Is Europe Leading the Rat Poison-ETF Space?
The US authorities have not yet allowed the start of cryptocurrency-ETFs, until today, May 1. In Canada, the first one started on February 18, 2021, “The Purpose Bitcoin ETF” (ticker: BTCC). But in Europe, many similar, ETF-like exchange-traded products (ETPs) exist for years. They are categorized as ETPs or ETNs or called certificates.
“Crypto made easy” is the slogan of one of the competitors. But compared with direct crypto-buying, these products bear additional risks, in first-line, counterparty risk. The question is, how are the underlying assets tracked? Are they safely backed with cryptos? To what extent does this “securitization” increase the already high risk of cryptocurrencies?
“Probably rat poison squared,” said Warren Buffett about Bitcoin in 2018. Are crypto-based investment products, ETPs even more dangerous? “Rat poison cubed,” or even on the fourth power?
Why Are Crypto-Funds, ETPs Useful and Popular?
With the new cryptocurrency bull market of 2020-2021, and as the mainstream acceptance of the sector increases, the number of related investment products is also growing strongly. In Europe, new projects are starting, and the capital in cryptocurrency-linked exchange-traded products arrived in the billion-euro territory end of last year already.
ETPs (Exchange-Traded Products) offer a convenient way for small investors to buy cryptocurrencies. So, there is no need to follow the strict security rules of cryptocurrency storage and transfers. They are not exposed to hacker attacks. In some countries, conventional exchange-listed funds or notes also offer tax benefits over direct bitcoin purchases.
Many institutional investors also use ETPs to gain exposure in the crypto-space, as laws or internal asset allocation rules don’t permit direct buying.
The Most Important Difference Between ETFs and ETNs
ETFs and ETNs are similar. Both intend to track the price of the underlying assets, mostly an index or a single commodity. Both are traded on stock exchanges. Management fees and other expenses are often low, but not always. Some may reach the 1.0-2.0 percent territory, so are they in the crypto-industry, too.
By definition, an ETF is an investment fund that is the owner of the underlying assets. (Stocks, commodities, bonds, derivatives, etc.) So that investors also become indirect owners of these investments. Funds hold investors’ assets separated from the resources of the fund management company. The fund’s assets are kept by a custodian, which is independent of the fund manager. This method protects investors even in case of the insolvency of the issuer.
An exchange-traded note (ETN), or a certificate, in contrast, is a debt security, a bond issued by an underwriting bank or other institution, company. ETNs are backed basically by the issuer, and if it goes bankrupt, the investors risk a total capital loss. So, ETFs are more secure than ETNs and certificates.
- ETF: Exchange-Traded Fund–investment fund backed with the “physical” assets it is tracking.
- ETN: Exchange-Traded Note–debt security of the issuer.
- ETC: Exchange-Traded Commodity–debt security, tracking commodities.
- ETC (new usage form): Exchange-Traded Crypto(currency)–debt security, tracking cryptocurrencies.
- ETP: Exchange-Traded Product–the collective name of the other exchange-traded categories
- Certificate: Debt security similar to ETNs.
But ETNs can be unsecured or covered (collateralized). Covered ETNs (and ETCs) are secured by deposits of the underlying asset or other collateral (e. g. government bonds). Investors use the word certificate often as a synonym of ETN, mainly in Europe. But there may be other differences. For example:
Independent market makers support the liquidity of the ETNs, while in the case of certificates, only the issuer guarantees trading. (Wikipedia)
The Essential Question About All Bitcoin ETFs and ETPs
Besides the category, we must consider additional factors to judge the risk of a product. For ETFs and covered ETNs, which custodian(s) manage(s) the underlying investments. In the case of ETNs, also the company’s capital adequacy of the issuer is essential, its solvency, perhaps its credit rating. And eventual additional security solutions, like guarantees, are also relevant.
ETPs replicate the return of an asset by either directly buying and holding those assets (known as physical replication) or by entering into a contractual agreement (i. e., a swap contract) with a counterparty who is obliged to provide the daily return of the underlying index or asset (known as synthetic replication). (Source: XBT Provider)
In the following table, I collected basic information about the crypto-ETPs in the European markets. After that, I describe the European ETP issuers and try to find answers to basic questions like:
- Is the product an ETF, ETN, or certificate?
- Who is the issuer?
- Who is the custodian storing the cryptocurrencies?
- Who is the guarantor, if any is present?
- What other risk factors should investors consider?
1. Tracker certificates of XBT Provider
Bitcoin Tracker One from XBT Provider (Stockholm, Sweden) was launched in 2015. “Became the first bitcoin-based security available on a regulated exchange,”–wrote the issuer. The company added similar products following Ether, Litecoin, and XRP prices some years later. The securities are called “tracker certificates.”
The company adds a guarantee from CoinShares (Jersey) Limited to the product. (In earlier documents: Global Advisors Jersey Ltd.) The issuer and the guarantor are members of the “Global Advisors/CoinShares Group,” Jersey. (Not to be confused with State Street Global Advisors seated in Boston, US.) By the base prospectus, the main shareholders of the issuer group are its managers, in first-line, Russell Newton, Jean-Marie Mognetti, and Daniel Masters.
To hedge its exposure, XBT Provider (the issuer) enters into an intra-group collateral management arrangement with an affiliate (CoinShares Capital Markets). (…) The issuer provides cash raised from the issuance of the certificate to the CoinShares Capital Markets in exchange for a contractual promise to pay the settlement amount of the note. (…) CoinShares Capital Markets purchases the relevant cryptocurrency on a 1:1 basis, in both physical form and using derivative contracts. (XBT Provider)
In brief, members of the same group of companies manage the assets, hedge the risk and undertake a guarantee to repay it. Roles are not strictly separated between independent financial groups, as in the case of investment funds. (Between the fund manager and the custodian or depositary firm.)
2. The CoinShares Physical ETPs
The Physical Bitcoin ETP (BITC) and some others were also issued by another company of the mentioned “Global Advisors/CoinShares Group,” CoinShares Digital Securities Limited. This Bitcoin product is listed in Switzerland from January 2021. By the official documents:
- The product is not covered by investor protection or guarantee scheme.
- Each BITC security is 100% physically backed by bitcoin.
- Investors have the option to redeem their securities directly for bitcoins.
- BITC securities are structured as a debt security, not equity.
- Unlike other providers, we never lend out bitcoins. (Source: CoinShares Digital)
The custodians play an important role in the security of a fund or ETP. In this case, it is Komainu (Jersey) Ltd., a less known name in the capital markets. But by their home page, this is a joint venture of CoinShares (the issuer group), Ledger (a leading cryptocurrency hardware-wallet manufacturer), and Nomura, a large Asian financial services group. The CoinShares Physical Bitcoin ETP is not offered for retail investors.
3. The Big Family of 21Shares
“This product is a non-interest bearing bond under Swiss law that is fully secured by holdings,”–wrote 21Shares in its legal documents. That means the product family contains covered ETNs. “Fully collateralized instrument,” “institutional-grade security and custody solution”–explains the issuer.
The company registered in Switzerland is a subsidiary of Amun Holdings Ltd., but the ultimate owner is Samer Rashwan. Custodians may vary by product, and some ETPs have two custodians. There are at least five:
- Coinbase Custody AG
- Coinbase Custody Company LLC (frequent)
- Bank Frick & Co. AG
- Bitcoin Suisse AG
- Kingdom Trust (Murray, KY, USA) (frequent)
Coinbase is an important cryptocurrency trading platform in the USA, founded in 2012.
Coinbase Custody is a fiduciary under NY State Banking Law. All digital assets are segregated and held in trust for the benefit of our clients. Dedicated on-chain addresses secured by Coinbase’s battle-tested cold storage. The industry’s leading insurance policy. We undergo regular financial and security audits by external firms. (Source: Custody.Coinbase.com)
Part of the presentation of the other more frequent custodian partner:
Kingdom Trust is an independent qualified custodian regulated by the South Dakota Division of Banking. We specialize in unique and innovative custody solutions for individual investors, investment sponsors, family offices, advisory firms, broker-dealers, and various other investment platforms. We currently serve over 100,000 clients and have over $12 billion in assets under custody. (Source: Kingdomtrust.com)
How to Short Bitcoin?
An interesting product is the 21Shares Short Bitcoin ETP. It claims to be the “world’s first digital asset inverse ETP.” It seeks to provide a -1x return to the performance of Bitcoin on a daily basis. The ETP “obtains short exposure through borrowing Bitcoin and simultaneously selling it on an execution platform.” The company “works with industry-leading lending facilities in the crypto industry, custodians and trading desks.” The custodians are Bank Frick & Co. AG and Coinbase Custody AG.
4. 15 FiCAS Active Crypto ETP
The new “15 FiCAS Active Crypto ETP”, type “debt instrument,” invests in the Top 15 cryptocurrencies. “For risk management reason, six different custodians”–wrote the Swiss FiCAS AG, the owner of the issuer, the Bitcoin Capital AG.
Basically, sharing risk in this way seems like a good idea. But which ones are the custodians? See the list (which grew to 7 items for some reason). Some names sound more familiar in the crypto-industry, some less.
- Sygnum Bank AG
- Crypto Broker AG
- SEBA Bank AG
- Bitstamp Ltd
- Coinbase Ltd
- Payward Ventures Inc (Kraken)
- Bitcoin Suisse AG
5. VanEck Vectors: “Fully-Collaterized”
This product was launched in November 2020 in Liechtenstein. The ETP is tradeable “like an ETF” in Germany, in the Xetra system. But it is also registered in a dozen other European countries.
“The VanEck Vectors Bitcoin ETN is a fully-collateralized exchange-traded note,” – wrote the issuer company. “100% backed by bitcoin and stored in cold storage at a regulated crypto custodian with crypto insurance (up to a limited amount)”– they explain.
VanEck Vectors is a famous market player with a long history. For example, Gold Miners ETF (GDX), launched in 2006, “was the first exchange-traded fund in the US offering broad exposure to gold mining equities.” (Wikipedia) But the issuer is a subsidiary of VanEck in Liechtenstein, the VanEck ETP AG. The “Custodian and Safekeeper” is Bank Frick, established in 1998 in the Principality of Liechtenstein.
The word “insurance” sounds promising, offering more security. But we couldn’t find more about it in the official prospectus. The notes will not be guaranteed or insured by other entities – also to read in the document.
6. WisdomTree: Famous, Cheap, and Secure?
WisdomTree Bitcoin is a “physically backed Exchange Traded Product.” The issuer promises a “simple, secure and cost-efficient way to gain exposure to Bitcoin” and “institutional-grade storage solutions without needing to set it up with a custodian themselves.”
WisdomTree Investments, Inc. is another big international player in the exchange-traded product market, a New York-based asset manager. The company launched its first ETFs in 2006 and is one of the major ETF providers in the United States today.
The European Bitcoin ETP, launched end of 2019 by WisdomTree Issuer X Ltd., is relatively cheap. The 0,95 percent annual fee is lower than by competitors (mostly 1.49 to 2.5 percent).
The custodian is Swissquote Bank Ltd., a member of Swissquote Group Holding, known for its online financial and trading services in Switzerland.
7. Giving New Meaning to the Word ETC
ETC Group Physical Bitcoin (BTCE) is fully fungible with bitcoin and can be redeemed for bitcoin or cash–the issuer assures investors. The company uses the expression “exchange-traded cryptocurrency” or ETC. However, ETC also means Exchange-Traded Commodity for many years. But officially, BTCE shares are “bonds.”
An interesting detail is, the fund may cover the maximum number of bitcoins possible ever in circulation, 21 million, in theory.
“100% physically backed by bitcoin and trades on Deutsche Börse XETRA. It is the world’s first centrally cleared Bitcoin ETC, providing investors with an easier and safer way to gain exposure to bitcoin,”–wrote the issuer. “Bitcoins held to back BTCE are held institutionally by BitGo Trust Company Inc, a regulated qualified cryptocurrency depository in South Dakota, USA (the “Depositary”). The issuer has appointed APEX Corporate Trustees (UK) as a collateral trustee”.
The issuer, ETC Issuance GmbH, is largely controlled by a few individuals (Alexander Gerko, Oleg Mikhasenko, Maximilian Monteleone) and “other co-founders, partners, and management.”
8. Vontobel-Certificates With and Without Leverage
The Vontobel Financial Products GmbH, Germany, issues many “certificates” available on German exchanges for years. These certificates mostly don’t appear in the category ETPs or ETNs. Some products are tracking (participation) certificates without leverage. Others are “mini futures” with different leverage grades. The company has mostly one tracking certificate per cryptocurrency and dozens of leveraged ones. In addition to bitcoins, there are also ether, bitcoin cash certificates available. (A short time ago, also Litecoin and XRP.)
The first page of the main prospectus of the product family highlights the guarantee of the Vontobel Holding AG, Zurich–the main holding company of the group. But no custodian is mentioned.
Grayscale in the US, ETF-wave in Canada
In the USA, the main cryptocurrency investment product for some years was the Grayscale Bitcoin Trust. Now, it is part of an investment trust family. Trusts are dedicated to institutional investors, with a minimum investment of 25 or 50 thousand USD. The trusts are also “physically backed”. The issuer is Grayscale Investments LLC, and the custodian is Coinbase Custody Trust Company, LLC. In Canada, the first crypto-ETFs already started this year, but this market may be the subject of another article.
Conclusions–Smells Like an ETF, But Still Stays a Bond
“Paper gold,” like gold ETFs or ETNs, is considered less secure than physical gold. The same distinction may also persist between securely (offline) stored cryptocurrency and “paper-cryptocurrency,” or securitized crypto-assets. But ETP issuers are obviously aware of the problem and, as we have seen, are trying to increase the safety of their products with institutional solutions.
Europe has plenty of Bitcoin and crypto exchange-traded products that, in effect, operate like an ETF. European crypto-ETPs look like an ETF–but legally, they are still bonds. The listed ETPs in this article always have a custodian, or a guarantor, to decrease the counterparty risks of the investment. Still, real ETFs may be more secure than backed ETNs.
Products backed with physical assets by custodians, or backed with a guarantee of a strong institution, are more secure than “self-custody” or “self-guaranteed” products. (Also, where the depositary is a member of the same group of companies as the issuer.)
From an investor’s perspective, it is advisable to examine the exact legal background, know the participants to make the right decision, according to our risk tolerance.
Avoid a Second Mt. Gox
An increase in the number of cryptocurrency products traded on traditional exchanges may result in more and more investors buying cryptocurrency exposure. This, in turn, could prolong the life of the current bull market. However, the bankruptcy of an exchange-traded product, the loss of the assets entrusted to it could delay the progress of the whole sector globally. (As it was the case after the bankruptcy of the Japanese Mt. Gox platform, the main bitcoin trading place of the world, in 2014.)
Appropriate legislation could help to reduce the risks. The European Union is already working on the regulation of cryptocurrencies. I hope that it will arrive on time and help the development of this sector.