ETNs for Bitcoin and Ether: explained

The London Stock Exchange (LSE) recently announced that it will begin accepting applications for Bitcoin and Ether exchange-traded notes (ETNs) in the second quarter of 2024.

According to the Crypto ETN Admission Factsheet outlining the requirements for these products released by the LSE, the ETNs that will be processed for review need to be backed by Bitcoin (BTC) or Ether (ETH). The products also need to be non-leveraged and have a publicly available market price or value measure. The exact date for accepting applications was not provided by the LSE; however, no statements from major financial institutions confirm that they will be applying, although this may change in the coming months as the applications begin.

According to the factsheet, the underlying crypto assets must be “wholly or principally” held in cold wallets or similar secure storage by custodians subject to Anti-Money Laundering (AML) laws in the United Kingdom, European Union, Switzerland, or the United States.

The Financial Conduct Authority (FCA) stated that it will not object to Recognised Investment Exchanges (RIEs) creating market segments for crypto-backed ETNs. However, the regulator emphasized that these products are aimed at “professional investors,” including credit institutions and investment firms authorized or regulated to operate in financial markets.

“The FCA continues to remind people that cryptoassets are high risk and largely unregulated. Those who invest should be prepared to lose all their money,” the FCA stated.

While we already have ETFs for Bitcoin and an Ethereum ETF is already undergoing approval from the Securities and Exchange Commission (SEC), ETNs for Bitcoin and Ether are new and may signal a new opportunity for investors.

So, what are ETNs exactly, and how do they differ from ETFs?

ETNs and ETFs, explained.

Exchange-Traded Notes (ETNs) are unsecured debt securities that track an underlying index and trade on major exchanges like stocks. Issued by financial institutions, ETNs have a maturity date, and the repayment of principal depends on the issuer’s financial viability. ETNs do not make regular interest payments but can provide returns based on the performance of the underlying index.

Fidelity Investments, a US-based financial services firm, has the following advice for investors:

“The decision of whether to opt for an ETF or ETN in the same product area depends largely on your investment time frame. Given that ETFs are subject to yearly capital gain and income distributions which are taxable events to the holder—and ETNs are not—it seems reasonable to conclude that ETNs are a superior product for the long-term investor.”

According to Fidelity, ETNs may pose as an “ironic” investment type given how they offer tax advantages, but they also carry significant risk given how they only provide access to “more niche product areas,” which may not be generally recommended as staples for long-term investors.

While ETNs and Exchange-Traded Funds (ETFs) both track underlying benchmarks and trade on exchanges, they have distinct differences. ETFs are similar to mutual funds, holding assets such as stocks or commodities that determine the ETF’s price.

Investing in an ETF provides ownership of a diversified basket of assets. In contrast, ETNs are debt securities that promise to pay the index’s value at maturity, minus fees, exposing investors to the issuer’s credit risk. ETNs do not own the underlying assets they track.

ETFs offer several advantages over ETNs, including greater tax efficiency, as taxes are only incurred upon sale. ETFs provide instant diversification by holding a basket of assets, reducing risk for investors. They also have lower expense ratios compared to actively managed mutual funds, making them cost-effective. Dividends in ETFs are reinvested immediately, and they offer liquidity and flexibility for trading. Further, ETFs generally have lower tracking errors than ETNs.

On the other hand, ETNs may be preferable for investors seeking exposure to specific indices or assets not available through ETFs. They can also be more tax-efficient for certain strategies, such as short-term trading, as taxes are only incurred upon sale. However, ETNs come with credit risk tied to the issuer’s financial stability, which investors must consider.

Notes towards a possible crypto ETN

The introduction of crypto ETNs on the London Stock Exchange (LSE) could have both positive and negative implications for the crypto industry, depending on one’s perspective on decentralization and regulation.

On one hand, the acceptance of crypto ETNs by a major traditional financial institution like the LSE could be seen as a step towards mainstream adoption and legitimization of cryptocurrencies. This move may attract more institutional investors to the crypto space, potentially increasing liquidity and stability in the market. The inclusion of crypto ETNs on a regulated exchange could also provide a safer and more accessible entry point for investors who may have been hesitant to invest directly in cryptocurrencies due to concerns about security, volatility, or lack of regulation.

However, the increased involvement of traditional financial institutions and regulatory bodies in the crypto space could be viewed as a move away from the decentralized ethos that underpins many cryptocurrencies. The original vision of Bitcoin and other cryptocurrencies was to create a decentralized, peer-to-peer financial system that operates independently of central authorities and traditional financial intermediaries. The introduction of crypto ETNs on a centralized exchange, subject to regulatory oversight, could be seen as a step towards the co-opting of cryptocurrencies by the very institutions they were designed to circumvent.

The involvement of state institutions in regulating crypto ETNs could be interpreted as an extension of their authority over the crypto industry. While some argue that regulation is necessary to protect investors and prevent fraud or manipulation, others view it as an infringement on the crypto space’s freedom and autonomy. For example, the FCA’s ban on selling crypto ETNs to retail investors could be seen as a move that limits individual choice and undermines the principle of financial sovereignty.

The impact of crypto ETNs on the crypto industry will depend on how they are implemented and regulated, as well as the response from the crypto community. While some may welcome the increased mainstream adoption and potential for growth, others may view it as a dilution of the core principles of decentralization and a step towards the centralization of power in the hands of traditional financial institutions and state authorities.

From the discussion, we can see that ETNs and ETFs differ greatly and that both may be lucrative investment instruments for specific types of investors who are in for the long term.

With this, it’s important to note that regulators such as the FCA have actively urged exchanges to ensure sufficient controls are in place to protect investors adequately and emphasized that crypto-backed ETNs must meet requirements such as ongoing disclosure and regularly updated prospectuses, which are part of the UK listing regime. The regulator also reiterated that selling crypto-backed ETNs to retail consumers will remain banned due to the high risks associated with cryptocurrencies.