Exploring the Influence of Spot ETFs on Bitcoin Valuations

On January 10th, the U.S. SEC approved 11 applications for Bitcoin spot ETFs, officially marking the entry of cryptocurrencies into the core asset allocation pool of global mainstream institutions. However, on the first day after the ETFs opened, the price trend of Bitcoin was completely opposite to the previously high market sentiment. It fell from $49,000 to a low of $41,500, erasing nearly all the gains of the past month. What exactly happened in this situation? What caused this significant drop, and why did a large amount of capital flow out of the BTC market rather than into it after the approval of the spot ETFs? After practical operations, we take the entire process of circulating $1000 in ETFs as an example to help you understand the trading execution mechanism behind ETFs, hoping to assist investors in better grasping investment opportunities in cryptocurrencies during the ETF era.

Part 1: Unveiling the Capital Flow Behind ETFs Through a $1000 Operation
Part 2: The Buy and Sell Transaction Volume in ETF Secondary Market ≠ Net Inflow and Outflow of Funds in the Bitcoin Market
Part 3: Why Did the Grayscale Bitcoin ETF Experience a Large Outflow of Funds? How Long Will This Outflow Last?
Part 4: ETFs Will Bring a Wider Range of Investors into the Crypto Market, Beneficial in the Long Term Part 5: In the Next Three Months, Three Major Events Will Be Crucial for the Crypto Market

Part 1: Unveiling the Capital Flow Behind ETFs Through a $1000 Operation First, it’s essential to understand the four key participants in the Bitcoin spot ETF ecosystem:

The Sponsor: Responsible for designing and managing the ETF product, calculating the ETF’s daily Net Asset Value (NAV), and collecting management fees. Currently, there are 11 approved sponsors, including Blackrock, Fidelity, Ark, Grayscale, etc.
Authorized Participants (AP): The only entities authorized to directly subscribe to and redeem ETF shares with the issuer, typically asset management companies or broker-dealers.
Market Makers: Provide liquidity in the secondary market, buying and selling ETF shares. When they detect a shortage or excess of liquidity, they request the subscription/redemption of ETF shares from the Authorized Participants (AP).
Investors: Individual or institutional investors who buy and sell ETF shares on the secondary market.

Understanding these participants, let’s follow a $1000 ETF investment to reveal the underlying capital flow process. Note：the U.S. SEC has only approved Bitcoin ETFs based on cash subscriptions and redemptions, so all currently issued Bitcoin ETFs cannot engage in physical subscriptions and redemptions. Therefore, the process of capital flow can only occur in the following way:

When you decide to use $1000 to buy a Bitcoin spot ETF, you usually do this through an online trading platform like Robinhood or Interactive Brokers (IBKR). You place an order at the market price, and once the trade is successful, your $1000 flows to the Market Maker;
Simultaneously, the Market Maker might receive many such $1000 buy orders and may not have enough ETF shares to satisfy these orders. If the ETF price rises and its market value deviates from the total Bitcoin assets held by the issuer, creating a premium, then the Market Maker will request the Authorized Participant (AP) to help subscribe for more ETF shares. A portion of your $1000, say $200, is transferred to the Authorized Participant (AP);
Upon receiving the subscription request and $200, the Authorized Participant (AP) will apply to the Sponsor for ETF shares, transferring $200 to the Sponsor;
The Sponsor then uses this $200 to buy Bitcoin through platforms like Coinbase. Depending on the fund’s policy, this purchase can happen on the same day of the subscription or 1–2 days after. Ultimately, the funds flow into the cryptocurrency market;

Part 2: The Buy and Sell Transaction Volume in ETF Secondary Market ≠ Net Inflow and Outflow of Funds in the Bitcoin Market

Through studying and operating the flow process, we can conclude that the transaction volume of buying and selling in the ETF secondary market ≠ the net inflow and outflow of funds in the Bitcoin market. These two values are not directly equivalent but influence each other. When discussing the impact of Bitcoin spot ETFs on Bitcoin prices, the essential question is how much USD is flowing from the traditional financial market into the Bitcoin market to purchase Bitcoin spot via ETFs, i.e., the Total Net Inflow.

So, how is the Net Inflow calculated? It can be calculated by summing the overall subscription and redemption data of these 11 ETFs. Each sponsor discloses the relevant figures on their official websites, and they can also be tracked through professional data tracking tools, such as Bloomberg or the ETF dashboard of SoSo Value, with daily updates. For example, let’s look at the SoSo Value ETF dashboard.

We can see that on January 16th (the third trading day after approval), Grayscale’s GBTC ETF experienced an outflow of $594 million. In the two trading days following the ETF approval (11th and 12th), there were also redemptions, with net outflows of $95 million and $480 million, respectively, totaling $580 million in outflows over these two days. Therefore, although the total ETF market transaction volume on the 11th and 12th was as high as $4.67 billion and $3.19 billion, respectively, and other ETFs like ARK, Blackrock, and Fidelity gained a net subscription of $1.4 billion, the substantial net outflow from Grayscale ETF resulted in a much lower overall Bitcoin market net inflow than expected. This contributed to Bitcoin correction starting on the 12th (see the data snapshot below for January 12th).

Source: SoSo Value Data Snapshot as of January 12, 2024.

Part 3: Why Did the Grayscale Bitcoin ETF Experience a Large Outflow of Funds? How Long Will This Outflow Last?

The continuous redemptions over three days from the Grayscale Bitcoin ETF resulted in a selling pressure of approximately 26,000 to 28,000 Bitcoins, increasing the market’s wait-and-see sentiment. According to SoSo Value data, on January 11th, 12th, and 16th, Grayscale’s GBTC saw redemptions with a total net outflow of $1.174 billion.

Source: *SoSo Value * Data Snapshot as of January 16, 2024.

Charging management fees six times higher than competitors, and the closing of early trust discount arbitrage trades, are the two core reasons for the net outflow from Grayscale Bitcoin ETF. Grayscale Bitcoin Spot ETF (ticker symbol GBTC), previously a Bitcoin trust, only allowed for subscriptions and secondary market trading, without permitting redemptions.

From the perspective of the Bitcoin market, this meant that funds flowing into Bitcoin through Grayscale’s Bitcoin Trust couldn’t flow out, making it a one-way channel into Bitcoin.

Over the 8 years since GBTC’s launch, it has accumulated about 620,000 Bitcoins. On January 10th, with SEC approval, it was upgraded to an ETF, finally allowing investors to freely redeem through authorized participants (AP), converting their ETF shares into cash.

This opened the channel for funds to flow out of the crypto asset market via Grayscale. The specific redemption trades, based on different investor types, can be divided into two main categories. Analyzing these investors’ trading intentions and behaviors can offer a clearer prediction of how long and in what manner this round of net outflow from Grayscale ETF will impact Bitcoin prices:

The first type of investor: those who are long-term bullish on Bitcoin assets but are moving to other ETFs due to Grayscale’s high management fees.

Comparing horizontally among the 11 ETFs, Grayscale GBTC’s management fee is 5–6 times that of its competitors. Grayscale charges a 1.5% management fee, while others are generally below 0.3%, and they offer fee discounts to early investors. For investors with larger funds, it’s very motivating to sell Grayscale ETF and switch to other ETFs.

For example, Ark, once a top ten investor in GBTC, is expected to shift its position to its own ETF (ARKB). Whether Blackrock and Fidelity, which might have previously held positions in Grayscale, need to shift their positions, remains unknown. This shifting process will create a time lag in fund inflow and outflow from the crypto market, and the resultant BTC price drop during this lag could increase the wait-and-see sentiment of new market funds.

The second type of investor: Arbitrageurs of Grayscale GBTC’s discount rate, hedging by shorting BTC in the over-the-counter market. Due to the cascading effects in the crypto asset market triggered by FTX’s collapse, and the non-redeemable nature of Grayscale’s GBTC trust shares, GBTC’s discount rate soared to as high as 49%, and remained around 20% for a long period.

Six months ago, the market began to anticipate that the SEC would approve Bitcoin spot ETFs, allowing GBTC to transition from a trust to an ETF with NAV-based redemptions, and the discount was expected to vanish. Arbitrage funds started to intervene, buying discounted GBTC shares and shorting BTC in the over-the-counter market to capitalize on the discount rate. After the Bitcoin spot ETF was approved on January 10th, by January 12th, GBTC’s discount rate was only -1.18%. Therefore, some investors who hoped to profit from the disappearance of the discount had a strong motivation to realize their profits.

Since most funds arbitraging the discount rate likely had corresponding hedging mechanisms in the over-the-counter market, their hedge short positions would also be closed after taking profits. Thus, logically, the overall arbitrage of the discount rate should not have a significant impact on BTC’s price. From the analysis above, we can conclude that in the next 1–2 months, the selling pressure from Grayscale GBTC will directly affect Bitcoin’s price. But how long will Grayscale GBTC’s net outflow last? Given Grayscale’s current total Bitcoin holdings of around 620,000 BTC, and an average daily sell-off of about 9,000 BTC over the past three trading days, at this rate of outflow, the impact of Grayscale GBTC’s net outflow on Bitcoin’s price fluctuations should not last more than two months.

Part 4: ETFs Will Bring a Wider Range of Investors into the Crypto Market, Beneficial in the Long Term

Although Grayscale has brought some short-term selling pressure on Bitcoin spot, looking at all Bitcoin spot ETFs, from January 11th to 16th over three trading days, they still brought a net buying of $740 million to Bitcoin. Among them, Blackrock’s ETF (IBIT) led with a net inflow of $710 million. After the news of Grayscale transferring 9,000 Bitcoins to Coinbase on the 16th, which caused a rapid plunge in Bitcoin’s price, there was a quick rebound to around $43,000, indicating a stabilizing trend in the Bitcoin price.

The underlying reason for this is that the redemption pressure from Grayscale on the overall Bitcoin market is short-term, while the participation of a broader investor base in crypto assets is the main narrative of the ETF era. As analyzed in the previous section, investors relocating due to management fee rates are expected to buy other Bitcoin ETFs, continuing to contribute to Bitcoin’s buying pressure.

The impact of investors capitalizing on the discount is neutral on Bitcoin. On the other hand, let’s look at the capabilities of the new managers of Bitcoin spot ETFs. The issuers approved this time, such as Blackrock (managing total assets of $8.59 trillion), Fidelity (managing total assets of $4.5 trillion), and Invesco (managing $1.6 trillion), are among the top asset management firms globally. Blackrock, Vanguard Group, and State Street Bank, once referred to as the ‘Big Three’, dominate the entire U.S. index fund industry.

Meanwhile, the entire cryptocurrency market is only valued at $1.7 trillion. Top asset management companies are generally recognized for their ample management experience, stricter compliance processes, and stronger loss acceptance capabilities, which can enhance investor trust in emerging assets like Bitcoin. Additionally, the global sales channel networks built over many years by these leading brands will help promote Bitcoin spot ETFs, a new category of asset.

Part 5: In the Next Three Months, Three Major Events Will Be Crucial for the Crypto Market

Ranked in order of importance, they are as follows:

1/ Bitcoin Halving: Expected in April 2024, Bitcoin’s new supply will significantly decrease, while demand increases with ETFs. Bitcoin ensures its total supply never exceeds 21 million coins through a mechanism that halves its output every four years. The halving will directly result in a substantial reduction in Bitcoin’s new supply. Combined with the approval of Bitcoin ETFs, which opens the channel for funds to flow into Bitcoin, there’s a surge in new demand for Bitcoin. On one hand, Bitcoin’s new supply is about to be halved; on the other, demand is continuously increasing. Additionally, the interest rate cut cycle in the US dollar is enhancing risk asset preferences. Crypto market investors generally believe that 2024 will usher in a new bull market, often referred to as a ‘clear card’ bull market.

We can refer to Bitcoin’s price changes within a year after past halvings. Bitcoin was launched in 2009, with an initial mining output of 50 BTC per block. Since then, it has undergone three halvings.

The first halving occurred in November 2012, with mining output decreasing from 50 to 25 BTC per block. Within a year, the price of Bitcoin rose from $13 to a high of $1152.

The second halving in July 2016 reduced mining output further to 12.5 BTC per block, and Bitcoin’s price rose from $664 to a high of $17,760.

The third halving in May 2020 saw mining output halving again to 6.25 BTC per block, with Bitcoin’s price rising from $9734 to a high of $67,549.

The next halving is expected in April 2024.

Furthermore, according to a Coinshares report, after this Bitcoin halving, the average mining cost per Bitcoin (excluding one-time mining equipment costs and including electricity consumption + maintenance costs, etc.) will rise to $37,856.

2/ Approval of Ethereum Spot ETF: Expected in May 2024. Institutions like Blackrock, Fidelity, and Invesco have also applied for Ethereum spot ETFs, and the likelihood of approval is high. With the approval of Bitcoin ETFs, the market is beginning to expect the approval of Ethereum ETFs in May, and the price has already started to react accordingly.

3/ Ethereum Cancun Upgrade: Expected in February-March 2024, it will reduce the transaction costs on the Ethereum Layer2 network to one-tenth. The Cancun upgrade for Ethereum could be akin to the iPhone moment for the mobile internet. Lower transaction fees and improved trading experience will give rise to more applications that can truly serve a large user base.

Most of the time, people tend to overestimate the short-term impact and underestimate the long-term influence. The launch of Bitcoin spot ETFs is a milestone, the first gateway to introducing crypto assets into the core of financial assets. Looking back after many years, this will undoubtedly be seen as a lasting and long-term positive development.

Read the original text