ETFs
Jan 25, 2024

How do ETF issuers ‘Buy’ Bitcoin?

Understanding the Mechanics of Spot Bitcoin ETFs: Connecting investor interest in Bitcoin ETFs to actual on-chain activity

How do ETF issuers ‘Buy’ Bitcoin?

What exactly is a spot Bitcoin ETF?

  • Okay so Bitcoin spot ETFs are here, but how do they actually work? 
  • When people ‘buy’ an ETF, what actually happens? Who’s involved? And how does this actually relate to the buying and selling of the underlying asset (BTC)?
  • In other words, how do we get from boomer FOMO to actual on-chain activity?
  • Here’s the simplified step-by-step process

1. Retail demand: Investors to Brokers

  • Investors Range from individual investors seeking portfolio diversification to institutions looking for digital asset exposure.
  • Their interest in Bitcoin ETFs drives market demand, influencing the creation and redemption of ETF shares.
  • Brokers Serve as a bridge between retail and institutional investors and the stock market where Bitcoin ETFs are traded.
  • Brokers Reflect and amplify investor demand, directly influencing the trading volume and price of ETF shares.
  • What does this look like? Investors could be family offices, institutional investors, or anyone with a 401k wanting to rotate into Bitcoin ETFs. As soon as the ETFs are approved, these investors will be on the phone to their brokers instructing them to buy.
Investors to Brokers
Investors to Brokers

2. Wholesale demand: Brokers to Authorized Participants (APs)

  • So, where do Brokers get the ETF Shares to sell to investors? From Authorized Participants (APs).
  • APs are specialized financial institutions authorized to directly transact with the ETF Sponsors for share creation and redemption. For example, the Blackrock/iShares ETF has Jane Street and JP Morgan as APs.
  • You can think of Brokers as being retailers of ETF shares, and APs being wholesalers.
  • APs monitor the supply/demand of ETF shares, and play a key role in keeping the Share Price in line with its Net Asset Value (more on this later).
Wholesale Bitcoin Buying
Wholesale Buying

3. Share Creation: APs to Sponsors

  • Once the APs know how much demand there is, it’s time to mint some fresh ETF shares.
  • To do this, APs will go to the ETF Sponsor they deal with, and deposit cash in order to create the shares.
  • Sponsors are responsible for the overall management and compliance of the ETF. They’re the big names you’ve been hearing about: Blackrock, VanEck, Fidelity etc.
  • Sponsor Coordinates with Bitcoin Counterparties for the necessary Bitcoin transactions during the share creation and redemption process.
  • How it works: APs either create new shares with Sponsors (when demand is higher), or redeem shares for cash (if demand is lower).
  • This ‘demand’ directly influences the premium or discount of the ETF market price relative to its NAV. APs take advantage of this premium or discount and in turn this arbitrage tends to keep the gap between market price and NAV as narrow as possible subject to factors such as transaction costs etc. 
  • So what this looks like: JP Morgan’s phones are ringing off the hook from all their Brokers, demanding more and more ETF Shares from Ark/21 Shares. So then someone at JP Morgan (I’m assuming Jamie Dimon, personally) gets on the phone to Cathie Wood and says, “We need billion more shares of your ETF please - here’s all the cash we have.”
Bitcoin ETF Share Creation
ETF Share Creation

4. Sponsors and Counterparties

  • Counterparties are entities like Coinbase and handle the buying and selling of Bitcoin for the ETF.
  • Operate based on instructions from the Sponsor, aligning the ETF's Bitcoin holdings with its share count.
  • Custodians (also eg Coinbase) are responsible for the secure storage of the ETF's Bitcoin holdings.
  • Ensures the safety and regulatory compliance of the Bitcoin assets held by the Trust.
  • The Sponsor directs the Bitcoin Counterparty in buying or selling Bitcoin in response to APs' activities (creating or redeeming shares of the ETF).
  • So after Jamie Dimon orders all the shares from Cathie Wood and creates as many as he possibly can, Cathie then calls up Brian Armstrong at Coinbase.
  • This is where the on-chain fun happens. Cathie says to Brian, “Jamie is FOMO’ing in exactly like we knew he would. I need to smash buy all the BTC you have, please, right now.”
Sponsors and Custodians in Bitcoin
Sponsors and Counterparties

5. Bitcoin Counterparty Buys BTC

  • Once acquired, Bitcoin is transferred to the Custodian for secure storage.
  • This is a critical step for mitigating risks like hacking or theft, securing the digital assets underpinning the ETF.
  • In Ark’s case, Coinbase has acted as both the Counterparty, and also the Custodian. For Fidelity, they are going to self-custody the BTC and hold their own keys.
Buy Bitcoin
Buy Bitcoin

Bonus: How ETF Share Price and Bitcoin Price relate

  • The ETF’s share value is based on the CME CF Bitcoin Reference Rate - New York Variant, ensuring a market-reflective valuation of Bitcoin.
  • This index reflects an aggregate of Bitcoin prices from multiple exchanges, providing a standardized benchmark.

Bonus 2: How do Fees work

  • The Sponsor fees are paid to the Sponsor our of the Trust assets, expenses related to the management, operation, and marketing of the ETF.
  • They aren’t paid directly by investors, but rather are factored into the calculation of the ETF’s NAV
  • Therefore (simplistically): because fees reduce the total value of the Trust’s assets, they reduce its NAV and the investors’ return is reduced by the amount of fees..