Spot bitcoin ETFs spawn nascent derivatives ecosystem

The first derivative-based strategy piggybacking off US-listed bitcoin exchange traded funds has started trading, as experimentation in the fund industry accelerates at breakneck speed.

Roundhill Investments’ Bitcoin Covered Call ETF (YBTC) aims to generate a yield from bitcoin and, like other covered call strategies such as JPMorgan’s wildly popular Equity Premium Income ETF (JEPI), investors surrender some potential market gains in return.

“This is a unique intersection of two areas that have been very much in demand, income generation and crypto,” said David Mazza, chief strategy officer at Roundhill.

YBTC is among the first in an anticipated wave of novel ETF launches in the wake of the recent approval of US-listed “spot” bitcoin ETFs investing directly in the cryptocurrency, industry observers say.

“We are at the beginning, not the end, of ETF innovation tied to cryptocurrencies. The door is open to bring strategies to the public that provide exposure to bitcoin in a risk-on and risk-off manner,” said Todd Rosenbluth, head of research at VettaFi, a consultancy.

Crypto powerhouse Grayscale Investments has filed with the US Securities and Exchange Commission to launch a Bitcoin Trust Covered Call ETF, which would be based on options on its $23.5bn Bitcoin Trust ETF (GBTC), the world’s largest crypto fund.

Other novel ETFs in the works include proposed vehicles from ProShares and Direxion, which have each filed to launch five ETFs offering leveraged and inverse exposure to bitcoin, amplifying the swings of the already volatile asset.

Covered call ETFs are designed to do the opposite: reduce risk. They work by selling out-of-the-money call options, allowing the purchasers to buy the underlying asset, in this case bitcoin, at a set price and a fixed expiration date. If bitcoin rises sufficiently for this option to be triggered, this caps upside returns for investors, meaning they may underperform the rise in the digital asset.

However, the ETF pockets the premium income from writing the options irrespective of what happens — cushioning investors if the options are triggered, or helping them outperform if they are not.

Mazza argued that bitcoin’s high volatility meant it was ideally suited to this approach.

“When you’re combining crypto, particularly bitcoin, with a covered call strategy, one of the biggest things is the potential for higher income,” he said.

“Because bitcoin is so volatile as an instrument, when you are selling and capping some of your upside, the benefit is that you get paid a pretty attractive premium for doing so. It has the potential to get a higher yield than you would get with equities.”

This “manufactured” income stream may be welcome to some investors because bitcoin has no yield. This is because “mining” of new coins works on the basis of “proof of work”.

Many other cryptocurrencies, such as ether, cardano and polkadot, instead use a “proof-of-stake” mechanism. This allows investors to lock away crypto assets for a set period of time to help support the operation of the blockchain. In return they earn more cryptocurrency, effectively generating income.

“Being able to invest in GBTC and have a passive long-term exposure to bitcoin, while also allowing having an additional income or yield, is quite attractive,” said Michael Sonnenshein, chief executive of Grayscale.

Rosenbluth saw a potential market for covered call ETFs. “The number one concern that we hear from advisers about bitcoin is that it is volatile, so these products would help alleviate some of these concerns by having some downside protection and income generation,” Rosenbluth said.

But he pointed out the reverse could also be true. “The counter is that many people want exposure to bitcoin to take advantage of that volatility. They like that it’s a high-risk/high-reward experience.”

Bryan Armour, director of passive strategies research, North America at Morningstar, also pointed to the allure of volatility, saying he did not “understand the desire for a bitcoin covered call ETF”.

“Volatility is why investors buy bitcoin — capping upside seems antithetical to its investment thesis,” Armour said. He added that a covered call ETF “keeps the tail risk of bitcoin, meaning if it craters like it did in 2022, investors will still lose a substantial amount of their investment. I don’t see these as a useful product for most investors.”

Until this month Grayscale’s GBTC was a private trust traded on the over-the-counter market. As such, there were no options listed on it. Sonnenshein hinted that this picture was changing.

“We are committed to GBTC and growing the ecosystem around it,” he said. “There is a lot of investor interest and excitement about the development of an options ecosystem.”

Roundhill, which does not have its own spot bitcoin ETF, is instead basing its options on the ProShares Bitcoin Strategy ETF (BITO), at $1.8bn by far the largest bitcoin futures ETF.

This is because, as yet, there are no options listed on the new spot ETFs, although several exchanges have filed with the SEC to launch them.

“We are closely monitoring what occurs with spot ETFs,” said Mazza, who added that YBTC has the freedom to “pivot to where the largest options market is”.

YBTC has a fee of 95 basis points. Grayscale has yet to provide details of its proposed ETF.

Rosenbluth believed many more flavours of bitcoin exposure were likely to be on the way in the US.

Buffered ETFs — which use options to provide some downside protection — are one possibility. Other vehicles such as the Cyber Hornet S&P 500 and Bitcoin 75/25 Strategy ETF (ZZZ), which provides exposure to bitcoin futures and Wall Street stocks, launched late last year.

“It seems inevitable that we see more asset allocation approaches that incorporate bitcoin exposure in that package.” Rosenbluth said.