XBTF: Question & AnswerKyle DaCruz, Director, Digital Assets ProductNovember 19, 2021
Since its release in 2009, Bitcoin adoption has grown exponentially, with tens of millions of owners, and access provided by mainstream investment firms and payment applications. As Bitcoin’s popularity and usage skyrocketed, investors have demanded access to this emerging asset via a more traditional wrapper, such as an ETF. VanEck is proud to have played a key role in educating investors on the benefits of an ETF access vehicle for those wanting to participate in the Bitcoin investment story. This blog is intended to answer frequently asked questions about investing in Bitcoin futures and, more specifically, the VanEck Bitcoin Strategy ETF (XBTF).
- Q: What differentiates VanEck Bitcoin Strategy ETF from other methods of Bitcoin investment available to U.S. investors?
- Q: What are futures contracts?
- Q: What makes up the total return of futures contracts?
- Q: What is contango?
- Q: What is backwardation?
- Q: What are the benefits of Bitcoin futures?
- Q: What are some drawbacks of Bitcoin futures?
- Q: What is the relationship between Bitcoin futures and the underlying spot market?
- Q: On which exchange is Bitcoin futures listed?
- Q: What are the Bitcoin contract specifications?
- Q: How are Bitcoin futures ETFs taxed?
- Q: What is the difference between a RIC and a C-Corp as it relates to ETF tax structure?
- Q: Why did VanEck choose to go with a C-Corp structure?
Q: What differentiates VanEck Bitcoin Strategy ETF from other methods of Bitcoin investment available to U.S. investors?
A: The VanEck Bitcoin Strategy ETF provides investors access to Bitcoin futures in an ETF wrapper, allowing both retail and institutional investors to participate in Bitcoin’s price action within the traditional, regulated ETF structure and available in brokerage accounts.
Three other ways that investors can currently access Bitcoin in the U.S. are described below, along with their respective drawbacks.
Direct Bitcoin investment:
- No clearing mechanism when purchasing Bitcoin directly. Purchases and sales inherently entail counterparty risk.
- There is no traditional custodian for Bitcoin. Direct ownership requires either self-custody, which creates operational risk and is impractical for many investors or storage with a third party, creating ongoing counterparty risk (i.e., counterparty risk extending through the entire life of the investment, not just the purchase or sale).
- Cannot be bought or sold in traditional brokerage or prime broker accounts; requires establishing an account with a Bitcoin exchange or OTC counterparty.
OTC listed vehicles:
- Over-the-counter (OTC) vehicles are traded directly between counterparties without being listed on an exchange.
- Many of the OTC listed vehicles do not allow for direct daily creation and redemption activity.
- Bitcoin-focused OTC listed vehicles have historically experienced steep premiums, which means performance can deviate significantly from the price of Bitcoin.
- Liquidity is inherently limited and cannot easily increase because there are no continuous creates.
Crypto hedge funds:
- A hedge fund is a pooled investment fund that is able to make use of more complex trading and portfolio construction strategies. Generally speaking, hedge funds require a higher initial investment from investors when compared to ETFs, and may require a lock-up period for assets invested.
- Full reliance on the hedge fund to mitigate operational risk, counterparty risk, and custody concerns.
- No on-demand redemption, which may raise issues for institutional investors.
- Complex fee structures, which may include high performance fees.
Q: What are futures contracts?
A: Futures contracts are financial instruments whereby two parties agree to buy and sell an asset of specific quantity at a predetermined price, and at a specific date in the future.
All futures contracts have a specified time at which they expire (expiry date). Prior to this date, traders have a number of options to either close out or extend their open positions without holding the trade to expiration, but some traders will choose to hold the contract and go to settlement.
Futures contracts allow investors to speculate on the direction of a security, commodity or other financial instrument. Futures can also be used to hedge the price movements of underlying assets to help prevent losses from unfavorable price changes.
Q: What makes up the total return of futures contracts?
A: The total return of futures contracts are made up of three components:
- Spot return: Measures the price movement of the underlying physical commodities.
- Roll yield: The positive or negative contribution caused by rolling the contracts from one futures contract to a longer-dates contract.
- Cash yield: Interest earned on assets held in cash, as collateral for futures contracts.
Q: What is contango?
A: Contango occurs when the price of a futures contract is above the expected future spot price at the time the contract expires (i.e. futures prices are falling, seller benefits).
Q: What is backwardation?
A: Backwardation occurs when the price of a futures contract is below the expected future spot price at the time the contract expires (i.e. futures prices are rising, buyer benefits).
Q: What are the benefits of Bitcoin futures?
A: CME Bitcoin futures provide investors exposure to the price of Bitcoin without the need to hold the underlying asset. CME Bitcoin futures contracts are cash-settled and thus do not require investors to receive delivery of Bitcoin were contracts to expire without being rolled. Additionally, CME is regulated by the Commodity Futures Trading Commission (CFTC).
Q: What are some drawbacks of Bitcoin futures?
A: Over the past few years, CME Bitcoin Futures markets have been in contango leading to negative roll yield, which leads to lower returns for the holders of Bitcoin futures contracts versus the underlying spot price of Bitcoin.
Rolling from front month contract to the next month when forward prices are higher will lead to negative roll costs. This roll process has detracted approximately 10% YTD* from returns versus the spot price of Bitcoin.
*Source: Bloomberg, Morningstar. Data as of October 2021.
Q: What is the relationship between Bitcoin futures and the underlying spot market?
A: CME Bitcoin futures are based on the CME CF Bitcoin Reference Rate (BRR), which aggregates Bitcoin trading activity across major Bitcoin spot exchanges between 3:00 p.m. and 4:00 PM London time.
Q: On which exchange is Bitcoin futures listed?
A: Bitcoin futures are listed and cleared on CME, a U.S.-Registered designated contract market (DCM) and derivatives clearing organization (DCO). CME is regulated by the Commodity Futures Trading Commission (CFTC).
Q: What are the Bitcoin contract specifications?
A: Each Bitcoin contract on the CME represents five Bitcoins. The contract is priced in U.S. dollars and cents per Bitcoin, and uses the CME CF Bitcoin Reference Rate (BRR) as the pricing source on the contracts.
Q: How are Bitcoin futures ETFs taxed?
A fund built to invest in Bitcoin futures presents unique challenges that upend the typical way mutual funds and ETFs are structured. VanEck Bitcoin Strategy ETF was built to be as cost and tax efficient as possible for long-term investors.
The typical mutual fund and ETF are structured as a Regulated Investment Company (“RIC”) for tax purposes. Assuming they satisfy certain conditions for diversification, types of income earned and distributions, any income earned is “passed-through” to shareholders to be taxed at the individual investor’s tax rate. Income and gains from Bitcoin futures are treated as non- qualifying income / gains for RICs by the Internal Revenue Service. In order for an ETF to qualify as a RIC, it must generate 90% of its income from qualifying sources.
Accordingly, RICs that invest in Bitcoin futures typically need to do so through a Cayman subsidiary in order to qualify as a RIC. Investing through a Cayman subsidiary allows the fund to treat the income and gains earned by that subsidiary as qualifying income for purposes of the RIC requirements even if those investments would not generate qualifying income if invested in by the fund itself. However, investing through a Cayman subsidiary results in other adverse tax consequences regarding how distributions and losses on Bitcoin futures are treated for tax purposes.
The alternative is to be classified and taxed as a corporation, a “C-Corp”. This obligates the fund to pay taxes at the entity level and at corporate tax rates instead of just passing all of its income and gains through to investors. A C-corp fund is also required to distribute its earnings from income and short term capital gains to shareholders in order to avoid additional layers of tax. However, there may be several benefits available to a C-Corp investor that may outweigh the impact of two-level taxation.
Q: What is the difference between a RIC and a C-Corp as it relates to ETF tax structure?
A: While there are several differences between a RIC and C-Corp, those that impact taxation primarily fall into three categories:
- Fund level vs pass-through taxation: While C-Corps must pay corporate taxes at the fund level, RICs avoid this and pass through taxable distributions investors.
- Treatment of capital losses: A significant benefit to the treatment of C-Corps is their ability to carry forward capital losses to offset future investment gains. Similarly, in the event of a loss, a C-Corp can also reclaim taxes paid on gains in prior years. RICs that invest in Bitcoin futures through a Cayman subsidiary are unable to take advantage of this treatment, thus investors must pay current tax on all gains earned during years of positive returns regardless of losses from prior periods.
- Distributions: Both structures are required to make distributions, however a C-Corp may distribute income and short term capital gains on a one-year lag and is not required to distribute earnings from long-term capital gains. Additionally, C-Corp distributions are Qualified Dividend Income (QDI) eligible and are taxed at the same rates as long-term capital gains. On the other hand, RIC distributions from income and gains on Bitcoin futures are taxed at investor’s ordinary income rates which can be as high as 37%. C-Corp distributions are also Dividends Received Deduction (DRD) eligible, meaning that corporations that invest in a fund that elects to be treated as a C-Corp may deduct 50% of its distributions from its income tax.
Q: Why did VanEck choose to go with a C-Corp structure?
A: Bitcoin is known not only for its dramatic price appreciation but also for wide price swings. Investors looking to gain long-term exposure to Bitcoin via an ETF that invests in Bitcoin futures may find that one structured as a C-Corp may offer a better after- tax return experience. This tax efficiency may be realized by utilizing the carry forward and carry back of capital losses and by making QDI and DRD eligible distributions, and deferring these distributions to the following year. Similarly to a RIC, investors can expect to receive form 1099’s at year-end.
The value of Bitcoin and the Fund’s Bitcoin Futures holdings, could decline rapidly, including to zero. You should be prepared to lose your entire investment. The Fund does not invest in Bitcoin or other digital assets directly.
The further development and acceptance of the Bitcoin network, which is part of a new and rapidly changing industry, is subject to a variety of factors that are difficult to evaluate, the slowing, stopping or reversing of the development or acceptance of the Bitcoin network may adversely affect the price of Bitcoin and therefore cause the Fund to suffer losses, regulatory changes or actions may alter the nature of an investment in Bitcoin or restrict the use of Bitcoin or the operations of the Bitcoin network or venues on which Bitcoin trades in a manner that adversely affects the price of Bitcoin and, therefore, the Fund’s Bitcoin Futures. Bitcoin generally operates without central authority (such as a bank) and is not backed by any government, Bitcoin is not legal tender and federal, state and/or foreign governments may restrict the use and exchange of Bitcoin, and regulation in the United States is still developing.
Futures Contract Risk. The use of futures contracts involves risks that are in addition to, and potentially greater than, the risks of investing directly in securities and other more traditional assets. The market for Bitcoin Futures may be less developed, and potentially less liquid and more volatile, than more established futures markets. Bitcoin Futures are subject to collateral requirements and daily limits that may limit the Fund’s ability to achieve its target exposure. Margin requirements for Bitcoin Futures traded on the Chicago Mercantile Exchange (“CME”) may be substantially higher than margin requirements for many other types of futures contracts. Futures contracts exhibit “futures basis,” which refers to the difference between the current market value of the underlying Bitcoin (the “spot” price) and the price of the cash-settled futures contracts.
This risk may be adversely affected by “negative roll yields” in “contango” markets. The Fund will “roll” out of one futures contract as the expiration date approaches and into another futures contract on Bitcoin with a later expiration date. The “rolling” feature creates the potential for a significant negative effect on the Fund’s performance that is independent of the performance of the spot prices of the Bitcoin. A market where futures prices are generally greater than spot prices is referred to as a “contango” market. Therefore, if the futures market for a given commodity is in contango, then the value of a futures contract on that commodity would tend to decline over time (assuming the spot price remains unchanged), because the higher futures price would fall as it converges to the lower spot price by expiration. Extended period of contango may cause significant and sustained losses.
An investment in the Fund may be subject to risks which include, among others market and volatility, investment, futures contract, derivatives, investments related to Bitcoin and Bitcoin futures, derivatives, counterparty, investment capacity, target exposure and rebalancing, borrowing and leverage, indirect investment, credit, interest rate, illiquidity, investing in other investment companies, management, new fund, non-diversified, operational, portfolio turnover, regulatory, repurchase agreements, tax, of cash transactions, authorized participant concentration, no guarantee of active trading market, trading issues, fund shares trading, premium/discount and liquidity of fund shares, U.S. government securities, debt securities, municipal securities, money market funds, securitized/asset-backed securities, and sovereign bond risks, all of which could significantly and adversely affect the value of an investment in the Fund.
Investing involves substantial risk and high volatility, including possible loss of principal. An investor should consider the investment objective, risks, charges and expenses of a Fund carefully before investing. To obtain a prospectus and summary prospectus, which contain this and other information, call 800.826.2333 or visit vaneck.com. Please read the prospectus and summary prospectus carefully before investing.
Cryptocurrency is a digital representation of value that functions as a medium of exchange, a unit of account, or a store of value, but it does not have legal tender status. Cryptocurrencies are sometimes exchanged for U.S. dollars or other currencies around the world, but they are not generally backed or supported by any government or central bank. Their value is completely derived by market forces of supply and demand, and they are more volatile than traditional currencies. The value of cryptocurrency may be derived from the continued willingness of market participants to exchange fiat currency for cryptocurrency, which may result in the potential for permanent and total loss of value of a particular cryptocurrency should the market for that cryptocurrency disappear. Cryptocurrencies are not covered by either FDIC or SIPC insurance. Legislative and regulatory changes or actions at the state, federal, or international level may adversely affect the use, transfer, exchange, and value of cryptocurrency.
Investing in cryptocurrencies comes with a number of risks, including volatile market price swings or flash crashes, market manipulation, and cybersecurity risks. In addition, cryptocurrency markets and exchanges are not regulated with the same controls or customer protections available in equity, option, futures, or foreign exchange investing. There is no assurance that a person who accepts a cryptocurrency as payment today will continue to do so in the future.
Investors should conduct extensive research into the legitimacy of each individual cryptocurrency, including its platform, before investing. The features, functions, characteristics, operation, use and other properties of the specific cryptocurrency may be complex, technical, or difficult to understand or evaluate. The cryptocurrency may be vulnerable to attacks on the security, integrity or operation, including attacks using computing power sufficient to overwhelm the normal operation of the cryptocurrency’s blockchain or other underlying technology. Some cryptocurrency transactions will be deemed to be made when recorded on a public ledger, which is not necessarily the date or time that a transaction may have been initiated.
- Investors must have the financial ability, sophistication and willingness to bear the risks of an investment and a potential total loss of their entire investment in cryptocurrency.
- An investment in cryptocurrency is not suitable or desirable for all investors.
- Cryptocurrency has limited operating history or performance.
- Fees and expenses associated with a cryptocurrency investment may be substantial.
There may be risks posed by the lack of regulation for cryptocurrencies and any future regulatory developments could affect the viability and expansion of the use of cryptocurrencies. Investors should conduct extensive research before investing in cryptocurrencies.
Information provided by Van Eck is not intended to be, nor should it be construed as financial, tax or legal advice. It is not a recommendation to buy or sell an interest in cryptocurrencies.
Authored byKyle DaCruz
Director, Digital Assets Product