Understanding the Impact of Spot ETFs on Bitcoin Prices - A Practical Example with $1000

Part 1: Unveiling the Capital Flow Process Behind the ETF Through a $1,000 Operation

First, it is essential to understand the four key participants in the Bitcoin spot ETF system:

Sponsor: Responsible for designing and managing the ETF product, calculating the daily net asset value (NAV) of the ETF product, and charging management fees. Currently, 11 companies have been approved, including Blackrock, Fidelity, Ark, Grayscale, etc.
Authorized Participant (AP): The only institution authorized to directly subscribe and redeem with the issuer, usually asset management companies/brokerages.
Market Maker: Provides liquidity in the secondary market, buys and sells ETF shares, and requests the authorized participant (AP) to subscribe/redeem ETF shares when liquidity is insufficient/excessive.
Investor: Individual or institutional investors who buy and sell ETF shares through the secondary market.

Having understood the above participants, let’s follow a $1,000 ETF investment to unveil the capital flow process behind it. It is important to note that since the U.S. SEC has only approved Bitcoin ETFs based on cash subscriptions and redemptions, all currently issued Bitcoin ETFs cannot be redeemed for physical assets. Therefore, the capital flow process can only occur in the following manner:

When you decide to purchase a Bitcoin spot ETF for $1,000, you typically choose an online trading platform, such as Robinhood or Interactive Brokers (IBKR); you place an order at the current market price, and once the transaction is successful, your $1,000 flows to the market maker;
At the same time, the market maker may receive numerous buy orders of $1,000, and the ETF shares they hold are insufficient to meet the demand for buy orders. The ETF price rises, and its market value becomes unanchored from the total Bitcoin assets held by the issuer, creating a positive premium. In this case, the market maker will apply to the authorized participant (AP) for assistance in subscribing to ETF shares, and a portion of your $1,000, say $200, will be transferred to the authorized participant (AP);
The authorized participant (AP), upon receiving the subscription request and $200, will apply to the issuer (Sponsor) for ETF shares, transferring the $200 to the issuer (Sponsor);
The issuer (Sponsor) will use this $200 to purchase Bitcoin through platforms like Coinbase, and according to the agreements of different funds, the time for purchasing Bitcoin can range from the day of subscription to 1-2 days after the subscription, ultimately flowing the funds into the cryptocurrency market;

Part 2: ETF Secondary Market Buy and Sell Transaction Volume ≠ Net Inflow and Outflow of Capital in the Bitcoin Market

Through the study and operation of the flow process, we can conclude that the ETF secondary market buy and sell transaction volume ≠ net inflow and outflow of capital in the Bitcoin market; these two values cannot be directly equated but influence each other. When we discuss the impact of Bitcoin spot ETFs on Bitcoin prices, the most crucial question is to focus on how many USD are flowing into the Bitcoin market through the ETF to purchase Bitcoin spot, i.e., the total net inflow (Total Net Inflow). So how is the net inflow calculated? By summing the overall subscription and redemption data of these 11 ETFs, we can calculate it. Each issuer (sponsor) will disclose the corresponding values on their official websites, and it can also be tracked through professional data tracking tools, such as Bloomberg or the ETF section of SoSo Value, queried daily. Taking the SoSo Value ETF dashboard as an example, we can see that Grayscale GBTC experienced an outflow of $594 million on January 16 (the third trading day after approval), while there were also redemptions on the two trading days after the ETF approval (January 11 and 12), with net outflows of $95 million and $480 million, respectively. Thus, despite the total transaction volume of ETFs in the market reaching $4.67 billion and $3.19 billion on January 11 and 12, respectively, and other ETFs like ARK, Blackrock, and Fidelity collectively receiving $1.4 billion in net subscriptions, the significant net outflow from Grayscale ETF led to the overall net inflow of capital in the Bitcoin market being significantly lower than market expectations, resulting in the Bitcoin correction that began on January 12 (see the data snapshot from January 12 below).

Source: SoSo Value January 12, 2024 data snapshot (https://alpha.sosovalue.xyz)

Part 3: Why Did Grayscale Bitcoin ETF Experience Large Capital Outflows? How Long Will This Outflow Last?

The consecutive redemptions of Grayscale Bitcoin ETF over three days brought about a selling pressure of approximately 26,000 to 28,000 Bitcoins, increasing market watchfulness. According to SoSo Value data, Grayscale GBTC experienced redemptions on January 11, January 12, and January 16, with a total net outflow of $1.174 billion.

Source: SoSo Value January 16, 2024 data snapshot (https://alpha.sosovalue.xyz)

The management fee is 6 times higher than competitors, and the liquidation of the previous trust discount arbitrage positions are the two core reasons for the net outflow of Grayscale Bitcoin ETF. The Grayscale Bitcoin spot ETF (stock code GBTC) was previously a Bitcoin trust that only allowed subscriptions and secondary market trading, with no redemptions permitted. From the perspective of the Bitcoin market, the funds flowing into Bitcoin through Grayscale's subscription to the Bitcoin trust could not flow out, akin to a Pi Yao that only allows Bitcoin to enter but not exit. Since its launch 8 years ago, GBTC has accumulated approximately 620,000 Bitcoins. With the SEC's approval to upgrade to an ETF on January 10, investors can finally redeem freely through authorized participants (AP), converting their ETF shares into cash, thus opening the channel for this portion of funds to flow out of the crypto asset market. The specific redemption transactions can be divided into two main types based on the attributes of the investors. By analyzing the trading intentions and behaviors of these two types of investors, we can more clearly predict how this round of Grayscale ETF net outflows will affect Bitcoin prices over what time frame:

The first type of investor: Long-term bullish on Bitcoin assets but shifting to other ETFs due to Grayscale's high management fees. Among the 11 ETFs, Grayscale GBTC's management fee is 5-6 times that of its competitors, with Grayscale's management fee rate at 1.5%, while others are generally below 0.3%, and early investors receive management fee discounts; for investors with large capital amounts, there is a strong incentive to sell Grayscale ETF and switch to other ETFs; for example, Ark was once among the top ten investors in GBTC and is expected to shift its positions to its own issued ETF (ARKB). Whether Blackrock and Fidelity previously held corresponding positions in Grayscale and need to shift is unknown. This process of shifting subscriptions and redemptions will create a time lag in the outflow and inflow of capital into the cryptocurrency market, and the price drop of BTC caused by this time lag will further increase the market's watchfulness towards new inflows of capital.

The second type of investor: Arbitraging the discount rate of Grayscale GBTC, shorting BTC over-the-counter for hedging. Due to the chain reaction in the crypto asset market triggered by the FTX collapse, the GBTC trust shares of Grayscale could not be redeemed, leading to a maximum discount rate of 49%, which has long remained around 20%. Six months ago, the market began to anticipate that the SEC would approve Bitcoin spot ETFs, allowing GBTC to convert from a trust to ETF shares redeemable based on NAV, thus eliminating the discount. Arbitrage funds began to intervene by purchasing discounted GBTC and shorting BTC over-the-counter to profit from the discount rate. After the approval of Bitcoin spot ETFs on January 10, the discount rate of GBTC on January 12 was only -1.18%, providing strong profit-taking motivation for some investors hoping to benefit from the disappearance of the discount. Since most of the arbitrage funds should have corresponding hedging mechanisms in the over-the-counter market, after profit-taking, the corresponding short positions in the over-the-counter market will also be closed, so the overall arbitrage discount rate funds logically should not have a significant impact on BTC prices.

Through the above analysis, we can conclude that in the next 1-2 months, the selling pressure from Grayscale GBTC will directly affect Bitcoin prices. So how long will the net outflow from Grayscale GBTC last? Based on Grayscale's total Bitcoin holdings of around 620,000 Bitcoins and the average daily sales of approximately 9,000 Bitcoins over the past three trading days, at this outflow rate, the net outflow from Grayscale GBTC should not affect Bitcoin price fluctuations for more than two months.

Part 4: ETFs Will Introduce a Broader Range of Investors to Participate in the Crypto Market, Long-Term Positive

Although Grayscale has brought some selling pressure to Bitcoin spot in the short term, looking at all Bitcoin spot ETFs, the three trading days from January 11 to January 16 still brought a net buying of $740 million to Bitcoin, with Blackrock ETF (IBIT) leading with a net inflow of $710 million over three days. After the news on January 16 that Grayscale transferred 9,000 Bitcoins to Coinbase, Bitcoin price quickly rebounded to around $43,000 after a rapid drop, indicating a trend of stabilization.

The underlying reason is that the redemption pressure from Grayscale has a short-term impact on the overall Bitcoin market, while a broader investor base participating in crypto asset investments is the main narrative of the ETF era. As analyzed in the previous section, if investors are merely relocating due to management fee rates, they are expected to buy other Bitcoin ETFs later, which will continue to contribute to Bitcoin buying; investors profiting from the discount will have a neutral impact on Bitcoin. On the other hand, let’s look at the strength of the newly approved Bitcoin spot ETF managers. The approved issuers, such as Blackrock (managing a total of $8.59 trillion in assets), Fidelity (managing $4.5 trillion), and Invesco (managing $1.6 trillion), are all top companies in the global asset management industry. Blackrock, Vanguard, and State Street have even been referred to as the "Big Three," controlling the entire index fund industry in the U.S.; while the entire cryptocurrency market currently stands at only $1.7 trillion. Leading asset management companies are generally considered to have more ample management experience, stricter compliance processes, and stronger loss absorption capabilities, which can enhance investor trust in emerging assets like Bitcoin. Additionally, the well-established global sales channel networks of top brands will help promote this new category of asset, Bitcoin spot ETFs.

Part 5: In the Next Three Months, There Are Three Major Nodes That Are Crucial for the Crypto Market

Arranged by importance as follows:

1/ Bitcoin Halving: Expected in April 2024, the new supply of Bitcoin will be significantly reduced while demand increases with the ETF. Bitcoin ensures that its total supply will never exceed 21 million through a halving mechanism every four years, which will directly lead to a significant reduction in the new supply of Bitcoin. Combined with the approval of Bitcoin ETFs, which has opened the channel for funds to flow into Bitcoin, this brings a large new demand for Bitcoin. On one hand, the new supply of Bitcoin is about to be halved, while on the other hand, demand is continuously increasing. At the same time, the dollar interest rate cut cycle enhances the preference for risk assets, and crypto market investors generally believe that 2024 will usher in a new round of upward trends, commonly referred to as a clear bull market. We can refer to the historical changes in Bitcoin prices within one year after past halvings. Bitcoin was issued in 2009, with a mining output of 50 BTC per block at that time. It has since undergone three halvings. The first halving occurred in November 2012, reducing the mining output from 50 BTC per block to 25 BTC, and the price of Bitcoin rose from $13 to a peak of $1,152 within a year. The second halving occurred in July 2016, further reducing the mining output to 12.5 BTC per block, and the price of Bitcoin rose from $664 to a peak of $17,760. The third halving occurred in May 2020, again halving the mining output to 6.25 BTC per block, and the price of Bitcoin rose from $9,734 to a peak of $67,549. The next halving is expected to occur in April 2024. Additionally, according to a report by Coinshares, the average mining cost per Bitcoin for miners after this halving (excluding one-time mining machine costs, electricity consumption, maintenance costs, etc.) will rise to $37,856.

2/ Ethereum Spot ETF Approval: Expected in May 2024. Institutions such as Blackrock, Fidelity, and Invesco have also applied for Ethereum spot ETFs, with a high likelihood of approval. Following the approval of Bitcoin ETFs, the market is beginning to anticipate that Ethereum ETFs will be approved in May, and prices have already begun to react to this.

3/ Ethereum Cancun Upgrade: Expected in February-March 2024, which will reduce transaction costs on the Ethereum Layer 2 network to one-tenth. The Cancun upgrade for Ethereum may be similar to the iPhone moment for mobile internet. Lower transaction fees and better trading experiences will give rise to more application scenarios that can genuinely serve large-scale users.

Most of the time, people tend to overestimate short-term impacts while underestimating long-term effects. The launch of Bitcoin spot ETFs is a milestone, marking the first step in bringing crypto assets into the core assets of finance. Years later, looking back, this will undoubtedly be a lasting long-term benefit.

New Developments on Bitcoin ETF

Despite mixed and contradictory news regarding the approval process of BlackRock's Bitcoin spot ETF, the market has entered a new round of frenzy as Bitcoin briefly surpassed the $35,000 mark. Will there be further reversals? What other news should be noted?

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