How crypto ETFs can open doors for traditional finance to enter DeFi

Crypto ETFs make it easy to invest in digital assets without the complexities, writes Kevin Tai of Linear Finance. Imagine what a crypto index can do.

Digital assets are becoming too large to ignore. The latest data from CoinMarketCap shows that the market capitalization of the entire industry stands at over $2.3 trillion. And as Bitcoin nears mainstream investment through Bitcoin exchange-traded funds (ETFs), this propelled Bitcoin to reach a record high of more than US$66,000 in October, pushing past its previous all-time high of just under $65,000 back in April.

One of the main reasons for Bitcoin’s recent price surge is that Bitcoin-related ETFs, such as the launch of the ProShares Bitcoin Strategy ETF, the first in the US, are making it easier for anyone to invest in the digital asset without the complexity and required knowledge of crypto investment. But with more institutional and retail investors dipping their toes into cryptocurrencies, crypto ETFs could become a key factor for more traditional investors to enter the decentralized finance (DeFi) market.

What are crypto ETFs and why are they valuable?

A crypto ETF is similar to a fund or an investment vehicle, whereby investors are exposed to a diversified portfolio of crypto tokens. By allowing investors to access the market in this manner means they avoid spending time, gas fees and the effort to allocate their investments. 

Whereas traditional ETFs track an index or a basket of assets, crypto ETFs track one or more crypto assets. Given the skyrocketing price of crypto, in particular Bitcoin, over the last few years, notwithstanding the current dip, crypto ETFs provide an easy to deploy alternative to investors who want to put money into a digital asset.

What are the differences between ETFs and indices offered by TradFi, CeFi and DeFi?

From a methodology and portfolio construction perspective for an ETF, it is quite uniform between TradiFi, CeFi and DeFi — TradFi being traditional finance relating to conventional banks, CeFi, or centralized finance (such as centralized exchanges) that focus on bridging the gap between TradFi and new financial applications, and DeFi, or decentralized finance, which is powered by decentralized apps built on blockchain in a decentralized manner.

However, the major difference lies in investor access. Currently within TradFi, the number of crypto ETFs is very limited. While it’s not an ETF, there is the Grayscale Bitcoin Trust, which enables investors to gain exposure to the price movement of Bitcoin through a traditional investment avenue without needing to worry about the issues of buying, storing, or securing digital assets.  But, in the U.S., we are still awaiting the approval of a true crypto ETF.

Another difference is the tax in ETFs. When an ETF creates and redeems shares, we call it an in-kind transaction that doesn’t generate any taxes. ETF buyers in the U.S. tend to benefit from their tax-efficient structure, but it is important to understand how it works. When an investor sells an ETF at a profit, it is taxable. 

Crypto indices offered by DeFi will draw institutional and retail interest

The U.S. Securities and Exchange Commission’s (SEC) approval of ProShares Bitcoin futures ETF has certainly signaled positive change for the market. Everyone who’s anyone can now easily buy exposure to Bitcoin, and the fact that it took eight years for such a thing to become possible is even more reason to celebrate. Yet, the fund only tracks contracts speculating on the future price of Bitcoin rather than the physical price of it. For existing investors this isn’t an ideal solution, and for others “it’s hard to imagine a less appealing financial product.”

With the view that any type of Bitcoin ETF in the market is not answering market needs, DeFi is catering to this by disrupting and changing TradFi. Whether it’s investments, lending, payments, or trading, the financial ecosystem is being reshaped. Yes, a Bitcoin futures ETF is a significant milestone, but true crypto indices are delivering cost-effective and efficient means of crypto trading along with custody of the underlying assets in a permissionless manner.

These include the likes of Index Coop, a decentralized organization focusing on the creation and adoption of crypto indices, the DeFi Pulse Index, a collaboration between Pulse Inc. and Index Coop, which tracks the performance of Ethereum-based DeFi tokens, Indexed Finance, a decentralized protocol providing exposure to passively-managed crypto index portfolios, PieDAO, an asset management DAO that governs tokenized portfolios, and research houses like Xangle, who have created large cap indices and many more.

The risks of investing in crypto indices

While crypto ETFs provide low-cost access to a number of different asset classes and crypto sectors, there are specific risks that investors should be aware of. Namely that any crypto ETF is subject to market volatility and or industry/sector volatility. There may also be issues with liquidity depending on where crypto ETFs are traded, and in some cases, due to market conditions, tracking errors can be large, which may adversely affect the return on investment (ROI).

Just like crypto ETFs, crypto indices are also subject to market volatility. On top of this, some crypto indices can be at risk if one or more of their components are illiquid. Lack of liquidity may come in many forms; for example, it could be that one of the assets is only listed on a few not-so-popular decentralized exchanges and is subject to price manipulation. Crypto index providers should have a strict liquidity criterion, taking into account factors such as the percentage of token circulating market cap on a DEX and daily trading volume, to name a few.

Crypto ETFs can open doors for investors 

The launch of the first U.S. Bitcoin futures ETF has certainly made waves in and outside the crypto market. Yet, it’ll be down to the crypto ETFs already available, and those yet to come, that will change how people view crypto as a valuable form of investment. Already, many asset management companies are putting in the time and effort seeking approval for crypto ETFs on Wall Street as knowledge remains a barrier to entry.

If the Bitcoin futures ETF is any indication as to the demand it has experienced during its short timespace, once crypto ETFs are approved it will open the doors to mainstream investors purchasing digital assets. Not only because they would receive low-cost access to a number of different asset classes and trust the knowledge and reputation of asset managers and index providers, but because crypto ETFs are answering the needs of the market.