The world has been abuzz with the word 'crypto currency' and its affiliated terminologies like Bitcoin, Ripple, Ethereum, NFT, and De-Fi. To grasp all these topics, we must understand the principle behind all these – blockchain. In simple terms, a blockchain is a form of a database. In a traditional database, data is organized in a table or matrix and usually held within a single system or shared through servers. In a blockchain, data and information are stored in blocks, and new blocks are linked to older blocks through a 'chain' in chronological order. The most common form of data in a blockchain is transactional data, also known as a ledger entry. While a traditional database is controlled by a single or a set of users, the blockchain is decentralized. In other words, every user has access to the same information and has joint control over the chain. Each new block is identified with a particular time in chronological order, and past blocks cannot be modified or changed. That's why most blockchains are called 'immutable.' In a blockchain-based currency transaction, for instance, Bitcoin, every transaction is distributed to the network of systems that have access to the chain. These systems then solve a set of equations to validate the transaction – a process known as mining. The miners are rewarded with Bitcoins for contributing their computing power to solve the equations.
There are hundreds of cryptocurrencies, and new ones are offered now and then. How are these created and made available to the public? The process involves two more terminologies, Coins and Tokens. Coins are built on their own blockchain, essentially an entirely new piece of code. Coins are meant to be used as a currency, just like the Dollar or the Rupee. Bitcoin and Ether are two examples, based on the Bitcoin and Ethereum blockchains, respectively. Tokens can be built on a new blockchain or on an existing blockchain. Tokens may also be used as currencies but are more prevalently used as a conduit for smart contracts. Smart contracts can be used for validating ownership outside of the blockchain. Non-digital assets like real estate can also be owned through smart contracts. Examples of tokens include Tether and Polygon.
The market for crypto coins and tokens has grown significantly in the past few years. Some of the coins and tokens available have market sizes comparable to large-cap US stocks. We can see below some of the top coins and tokens compared to famous companies:
Source: Coinbase and MSCI
Direct investing in cryptocurrencies is possible through the many exchanges and platforms. However, costs vary between exchanges. Additional expenses are involved in the form of transaction charges and wallet charges for securing the storage.
A second option for indirect exposure is investing in a cryptocurrency exchange. Coinbase is one of the prominent exchanges and had its IPO in April 2021. Grayscale, a crypto asset manager offers products that invest in Bitcoin and Ether; however, these are traded over the counter and not available to all investors.
Exchange-traded products linked to cryptocurrencies, especially Bitcoin, the largest of them, are new to the market and were available for the public only recently. ProShares Bitcoin Strategy (BITO) is one of them. These, too, do not invest directly in Bitcoin but rather in futures contracts based on Bitcoin. This class of ETFs is like commodity ETFs in this context. The underlying market in Bitcoin and other cryptocurrencies is unregulated. Hence, the SEC feels there is potential for market manipulation and does not allow products that directly invest in Bitcoin at this point. One difference between direct investment versus futures comes into play due to the structure of future markets, mainly the futures curve.
There are two main ways in which futures markets can behave. The first is when the far-month prices of futures contracts are higher than near-month prices. This is known as Contango. In a Contango market, every time the holder (in our case, the ETF) rolls into a new contract, a small extra cost is involved, called the roll yield.
The second case is when far-month prices are lower than near-month prices. This is called Backwardation in the futures market. In this case, the roll yield is positive, and a small yield is earned. The commodity ETFs have been dealing with these phenomena for years, and it is something that the Bitcoin ETF would also see. The result of this is that a product based on futures would not mirror the performance of the underlying asset one to one. There would always be a difference in the performance.
Still, there are advantages of investing in such a product in transparent costs, better liquidity, lower spreads, and the avoidance of custodianship, wallets, etc. On the flip side, investors in ETFs cannot transact in Bitcoin.
Many ETFs are available that invest in the blockchain technology and companies behind them. While these are not comparable to investment in coins and tokens, these are rather plays on the potential for blockchain to become a dominant technological framework, akin to the internet in the 90s. Some of the popular ETFs in this space include Amplify Transformational Data Sharing ETF (BLOK) and Siren ETF Trust Siren Nasdaq NextGen Economy ETF (BLCN).
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