Do We Really Need a 2x Leveraged Bitcoin Futures ETF?

We’ve written in the past about our concerns with a spot bitcoin ETF. To date, the SEC has still refused to approve a spot bitcoin ETF primarily due the lack of a “comprehensive surveillance-sharing agreement with a regulated market of significant size”. In other words, the SEC doesn’t seem to trust the underlying bitcoin exchanges. Considering the recent events at some of the large crypto exchanges, we think it’s safe to say that the SEC is correct in their suspicions.

However, for some reason back in October 2021, the SEC allowed a futures-based bitcoin ETF to list and begin trading.  This made no sense to us because the bitcoin futures that are in this ETF are priced off of the CME CF Bitcoin Reference Rate (BRR) which uses pricing data from multiple bitcoin spot exchanges that do not have surveillance sharing agreements. We believe that the SEC made a major mistake by allowing this product to list since it would likely set precedent for more futures-based bitcoin ETFs.

And this is exactly what happened yesterday when the 2x Bitcoin Strategy ETF (BITX) listed on the Cboe BZX exchange and began trading.  According to the sponsor, Volatility Shares, here is the goal of this new ETF:

“2x Bitcoin Strategy ETF (the “Fund”) seeks daily investment results, before fees and expenses, that correspond to two times (2x) the return of the S&P CME Bitcoin Futures Daily Roll Index (the “Index”) for a single day, not for any other period.”

We read that sentence and all sorts of alarm bells started ringing so we took a closer look at the prospectus and sure enough our suspicions were confirmed with over 10 pages of risk factors which included:

Compounding Risk – The Fund has a single day investment objective, and the Fund’s performance for any other period is the result of its return for each day compounded over the period. The performance of the Fund for periods longer than a single day will very likely differ in amount, and possibly even direction, from twice (2x) of the daily return of the Index for the same period, before accounting for fees and expenses.

Futures Contract Risk – The costs associated with rolling bitcoin futures typically are substantially higher than the costs associated with other futures contracts and may have a significant adverse impact on the performance of the Fund.”

Bitcoin Futures Risk – “The market for bitcoin futures may be less developed, less liquid and more volatile than more established futures markets.

Liquidity Risk – The market for the bitcoin futures contracts is still developing and may be subject to periods of illiquidity.

Leverage Risk – The Fund seeks to achieve and maintain the exposure to the price of bitcoin by using leverage inherent in futures contracts. Therefore, the Fund is subject to leverage risk.

The SEC Knows About the Risks

In addition to this ETF relying on an index based on pricing from crypto exchanges that do not have a comprehensive surveillance sharing agreement, the ETF also has compounding risk which means that investors who hold this ETF for longer than a day will likely experience returns that don’t exactly match the returns of the bitcoin index. The SEC issued an investor bulletin earlier this year on leveraged and inverse ETFs where they warned about this risk:

Why do leveraged and inverse ETFs have extra risks for buy-and-hold investors? 

Most leveraged and inverse ETFs “reset” daily, meaning that they are designed to achieve their stated objectives on a daily basis. Their performance over longer periods of time — over weeks or months or years — can differ significantly from the stated multiple of the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time. This effect can be magnified in volatile markets. As the examples below demonstrate, an ETF that is set up to deliver twice the performance of a benchmark from the close of trading on Day 1 to the close of trading on Day 2 typically will not achieve that goal over weeks, months, or years and may potentially expose investors to significant and sudden losses.

What are some examples?

The following two real-life examples illustrate how returns on a leveraged or inverse ETF over longer periods can differ significantly from the performance (or inverse of the performance) of their underlying index or benchmark during the same period of time.

  • Over four months, a particular index gained 2 percent. However, a leveraged ETF seeking to deliver twice that index’s daily return fell by 6 percent—and an inverse ETF seeking to deliver twice the inverse of the index’s daily return fell by 25 percent.
  • During that same period, an ETF seeking to deliver three times the daily return of a different index fell 53 percent, while the underlying index actually gained around 8 percent. An ETF seeking to deliver three times the inverse of the index’s daily return declined by 90 percent over the same period.

The SEC also issued an investor bulletin back in 2021 and warned about funds trading in bitcoin futures:

Difference in investment outcome. A rise in Bitcoin prices may not result in a similar increase in the value of a fund holding positions in Bitcoin futures contracts. This is in part because funds that trade commodity futures contracts may not have direct exposure to the contracts’ underlying assets. Futures contract prices can vary by delivery months and differ from the underlying commodity’s spot price. Futures contracts also expire periodically, resulting in fluctuations of portfolio exposure as expiring futures positions are typically rolled into new contracts. The value of a particular fund may be affected by this maintenance of futures contract exposure.

Considering these two investor bulletins, we wonder why the SEC didn’t put a stop to this 2x Bitcoin ETF?  Clearly, they know that his product is filled with risks that the average investor will likely overlook. By allowing this product to list, the SEC is just inviting more trouble. We think this means that even more leveraged and inverse leveraged products tied to bitcoin futures will begin to get listed. Can anyone say 5x Inverse Leveraged Bitcoin Futures ETF?