Institutional top of mind | #11

Keep up with the top industry updates as we present bi-weekly market insights that are important to traders in the institutional space.

In this week's edition, Kelvin Lam, CFA, Head of Institutional Research for OKX, explores the profound market impact resulting from the recent launches of spot Bitcoin ETFs in the US. He analyzes the dynamic interplay between supply and demand and the consequential changes in market structure. Additionally, he highlights potential trading opportunities that institutional traders can seize following this significant market event.

The market impact of spot Bitcoin ETFs and upcoming opportunities for institutional traders

TL;DR

• The approval of spot ETFs has far-reaching implications for the underlying supply and demand dynamics of Bitcoin, given the material flow of funds. In the near term, the outflows from Grayscale could potentially place selling pressure on Bitcoin, while the majority of inflows from registered investment advisors (RIAs) into the newly launched spot ETFs may require additional time to fully manifest.

• The highly anticipated and subsequent approval of spot ETFs has had a profound impact on the market structure on both Bitcoin spot and derivatives markets. It's crucial to closely monitor metrics such as liquidity, open interest, funding rate, and options implied volatility (IV) to gain valuable insights into traders' preferences and activities. These metrics provide additional perspectives on market dynamics and help identify trends.

• Traders have quickly shifted their focus into other upcoming market developments and potential trading opportunities. These include a potential spot ETH ETF approval, Ethereum upgrade, and trading activities arising from the spot BTC ETFs.

How does the trading of spot ETFs affect the supply/demand for the underlying Bitcoin?

On January 10, 2024, the Securities and Exchange Commission (SEC) approved all 11 spot Bitcoin ETFs, meeting the market consensus decision deadline. Subsequently, these ETFs began trading on January 11, 2024. Although the market has interpreted this as a "sell-the-news" event, resulting in Bitcoin dropping from $48.5k to below $42k within 48 hours of the ETF launch, it's important to consider the underlying supply and demand dynamics, including fund flows and ETF mechanisms, which also contributed to the short-term price actions.

Source: Bloomberg, Jan 11, 2024; Investopedia, Jan 10, 2024.

Despite the positive inflows into the new spot Bitcoin ETFs during the first two days, the assets under management (AUM) of GBTC remain significantly larger compared to the size of these inflows. GBTC, now being converted into a spot ETF with redemption options available, carries the highest management fee of 1.5%.*

This conversion has triggered a wave of redemptions, which will exert selling pressure on the Bitcoin spot market. According to data from Arkham Intelligence, as of January 16, 2024, Grayscale has sent an additional 9,000 Bitcoin to a crypto exchange, which is believed to be in preparation for meeting upcoming redemption demands. While part of this capital may reasonably shift towards the spot Bitcoin ETFs or other instruments with lower cost, some traders may choose to take earnings after successful betting on the closure of GBTC's discount and wait for a better time to re-enter the market, considering GBTC's remarkable 220%+ return** over the past year.

*Source: Grayscale

**Source: Yahoo Finance

Many industry predictions suggest that the majority of inflows into the first-year spot ETFs will come from wealth managers and RIAs. These financial practitioners are required to conduct thorough due diligence on funds before recommending them to their clients. A crucial criterion for assessing these funds is their track record, making these spot Bitcoin ETFs uninvestable for this group until a certain track record has been established. Consequently, the initial hype and high expectations of inflows into these new spot Bitcoin ETFs won't materialize in the latter half of the year. In fact, we're already witnessing net outflows from these spot Bitcoin ETFs in the second week of trading from the table above.

The changes in market structure for Bitcoin spot and derivatives markets

Order book liquidity (US-based crypto exchanges)

The launch of spot Bitcoin ETFs will have the most significant impact on US-based crypto exchanges, as ETFs can be treated as substitutes for trading venues by Bitcoin traders. The liquidity of order books for fiat pairs on these exchanges started deteriorating a few days before the launches, returning to normal levels over the weekend. This data point is worth tracking in the upcoming weeks to gauge traders' preferences between ETFs and crypto exchanges.

Source: Kaiko, Jan 15 2024

Open interest and funding rate market for perpetuals

Open interest has been on an upward trend since August 2023 as the market speculates on the potential approval of spot Bitcoin ETFs. However, it retraced by about $1B shortly after the launch of spot ETFs, although it still maintains an elevated level compared to August 2023. The funding rate has also remained positive since late October 2023, and experienced surges momentarily. This indicates that traders have positioned themselves heavily for long positions. However, the funding rate experienced a significant reset on January 3, 2024 coinciding with market predictions regarding the rejection of spot ETF applications. Following the launch of spot ETFs, the funding rate trended lower but remained positive.

Source: Laevitas, Jan 17 2024

Options IV

Options implied volatility surged as traders positioned themselves against the previous January 11, 2024 deadline for potential ETF approval. Both 1-week and 1-month implied volatility reached a one-year high, surpassing 90 and 70 respectively, forming a backwardation structure. Options activities were heightened until shortly after the SEC granted approvals to the ETFs. Implied volatility then experienced a significant decline, returning to a contango structure similar to that of two months ago.

Source: Laevitas, Jan 18 2024

What are the next trading opportunities after spot Bitcoin ETF approvals?

Spot Ethereum ETF applicants and potential approvals window

As observed in the option flows, trading activities have quickly shifted to ETH derivatives as multiple asset managers (those with spot Bitcoin ETFs approved) have already filed for spot Ethereum ETFs. May 23, 2024 is the SEC's final deadline for VanEck's application.*

*Source: Cointelegraph, Jan 10 2024

Pick-up of trading activity surrounding altcoins

The long-anticipated Dencun upgrade for Ethereum is expected in the first quarter of 2024*. This upgrade is expected to substantially lower transaction costs for Ethereum decentralized applications, particularly benefiting Layer 2 rollup chains. This can potentially act as a fundamental catalyst, encouraging more on-chain activities and driving up trading activities around altcoins. There's been a retracement in the BTC dominance percentage recently to below 50%**, indicating a favorable environment for altcoins.

*Source: The Block, Jan 17 2024

**Source: Coingecko, Jan 18 2024

Arbitrage opportunities between traditional and crypto-native trading venues

The launch of spot ETFs in the US paves the way for increased institutional adoption and participation in cryptocurrency trading. We've already observed promising trading volumes during the first week of trading for these spot ETFs and this opens the door for more arbitrage opportunities. One such opportunity lies in the potential widening of basis spreads between CME BTC futures and crypto exchanges. Additionally, there's the possibility of spot exchange arbitrage as there could be price disparities between various crypto exchanges arising from the pricing benchmark of the spot ETFs.

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