How do Bitcoin ETFs change the risk-reward ratio for institutional investors?

Author: Steve Scott, CoinDesk; Compiler: Deng Tong, Golden Finance

As expected, the launch of spot Bitcoin exchange-traded funds (ETFs) in the U.S. market had a huge positive impact on the digital asset industry. It triggered a stampede of retail investors and set investment records for Bitcoin (BTC) and ETFs.

More importantly, becoming an SEC-approved product changed the risk-reward profile of Bitcoin, bringing the cryptocurrency back into the institutional investment conversation. This has sparked new interest in some companies and encouraged others to restart suspended projects. The door to the mainstream financial system has been reopened.

Three Dimensions of Risk

Institutional investors consider risk from multiple dimensions, including: the risk of the product, the counterparty, and the underlying asset itself. In traditional finance (TradFi), all of this is well understood.

These products have become commoditized, with many companies offering similar products. The counterparties that help absorb the risk of a transaction - market makers, custodians, clearing houses, etc. are well known. The different asset classes are also well understood, and there are some time-honored methods for assessing the risk of a particular asset.

A lot of risk and volatility has been removed from the system over the years. It's the black swan events that cause problems. The risk is low, but the reward is also low. The opportunity to beat the market is hard to find.

What we've seen in the crypto space is a series of events that have had a negative impact, but these events were predictable given the lack of regulation and control in the industry. The risk of these events happening is too high for institutions to pursue huge returns.

Reduce Risk

Bitcoin ETFs reduce risk on all three fronts.

ETFs have been in the US market for more than 30 years. Everyone understands the product. Buying assets in a securitized product is simpler than buying spot Bitcoin directly. Many investors believe that paying management fees and letting someone else handle custody, settlement risk and other operational aspects of Bitcoin trading is a better route. They no longer have to bear these risks directly.

The presence of big brands such as BlackRock, Fidelity, etc. reduces counterparty risk. There are many crypto-native custodians, liquidity providers and market makers, but they are relatively unknown in the world of TradFi.

ETFs introduce ordinary investors to some of the trusted counterparties in the crypto space. Knowing that the large TradFi players have done due diligence on their finances, processes and procedures, and security practices reduces the fear factor. Not only that, it also shows them who they can turn to for help if they want to hold Bitcoin and other digital assets and conduct spot trading themselves in the future.

By approving Bitcoin as a base product in the ETF space, the SEC has reduced the risk of the asset at a fundamental level - namely the fear that cryptocurrencies could be banned entirely in the U.S. Obviously greater regulatory clarity can further reduce the risk of assets, but the market demand for ETFs has prompted the agency to address some important issues. It has also prompted ETF issuers to put in place many common elements to reduce the risks that institutional players expect to see.

All of these factors build market trust, which is essential to reviving the journey of digital assets into the mainstream. There is a lot of ideology, jargon, and technical terms around cryptocurrencies. But at its core it is just another asset class using different technology.

Before FTX, a lot of people put these risks aside and focused on price appreciation and getting into the market. After FTX was launched, people said, I want to participate in this, but I need to know that I am protected at a fundamental level. ETFs do that while giving institutional investors exposure to dependent counterparties in the cryptocurrency space. They have put the industry back on track.

There are two things that are keeping institutions away from digital assets right now. One is philosophical. They don’t believe in or like Bitcoin or cryptocurrencies. Then there is a second camp for whom the risk/reward ratio is still not attractive enough. For these people, the success of ETFs makes it increasingly difficult to sit on the sidelines, especially when clients demand crypto products.

One day, the main risk in Bitcoin and other digital assets will appear at the fundamental level of asset performance - just as it is the case in TradFi. It won’t be one ruling or one product that will magically make this happen. It will be a long process, but eventually all the questions about products, counterparties and regulations will disappear.

The only question is, do you want to invest in digital assets?