moment they decide they want to and let their operations people worry about all the rest later.

In crypto, it’s the opposite. You can’t sell until you’re ready to deliver — and now that ETFs have bitcoin trading like a stock, this is causing problems. 

If, for example, a retail investor has 10 shares of a bitcoin ETF like HODL, they can enter a market order with Fidelity or whomever and chances are someone else will have 10 HODL to sell and it will all proceed exactly like an exchange of any stock — without any bitcoin being exchanged anywhere.

If, however, an institutional buyer decides to buy, say, $250 million worth of HODL, here’s what might happen instead:

The institutional buyer purchases the ETF from a market maker who then hedges their short HODL position by buying CME bitcoin futures from a market maker who hedges that short exposure by buying bitcoin perps on Binance from a market maker who hedges that exposure by buying spot bitcoin on Binance from a high-frequency trader that’s selling short on Binance to buy long on Bybit where there happens, finally, to be a real seller of spot bitcoin.

Then, at 3 pm, the market maker that sold HODL short will unwind their hedged position in the once-a-day window to create the HODL ETF, possibly starting a chain reaction in the opposite direction.

It’s far from ideal, but this is what happens when we try to trade an atomic-settlement commodity in cash-create ETFs as if it were a T+2 stock.

It’s also probably part of the reason that bitcoin has shot higher over the last few weeks — all of these frictions create short-term imbalances that exacerbate volatility.

The other (likely bigger) reason why ETF inflows have had such a dramatic impact on the price of bitcoin is that there are simply not very many bitcoins to go around — there are only about two million bitcoins currently available for sale on exchanges, which means that 90% of the bitcoin in existence are not for sale.

Higher prices of course bring more bitcoin out of cold wallets and onto exchanges, but this is a slow process.

Unlike a seller of stock, a seller of self-custodied bitcoin can’t sell in the exact moment they decide to — they have to first get their coins ready for delivery, which means remembering where they left their hardware wallet, finding the piece of paper with their seed phrase, resetting their lost password on Coinbase, sending their bitcoin to the exchange, and then, finally, selling to one of the buyers there (who is probably a high-frequency trader buying to sell to the real buyer on some other exchange). 

This, I suspect, is why bitcoin was down 10% yesterday — Monday’s all-time highs finally induced some of those long-held coins out of cold storage and they all happened to arrive for sale at the same time.

More often, though, these frictions in the “market structure” of bitcoin ETFs will cause volatility to the upside.

Matt Sheffield of Falcon X expects that as ETF buyers increasingly drain bitcoin from exchanges, the price impact of ETF inflows will increase, “leading to BTC’s market cap expanding at a faster and faster rate for any given inflow.”

In his must-read report, Sheffield cites a pre-ETF estimate from CryptoQuant that $1 of net inflows to bitcoin likely adds $3-5 to the market cap of Bitcoin. 

Now, however, Sheffield estimates that, as ETF demand reduces the number of “marginal sellers” of bitcoin, $1 of net inflows may translate to $10-20 of Bitcoin market cap.

$10-20! 

That’s a lot higher than I would have guessed, and with TradFi demand for bitcoin also a lot higher than I would have guessed, it feels like I may have to rethink this whole ETF thing.

DES London

When I first saw that DAS London would have a panel on ETFs, I wasn’t sure there’d be all that much to talk about  — the ETFs will have been trading for more than two months by the time DAS London convenes the week after next — surely, I thought, two months would be more than enough to know whatever there was to know about their impact.

Now it feels like we could spend the whole two days of DAS just on the topic of ETFs.

I have questions for our ETF panelists.

Is $8.6 billion a lot? 

Spot ETFs have taken in $8.6 billion to date and that seems like a huge number — but it seems tiny, too: As of Q3 2023, assets under management by ETFs were $7 trillion. 

As amazing as the inflows have been, bitcoin ETFs therefore account for only about 0.1% of the ETF market.

What if they attract 1% of ETF assets? Or 10%? 

Better yet, what if they attract some small fraction of the $90 trillion of US stocks and bonds not held by ETFs?

$8.6 billion might turn out to be a small number.

Are RIAs buying yet?

The real import of spot ETFs was said to be that they would give registered investment advisors the ability to suggest bitcoin to their customers for the first time.

But it takes at least three months for RIAs to get internal approval to recommend a new ETF to customers and it hasn’t been three months yet.

Are we only just getting started then?

Are institutions buying?

ETFs are generally a retail product, but per the example trade flow above, some of the action has looked distinctly institutional.

Could ETFs advance the institutional adoption of crypto?

We’ll find out who’s been buying when large investors file their 13Fs in mid-May.

Will ETFs make bitcoin part of the 60/40 portfolio?

The Fidelity All-in-One Balanced ETF is 59% equities, 39% fixed income and 2% crypto.

That’s only on offer in Canada, but what if even a small fraction of US investors with the aforementioned $97 trillion of assets got the same idea? 

Is this just a US thing?

Bitcoin ETFs are expected to be available soon in both Hong Kong and South Korea.

I haven’t seen any estimates of what kind of inflows that might attract so, whatever it is, it’s probably not priced in yet.

Wen gold flippening?

Spot ETFs appear to have catalyzed bitcoin’s long-hoped-for cannibalization of gold’s share of the store-of-value market.

All the bitcoin in the world is still only worth about 1/14 of all the gold in the world.

So what happens to Matt Sheffield’s marginal-seller theory if we get even halfway there?

We may need the Bitcoin devs to start working on T+2 settlement.

― Byron Gilliam

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