ETFs and Bitcoin

Bitcoin and ETFs

Yesterday (20 Oct 2021), the impossible had happened. Bitcoin ETF by ProShares (aka “BITO” ticker)was approved by the SEC under the mutual fund rules, which requires funds to provide investor protection.

On its debut, the ETF recorded the second-best performance in terms of volume traded, touching ~ US$ 1B.

Is the hype justified, though?

Firstly, let’s define quickly what an ETF is. An ETF is an exchange-traded fund, which means that units of funds traded to/from an asset management company can now trade on an exchange just like any other company share. ETFs have gained popularity because of their lean cost structure, with low expense ratios (typically < 1%), attracting significant investor capital.

So why create an ETF for Bitcoin when you could purchase the Bitcoin itself?

BITO is a Bitcoin Futures ETF?

Futures are financial derivative contracts that allow investors to speculate or hedge on the future prices of an underlying asset.

BITO is traded in the New York Stock Exchange (NYSE). Although the interest in this product is genuine, there are some palpable limitations, which may not be immediately felt as necessary:

  • no physical redemption
  • not traded 24/7 (although an alternative trading platform called Blue Ocean is bridging this gap)
  • not custodial
  • not collateralized with real Bitcoin

The ETF is essentially providing exposure to an asset that represents freedom from institutional go-betweens, yet, the hype has obfuscated the urgent need to have assets traded globally and across time zones without stops.

By purchasing this ETF through brokers, not only do investors abandon the idea of managing their finances by self-custodising, but they wouldn’t be able even if they wanted to: futures are not collateralized with Bitcoin. Futures are usually meant to be cash-settled as the primary purpose is to either hedge other positions (most of the time) or speculate.

Several projects in DeFi are tokenizing funds and listing them on decentralized exchanges, creating what are known as decentralized traded funds.

DEXTF is one of these protocols that provide portfolio tokenization capabilities. XTF2s (all fund tickers’ heading starting with this acronym) are collateralized with tokens, redeemable for the same tokens, and most importantly traded 24/7 because decentralized exchanges don’t take rest days.

Additionally, creating XTF2 is a permissionless operation, quickly done in a matter of seconds through the dApp. The platform has recently pushed the rebalancing module (read “The Power of Rebalancing”), enabling funds to be dynamic rather than maintain their fixed allocations.

In summary:

  • physical redemption
  • traded 24/7
  • custodial
  • collateralized with real assets

Investors can create carbon-neutral strategies and tokenize funds by pairing $MCO2 (tokenized carbon offsets) to your favorite tokens.

A first iteration is the green bitcoin.



Capital Structured Tokens

Capital Structured Tokens

In the investment world, the two critical factors that investors consider are risk and return. While everyone wants to fetch the highest return with the lowest risk for their investments, that is never the case. Risk and returns are positively correlated- the higher the risk, the higher the return, and vice versa.


Markowitz theorizes this framework in his Modern Portfolio Theory.


Financial Engineers and Wall Street Stalwarts have tried multiple ways to develop products that provide the best of both worlds (see concept explainer in Newsletter #14). Still, it’s not a one solution fits all situation, and now we have a variety of structured products, optimizing for risk and return but at the expense of transparency.


Structured products are essentially a basket of assets that returns an optimized risk-return profile. A typical structured product is a capital protected note built with two components:

  1. Interest-bearing bond (low risk)
  2. High growth derivative (relatively higher risk)


The lower risk component provides capital protection through its yield, while the riskier derivative sets the participation rate.


The participation rate is the rate at which a note holder gains when the underlying increases in price. 


Fund diversification benefits are delivered when the underlying assets also have a diversified payoff. That means you need to combine different asset classes.  


Bitcoin and crypto have been correctly lumped together as an asset class because Bitcoin had an enormous pricing power over the remaining crypto market. A reality that is changing over time as financial payoffs of different nature is tokenized.


The above tweet is no longer accurate. However, Tradfi may still have the extreme view that crypto is a $ 2.3T market in bubble.


And when these structured product dynamics are applied to crypto, things become more attractive. Investing in crypto may seem appropriate only for degens (abbr for degenerates, read this poetic definition of it here), however volatility is what attracts traders with their capital to grow this space. Everything needs bootstrapping, and to start a new industry, financial volatility provides the best risk-reward environment to get achieve growth for everyone involved.


Volatility however is not great when it comes to the actual consumption of the services that crypto project may provide. In fact it is inversely correlated to its utility. That’s why liquidity providers exist to reduce slippage to trade in and out of assets. Insurance against smart contract bugs and hacks are helping to reduce the risk as we speak. Options markets to provide indeed more avenues of exposure to crypto assets. 


The equivalent of structured products in DeFi are structured tokens. 

The first ever structured token was developed by DEXTF Protocol, that launched the Structured Floor Token (SFT) on ETH. The SFT on ETH returned your original capital if the price was below the strike price at expiration and profit as if you were holding 1:1 ETH if above the strike price.


Today we have a better understanding of what a floor price as evangelized through NFTs on Opensea. SFTs are therefore capped on the downside and unlimited on the upside.


While these may sound like fantastic products, these tokens would be intended only for those investors who want to have:

  • A diversified portfolio and want to protect their principal while still gain exposure to large uponly movements 
  • An exposure to a highly performant cryptocurrency like Ethereum but wouldn’t want to invest in the same directly


So if we look at it at a glance- 

  • Structured tokens are a hybrid investment made up of a bond and an option
  • They offer a relatively higher return considering the risk they mitigate 
  • Structured tokens are a low-risk investment and may receive up to 100% capital protection depending on the market condition and other factors 
  • This product is ideal for investors who wish to enter the crypto markets but are afraid of volatility and the risk it brings with it. 


Bonding Curves

Bond, bonding, bonding curves

Bond, bonding, bonding curves. A quite abstract word, to begin with, is starting to appear more frequently in the DeFi realm.

A bond is a relationship between two parties.

In the context of DeFi, many projects have started to consider using bonding to bootstrap token liquidity and demand more sustainably.

One way of understanding this is that bonding with someone assumes you have a vested interest.

Similarly, a protocol can purchase “liquidity bonds” or “reserve bonds” in exchange for the native token that is sold at a discount to the buyer.

Liquidity bonds are liquidity provider tokens. Reserve bonds are other tokens that are not LP.

The native token purchased is said to have a discounted “bond price”, which vest over a period of time. The cool thing though is that there exists a secondary market for the bonds that can affect the discount that the protocol might offer on the subsequent bond sales.

Bond sales generate profit that can be distributed to stakers.

This is an extremely powerful idea because, with liquidity bonds, the protocol purchases liquidity which means that it owns the pools, ensuring both stability and profitability. All fees generated by trading utilizing the pool are then distributed to stakers.

If compared with liquidity mining, the bonding ensures that interests between the protocol and users are aligned. Liquidity pool tokens are not owned by the users, but they now have exposure to the native tokens that are vesting and compounding if they are also staked.

But bonding curves are also fair…

Yes, bonding curves are also about relationships and specifically between supply and demand.

Bonding curves are used by projects to raise funds, fairly and deterministically, as these are mathematical formula built into smart contracts that have mint and burn functions.

Traders interact with the bonding curve as they buy and sell.

Bonding curves are Automated Market Makers, because the counterparty of a trader is the smart contract, as opposed to another trader as it works with orderbook-based exchanges where bid and ask has to be matched by a centralized party. It’s also fair because, at any time of the process, anyone can determine the price at which the token is going to sell. When token supply is low, the price is also low. Price increases deterministically as more tokens are minted, providing the early birds a sizable return.

Despite the price automation, the curve can be customized and include fees that can then be used by the protocol to bootstrap liquidity or community initiatives.

Fees can be charged on:

  • spreads between buy and sell
  • swaps (against ETH or stablecoins)
  • transaction fees with the bonding curve



What are synthetics?

Synthetics are derivative assets whose value can be custom-built to mimic a particular situation.

We refer to a situation because a situation can either be temporary or persistent, in which case we say that something expires or it doesn’t.

Options are synthetics as we say these can be written and sold.

If you wanted to take a position on 1 BTC without forking out 55k, you could long a call and sell a put at the same strike of, say 55k.

In this situation, by longing a call with strike 55k, you’d be purchasing BTC if the spot price is greater than 55k. Conversely, by selling a put, you’re still long on BTC because the put buyer will be short (as he/she hopes to gain a profit if prices fall, while you wish to cash in on the premium). Therefore, if the price fall below 55k, the put buyer will sell the BTC to you at 55k. In both cases, you end up with BTC at 55k by paying the difference between the premium received (selling the put) and premium paid (purchasing call).

Options are just an example of the potential of synthetics. Issuing synthetic assets is no longer the prerogative of investment bankers. Anyone with an internet connection can create synthetic assets without knowing anything other than the price of the asset it’s tracking.

In crypto, several projects have figured out that by locking some collateral capital, you can guarantee the creation of any asset that you can imagine. What used to be a thought experiment is now a reality; you can gain exposure to gold, FX, real-world stocks without the need of a broker that necessarily follows an opening and closing time. However, a synthetic asset position does not give you, on first analysis, the same peace of mind that an actual spot position gives you. You can hold a spot position for as long as you need, while a synthetic position can be liquidated if undercollateralized or if it expires when overdue.

Collateralization drives DeFi value capture, as it represents the value locked in a protocol/platform.

While a relatively big over-collateralization ratio minimizes systemic risks, it might not be sufficient to withstand the violent price action in crypto. This is especially true when the collateral is different from the asset it’s tracking.

Imagine if you have a synthetic position on BTC that you can mint by collateralizing ETH. Let’s assume that the collateral ratio is 2. For every BTC you mint, you need to deposit 110k in ETH.

Now you have 1 BTC.

Suppose that next week BTC goes to 100k while ETH suffers and halves in price. Your collateral suddenly is valued at 55k, but your synthetic BTC is now worth 100k. The collateral ratio has fallen, and now you need 200k to guarantee that the synthetic BTC is liquid if you want to cash out. How do you mitigate this issue? Collateral could be converted to BTC if it falls below a certain threshold, stopping the collateral bleeding.

Synthetics is an up-and-coming section of DeFi as its value derives from composability through payoff engineering. As a result, incentive schemes can be built for example, to align a community around achieving a certain TVL on a platform by distributing synthetic rewards that have binary payoffs based on whether a target is achieved or not.

Although use cases are not limited to trading assets, you could build a contract with its conditions tied to payoffs that incentivize the parties to comply with the agreement through oracles that observe the state of the world.

Therefore, synthetic assets are a compelling human invention that seeks to create what exists but are too expensive to buy outright and arguably makes abundant what is scarce.