A Deep Dive into Bitcoin Spot ETF Mechanics
Breakdown of Key Facts, Trade-offs, and a Detailed Trading-Day Example of Market Maker Role
In response to a reader's request, this post discusses key facts and mechanics of the Bitcoin spot ETFs. I use BlackRock's IBIT specifically but the same breakdown can be accomplished for all other ETFs. We delve into the construction of the ETF, clarifying the valuation of shares against Bitcoin's market price, and articulate the daily interplay among investors, market makers, and ETF issuers. I walk through an example using Alice and Bob to show the trading, hedging, and settling processes. Let’s get started.
Key Facts
Each IBIT share represents 0.0005695 BTC. We get this amount by taking the Basket Bitcoin Amount of 22.78, which is the denomination used by Authorized Participants for creations and redemptions, and dividing it by the number of shares in a basket, that being 40,000 for IBIT. At a current market price of $71,550, that works out to $40.75 a share. That checks out because, at the same time, the price of IBIT was $40.91. You would need approximately 1,756 IBIT shares to equal 1 BTC.
Since the launch of Bitcoin spot ETFs, a consistent settlement pattern has developed. While the ETFs' official documents permit a settlement timeframe of up to T+2 days, actual practices have seen daily settlements. Notably, these are often conducted on Coinbase Prime the following morning. For those interested in real-time insights, HODL15Capital on X is a recommended follow, offering daily updates.
Market makers and issuers reference the CME CF Bitcoin Reference Rate (BRRNY), a standardized reference rate published by CF Benchmarks Ltd., designed to reflect the performance of bitcoin in USD. It is a once-a-day benchmark rate of the USD price of bitcoin, calculated as of 4:00 p.m. ET, and was created to facilitate financial products based on bitcoin. Each day, market makers and issuers use this rate to determine necessary settlement figures. Additionally, market makers remain active throughout trading hours to effectively manage their risk exposure.
Trade-offs of Bitcoin ETFs
The market for Bitcoin spot ETFs, like BlackRock's IBIT, involves a nuanced interaction among investors, market makers, issuers, and trading platforms. Market makers are crucial in this system, ensuring liquidity by facilitating buy and sell orders, and hedging their positions using Bitcoin futures or direct purchases.
For instance, when an investor buys shares in a Bitcoin spot ETF, a market maker may need to purchase Bitcoin in the spot market to maintain a balanced position, directly influencing Bitcoin's price. Conversely, if an investor sells ETF shares, a market maker might need to short Bitcoin futures to hedge. Issuers of these ETFs, responsible for the product's structure and compliance, interact with various market platforms to manage the fund's holdings, ensuring the ETF's price aligns with Bitcoin's market value.
This interconnected ecosystem not only enhances market depth and efficiency but also provides a structured and regulated environment for Bitcoin exposure. There are, of course, trade-offs. When you gain Bitcoin exposure through an ETF, you are several steps removed from owning the actual Bitcoin. However, the ETFs enable the market to accommodate a range of strategies and investor preferences, and it integrates Bitcoin ownership into the incentive structure of the global financial system.
Example of ETF Mechanics
Alice is an investor interested in a Bitcoin ETF, and Bob is the market maker. Here's how their interactions unfold throughout the trading day:
Investor's Purchase: Alice decides to invest in a Bitcoin ETF. She logs into her brokerage account and purchases $250 worth of the ETF. Alice can buy her shares from another investor looking to sell, or if there is more buying demand from new investors than selling demand from existing investors, a market maker is needed.
Market Maker's Role: Bob, the market maker, sells the Bitcoin ETF shares to Alice. His role is to provide liquidity, enabling Alice to buy the ETF shares easily. He makes money from the bid/ask spread, he’s an arbitrager.
Hedging the Position: When Bob sells Bitcoin ETF shares to Alice, he's taking on an exposure that he needs to neutralize to remain market neutral, as his goal is to earn from the spread, not from betting on Bitcoin's price movements.
Immediate Hedging: After selling the ETF shares, Bob promptly acquires Bitcoin or similar assets to counterbalance the risk from the sale.
Hedging Instruments: Bob can choose various tools for hedging, such as direct Bitcoin, futures, or other Bitcoin-related products, depending on costs and tracking accuracy.
Dynamic Hedging: His hedging is ongoing, adjusting to the ETF and Bitcoin price changes to keep his position neutral.
Monitoring and Adjustments: Bob continuously monitors the market to adjust his hedge and maintain neutrality amidst price fluctuations.
Indirect Impact on the Market: Bob's hedging actions, while aimed at neutralizing his position, have indirect consequences on the Bitcoin market.
Demand Introduction: Bob's Bitcoin purchases for hedging add to the market's demand, potentially affecting Bitcoin's price.
Liquidity Contribution: His buy and sell actions enhance the market's liquidity, offering more trade opportunities for participants.
Price Discovery Role: Bob's hedging-related trades assist in establishing Bitcoin's market price through ongoing buying and selling.
Collective Impact: While Bob's impact may be limited, the combined actions of all market makers can significantly influence Bitcoin's liquidity and price.
End-of-Day Balancing:
Evaluation: At the close of trading at 4pm ET, Bob reviews his transactions. His main activity was the sale of Bitcoin ETF shares to Alice.
Creation Unit Order: To balance his books, Bob initiates a Creation Unit with the ETF issuer, exchanging Bitcoin for new ETF shares. This process neutralizes his short ETF position.
Risk Management: The Creation Unit order allows Bob to manage his risk, eliminating his exposure to overnight price movements in Bitcoin.
Liquidity and NAV Alignment: The Creation Unit process ensures that the ETF's liquidity is maintained and its share price remains aligned with the Bitcoin NAV.
Unwinding the Hedge: With his short ETF position covered by new shares, Bob sells the Bitcoin he bought to hedge, balancing his position and locking in his arbitrage profit.
Resulting Positions: After these steps, Bob's positions are balanced—he has no unwanted overnight risk. The Bitcoin ETF has increased its Bitcoin holdings and issued new shares, reflecting Alice's investment. Alice now holds the ETF shares, giving her exposure to Bitcoin's price movements.
This process works in reverse when decreasing the ETF’s Bitcoin holdings due to more selling relative to buying pressure. However, that is not necessarily represented by the price going down. Some people have wrongly said that if the ETFs buying bitcoin results in the price going up, that the price going down must be the result of the ETFs selling. That is a logical fallacy. If Alice can buy from Eve without involving market-maker Bob, the price might go down or up, but the market maker and ETF issuer have not done any additional hedging, buying or selling.
Through this detailed process, we can see how the actions of individual market participants like Alice and Bob contribute to the broader dynamics of the ETF and Bitcoin markets, ensuring liquidity, market efficiency, and alignment of ETF prices with underlying asset values.
President of Bitwise Investments, Teddy Fusaro, has a similar example on X. It’s worth the read.
Missed out on this week's Bitcoin Magazine Pro insights? Here's your opportunity to catch up:
Don't miss these essential reads to stay ahead in the world of Bitcoin!
If you liked this content please give a like and share! Comment below with your reactions to this post and any recommendations for future topics.
Thank you for reading Bitcoin Magazine Pro™, we sincerely appreciate your support!
Not Financial Advice.
 | A guest post by
|
Amazing 😍
Thanks for the reference to Teddy Fusaro's post.