How Do Cryptocurrency Exchange-Traded Funds (ETFs) Work?

What Is a Cryptocurrency ETF? 

A cryptocurrency exchange-traded fund (ETF) is a fund consisting of cryptocurrency-linked instruments. While most ETFs track an index or a basket of assets, a cryptocurrency ETF is designed to track the price of one or more digital tokens. Based on investor sales or purchases, the share price of cryptocurrency-linked ETFs fluctuates daily. Just like common stocks, they are also traded throughout the trading day.

How Does a Cryptocurrency ETF Work?

Cryptocurrency ETFs provide several benefits to investors, such as significantly lower cryptocurrency ownership costs and outsourcing of the steep learning curve required to trade cryptocurrencies.

As of October 2023, only one kind of cryptocurrency ETF is available in the U.S., a synthetic variant that tracks cryptocurrency derivatives like futures contracts and cryptocurrency exchange-traded products (ETPs). For example, many ETFs proposed to the U.S. Securities and Exchange Commission (SEC) track prices of bitcoin futures contracts traded at the Chicago Mercantile Exchange (CME).

The ETF share price mimics price movements of derivatives instead of prices of actual cryptocurrencies. Therefore, the price of shares in a given cryptocurrency ETF rises and declines following futures contract prices. Like other derivatives, synthetic cryptocurrency ETFs carry added risk because their operations may not always be transparent.

Spot Crypto ETFs

As of Oct. 11, 2023, the Securities and Exchange Commission has not approved any ETFs that hold cryptocurrencies. In this type of ETF, called spot crypto ETFs, the fund would purchase cryptocurrencies and securitize them. These funds are intended to allow investors to buy and sell shares as needed, just like a traditional securities ETF.

In a spot crypto ETF, the fund can issue and redeem shares, offering retail and other investors more liquidity in the crypto market and a chance to gain exposure to these assets.

Brokers have been seeking approval for spot Bitcoin ETFs since the Winklevoss twins filed an ETF proposal for the cryptocurrency with the SEC in 2014. Since the SEC rejected the Winklevoss twin's 2014 application, there has been a flurry from various investment firms—including one set up by the Winklevoss twins, who continue to apply—seeking to profit off Bitcoin's price volatility. Between Oct. 11, 2022, and Oct. 11, 2023, the SEC received more than 3,500 crypto-related fund applications.

Benefits of Cryptocurrency ETFs

Cryptocurrency ETFs are a nascent asset class, and given the regulatory uncertainty, their market is still being defined. But they might be one of the best instruments through which to own cryptocurrencies. Some of the benefits of owning shares in cryptocurrency ETFs are as follows.

Exposure Without Ownership

Perhaps the most significant benefit of cryptocurrency ETFs is that they provide exposure to crypto without additional ownership expenses. For example, there are custody charges associated with cryptocurrencies, and some secure digital wallets that store purchased cryptocurrencies charge an annual fee. These charges can add up to a tidy annual sum. Cryptocurrency ownership also comes with other hidden costs, such as transaction and network fees, so cryptocurrency ETFs outsource these expenses to ETF providers.

Reduce the Learning Curve

Cryptocurrency jargon, steeped in its technological underpinnings, has remained a persistent roadblock to crypto adoption. It is difficult for average investors to grasp the scope and functioning of cryptocurrencies. Investors unfamiliar with technology may find crypto-speak, such as halving and blockchain, a somewhat fraught learning curve. Investing in a cryptocurrency ETF outsources the learning curve to analysts.

More Secure for Investors

Cryptocurrency exchanges, storage devices, wallets, and some poorly designed blockchains have been hacked since they were launched, leading to a big question about security. Cryptocurrency security can be a tall order from individual investors, who may not be familiar with the required methods. A cryptocurrency ETF outsources security functions to the providers of these ETFs.

Reduces Costs To Investors

There are more than 8,600 cryptocurrencies available in trading markets. The infrastructure to buy and sell these tokens is becoming more sound, but it is still underdeveloped compared to securities exchanges. For example, some tokens are available on certain cryptocurrency exchanges while others are not, and some exchanges are not allowed to operate in some countries while others are. There are also significant costs associated with the purchase of these tokens. Cryptocurrency ETFs enable investors to diversify without incurring costs and enduring exchange hassles.

Alternatives to Cryptocurrency ETFs

While there are no cryptocurrency-backed ETFs trading in U.S. markets, investors can put their money into a number of other ETF-like products for crypto exposure.

Crypto Trusts

The closest product to a cryptocurrency ETF product is a Bitcoin investment trust. These trusts are closed-end funds that resemble the ETF many are pushing for—it owns bitcoins on behalf of investors, and its shares trade in over-the-counter (OTC) markets.

But these trusts are not ETFs. They are open only to investment firms, accredited investors, or high-net-worth individuals (HNWIs) and are not accessible to a mainstream audience. They tend to have a high minimum investment amount, and each purchase of shares is accompanied by a lock-up period for investors.

Companies That Hold Crypto

Investing in companies that hold bitcoin on their balance sheet is another way to invest in cryptocurrencies without direct ownership. Some publicly listed companies have become holdings for bitcoin. For example, MicroStrategy Inc. (MSTR) owned 152,8008 bitcoins purchased at an average price of $29,672 as of July 31, 2023. Galaxy Digital Holdings Ltd. (BRPHF) and Square Inc. (SQ) are publicly listed companies with bitcoin on their balance sheets.

The Bottom Line

Exchange-traded funds are a retail investor-friendly way to gain exposure to assets that might otherwise be too costly to obtain. Brokers want to offer exchange-traded funds linked to cryptocurrency so that average investors can participate in cryptocurrency investing.

Regulators have kept ETFs from directly holding cryptocurrency, but the fight for crypto exposure isn't over as the SEC and brokers continue to battle over the legality of these funds.