How Bitcoin ETFs Are Changing the Risk-Reward Ratio for Institutional Investors

As expected, the launch of spot Bitcoin exchange-traded funds (ETFs) in the US market has had a major positive impact on the digital asset industry. This created a stampede among retail investors and broke records for investment in bitcoin {{BTC}} and ETFs.

More importantly, being involved in a product approved by the U.S. Securities and Exchange Commission (SEC) changed the risk reward ratio for Bitcoin, bringing crypto back into the institutional investment conversation. This is sparking new interest in some companies and encouraging others to restart paused projects. The door to the mainstream financial system has reopened.

Note: The opinions expressed in this column are those of the author and do not necessarily reflect the views of CoinDesk, Inc. or its owners and affiliates.

3 dimensions of risk

Institutional investors think about risk in many dimensions; some of these include: products, counterparties and risks around the underlying asset. In traditional finance (TradFi) this is all well understood.

Products became commoditized, with many companies offering similar products. Counterparties (market makers, custodians, clearinghouses, etc.) that help absorb trading risk are well known. The different asset classes are also well understood and there are traditional ways of assessing the risks of a particular asset.

Many risks and volatility have been removed from the system over many years. It is the black swan type events that create problems. The risk is low, but so are the rewards. Opportunities to beat the market are hard to find.

What we are seeing in crypto is a series of events that have a negative impact but are predictable given the industry’s lack of regulation and control. The risk of these events occurring is too high for organizations to pursue large rewards.

Reducing risks

Bitcoin ETFs reduce risk in all three dimensions.

ETFs have been available in the US market for over 30 years. Everyone understands the product. Purchasing the asset through a securitized product is easier than purchasing spot Bitcoin outright. Many investors feel that paying management fees is a better way to let someone else handle the custody, settlement risk, and other operational aspects of Bitcoin trading. They no longer have to take these risks directly.

The presence of big brand names like BlackRock, Fidelity and others reduces counterparty risk. There are many crypto-native custodians, liquidity providers and market makers, but they are relatively unknown in the TradFi world.

The story continues

See also: Bitcoin ETFs Also by Steven Cohen’s Point72

ETFs introduce some reliable counterparties in the crypto universe to general investors. Knowing that the major TradFi players do their due diligence on their finances, processes and procedures, and security practices reduces the fear factor. Not only that, but it also shows them who they can turn to for help if they want to hold bitcoin and other digital assets and engage in spot trading in the future.

By approving bitcoin as a core product in the ETF space, the SEC has reduced risk at the underlying level of the asset; namely the fear that cryptocurrency could be banned entirely in the US. Frankly, greater regulatory clarity could further reduce asset risk, but market demand for ETFs has pushed the agency to resolve some key questions. It has also pushed ETF issuers to implement many simple elements that reduce the risk institutional players expect to see.

All these elements create trust in the market, which is crucial for digital assets to continue their journey to the mainstream. There is a lot of ideology, jargon, and technical terms surrounding crypto. But it is essentially another asset class using a different technology.

Before FTX, many people put these risks aside and focused on price appreciation and market access. Post-FTX people say I want in, but I need to know I’m protected at a basic level. ETFs do this by exposing institutional investors to crypto-dependent counterparties. They put the industry back on a positive path.

See also: Bitcoin ETF Holdings Announced by Morgan Stanley

There are two things currently keeping institutions away from digital assets. One is philosophical. They don’t believe in or like Bitcoin or crypto. There is also a second group for whom the risk/reward ratio is still not attractive enough. For these people, the success of ETFs is making it increasingly difficult to stand on the sidelines, especially as customers want crypto products.

The day will come when the main risk with Bitcoin and other digital assets is at the fundamental level of asset performance, just like with TradFi. There will be no single provision or single product that will magically make this happen. This will be a long process, but eventually all questions about products, counterparties and regulations will disappear.

The only question will be: Do you want to invest in digital assets or not?