1.1 Channels for Exposure to Bitcoin

Question 1

A significant merit of digital assets is ability to SC - but what 4 things prevent some institutions from doing this?

Answer 1

Self-custody (direct ownership).
1. security issues
2. risk management
3. operational limitations
4. regulatory limitations

Question 2

Three benefits of third-party custody (IG, LC, CE)

Answer 2

1. institutional grade custody and trading
2. low costs
3. capital efficiency opportunities

Question 3

Digital asset custodians are often heavily (1), may undergo (2) audits and even hold (3) or (4)

Answer 3

1. regulated
2. system and organisational control (SOC) audits
3. national banking charters
4. state trust licenses

Question 4

Some Bitcoin custodians having met these institutional standards may be deemed as (1)

Answer 4

1. qualified custodians

Question 5

Custody costs for digital assets are for the most part under (1) of total assets under custody

Answer 5

1. 50 bps

Question 6

Trade execution costs, which incorporate both (1) and (2), are expressed as a (3)

Answer 6

1. trading (taker) fees
2. slippage
3. percentage of order size

Question 7

As an order gets larger, slippage costs will (1) and trading costs will (2).

Answer 7

1. increase
2. decrease

Question 8

Bitcoin’s advantages of (1, 2, 3, 4) are appealing to lenders.

Answer 8

1. liquidity
2. fast settlement
3. real time price discovery
4. borderless structure

Question 9

Three challenges of third party custody (DD, FL, AI)

Answer 9

1. technical due diligence
2. fragmented liquidity
3. traditional asset integration

Question 10

Two examples of where investor may not have technical knowledge for adequate DD (e.g. S v O custody, or HSM vs MPC)

Answer 10

segregated vs omnibus custody

hardware security models (HSMs) versus multi-party computations (MPCs)

Question 11

Issue of fragmented liquidity (cf. traditional capital markets)

Answer 11

While in traditional markets, exchanges are required to give the NBBO (national best bid offer) or best available purchase and sale prices, digital asset exchanges vary in terms of security, transparency, and regulation and are not required to guarantee “best execution”

Question 12

Two benefits of passive Bitcoin funds: F+C, A.

Answer 12

1. familiarity and convenience
2. accounting: whilst on a public company balance sheet, an investment in Bitcoin is classified as an indefinite-lived intangible asset recorded at the lowest traded price each period, a passive bitcoin fund may be categorised as equity and recorded at fair value.

Question 13

Two disadvantages of passive bitcoin funds: C, R (M and F)

Answer 13

1. costs: investors will incur annual management fees between 50 and 200 basis points along with custody, trade execution, and other fund administration costs (pressure is being put on costs as new players enter the market)
2. redemptions: differing mechanisms (e.g. in-kind physical Bitcoin, cash, or secondary market share redemptions) and frequencies

Question 14

Example of an open-ended private trust for bitcoin? G-

Answer 14

Grayscale Bitcoin Investment Trust (GBIT)

Question 15

Open-ended private bitcoin trusts provide investors with exposure to Bitcoin through (1) which represent (2). The trust is set up to (3). Both retail and institutional investors may participate in the trust, although AI may participate at (4) via (5) and after a six-month lockup period (6)

Answer 15

1. publicly traded shares
2. ownership in the trust
3. hold Bitcoin and track its price movements
   AI - accredited investors
4. net asset value
5. daily private placements
6. sell shares in the secondary market

Question 16

Open-ended private bitcoin trusts - benefits:
1. access
2. avoid

Answer 16

1. access to these investments via traditional brokerage firm channels
2. avoids the complex logistics of physical Bitcoin ownership

Question 17

Open-ended private bitcoin trusts - challenges:
1. fee
2. non-aligned

Answer 17

1. high management fees and trading premiums/discounts associated with secondary shares due to absent redemption mechanisms
2. Non-aligned liquidity and trading hours between traditional Bitcoin exchanges and secondary markets

Question 18

The two types of regulated futures markets for Bitcoin are (1). Bitcoin futures may be used by investors to add (2), establish (3), and create (4). Futures may be highly regulated on common platforms or loosely regulated on offshore platforms.

Answer 18

1. cash-settled and physical-settled futures
2. long exposure
3. risk-neutral exposure
4. hedge spot exposure

Question 19

Cash-settled Bitcoin futures are offered and regulated by (1) and trade on the same platforms as futures contracts on other assets (2)

Answer 19

1. the Commodity Futures Trading Commission (CFTC)
2. e.g. Chicago Mercantile Exchange [CME]

Question 20

Cash-settled Bitcoin futures trading on the CME (1) also provides access to (2 FCM) that can be used to (3). Another benefit of cash-settled futures is that there is no need to… (4)

Answer 20

1. Chicago Mercantile Exchange
2. futures commission merchants (FCMs)
3. access and clear other contracts
4. no need to worry about custody upon physical delivery

Question 21

Which have been more popular - cash or physical settled bitcoin futures? [FCM support]

Answer 21

Cash-settled. Physical-settled futures have not produced the same open interest and volume as cash-settled futures, which may be due to a lack of support from FCMs not wanting to clear and settle physical transactions.

Question 22

Two reasons why someone would choose physical settled over cash settled BTC future?

Answer 22

1. they want to hold the physical asset
2. want to avoid risks of spot exchange manipulation that can impact cash-settled transactions

Question 23

What is a concern with cash-settled BTC futures? (PM)

Answer 23

Price manipulation: as the settlement price will depend on a spot price index.

Question 24

Why can long exposure created by cash-settled future be more expensive? Why?

Answer 24

Cash-settled futures trade at a premium to spot, and longer-dated futures trade at higher premiums than shorter-dated futures?

This may be a result of custody costs or due to the attractiveness of avoiding the operational and/or regulatory limitations associated with spot Bitcoin acquisitions

Question 25

What are three benefits of the ETF structure for Bitcoin investments? PA, RM, A

Answer 25

1. product acceptance - an ETF trading on a national exchange would offer more disclosures and protections than the digital asset vehicles currently available in the marketplace
2. redemption mechanisms - potential for real-time redemptions through authorized participants who arbitrage ETF shares when share values in secondary markets deviate from NAV. Publicly traded trusts, which were discussed earlier, often trade at discounts or premiums because of the lock-up period associated with private placements.
3. accessibility - (1) low cost, (2) likely to trade at values close to NAV, and (3) available through financial institutions and traditional brokerage firms

Question 26

Why has SEC previously rejected Bitcoin ETFs? (C, MS, S, M)

Answer 26

Concerns regarding custody, market size, and surveillance of and manipulation within Bitcoin markets.

Question 27

Comparing spot trading and custody, private passive bitcoin fund and CME bitcoin futures, which is the most economical for $5M, $50M and $1B investment?

Assumptions for spot trading and custody platform is an annual custody fee of 35 basis points, a one-time $10,000 custody initiation fee, and total trading costs of 0.175%, 0.14%, and 0.225% for $5 million, $50 million, and $1 billion positions, respectively. The private passive Bitcoin fund has assumed expense ratios of 50 basis points, 75 basis points, and 200 basis points. For the CME Bitcoin futures, quarterly rolling of the contract was assumed, and custody fees were not required (for cash-settled Bitcoin futures). Also, the natural contango (premium) for Bitcoin futures over spot prices was not considered, nor was the increase in time required to roll larger positions.

Answer 27

The ranking from most to least economical for both the $5 million and $50 million positions were CME Bitcoin futures, followed by spot trading and custody, and then private passive Bitcoin funds. For the $1 billion position, the most economical choice was spot trading and custody, followed by the private passive fund with a 50 basis point expense ratio, and then rolling CME Bitcoin futures. In all three investment channels, the private passive Bitcoin fund with a 200 basis point expense ratio was the most expensive.