The US Securities and Exchange Commission (SEC) approved the listing and trading of multiple exchange-traded products (ETPs) holding direct (spot) interests in bitcoin and ether. This landmark decision represents a significant regulatory milestone, offering investors new avenues to gain exposure to major crypto assets through traditional financial instruments. These ETPs provide a potentially more accessible and convenient method for investing in digital currencies, whether for individual or institutional portfolios.
This article explores the structure, benefits, tax implications, and future outlook of these newly approved investment vehicles.
The Regulatory Breakthrough for Crypto ETPs
On January 10, 2024, the SEC approved the first wave of spot bitcoin ETPs for listing and trading in the United States. This decision marked a pivotal shift from the agency’s previous stance, which had consistently denied such applications since 2018 due to concerns over market manipulation, investor protection, and the lack of surveillance-sharing agreements with regulated crypto markets.
The path to approval was influenced by a significant legal development. In August 2023, the US Court of Appeals for the District of Columbia Circuit vacated an earlier SEC denial of a spot bitcoin ETP application, finding the agency’s reasoning inconsistent with its approval of bitcoin futures-based products. This court ruling effectively compelled the SEC to reevaluate its position, leading to the historic January approvals.
Shortly after the bitcoin ETP approvals, the SEC also greenlit the listing of spot ether ETPs, further expanding the ecosystem of crypto-based exchange-traded products.
ETF vs. ETP: Key Differences Explained
While the terms are often used interchangeably, there are crucial legal and structural differences between an Exchange-Traded Fund (ETF) and an Exchange-Traded Product (ETP).
An ETF is a specific type of investment company registered under the Investment Company Act of 1940 ('40 Act). It issues shares that are traded on exchanges, and its operations involve authorized participants (APs) who create and redeem shares directly with the fund, typically in-kind (exchanging securities for ETF shares).
The newly approved spot crypto products, however, are not ETFs. They are ETPs registered under the Securities Act of 1933 ('33 Act). This distinction arises because bitcoin is not classified as a security by the SEC. Consequently, these trusts operate under a different regulatory framework.
A critical operational difference is that these spot crypto ETPs use a cash create and redeem process. Unlike traditional ETFs, where APs exchange a basket of securities for shares, the APs here use cash. The ETP sponsor then uses that cash to buy or sell the underlying digital asset (bitcoin or ether) to fulfill the creation or redemption. This cash-only mechanism was a specific requirement from the SEC during the approval process.
Furthermore, the sponsors of these ETPs are not registered as investment advisers under the Investment Advisers Act of 1940, meaning they are not subject to the same custody rules as traditional ETF advisers. Their reporting requirements also differ, filing annual (10-K) and quarterly (10-Q) reports like a public company, rather than the forms required of investment companies.
How Spot Crypto ETPs Are Structured and Taxed
For U.S. federal income tax purposes, both bitcoin and ether spot ETPs are structured to be treated as grantor trusts. This status is critical for their tax efficiency.
A grantor trust has a single class of ownership interest, and the trustees have no power to vary the investments of the trust. This structure allows the ETP to avoid entity-level taxation. Instead, the tax obligations "flow through" to the individual shareholders, who are responsible for reporting gains, losses, and income on their own tax returns.
While sponsors have obtained legal opinions supporting this grantor trust status, they uniformly disclose that the Internal Revenue Service (IRS) could potentially challenge this treatment. If successful, such a challenge could result in the ETP being classified as a publicly traded partnership subject to corporate-level tax, significantly altering its tax implications.
A notable feature absent from the first wave of ether ETPs is staking. Initial applications included plans to stake the underlying ETH to generate rewards for investors, but this feature was removed prior to SEC approval. The ability to stake could complicate the grantor trust status, as it might be viewed as the trustee "varying the investment." There is also significant tax uncertainty around the character and sourcing of staking rewards, creating potential complications for both domestic and foreign investors.
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A Look at Futures-Based Crypto ETFs
Prior to the spot ETP approvals, the main way to gain crypto exposure through a traditional security was via futures-based ETFs. These funds, which hold bitcoin or ether futures contracts traded on the Chicago Mercantile Exchange (CME), are structured differently.
Because they hold derivatives with varying expiration dates and collateral requirements, futures ETFs cannot qualify as grantor trusts. Instead, most are registered under the '40 Act and elect to be taxed as Regulated Investment Companies (RICs).
The RIC structure presents several challenges for crypto futures:
- Income Source Test: RICs must derive at least 90% of their income from securities, which likely excludes income from crypto futures. To circumvent this, many funds hold futures in a Cayman Islands subsidiary, a Controlled Foreign Corporation (CFC), which creates complex tax implications.
- Concentration Limits: RICs cannot invest more than 25% of assets in a single security. Managing this limit with a highly volatile asset like crypto can force the fund to trade inefficiently, potentially creating a drag on returns.
- Tax Whipsaw: A major drawback is that net losses in a subsidiary cannot be carried forward to offset future gains. This can force the ETF to distribute taxable dividends to shareholders even in years when the overall value of their investment has decreased.
Why Consider Investing in a Spot Crypto ETP?
Given that these ETPs charge management fees, a logical question is: why invest through one instead of buying bitcoin or ether directly?
For many investors, direct ownership involves navigating digital asset exchanges, arranging secure self-custody of private keys, or paying fees to third-party custodians. This process can be a barrier for those unfamiliar with blockchain technology or concerned with security risks.
Spot ETPs offer a familiar and convenient alternative:
- Access in Retirement Accounts: They enable exposure to crypto within traditional retirement vehicles like IRAs and 401(k)s, which typically cannot hold digital assets directly.
- Simplified Access: Investors can buy and sell shares through their existing brokerage accounts, eliminating the need to manage private keys or use new platforms.
- Institutional Safeguarding: The model delegates the complex custody and security of the underlying assets to established, qualified institutions.
While not for everyone, spot ETPs significantly lower the barrier to entry, opening the crypto market to a broader audience of investors who prefer traditional financial channels.
Future Outlook and Potential Challenges
The approval of spot crypto ETPs is a major step toward the integration of digital assets into the mainstream financial system. However, several challenges could impact their long-term viability and success.
The requirement for a cash-only create/redeem process is a primary industry concern. Unlike commodity trusts for gold or silver that allow in-kind transactions, the cash mechanism can lead to wider spreads between the ETP's market price and its Net Asset Value (NAV). This can increase transaction costs and price volatility, potentially disincentivizing authorized participants and making direct coin ownership more attractive.
The absence of staking for ether ETPs is another significant hurdle. Staking rewards are a key component of the yield potential for holding ether directly. If ETPs cannot offer this feature, it may put them at a competitive disadvantage and challenge their appeal to yield-seeking investors.
Market reception has been mixed. The launch of ether ETPs in July 2024 initially saw net outflows, as some investors migrated from existing over-the-counter products to the new exchange-listed ones. The long-term flows will depend on investor appetite, product features, and overall crypto market conditions.
Frequently Asked Questions
What is the difference between a Bitcoin ETF and a Bitcoin ETP?
The key difference is their regulatory structure. A Bitcoin ETF would be registered under the Investment Company Act of 1940. The approved spot bitcoin products are ETPs registered under the Securities Act of 1933. This is primarily because bitcoin is not considered a security. This leads to differences in creation/redemption processes, reporting requirements, and custody rules.
How are spot crypto ETPs taxed?
They are designed to be treated as grantor trusts for U.S. federal income tax purposes. This means the trust itself is not taxed at the entity level. Instead, shareholders are responsible for reporting their share of the trust's gains, losses, and income on their individual tax returns, similar to owning the asset directly.
Why can't the ether ETPs offer staking?
Staking was included in initial applications but removed prior to SEC approval. The reasons are likely twofold: regulatory uncertainty from the SEC regarding staking and potential tax complications. Staking could be viewed as "varying the investment," which might jeopardize the ETP's qualifying grantor trust status and create complex tax reporting for staking rewards.
Can I buy a spot bitcoin ETP in my IRA?
Yes, one of the primary advantages of these products is that they can be held in traditional retirement accounts like IRAs and 401(k)s, which generally do not allow for direct ownership of cryptocurrencies.
What are the risks of investing in a futures-based crypto ETF instead of a spot ETP?
Futures-based ETFs can suffer from "tracking error," meaning their performance may not perfectly mirror the spot price of bitcoin due to the structure of futures contracts. They can also be less tax-efficient due to their corporate structure and may be forced to distribute taxable dividends even when the fund's value is down.
Conclusion
The SEC's approval of spot bitcoin and ether ETPs is a transformative event for the financial markets. It provides a regulated, accessible, and familiar vehicle for a wide range of investors to gain exposure to leading digital assets. While futures-based products paved the way, spot ETPs offer a more direct and potentially more efficient investment path.
However, investors must carefully consider the unique structures, tax implications, and ongoing challenges—such as the cash creation process and the lack of staking—before investing. As the regulatory landscape continues to evolve, these products represent a significant, yet developing, chapter in the integration of cryptocurrency into traditional finance.