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Fidelity: Analyze the trade-offs of six ways in which institutional investors deploy Bitcoin

So far, most of the discussion in the institutional investor community has focused on “Why Bitcoin?” If someone does come to the conclusion that Bitcoin is suitable for their investment portfolio, the next logical question is usually “how” to invest in Bitcoin.

In this article, we will discuss the advantages of different investment channels, including third-party custody, passive single asset funds, futures contracts, and actively managed funds.

A core feature of Bitcoin (and digital assets in a broad sense) is that holders can self-custodial assets and have real ownership, so there is no need to trust intermediaries that control assets. However, many institutions with fiduciary duties face regulatory and operational restrictions that prevent them from directly custody of these assets. In addition, as far as the current situation is concerned, self-regulation requires strong security and risk management processes, and some organizations may not be willing to undertake these processes, or they may not have the time and resources to improve these processes.

In order to adapt to this reality, with the increase of institutions’ interest in Bitcoin assets, the channels for investing in Bitcoin have increased significantly. In this article, we focus on the benefits and challenges of multi-channel investment that institutional investors may consider after deciding to allocate asset classes.

Spot trading and custody

Most of Bitcoin’s early infrastructure was built to meet the needs of trivial transactions, and there are fewer options for strong and secure institutional custody solutions. Historically, the lack of institutional-level solutions has always been an obstacle for institutional investors to invest in Bitcoin. In recent years, this challenge has been solved positively. Many digital asset native service providers have launched institutional-focused custody to protect customers’ assets from loss and theft, and to help them fulfill their regulatory and fiduciary duties.

Today, the benefits of obtaining Bitcoin exposure through cooperation with third-party custodians include the maturity of custodial solutions, the relatively low cost of maintaining spot exposure through custodians, and the potential capital efficiency of holding the underlying Bitcoin. . Therefore, spot trading and custody are the most common risk exposure channels. In the 2019-2020 Institutional Investor Survey, we found that about 60% of respondents with exposure to digital assets hold the underlying assets. Below we outline the benefits and considerations that investors need to pay attention to when considering exposure to spot Bitcoin.

Potential benefits

Institutional level trading and custody

In recent years, with the launch of integrated transaction execution and custody solutions specifically designed for institutional clients, the prospects of Bitcoin have matured significantly. These solutions are designed to facilitate the acquisition and long-term storage of Bitcoin by large, regulated investors And protection. Today, digital asset custody operates under a robust operational and regulatory framework. Many custodians regularly conduct operational and security (such as SOC) audits, following the standards of any traditional service provider. They may also hold a state trust license or a national bank license.

The satisfaction of these standards and other requirements set out in the Investment Advisers Act of 1940 have led some regulated entities to interpret certain Bitcoin custodians as qualified custodians. This is important for investors such as registered funds, who must hold investment securities of companies that are qualified custodians. Please note that Bitcoin is not classified as a security, but it is still important to properly match the characteristics of qualified custodial status.

low cost

Another advantage of spot bitcoin exposure is that it is one of the more cost-effective ways to acquire assets due to the relatively low total cost (transaction execution and custody costs) compared to most other methods we discussed. Annual custody fees and fee schedules vary from one provider to another, but most providers have total assets under custody of less than 50 basis points. Depending on the provider, the custody rate may also increase as the total assets of the platform grow. Transaction execution costs include transaction fees and the decline that investors may experience, especially when establishing large positions.

In a hypothetical test, assuming that the price of each bitcoin is $50,000, Coin Metrics estimates that the total transaction cost (transaction fee plus slippage) of $5 million orders executed in a day is 0.175% (higher transaction Cost but lower slip). The cost of executing a $1 billion order in approximately two weeks is 0.225% (higher latency, but lower transaction costs).

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Opportunities to improve capital efficiency

In addition to self-custody, depositing physical bitcoins with the custodian is the most direct way to establish exposure to the asset class. One of the key advantages of access to physical bitcoin is capital efficiency. As Bitcoin becomes more widely accepted as an investable asset, borrowers may increasingly use Bitcoin as collateral to obtain liquidity while maintaining their positions. Lenders may see the value of Bitcoin as collateral because it has certain attractive features, namely, strong liquidity, borderlessness, ease of fast final settlement, and real-time dynamic price.

Precautions

Technical due diligence

In view of the relatively more technical nature of digital asset custody, investors may feel that they are unable to properly communicate with due diligence service providers. For example, they may have difficulty understanding the differences between the hardware security module (HSM) and multi-party computing (MPC) models used to protect assets, or the advantages and disadvantages of integrated custody and isolated custody, and other issues. Therefore, due to gaps in technical knowledge and experience, some organizations may prefer to choose tools that allow them to outsource service provider assessments.

Decentralized mobility

The liquidity of the digital asset market is decentralized. Digital assets like Bitcoin are traded on multiple exchanges around the world, with varying amounts, transparency, security, and regulatory status. This is in sharp contrast with the traditional capital market. In the traditional capital market, transactions take place on a single exchange, and the law requires customers to provide customers with the national best bid and offer (NBBO), or the best available purchase ( Lowest) and sales (highest) price. Bitcoin exchanges are not subject to such requirements, and given the degree of fragmentation, it is unlikely to guarantee “best execution” on all platforms.

However, more and more institutional service providers are launching integrated execution services and smart order routing solutions, which will allow customers to fund a single account and obtain multiple liquidity providers to try better price execution and Improve capital efficiency.

Lack of integration with traditional assets

To a large extent, institutional investors cannot obtain Bitcoin through the same account or platform they use to obtain traditional asset classes. This creates a decentralized experience in managing the risk exposure of different asset classes and brings operational advantages. Challenges (such as taxation and reporting). For investors, being able to integrate Bitcoin assets into traditional investment portfolios and view these assets in a single interface will be a victory. If traditional banks and custodians start to provide digital assets while providing traditional assets by establishing, purchasing, or cooperating with sub-custodians, this may not be so worrying. Factors supporting this trend include interest from institutional customers and potential customers, regulatory support from key institutions such as the OCC, and competitive pressures.

Private placement of passive funds

The private placement of passive funds provides another channel for qualified institutional investors to gain exposure to only long bitcoins. Passive funds are popular because they abstract the complexity of Bitcoin trading and custody and present assets to investors in a familiar structure. The cost of convenience is that the fund not only charges investors transaction and custody fees, but also charges investors management fees. This fee is used not only for fund managers and business, but also for the costs incurred by the fund through its custodians.

Potential benefits

Convenience and legibility

Passive Bitcoin funds used by accredited institutional investors provide a convenient fund structure. Generally speaking, fund distributors can provide physical assets or legal assets and allow the fund to execute transactions on their behalf. Those fund managers who may be better able to analyze the prospects of service providers are also responsible for due diligence and the selection of custody and trading partners. Therefore, the allocator must have a high degree of trust in the fund management company in order to make appropriate decisions related to security, counterparty risk, etc. Passive funds can also provide simplified and easy-to-read tax and reporting benefits.

Accounting at fair value

More and more corporate finance teams are configuring Bitcoin’s balance sheet. One challenge that companies face when investing directly in Bitcoin is the accounting treatment of distributions. In the financial statements of listed companies, direct investment in Bitcoin is regarded as an intangible asset for an indefinite period. Therefore, the investment is written down to the lowest transaction price of Bitcoin in each accounting period, which has a potential adverse effect on the results of generally accepted accounting principles-the current market value of each accounting period is not reflected in the financial statements. By establishing Bitcoin exposure through passive funds, companies can achieve priority accounting treatment, because Bitcoin may be classified as “equity investment”, valued at market value during each fiscal period, and other potential tax and accounting benefits.

Precautions

Passive funds usually charge an annual management fee of 50 to 200 basis points, in addition to costs related to transaction execution, custody, and/or fund management. Therefore, given that fund managers do not provide significant advantages in buying and holding Bitcoin, private equity is a relatively more costly investment method. However, many new players entering the passive fund field are creating healthy competition and putting downward pressure on fees.

Investors should also assess the difference in the frequency and redemption mechanism of passive Bitcoin funds. Investors should determine whether the fund allows daily, weekly or other frequency redemptions. In addition, they should understand whether they can redeem physical bitcoin, cash, or shares on the secondary market, as we will discuss below.

Publicly traded stocks

Investors can also gain exposure to potential price changes in Bitcoin through publicly traded stocks. For example, Grayscale Bitcoin Investment Trust (GBTC) provides investors with an opportunity to gain exposure to Bitcoin through an open private trust. A trust issues stocks that are traded as securities on the open market. These stocks represent the ownership of the trust, and the sole purpose of the trust is to hold Bitcoin and track changes in its basic price.

Although secondary market stocks are open to retail and institutional investors, accredited investors can also participate in daily targeted placements with net asset value (NAV) and sell stocks on the secondary market after a six-month lock-up period.

The main benefit of gaining Bitcoin exposure through publicly traded stocks is that investors do not need to deal with the logistics related to custody, transfer, and acceptance of Bitcoin. They can access risk as easily and conveniently as any other publicly traded securities.

Unlike private passive funds, publicly traded bitcoin exposures not only need to pay a relatively high 2% management fee, but the secondary market may also be traded at a premium or discount due to the lack of communication between the secondary market and traditional bitcoin exchanges. Redemption mechanism, unsynchronized transaction time, and poor liquidity. In the past, the closing price of GBTC was twice the base price of Bitcoin. Since reaching a high of 137% at the end of 2017, the premium of GBTC has recently appeared at a discount to the net asset value. As the competition for structurally similar products heats up, it may be difficult for products like GBTC to obtain the same premium as before.

Bitcoin futures

Investors can also use Bitcoin futures to establish long exposures, hedge spot exposures, or establish neutral risk Bitcoin exposures. Bitcoin futures come in various forms and scales, from highly regulated products offered on familiar platforms to less regulated products with important leverage on overseas platforms.

Regulated cash-settled futures

Potential benefits

Cash-settled Bitcoin futures provided by platforms regulated by the Commodity Futures Trading Commission, such as CME, have become one of the most important products that satisfy the interests of institutions. CME’s cash-settled futures attract financial institutions because they are traded on the same platform as futures contracts for other assets. They are supervised by the same agency that supervises traditional commodity contracts (CFTC), creating a familiar arena.

Another advantage of trading on the Chicago Mercantile Exchange is that the exchange has established ties with futures commission dealers (FCMS), which institutions use to obtain and clear other futures contracts. More than 24 FCMS support Bitcoin futures settlement, including E*Trade, Macquarie, TD Ameritrade and Wedbush. Since FCMS has been integrated, it is easy for them to trade the new cash settlement products offered on the platform. The fact that futures are settled in cash adds another factor of convenience, because exchanges, FCMS and customers do not have to worry about custody issues when physically delivering.

Precautions

The settlement price of spot futures depends on the spot price index. Platforms that provide cash-settled futures must refer to a number of exchanges that are powerful, regulated and not affected by price manipulation.

In addition, cash-settled bitcoin futures usually have a futures premium compared to spot, which means that futures trading is at a premium over spot, and longer-term futures trading has a higher premium than shorter-term futures. Therefore, long-term holding of Bitcoin through futures may be a relatively expensive option, depending on the level of the futures premium. To maintain long-term exposure to Bitcoin through cash-settled futures, it is also necessary to roll the contract before expiration, thereby increasing transaction costs on top of the premium.

Generally speaking, futures contracts are traded at a premium to account for the storage costs of holding the underlying assets (such as physical commodities such as gold or oil). Therefore, Bitcoin futures may be traded at a premium to offset custody costs. A more likely explanation is that institutions facing regulatory or operational restrictions in acquiring spot bitcoins are willing to pay a premium to obtain bitcoin futures.

Although this premium may not be conducive to participants who establish long positions, it may also be a feature of traders who lock in risk-neutral rolling returns by long spot bitcoins (or shorter-term futures) and short longer-term futures.

Regulated physically settled futures

Potential benefits

Physically settled futures deliver Bitcoin to contract buyers when they expire (if the contract is not rolling), which is attractive to institutions that ultimately want to invest in the underlying asset, especially if the contract is provided by a regulated institution . In addition, stakeholders need not worry about potential manipulation of spot exchanges during settlement, just as they might manipulate cash-settled futures.

Precautions

Regulated physically settled futures (volume and open positions) have not yet received the same adoption as regulated cash settled futures. This may be because FCM is unwilling to support these contracts to avoid clearing and settlement of physical Bitcoin transactions. This is an obstacle for institutions whose counterparties may not support these contracts.

Active trading fund

Investors may also find the value of Bitcoin exposure gained through actively managed tools. As a transparent, highly liquid, unstable, and 24-hour trading asset, Bitcoin provides an attractive opportunity for active managers to generate “alpha” on top of regular price behavior. Although Bitcoin cannot adapt to traditional active management, which makes institutional investors abandon active management strategies, Bitcoin provides a unique set of tools that investors can use to evaluate its fundamentals.

Specifically, market participants can obtain more in-depth analysis of Bitcoin data than any other traditional asset. Just as a government statistics agency releases a country’s population and economic data, or a listed company releases quarterly financial statements that disclose growth rates and earnings, Bitcoin provides a real-time global ledger that releases data on network activities and internal economy.

The structure of actively managed Bitcoin instruments usually takes the form of a hedge fund. Expenses usually include management fees (1-2%) and incidental interest (10-20%). The lock-up period is longer than other venture capital instruments, usually 1 to 3 years, redeemed every quarter. Strategies vary, including neutral/hedging and arbitrage strategies. For investors looking for high-quality Bitcoin investment, an active management strategy may be the best path.

Exchange Traded Fund (ETF)

To date, multiple Bitcoin ETF applications including Canada and Brazil have been approved internationally. However, the US Securities and Exchange Commission (SEC) has not yet approved the Bitcoin ETF application. Although the SEC had previously raised a series of issues when it rejected the Bitcoin application, the maturity and institutionalization of Bitcoin custody and trading has led to a new round of Bitcoin ETF applications in the United States.

Potential benefits of ETF

Redemption mechanism

Publicly traded trusts are securities that are usually traded at a premium or discount, because private placement shares have a maturity period of 6 to 12 months, during which they must be locked, causing a disconnect between supply and demand in the secondary market. On the other hand, Bitcoin ETFs can be redeemed and created by authorized participants in real time. When the value of stocks on the secondary market deviates from the net asset value (NAV) held by the fund in real time, the role of authorized participants is to arbitrage ETF stocks.

Approved products

Certain trustees, such as registered investment advisers, want to obtain regulated products that address the operational constraints they may face (for example, products that can simplify reporting and trading on behalf of many clients). As we discussed, one of the best options at the moment is an over-the-counter publicly traded trust that usually deviates from the net asset value. However, some companies may only be authorized or prefer to trade securities on national exchanges with strict reporting requirements, thereby providing more visibility and transparency. Bitcoin ETFs approved by the U.S. Securities and Exchange Commission (SEC) and traded on national exchanges will provide greater protection and transparency than currently available tools.

Ease of use

In addition, Bitcoin ETFs will allow retail and institutional investors to obtain Bitcoin through low-cost secure packaging. For the above reasons, the stock price may be close to the net asset value, which can be obtained through traditional brokerage platforms and financial institutions, without the need to deal with digital asset exchanges and wallet. Greater transparency and ease of use can attract more retail and institutional investors.

The ETF will provide a tool for more conservative retail investors who are uneasy or worried about the appropriate recently reviewed digital asset service providers, while institutional investors may have similar concerns, or may be The available options are limited.

Potential challenges to ETF approval

The SEC raised a number of issues regarding the Bitcoin ETF application previously filed, including concerns about Bitcoin custody, Bitcoin market manipulation and regulation, and whether there is a large-scale Bitcoin market regulated by the United States. Advances in the field of digital assets are rapid, so these issues are worth reassessing.

Bitcoin custody

The safe custody and transaction of Bitcoin has always been a key issue of concern to regulators. In recent years, necessary time has been provided for the establishment of high-quality, sound and safe digital asset custody suitable for institutional participation. Organizations now have a variety of reputable trustees to choose from, and these trustees are demonstrating, iterating, and improving their security and robustness every day.

Manipulation, surveillance and scale of the Bitcoin market

Bitcoin trading is extremely fragmented because exchanges are trading all the time around the world, but they lack the interconnectivity experienced by traditional markets. The development of mature trading venues in the spot market and derivatives market has helped establish a reliable, regulated, and sizable market. As the field continues to grow, we have seen improvements in pricing efficiency, because large traditional market makers have begun to believe that the field is worthy of their participation.

The SEC has not yet commented on the growing number of ETF filings. When the time is right, the relevant decision will help to understand more clearly whether the regulator believes that these previously pointed out concerns have been properly addressed.

in conclusion

As a truly anonymous asset, Bitcoin’s custody structure poses unique challenges for entrusted asset managers. This provides a variety of investment tools for configurators to consider and utilize to gain exposure to Bitcoin. Each option has its own unique trade-offs in terms of hosting, cost, and operational burden, as well as other characteristics that need to be considered.

Over time, these products have become cheaper, easier to use, and more efficient. If the regulator finally approves a more traditional investment product, such as an exchange-traded fund (ETF), it may bring about a more competitive situation, which may greatly benefit the ultimate investor.

Insufficient regulatory transparency and the undesirable nature of some existing investment tools constitute investment barriers, preventing certain potential investors from owning these assets. For those who can analyze the various trade-offs associated with currently available risk exposure channels, and possibly configure them, the current situation gives them the opportunity to stay one step ahead of their peers.

Source link: www.chaincatcher.com

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