A New Chapter in Financial History

What the SEC's Approval of Bitcoin ETFs Means for Traditional Investors

I work in crypto because I believe that the existence of a secure and decentralized financial system is critical for continued human prosperity. Crypto is both a complement and a competitor to the modern global financial network backed by central banks and fiat currencies. It serves simultaneously as a hedge against the catastrophic collapse of our current system, and as a positive bet on accelerated economic progress in a new system. By providing viable competition to our existing financial system, crypto holds it accountable and will yield an overall reduction in the violence wrought from financial chaos worldwide.

One of my goals towards this end is the legitimization of cryptocurrencies in influential human institutions: universities, businesses, non-governmental organizations, etc. The approval of Bitcoin ETFs is a milestone in this process, and provides a great opportunity to explain, in straightforward terms, the significance of Bitcoin and its ETFs to a broad audience.

This blog post is intended for traditional investors.They are likely familiar with the concept of an ETF,  but they have no experience with cryptocurrencies for one reason or another: they haven’t heard of it, they don’t understand it, they are skeptical of it, and so on. It is not meant to be a comprehensive primer, but rather a doorway into the world of crypto and an invitation to explore it. By providing a simple and concise explanation of the current historical moment, I hope to prompt a (re)evaluation of Bitcoin’s importance to those who may have found it unapproachable until now. So, if you have family, friends, or acquaintances who have yet to swallow the orange pill - send them the below! This post is dedicated to them.

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Overview

Today, the United States Securities and Exchange Commission (SEC) approved 11 spot Bitcoin Exchange Traded Funds (ETFs). This historical decision reflects a growing acceptance of cryptocurrencies within the traditional financial sector, and presents a new opportunity for investors. Particularly for those who have ignored Bitcoin until now, these ETFs provide an occasion to understand the significance of Bitcoin from first principles, and gain exposure to the asset class of cryptocurrencies without logistical overhead.

What is Bitcoin?

Bitcoin, from the perspective of an investor unfamiliar with cryptocurrencies, can be understood as serving a dual purpose:

• It is a hedge against the traditional financial system backed by fiat currencies and overseen by central banks.

• It is a bet on a new financial system powered by decentralization, energy, and mathematics.

Unlike conventional assets, Bitcoin is not issued by any government, financial institution, or business; instead, it is a commodity produced by a decentralized network of computers. Bitcoin is created (“mined”) when one of the computers in the network expends enough energy to solve a cryptographic puzzle. Bitcoin constitutes the proof of the expenditure of energy, much like gold is proof of the energy spent to mine it out of the ground.

Transmitting value - i.e., sending and receiving Bitcoin - is done by updating a shared ledger, known as the blockchain, that is decided upon by the entire network of computers. Consequently, no single computer has the ability to censor, reverse, or corrupt transactions. This property of decentralization is not found in the traditional financial system, because middlemen such as banks and payment networks possess the power to unilaterally alter transactions.

The supply of Bitcoin is programmatically capped at 21,000,000, and its issuance approaches this number according to a set schedule. Bitcoin’s built-in scarcity, predictable supply, and backing by energy, invite many comparisons to digital gold. It is an asset of limited stock, which makes it an ideal store of value; but the flows to its supply are predetermined by a publicly verifiable computer program, making its future quantities far more foreseeable than gold. For the same reasons gold has served as a reserve asset and settlement currency for central banks, Bitcoin plays a similar role in the digital economy.

In its 15 years of existence, Bitcoin has carved out a niche in the financial world with its distinct risk and return profile. Over the past 10 years, it has had an annualized return of ~31%, compared to the S&P 500’s ~9%. Its value doesn’t derive from the performance of a company or the stability of a government, but from the security it provides and the demand of its users, making its market behavior different from typical stocks, bonds, or currencies. This unique nature positions Bitcoin as both a hedge against centralized financial systems — offering a safeguard in scenarios where these systems falter — and a positive bet on the future of financial innovation that the underlying technology enables. It is this dual role that attracts a diverse range of investors, from those seeking to protect against economic uncertainty to those eager to participate in the future of finance.

From https://www.galaxy.com/insights/research/bitcoin-data-shows-bullish-foundation/

As a relatively new technology, Bitcoin challenges the conventional understanding of what constitutes a financial asset. Moreover, the operational requirements of holding and transacting with Bitcoin requires a strong understanding of cryptography and blockchain technology, which can be daunting for traditional financial institutions accustomed to more conventional custody methods. For these reasons, the regulatory clarity necessary to integrate Bitcoin into the traditional financial system has been slow to develop. But today’s approval by the SEC may accelerate the pace at which financial institutions add Bitcoin to their portfolios, particularly through the approved ETFs.

There is much more to say about Bitcoin, including its fascinating history, its distinctive philosophy, and its technical specifications. And this is to say nothing of the many cryptocurrencies that have followed Bitcoin, including Ethereum and stablecoins. To learn more about Bitcoin, you can consult the following resources:

• Mastering Bitcoin by Andreas M. Antonopoulos

• Broken Money: Why Our Financial System is Failing Us and How We Can Make it Better by Lyn Alden

• The Bitcoin Standard: The Decentralized Alternative to Central Banking by Saifedean Ammous

What is an ETF?

Most investors are already familiar with ETFs: funds that track the performance of one or more assets and are traded on stock exchanges, much like individual stocks. The key feature of an ETF is that it grants investors exposure to the financial movements of the underlying assets without having to own the assets individually. For example, gold ETFs track the price of gold without investors having to custody physical gold themselves. The price of an ETF’s shares will fluctuate throughout the trading day as they are bought and sold on the market, mirroring the price of the underlying assets and offering flexibility and liquidity to investors.

Much like cryptocurrencies, the regulatory history of ETFs in the United States involves a complex journey with the SEC. ETFs initially faced skepticism due to their novelty and complexity relative to the financial instruments of their time. The first ETF in the United States, the Standard & Poor's Depositary Receipts (SPDR), launched in 1993 after the SEC granted the necessary exemptions from traditional mutual fund regulations. Over time, as the financial market evolved and the popularity of ETFs grew, the SEC continued to refine its regulations, addressing concerns such as market fairness, transparency, and the potential impacts on market volatility. Today, ETFs are some of the most popular financial instruments for long-term investors, with thousands of tickers and trillions of dollars of value behind them. 

History of Bitcoin ETFs

The journey towards the creation of Bitcoin ETFs has been a long and complicated journey. The story begins with the Winklevoss twins: Cameron and Tyler Winklevoss, co-founders of the cryptocurrency exchange Gemini and early investors in Facebook. In 2013, they filed for the first-ever Bitcoin ETF, the Winklevoss Bitcoin Trust. This proposed ETF aimed to make investing in Bitcoin more accessible to the general public by allowing them to purchase shares in the ETF, which in turn would hold actual Bitcoin. However, their proposal faced regulatory hurdles. The SEC expressed concerns about the volatility, regulatory landscape, and potential for market manipulation in Bitcoin markets. After several years of back-and-forth, the SEC ultimately rejected their proposal in 2017, citing concerns over the lack of regulation and the potential for fraud and manipulation in Bitcoin markets.

Four years later, the SEC approved Bitcoin Futures ETFs, such as the ProShares Bitcoin Strategy ETF (BITO), marking a significant milestone in the integration of cryptocurrency into the mainstream financial market. Launched in October 2021, BITO was the first U.S. ETF that provided exposure to Bitcoin through futures contracts traded on the Chicago Mercantile Exchange (CME), rather than direct investment in Bitcoin itself. This development was a critical step in offering investors a regulated and more familiar way to gain exposure to Bitcoin's price movements. It was also a somewhat puzzling regulatory result: why did the SEC approve an ETF for Bitcoin Futures Contracts, but not an ETF for Bitcoin itself?

This exact question was posed in the court case Grayscale Investments, LLC v. SEC. In 2013, Grayscale received approval from the SEC to launch Grayscale Bitcoin Trust (GBTC), one of the first investment vehicles to offer exposure to Bitcoin in the form of a security, without the challenges of buying, storing, and safekeeping Bitcoins directly. The Trust structure has shortcomings relative to ETFs. For example, unlike ETFs, GBTC has traded at a significant premium or discount to the underlying Bitcoin, owing to the limitations on the creation and redemption of shares. These price discrepancies are disadvantageous to investors, and have prevented GBTC from gaining wider adoption. Grayscale filed with the SEC to convert its GBTC trust into an ETF, but was rejected on similar grounds to the Winklevoss Bitcoin Trust. In return, Grayscale filed a lawsuit against the SEC.

In October 2023, the D.C. Circuit Court of Appeals ruled that the SEC was “arbitrary and capricious” in its rejection of Grayscale’s motion to convert GBTC into a spot ETF. This historic legal decision led to the SEC’s mandated reconsideration of GBTC, as well as other spot Bitcoin ETF applications, which ultimately resulted in the approvals today.

What this Moment Means

The existence of Bitcoin spot ETFs implies several important changes to the nature of how Bitcoin will interact with the traditional financial system.

Firstly, these ETFs vastly simplify the process of gaining exposure to Bitcoin across a diverse array of investment accounts. Investors can now include Bitcoin in their portfolios through familiar investment vehicles such as 401(k)s, Roth IRAs, and pension funds. This accessibility bridges the gap between traditional finance and the decentralized world of cryptocurrencies. Consequently, it makes Bitcoin a more tangible option for a broader investor base, including those who might not have the expertise or desire to engage directly with cryptocurrency exchanges or digital wallets.

Another crucial advantage of Bitcoin spot ETFs is the elimination of concerns around the self-custody of Bitcoin. Typically, owning Bitcoin directly involves managing private keys and digital wallets, a process that can be daunting and risky for those unfamiliar with the technology. With spot ETFs, the complexities of custody are handled by companies that specialize in this process, offering investors a straightforward and secure way to invest in Bitcoin. This reduces the barrier to entry for many and mitigates the risk of loss due to issues like misplaced private keys or security breaches.

Furthermore, the approval and operation of Bitcoin spot ETFs represent a significant stride in the legitimization of Bitcoin, a fully decentralized protocol, within the legacy financial system. It signals a recognition of Bitcoin’s value by institutional investors, and its market’s maturity by regulators. This legitimization could lead to increased adoption, more stability pave the way for more innovative financial products based on other cryptocurrencies and blockchain technologies.

We live in a volatile world. The past several years have brought record levels of inflation in our monetary system, deficit spending by governments, and geopolitical conflict in the world order. Trust in institutions is declining, and fiat currencies and central banks are only as strong as the institutions that back them. Bitcoin provides an asset that both hedges against the risk of these institutions collapsing and reflects a forward-looking vision of the global financial system. With the SEC’s approval of these ETFs, broad access to Bitcoin’s price movements has gotten far easier.