The ProShares Bitcoin Strategy exchange-traded fund (stock ticker BITO) launched last week to record-breaking acclaim. It hauled in more than $1 billion of assets in just two days, which is the fastest ascent to the billion dollar mark of any exchange-traded fund (ETF) in history. BITO is turning heads. But it’s getting attention for all the wrong reasons.

Bito doesn’t own Bitcoin

We’ll say it again – Bito doesn’t own any actual bitcoin. It owns Bitcoin futures. These are a type of derivative contract. It sounds scary and complicated but it is pretty straightforward.

A future is a contract between two parties to buy and sell something for a specific price at a future date. That’s it! Think of a farmer that wants to sell grain. They need to make at least a certain minimum amount to meet their margins but don’t know what the price of grain will be in six months when they go to harvest. They can enter a futures contract to lock in the price of grain and their margins now.

In this example the farmer owns the underlying asset (grain). But they don’t have to! Anyone could enter a contract to buy or sell grain without owning the actual underlying grain. Enter the world of commodities futures and Wall Street Traders. Enter BITO, the latest iteration of a futures strategy – Bitcoin not required.

You aren’t buying Bitcoin when you purchase BITO. You are buying into contracts that guarantee you a certain amount of Bitcoin at specified prices on specified future dates.

Futures contracts are traded on exchanges

This is a very important detail. Exchanges are safer than two people doing business over a handshake. Exchanges are regulated. They bring together many buyers and sellers, which creates liquidity (i.e. someone standing by with the cash to buy the stuff you want to sell). Exchanges have clearing services to ensure that trades are settled appropriately and that transactions are successful. They are transparent and follow regulated reporting requirements.

This is a great benefit, but its also a downside in BITOs case.

BITO is too big for its own good

Right now, BITO controls more than a fifth of all the outstanding bitcoin futures contracts expiring this month. It owns nearly a third of the Bitcoin contracts expiring next month. That’s enough to move the market.

Investors have two options when a futures contract expires: roll it into a new month’s contract or settle it. Settling requires exchanging the underlying asset. This is a non-starter for an ETF. BITO will take their profit or loss from the expiring contract and roll that into the next month’s contracts – it’s never going to take actual possession of Bitcoin.

Traders can anticipate moves in the bitcoin futures market due solely to how big BITO is. They know a fifth of all contracts are going to be rolled this month and a third will be rolled next month. They can employ tactics in their own accounts that pressure the price of Bitcoin futures. This can negatively impact BITO. The process is called “front running”. Its illegal in most cases but not here. The fact that it’s based on publicly available information makes it legal in this case.

How to manipulate the market (legally, anyway)

Futures contracts are generally more costly when they are further away from maturity. This is because there is generally more uncertainty, and therefore more to trade and speculate on, when something is thirty days from maturity as opposed to two days from maturity. This means that many futures contracts fall in price as they get closer to maturing. This is known as convergence.

The price of a futures contract on its very last day should equal the spot price (i.e. the price to buy the underlying asset right then and there “on the spot”). Why? Because delivery of the underlying asset is the same for both. There is effectively no difference between a futures contract on its expiration date and on the spot delivery. Markets will not allow the same commodity to trade at two different prices at the same place and at the same time.

For BITO, this means they’ll roll a bunch of expiring contracts at a price of $ into new contracts with a price of $$$.

But there’s more to it than that. BITOs size means that there is automatically going to be price pressure on specific contracts at the month’s end due to their need to roll over a good chunk of their portfolio. It doesn’t matter what the underlying price of Bitcoin actually is. Traders know there is going to be a big buyer, so they can purchase in their own accounts ahead of time. This puts upward pressure on the price next month’s futures contracts.

Savvy investors call this exposure “Roll Cost”. The roll cost could be multiple times the actual annual expense ratio of the fund (currently 0.95%). For example, the Roll Cost on bitcoin futures led to a roughly 13 percentage point deficit to the actual 118% return of Bitcoin this year.[1] Tack on the ETF expense ratio and it climbs to about 14%.

Roll Cost cuts both ways

Prices and markets generally rise over time. But its not linear. There are plenty of dips along the way. Commodities prices and Bitcoin can decline. Roll Cost can work to BITOs advantage in this situation. Futures contracts will get cheaper if traders expect the price of Bitcoin to decline in the future. This would change BITOs “roll cost” to a “roll addition” – they profit by rolling a contract for 100 Bitcoin into yet another contract for the same 100 Bitcoin but at a lower price.

Bitcoin is the best performing asset of the last ten years.[2] It could spend the next decade in decline, but we believe there is still some room to run. This would mean that Bitcoin futures are more likely to increase in price than to decrease in price if we’re correct, which would create constant drag for BITO as roll costs eats away at profits.

Buyer Beware

A Bitcoin ETF was inevitable. It’s another step towards mainstream adoption as the cryptocurrency gains steam. But its not a tool built for traditional finance. In fact, it was created to do just the opposite. Putting an ETF wrapper around it makes it a popular choice for traditional brokerage accounts, but this doesn’t make it an efficient form of ownership. Read the fine print and invest accordingly.

[1] Roll cost calculated by Solactive with data from the Horizons Bitcoin Front Month Futures index.

[2] Past performance is no guarantee of future results.

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