Why falling prices did not prevent an increase in Bitcoin holdings for new ETFs

The recently introduced Newborn Nine spot Bitcoin ETFs in the US have witnessed a remarkable surge in their total assets under management, reaching $5.1 billion within the nine trading days following their launch. Despite this growth, the price of Bitcoin has experienced a decline of approximately 20% during the same timeframe. Consequently, the share prices of these ETFs have also decreased in accordance with Bitcoin’s value. This raises the question: how can the ETFs continue to acquire more Bitcoin when their share values are falling?

Commodity-shares ETFs are structured to provide exposure to the underlying asset. In the case of spot Bitcoin ETFs, the underlying asset is Bitcoin itself. When capital flows into these funds, it is utilized to purchase Bitcoin at a corresponding rate. As demand rises, the value of the ETF shares also increases. The relationship between the share value and the underlying Bitcoin’s value is referred to as the ‘net asset value’ (NAV), which serves as a metric to evaluate whether the fund is overvalued or undervalued in relation to the Bitcoin it possesses.

Creation of ETF share baskets.

New shares in the ETFs are not generated spontaneously when an investor opts to buy in. Instead, they are produced in baskets by Authorized Participants (APs). For instance, BlackRock currently collaborates with ABN AMRO Clearing, Jane Street Capital, JP Morgan Securities, Macquarie Capital, and Virtu Americas as APs for the iShares Bitcoin Trust.

For BlackRock, these five firms are the sole entities authorized to create or redeem baskets of shares associated with the ETF. Baskets consist of 40,000 shares, each valued at approximately $906,365 as of the latest update. Each basket corresponds to around 22.7 BTC, meaning that whenever shares are generated for the ETF, at least 22.7 BTC (1 basket) must be acquired. When shares are redeemed, at least the same amount is sold for cash to provide to APs. Under the current framework, only cash can be utilized to create share baskets, indicating that APs cannot exchange Bitcoin with BlackRock in return for shares.

To address liquidity requirements, APs frequently purchase baskets of shares in advance to sell in the market. This process occurs once per trading day and employs the CF Benchmarks Index rate for Bitcoin (New York variant) to ensure shares are issued in accordance with Bitcoin’s price. High trading activity for an ETF signifies strong demand for shares, necessitating adequate liquidity to manage the volume. Baskets of shares will be created in alignment with the trading volume, and these new shares will be utilized to report inflows into the ETFs.

For example, if 7 million new shares are created, raising the total outstanding shares to 70 million, and the NAV price for the ETF is $22, the AUM increases by $154 million to $1.54 billion. However, these shares may not have been sold into the open market and could still be held by the APs, prepared to be used as liquidity for upcoming trading activities.

If Bitcoin’s price decreases, leading investors to sell shares in the ETF, the assets under management do not necessarily diminish at the same rate. While the AUM may decline in dollar terms if Bitcoin loses value, the quantity of BTC held in the fund remains constant until the AP redeems shares.

Authorized Participants proxy investment in Bitcoin

A decrease in ETF share price while its AUM rises due to additional Bitcoin acquisitions could indicate that the APs perceive the underlying asset as undervalued. APs can retain outstanding shares without redeeming them if they anticipate that Bitcoin will appreciate in the future. Each share is priced in relation to the AUM when assessed in dollar terms. Thus, by refraining from redeeming the shares if Bitcoin experiences a rally in the future, the AUM will also rise, enhancing the value of each share.

Given that both the Newborn Nine and the underlying Bitcoin have declined by approximately 18% since their launch, the combined assets under management have increased by around $550 million daily, suggesting that APs are not redeeming shares.

The only ETF experiencing outflows in terms of redemptions is Grayscale, which has a significant 1.5% fee and a majority of investors in profit. All other ETFs, particularly the Newborn Nine, are witnessing daily inflows through new share basket creations from APs.

There is approximately $1.5 billion in trading volume across the spot Bitcoin ETFs, necessitating substantial liquidity to support this activity. Should this liquidity diminish, some redemption activity may occur.

Until that point, the total cash utilized by US institutions to facilitate share creation for Bitcoin ETFs exceeds $27 billion. Given the price decline while new share baskets have been generated, it is plausible to conclude that some of this Bitcoin is effectively owned by APs such as JP Morgan and Jane Street Capital, among others.

Now, for the more speculative aspect of the argument. If JP Morgan, as a corporation, were as pessimistic about Bitcoin as CEO Jamie Dimon, one might expect baskets to be redeemed as long as sufficient shares exist in the market to manage liquidity. However, current data indicates that no share baskets have been redeemed for the Newborn Nine. Any shares that may currently be unallocated to investors belong to the APs who created the baskets.

Bitcoin ETFs highly liquid and actively traded.

For BlackRock’s iShares Bitcoin ETF (IBIT), 11.9 million shares were traded on Jan. 24, with 77.2 million shares outstanding. This results in an approximate liquidity rate of 15%.

In contrast, BlackRock’s iShares Core S&P 500 ETF (SPTR) has 854 million shares and an average volume of around 5.5 million, reflecting a trading volume of 0.6% of the float. For IBIT, this translated to roughly $270 million in volume, while SPTR recorded around ten times more at $2.7 billion. Thus, SPTR has ten times the volume, but IBIT boasts 25 times the liquidity.

The elevated liquidity of Bitcoin ETFs suggests robust, albeit potentially more speculative, interest in these financial products. SPTR’s lower trading ratio indicates its stable position in the market, with significantly less speculative trading. However, the Bitcoin ETF may also be less affected by large trades, given the ample liquidity available.

Overall, the introduction of spot Bitcoin on Wall Street has been a significant achievement. The investor interest is evident through the trading volume, and institutional interest and confidence are clearly reflected in the strong basket creation across the board.

It can be speculated that if trading volumes decline, we will continue to observe daily inflows into the Newborn Nine ETFs as long as Grayscale maintains its outflows. Considering how the Bitcoin price is calculated for ETFs, acquiring Bitcoin from Grayscale is an effective strategy for averaging dollar cost into Bitcoin. This is particularly relevant when, on paper, APs are providing cash to leading asset managers like BlackRock and Fidelity instead of holding Bitcoin themselves. Furthermore, there is no public visibility into this method of Bitcoin accumulation, resulting in low reputational risk.

Unfortunately, unlike blockchain, traditional finance remains opaque. There is no way to ascertain how many outstanding shares are held by APs and how many are in the hands of investors. Future disclosures and reports may provide insights into the situation, but we are largely left in the dark until traditional finance embraces a more transparent blockchain-based framework.

Is JP Morgan using BlackRock to buy Bitcoin behind closed doors?

The answer is uncertain. To explore whether institutions like JP Morgan and other APs could be utilizing ETFs such as BlackRock’s as a means to acquire Bitcoin, I will conclude with this statement from BlackRock’s prospectus;

” An Authorized Participant is under no obligation to create or redeem Baskets, and an Authorized Participant is under no obligation to offer to the public Shares of any Baskets it does create.“

This is standard language for such documents, but it raises questions. This flexibility could be significant. It suggests that these institutions have the latitude to manage their participation in the ETF in a manner that aligns with their investment strategies, including how they wish to expose themselves to Bitcoin.

Thus, if an institution believes that Bitcoin’s value will rise, it might create baskets to acquire more shares (and thus, more exposure to Bitcoin) without necessarily selling those shares to the public. Conversely, if they are less optimistic or wish to decrease their exposure, they might opt not to create baskets.

This approach could serve as a method for institutions to indirectly invest in Bitcoin, using the ETF as a mechanism to manage their investment without directly buying or selling Bitcoin itself.

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