The Difference between Spot Bitcoin ETF Custody and Exchange Custody

According to Yahoo Finance data, ten asset managers in the United States (US) have started trading billions in spot Bitcoin exchange-traded funds (ETFs) since the Securities and Exchange Commission (SEC) approved spot Bitcoin ETFs. The new Bitcoin ETFs topped $4.5 billion in volume on its first trading day.

While Bitcoin ETFs were launched with a bang, investors might wonder how these issuers ensure their products’ underlying assets are safe. Over the past few years, cryptocurrency exchanges have upgraded their security, which has resulted in them losing comparatively less money to hacks. However, even though the crypto exchange made security improvements in 2023, the community witnessed multimillion-dollar attacks on exchanges such as Poloniex. This left users wondering if anything makes a spot Bitcoin ETF safer than trading on exchanges like Poloniex as a retail user.

What is a Spot Bitcoin ETF?

A spot Bitcoin ETF is an investment fund that allows ordinary investors to gain direct exposure to Bitcoin (BTC) in their regular brokerage accounts. Unlike Bitcoin in futures ETFs, which are derivatives contracts based on their prices, spot Bitcoin ETFs are traded on traditional securities exchanges. They can be invested directly in Bitcoins as the underlying asset. BTC is the underlying asset of a spot Bitcoin ETF and offers a regulated and accessible way for mainstream investors to invest in the digital currency.

When you invest in a spot Bitcoin ETF, you do not own any BTC outright; instead, you buy shares in a fund that holds BTC. However, firms will charge for expenses like management fees and brokerage commissions for trading Bitcoin ETFs, though these are offset by not having the costs in time and exchange fees to hold and buy BTC directly. Spot Bitcoin ETF shares are listed on traditional stock exchanges like bonds or stocks that track a specific index, asset class, or sector, such as gold. 

Eleven spot Bitcoin ETFs were approved, even though US regulators initially hesitated about the move due to market manipulation and custodial risk issues. In 2021, the US SEC approved the first Bitcoin futures ETFs and, in 2024, the first spot Bitcoin ETFs. Regulators had been reluctant to approve any spot Bitcoin ETF applications and cited concerns over fraud, custody, market manipulation and investor protection. Previously, the SEC rejected several applications for a spot Bitcoin ETF by Grayscale Investments, a leading digital asset manager. In August 2023, a federal appeals court ruled that the rejection of Grayscale’s application by the SEC was wrong and had not sufficiently explained its reasoning.

Moreover, the SEC did not appeal the ruling. In January 2024, the regulator announced the approval of Grayscale’s application and other applications by major industry players. On January 11 2024, SEC Chair Gary Gensler released a warning and the approval. Gensler said, “While we approved the listing and trading of certain spot Bitcoin ETF shares today, we did not approve or endorse Bitcoin. Investors should remain cautious about the risks associated with Bitcoin and products whose value is tied to crypto.”

How do Spot Bitcoin ETFs Work?

Spot Bitcoin ETFs securely hold Bitcoins in a secure digital vault that registered custodians manage. The purpose of spot Bitcoin ETF is to mirror the price of Bitcoins in the crypto market:

  1. The ETF buys Bitcoins from authorised cryptocurrency exchanges or through other holders.
  2. The tokens are stored in a digital wallet, often using several security layers, including offline or cold storage, to reduce risks such as hacking.
  3. The ETF issues shares corresponding to a set number of Bitcoins.

The ETF share price then reflects the prevailing market price of the crypto, and then the shares are available for public trading on traditional stock exchanges. The ETF shares closely track the price of Bitcoins, and occasionally, the ETF rebalances its holdings by selling or buying tokens. The creation and redemption process is done by authorised participants (APs). Based on market demand, large financial institutions create or redeem shares of the ETF. If the ETF shares are trading at a discount or premium to the actual BTC price, the APs create or redeem ETF shares in large blocks, arbitraging the difference so that the ETF share price aligns with the cost of Bitcoins.

For investors and traders, buying a spot Bitcoin ETF is the same as buying shares in any other security or ETF. Market makers keep the market liquid and efficient by continuously offering to buy and sell shares of the ETF. Market maker’s activity is crucial in maintaining a stable market and ensuring that investors can buy or sell shares of the ETF easily when needed. Spot Bitcoin ETFs can create opportunities for retail and institutional investors to speculate on BTC without the technical challenges of managing a crypto wallet or the security concerns of safeguarding private keys. 

Spot Bitcoin ETFs vs Other Bitcoin ETFs

Spot Bitcoin ETFs and other Bitcoin ETFs differ in how they are structured and how much exposure they offer to BTC’s price changes. Spot Bitcoin ETFs directly hold Bitcoins, while other Bitcoin ETFs indirectly hold Bitcoins using financial instruments such as futures contracts to replicate BTC’s prices. Thus, spot Bitcoin ETFs have direct ownership of Bitcoins, and the exposure is more intuitive for investors, making spot Bitcoin ETFs straightforward for those investing in BTC. Spot Bitcoin ETFs are more transparent since each share of the ETF corresponds to a specific number of Bitcoins held. By contrast, other Bitcoin ETFs can be more opaque for investors, given that their value is derived indirectly from futures contracts, which can be influenced by several factors beyond Bitcoin’s spot price.

 Spot Bitcoin ETFs enhance the liquidity of the BTC market, which can lead to more stable prices and less volatility, making BTC more attractive to investors. The investment value of spot Bitcoin ETFs is derived mainly from the appreciation or depreciation in the price of Bitcoins. It does not pay dividends because Bitcoins do not generate any income. Spot Bitcoin ETFs could play a pivotal role in stabilising and boosting BTC adoption by attracting investors.

Fhumulani Lukoto Cryptocurrency Journalist

Fhumulani Lukoto holds a Bachelors Degree in Journalism enabling her to become the writer she is today. Her passion for cryptocurrency and bitcoin started in 2021 when she began producing content in the space. A naturally inquisitive person, she dove head first into all things crypto to gain the huge wealth of knowledge she has today. Based out of Gauteng, South Africa, Fhumulani is a core member of the content team at Coin Insider.

View all posts by Fhumulani Lukoto >

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