The Bitcoin ETF Tipping Problem

Dave Nadig has forgotten more about ETFs and how they work than I will ever know. He co-founded Cerulli Associates in the early 1990s, went on to be Managing Director at Wells Fargo Nikko before selling the firm to Barclays to form BGI, before THAT got bought to become Blackrock/iShares as it exists today. In the early 2000s Dave joined what would become ETF.com, where he helped build their ETF Data and Analytics business which was sold to FactSet in 2017 or so. Most recently Dave was part of the team that formed and sold VettaFi to the TMX group from 2020 to 2023. Dave is currently an "independent financial futurist" and will tell you what that means as soon as he figures it out!

You can contact Dave at dave.nadig@gmail.com and on Twitter at @DaveNadig. As with all of our guest contributors, Dave’s post may not represent the views of Epsilon Theory or Second Foundation Partners, and should not be construed as advice to purchase or sell any security.

Matt Hougan of Bitwise and I first worked together in 1997 or so as part of “OpenFund - the World’s First Transparent Mutual Fund!” While we got shellacked, it’s not a surprise to see Matt and the team at Bitwise carrying the twin torches of “institutional quality” and “radical transparency,” which they refueled last week with this fun little move:

My first thought on seeing the wallet address out there was “OK, that’s clever… after all, it’s a one-way door, it doesn’t make anything less secure, and instantly solves the tired “there's no gold in the vault” insanity that’s plagued GLD.” (Which mindboggling is still going on to this day.)

What I hadn’t expected was that within hours, someone had just sent random bitcoin to this address:

Hong Kim is the CTO at bitwise, and I thought he did a good job of explaining things in a tweet, but since a bunch of folks asked, here’s my interpretation of the details and some of the fun implications.

The Big Questions

• How the heck do you account for “donations”? Because I’m me, my immediate question was how this gets handled on the books of the fund. I’m pretty conversant in basic investment accounting principles, but not an actual CPA or lawyer or anything, but I stay up on GAAP changes (general accounting), the Uniform Principal and Interest Act (some Trust accounting) and the various interpretations for ETFs over the years, and I’m really pretty darn sure that the few hundred bucks showing up on the BITB books will have to be recorded as miscellaneous investment income on the funds Statement of Operations. Essentially adding a line we never see on, say, GLD’s annual:
• Who Gets It? Because the Bitcoin ETFs are all essentially structured like GLD - Grantor Trusts that cleave to the “Widely Held Fixed Income Trust” IRS interpretations (could be wrong) - there’s not traditionally a dividend mechanism for distributing this “income” out to investors regularly, like there is in a more normal ‘40 Act fund. That’s only a problem to the extent that the amount of donations exceeds trust expenses, which, in a non-waiver period, seems exceptionally unlikely. Theoretically, someone could donate an enormous amount of BTC to the fund, and thus put the trust in the odd position of having to report income that they have not distributed (triggering a tax event for shareholders), or of having to actually distribute the income, which also seems insane and to my knowledge has never happened in Grantor-Trust structured ETPs. So: income, which will be offset by expenses.
• Is this a threat? One wild idea I heard was that some bad actor could try and “poison” BITB or another ETF by routing a bunch of BTC through a sanctioned address and then sending it to the fund. The theory was that this would put the fund in some sort of illegal state, and tie it up with clawbacks and legal shenanigans. It’s an interesting idea (although I have no idea how one would do it or why one would want to), but if you dig into the Coinbase Custody agreements (or just their 2023 consent agreement with NY State) that’s just not how it works. As a big-boy institutional custodian, Coinbase siphons off anything from sanctioned addresses into a penalty box. As far as the Trust is concerned, no “bad” bitcoin ever goes anywhere near the fund — that’s for the Custodian to sort out with the Feds.
• Is it in NAV? This one I am 100% sure of. Once Coinbase has allowed the donated BTC through to the custodial account without being flagged for sanctions, that BTC is absolutely an asset of the trust and will be in the very next NAV calculation. In this case, $400 isn’t going move the penny on NAV. But if someone just “gave” the trust $400 million or something? Sure. It’s in the NAV.
• What about the NFTs!? Believe it or not, this is a thing. If you haven’t been paying attention to the NFT market, the new hotness for the last year has been “ordinals.” Every Satoshi (a 100 millionth of a Bitcoin) has a serial number from when it was minted. These days, you can embed some content in the process of minting a Satoshi, and that means you can make a crude, fully embedded NFT (not just a pointer to a JPG) - as long as the digital thing your inscribing on the Satoshi is less than 4MB. Turns out, a bunch of folks sent BITB some of them too.