Original title: “How do ETF issuers ‘Buy’ Bitcoin?”

Author: Julian Driver, Apollo

Compiled by: ChainCatcher

 

What is a Spot Bitcoin ETF?

Bitcoin Spot ETFs Are Already Here, But How Do They Actually Work?

What exactly happens when people “buy” an ETF? Who is involved? And how does this relate to the buying and selling of the underlying asset (BTC)?

Here is a simplified step-by-step process:

1. Retail demand: investors’ demand for brokers

  • Investors range from individual investors seeking to diversify their portfolios to institutions seeking exposure to digital assets.

  • Their interest in Bitcoin ETFs drives market demand and influences the creation and redemption of ETF shares.

  • Brokers act as a bridge between retail and institutional investors and the stock market where Bitcoin ETFs are traded.

  • Brokers reflect and amplify investor demand, directly affecting the trading volume and price of ETF shares.

  • As an example, an investor could be a family office, institutional investor, or anyone with a 401k that wants to move into a Bitcoin ETF. Once the ETF is approved, these investors would call their brokers and instruct them to buy it.

Investors to Brokers

2. Wholesale demand: Brokers to Authorized Participants (APs)

  • So where do brokers get ETF shares to sell to investors? From Authorized Participants (APs).

  • APs are professional financial institutions that are authorized to conduct share creation and redemption transactions directly with ETF sponsors. For example, the APs for the Blackrock/iShares ETF are Jane Street and JP Morgan.

  • You can think of the broker as a retailer of ETF shares and the AP as a wholesaler.

  • The AP monitors the supply and demand for an ETF’s shares and plays a key role in keeping the share price in line with its net asset value (more on this later).

Wholesale Purchase

3. Share creation: AP to the promoter

  • Once AP knows how big the demand is, it’s time to mint some new ETF shares.

  • To do this, the AP will go to the ETF sponsor it deals with and deposit cash to create the shares.

  • The sponsor is responsible for the overall management and compliance of the ETF. Sponsors are those big companies you’ve heard of: Blackrock, VanEck, Fidelity, etc.

  • The sponsor coordinates the necessary Bitcoin transactions during the share creation and redemption process with the Bitcoin counterparty.

  • How it works: AP either creates new shares with sponsors (when demand is high) or redeems shares for cash (if demand is low).

  • This "demand" directly affects the premium or discount of the ETF's market price relative to its NAV. The AP takes advantage of this premium or discount, and in turn, this arbitrage tends to keep the gap between the market price and the NAV as small as possible, subject to factors such as transaction costs.

  • For example, all of the brokers at JPMorgan were calling and being asked to buy more and more ETF shares from Ark/21 Shares. Then someone at JPMorgan (I personally think it was Jamie Dimon) called Cathie Wood and said, "We need to buy another billion ETF shares - this is all the cash we have."

ETF Share Creation

4. Sponsors and counterparties

  • The counterparty is the entity like Coinbase that handles the buying and selling of the ETF’s bitcoin.

  • Operate according to the sponsor's instructions to keep the ETF's Bitcoin holdings consistent with its number of shares.

  • A custodian (such as Coinbase) is responsible for the secure storage of the ETF’s Bitcoin assets.

  • Ensure the security and regulatory compliance of Bitcoin assets held in trust.

  • The sponsor instructs the Bitcoin counterparty to buy or sell Bitcoin based on the AP’s activity (creation or redemption of ETF shares).

  • So after Jamie Dimon ordered all the shares from Cathie Wood and created as many as possible, Cathie called Brian Armstrong at Coinbase.

  • Cathie says to Brian, “Jamie’s FOMO is just as we expected. I need to buy all your BTC right now.” This is where the on-chain fun is.

Sponsors and counterparties

5. Bitcoin counterparty purchases BTC

  • Once the Bitcoin is acquired, it is transferred to a custodian for secure storage.

  • This is critical to mitigating risks such as hacking or theft and ensuring the security of the digital assets that the ETF relies on.

  • In Ark’s case, Coinbase acts as both counterparty and custodian. For Fidelity, they will self-custody the BTC and hold their own keys.

Buy Bitcoin

Other: How ETF share prices are related to Bitcoin prices

  • The ETF’s share value is based on the CME CF Bitcoin Reference Rate – New York variant, ensuring that Bitcoin’s valuation reflects market conditions.

  • The index reflects the aggregate price of Bitcoin across multiple exchanges, providing a standardized benchmark.

Other: How to calculate the fee

  • Sponsor fees are paid to the sponsor out of the trust assets and expenses associated with the management, operation, and marketing of the ETF.

  • These fees are not paid directly by investors but are factored into the calculation of the ETF’s net asset value.

  • So (to put it simply): since fees reduce the total value of the trust's assets, they reduce its NAV, and investors' returns are reduced by the amount of the fees.