It seems inevitable that two of the hottest areas of the investment world would meet up sooner or later. For cryptocurrency enthusiasts and investors looking to capitalize on the growing popularity of exchange-traded funds (ETFs), the possibility of an ETF that tracks bitcoin is the best opportunity for this type of connection. However, there have been growing pains and problems in trying to launch the first bitcoin ETFs. The reason is that bitcoin, the largest cryptocurrency in the world by market cap, remains largely unregulated. Additionally, the U.S. Securities and Exchange Commission (SEC) is hesitant to allow an ETF focused on the new and largely untested cryptocurrency market to make its way to the public.

How Does a Bitcoin ETF Work?

Before we look at the potential benefits and risks of a bitcoin ETF, let's back up a step and go over what a bitcoin ETF is. An ETF is an investment vehicle that tracks the performance of a particular asset or group of assets. ETFs allow investors to diversify their investments without actually owning the assets tracked by an ETF. For those individuals looking to focus only on gains and losses, ETFs provide a simpler alternative to buying and selling individual assets. Further, because many traditional ETFs target larger baskets of names with something in common (a focus on sustainability, for instance, or stocks representing the video game industry and related businesses), they allow investors to easily diversify their holdings.

A bitcoin ETF is one that mimics the price of the most popular digital currency in the world. This allows investors to buy into the ETF without going through the complicated process of trading bitcoin itself. Moreover, because holders of the ETF won't be directly invested in bitcoin itself, they will not have to worry about the complex storage and security procedures required of cryptocurrency investors.

Why Not Just Invest in Bitcoin?

If a bitcoin ETF merely mirrors the price of the cryptocurrency itself, why bother with the middle man? Why not just invest in bitcoin directly? There are several reasons for this. First, as indicated above, investors don't have to bother with the security procedures associated with holding bitcoin and other cryptocurrencies. Further, there is no need to deal with cryptocurrency exchanges in the process; investors can just buy and sell the ETF through traditional exchanges and markets.

There is another crucial benefit to focusing on a bitcoin ETF rather than on bitcoin itself. Because the ETF is an investment vehicle, investors would be able to short sell shares of the ETF if they believe that the price of bitcoin will go down in the future. This is not something that can be done in the traditional cryptocurrency market.

Perhaps most importantly, though, ETFs are much better understood across the investment world than cryptocurrencies, even as digital coins and tokens have become increasingly popular in recent years. An investor looking to get involved in the digital currency space but without the time necessary to learn about all of the ins and outs could focus on trading a vehicle he or she is likely to have a better understanding of already.

The Road to Bitcoin ETF Approval

Firms looking to launch bitcoin ETFs have run into a difficult time with regulatory agencies so far. Cameron and Tyler Winklevoss, famous for their involvement in Facebook, Inc. (FB) and, more recently, for their Gemini digital currency exchange, had their petition to launch a bitcoin ETF called the Winklevoss Bitcoin Trust turned down by the SEC in 2017. The reason for the denial was that bitcoin is traded on largely unregulated exchanges, leaving it susceptible to fraud and manipulation. The Winklevoss brothers did not give up their efforts however; on June 19, 2018, the U.S. Patent and Trademark Office awarded them a patent for a firm called Winklevoss IP LLP for exchange-traded products.

The Winklevosses are not the only cryptocurrency enthusiasts looking to be the first to successfully launch a bitcoin ETF. Cboe Global Markets, Inc. (CBOE), the exchange responsible for bringing about bitcoin futures, hopes that the SEC will permit digital currency-related ETFs, too. Cboe also acquired Bats Global Markets, Inc., the exchange on which the Winklevoss ETF would have been offered.

VanEck and SolidX, a fintech company with projects related to bitcoin, announced plans earlier in 2018 for the VanEck SolidX Bitcoin Trust ETF (XBTC). This ETF would target institutional investors, according to ETF Trends, as it would open with a share price of $200,000. XBTC is designed to track an index related to a group of bitcoin trading desks. The idea is that, by spreading out the focus of the ETF somewhat, XBTC might be able to alleviate the SEC's concerns about funds that are linked to bitcoin itself. VanEck CEO Jan van Eck explained to CoinDesk that he "believe[s] that collectively we will build something that may be better than other constructs currently making their way through the regulatory process. A properly constructed physically-backed bitcoin ETF will be designed to provide exposure to the price of bitcoin, and an insurance component will help protect shareholders against the operational risks of sourcing and holding bitcoin."

The Bottom Line

Although the SEC has so far not approved any digital currency ETFs, investors remain broadly optimistic. A source at the Commodities Futures Trading Commission explained that the chance of a bitcoin ETF being approved in 2018 is "90% at this point." The reason for the shift may have something to do with the fact that "the crypto markets have moderated and regulators have watched the lack of drama surrounding bitcoin futures across several global exchanges."

The SEC has also opened up bitcoin ETF applications to public comments, with the vast majority of commenters voicing their approval for the new product. If and when the first bitcoin ETFs are launched, it's likely that they will see early success, as both cryptocurrency enthusiasts and traditional investors take part. In turn, the rise of bitcoin ETFs could also help to fuel gains in bitcoin as well, and, because many other digital currencies are closely tied to the performance of bitcoin, gains across the cryptocurrency market.

Ultimately, a source at the SEC explains, "U.S. residents are sending money to all sorts of exotic locations to invest in unregulated [cryptocurrency] instruments with absolutely zero recourse for losing every cent they've put at risk ... regulation will begin to solve those issues and keep client assets 'onshore.'"