Market View
It has been one week since spot bitcoin ETFs began trading (on January 11, 2024) during which we have seen more than $14B of aggregate trading volume – an order of magnitude greater than all other ETFs launched in 2023. Volumes appear to be stabilizing after a week of trading at around $2B per day, and account for a significant 15% of global spot BTC volume (see Chart 1). Together, the spot ETFs have seen a net inflow of $1.2B since inception (as of January 18), and we expect this number to continue rising over the medium term as more advisors and brokerages enable client access.
Not all of these early inflows are new entrants to the space, however. Some investors have rotated into spot ETFs from less efficient bitcoin vehicles, and capital may have also rotated away from bitcoin holding and mining companies into spot exposure instead. For example, BITO (ProShares Bitcoin Futures ETF) has seen more than $180M in outflows since the spot ETFs launch. Still, we continue to believe the spot ETF is a critical unlock that could set the foundation for new derivatives markets in the traditional financial world, although it’s still as of yet unclear whether these will be subject to regulatory approval. Several filings for leveraged ETFs and options trading are already underway.
The capital rotation out of the Grayscale Bitcoin Trust (GBTC) is also worth noting, with Grayscale now reporting total AUM of $25.3B – suggesting there’s been more than $1.6B of outflows since the ETF conversion. This was expected, in part, due to their annual fee (1.5%) being more than five times the average fee of its competitors. That said, GBTC’s outflows have been outpaced by inflows to other ETFs, and we expect this trend to continue throughout the next week of trading. Although the first week of bitcoin price action appears to have been a “buy the rumor, sell the news” event, the early numbers of the spot ETF show that this has unlocked a new vector of demand.
While spot ETF volumes remain strong, BITO volumes have dropped sharply. On launch day (January 11), BITO traded $2B in value and surpassed its previous record by more than 50%. Since then, BITO volumes have dropped about 75%, trading $503M in volume on Thursday (January 18).
Despite this drop, we view BITO as a continued integral part of the bitcoin ETF space. In fact, we suspect that some authorized participants (who have contractual agreements with the ETF issuers to create and redeem shares) potentially bought bitcoin in anticipation of the ETF launch and sold BITO (i.e. trading the basis) to hedge potential client buys and sells intraday which would be required because these are cash (rather than in-kind) creations for these ETFs. Indeed, following the launch of the spot ETF, the basis between CME futures and spot has compressed to less than 0.5% (see Chart 2) dropping its premium tenfold from its recent peak at the start of 2024. That may explain some of the activity described above. Regardless, we believe some APs (namely broker-dealers) will continue to rely on regulated means of hedging themselves, such as long CME futures or long BITO when creating shares (or short CME futures if redeeming).
Note that the open interest on CME bitcoin futures has also dropped by more than $1B from its January 10 peak – the first time in more than a year with a peak-to-trough drawdown of that size. With the improved ability to hedge across traditional financial systems as well as take exposure to the spot bitcoin ETFs, we expect the CME bitcoin futures basis to remain relatively subdued going forward. For institutional players, it’s no longer necessary to pay a large premium for BTC exposure on traditional exchanges. In contrast to bitcoin futures, the open interest on CME ether futures remains at its highest level since December 2021, and we expect its basis trade to continue to be an opportunity before spot ether ETFs are approved - potentially as early as May 23.
Separately, the outperformance of Ethereum following the spot BTC ETF approvals and the attention to its upcoming Dencun fork make it increasingly important to look into the economic sustainability of its layer-2 (L2) networks as its primarily scaling vector. At present, L2s are operated by centralized entities that earn revenue from transaction fees and pay variable costs to post data to the layer-1 (L1). In general, rollups benefit from economies of scale where profits increase with user activity since the marginal L2 transaction fees paid by the user are typically more than the L1 cost to post it. As a result, major L2s are profitable, although chains with less activity struggle with sustained profitability. Some even operate at a loss (see Chart 3).
In our view, many of the spikes in L2 activity (and thus profitability) occur as a direct result of airdrop farming or other transient attention cycles. This is evidenced by Arbitrum’s five fold rise in profitability and subsequent 60% drop following its airdrop in March 2023. Similarly, Optimism experienced short-term surges in profitability around its airdrops in May 2022 and February 2023. Thus, we think it’s likely that chains which have announced – but not yet released – tokens have their profitability temporarily skewed to the upside due to airdrop farming activities.
This fundamental need for sustained profitability – in conjunction with the network effects of liquidity, smart contract composability, and economies of scale – suggests to us that L2s will consolidate in the long run. (This also perhaps better justifies the necessity of layer-3s and beyond due to the lower activity threshold required to be profitable.) The Dencun upgrade could accelerate this trend by lowering the cost to post data to the L1 significantly, prompting L2s to lower the end user costs. The increased adoption of data availability (DA) solutions like Celestia and EigenDA are also likely to drive down L1 costs in a competition to attract users and developers with lower fees. Together, it is likely that these will eat into L2 profit margins in the absence of greatly increased user activity, which may increase the speed at which the space consolidates.
