Traditional securities vs. self-custody: Assessing the danger of bitcoin ETFs, stocks, and trusts

by Jameson Lopp a year ago 9 min read

When investors first allocate to bitcoin (BTC), they are typically faced with a paradox. While they appreciate the value of digitally native, censorship-resistant, hard money, they are often hesitant to realize that potential fully by taking custody of it themselves.

This reluctance is not surprising. For centuries, civilizations have normalized the outsourcing of custody to other third parties to sidestep personal risk. That same phenomenon has been reinforced in the modern era with a wide range of securities such as public companies, trusts, and exchange-traded funds (ETFs), many of which track the price of underlying commodities. The relationship investors have with ownership has been reduced from holding physical stock certificates to trading tickers in a brokerage account.

But is holding shares of these products as secure as holding bitcoin yourself with your own private keys? The answer is not so simple and requires one to develop a broad view of traditional financial markets, bitcoin’s design, and the tradeoffs and risks associated with traditional securities.

Please note this article is provided for informational purposes only and is not intended as financial, legal, tax, accounting, or investment advice. Casa urges you to consult a qualified professional for any such advice or service.

Types of bitcoin proxy securities

Since bitcoin originated, many have attempted to create security offerings for investors wishing to participate more passively in bitcoin’s price appreciation through a proxy, a trend that has picked up steam in recent years. Some exist today while others have wished for a worldwide spot bitcoin ETF with several large institutions and asset managers seeking to fill the void by applying to regulatory agencies.

Today, bitcoin has been packaged into many types of securities offerings that offer exposure to a basket of underlying assets. Here are some ways they can offer exposure to bitcoin, each with its own set of risks.

Spot: This product holds a finite amount of bitcoin per share.
Futures: This product allows you to trade bitcoin at a fixed price in the future.
Equity: This product represents an ownership stake in a company that holds bitcoin on its balance sheet.

For the purposes of this article we will focus on spot and general equity investments since these are designed to provide the closest approximation for BTC. Futures products and derivatives trading were previously discussed in this article.

What options exist today?

The most notable bitcoin-related investment vehicle is the Grayscale Bitcoin Trust (GBTC), a spot offering that holds more than 620,000 bitcoin as of this writing, a staggering 3% of the total circulating BTC supply. There are also other spot offerings, which vary by jurisdiction.

Additionally, there are several companies that hold bitcoin such as MicroStrategy, Tesla, and several bitcoin mining companies.

Why do people want a bitcoin ETF, stock, or other security?

Investors often find ETFs, trusts, and similar products attractive because of their convenience. Instead of doing the work of acquiring, holding, and managing assets, they can purchase an offering off the shelf on a public exchange and let an asset manager handle the administrative burden.

While retail investors can easily purchase spot bitcoin on crypto exchanges in friendly jurisdictions, this investment is typically conducted with post-tax income, which represents a small subject of overall financial markets. But these inflows are just one small piece of the pie.

Retirement is arguably the most common investment objective with massive influence on financial markets. Retirement assets totaled at approximately $35 trillion in the U.S. alone in Q1 2023, according to the Investment Company Institute. That amount accounted for more than 30 percent of all household financial assets.

Retirement contributions are frequently an employment benefit associated with tax breaks, and investors are usually incentivized to participate in them to avoid missing out on “free money” in the form of an employer match. This investing is generally done through pension funds and tax-advantaged accounts such as 401(k) in the U.S. and SIPPs in the U.K.

Why can’t you buy bitcoin directly in your retirement account?

Setting aside political motives, there are a few practical reasons why purchasing spot bitcoin in a retirement account is not that straight-forward.

Maintaining custody is a major part of managing retirement accounts. Because these accounts act as a tax shelter, governments don’t want investors commingling retirement assets with their other accounts. Additionally, retirement accounts have strict regulatory standards and compliance requirements, and they are typically overseen by investment advisers that register with their respective governments.

The most common way to hold spot bitcoin in a tax-advantaged account is to set up a self-directed IRA, though there is a paper trail involved. You also have to be diligent about keeping bitcoin separate from any bitcoin you may have acquired with post-tax income and avoid prohibited transactions. All in all, this process can be cumbersome and complicated, hence investors’ preference for proxy alternatives.

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As a protocol, bitcoin was designed to allow you to transact without having to trust a third party or government. When you purchase shares of a bitcoin-associated entity, you are inevitably placing some trust in third parties and the government. Below are some of the caveats you can expect.

Lack of visibility: When you hold bitcoin with your self-custody, you can audit and verify your ownership at any time. When you hold shares of an entity, you lose some visibility into the underlying assets. Corporate accounting does not provide public disclosures in real time like the bitcoin network does.

This is not to say an investment manager will disregard their fiduciary responsibility and fail to act on your behalf. The traditional financial system simply operates at a different speed, and it is an industry beholden to quarterly filings and lots of paperwork. Assets aren’t necessarily marked to market constantly like bitcoin is on exchanges. For instance, if an investment manager decides to sell bitcoin, it may be their legal prerogative, but it could be several weeks or months before you see it in a public report.

Lack of redemptions: When you buy bitcoin on an exchange,you essentially have an IOU which you can use to claim your assets later. This is not so simple in traditional finance.

Owning shares in a proxy investment does not necessarily mean you have any right to the underlying bitcoin. In fact, securities often exist without any redemption mechanism for commodities whatsoever, a lot of which has to do with regulation.

One high-profile example of a proxy vehicle without redemptions is GBTC. The trust operated a redemption program at one time but suspended it in 2014. While Grayscale has been in litigation with the SEC over a bid to convert GBTC into an ETF, this process is likely too complex for many investors to follow without a securities lawyer on retainer. Here’s an example:

“Effective October 28, 2014, the Trust suspended its redemption program, in which Shareholders were permitted to request the redemption of their Shares through Genesis, the sole Authorized Participant at the time out of concern that the redemption program was in violation of Regulation M under the Exchange Act, resulting in a settlement reached with the Securities Exchange Commission (“SEC”). At this time, the Trust is not operating a redemption program and is not accepting redemption requests. Subject to receipt of regulatory approval and approval by the Sponsor in its sole discretion, the Trust may in the future operate a redemption program. The Trust currently has no intention of seeking regulatory approval to operate an ongoing redemption program.”

— Grayscale Investments LLC, 10-Q, August 7, 2020

Market risk: A common trait people notice when they encounter bitcoin is the concept of 100% uptime. This is a far cry from the rest of the investing world which is bound by time constraints. For instance, the New York Stock Exchange trades from 9:30 a.m. to 4 p.m. EST and closes for several observed holidays throughout the year.

By contrast, bitcoin is the true city that never sleeps. Because bitcoin exists exclusively in cyberspace, real bitcoin markets trade 24/7 365 days a year without any concern for business hours. Though exchange websites often crash due to the sheer increase of customer volume at moments of high volatility, they strive to replicate bitcoin’s 100% uptime to serve an investor base that is, for lack of a better term, chronically online.

When compared to holding bitcoin in your self-custody, owning a proxy investment is a liquidity trap. If major market developments take place on the other side of the world, you can find yourself stuck while the rest of the bitcoin market carries on without you and engages in arbitrage.

Geopolitical risk: Many nations claim to operate according to the rule of law, but laws are promises written on paper and they frequently prove more malleable than one would think. Governments have a long history of seizing assets, restricting access to them, and nationalizing entire companies.

The playbook for this sort of actions is wide. The most famous example of this is the U.S. government’s attempt to confiscate gold in the 1930s. Every so often, nations experiencing economic strife will freeze accounts and cut depositors off from withdrawing cash, such as Lebanon in recent years. Other countries have co-opted oil producers, manufacturers, banks, and other corporations.

Government regimes can be unpredictable depending on where you live. Because banks and financial institutions are closely linked with the public sector, it’s worth giving some thought to how circumstances could play out if a government were to take a hard line against bitcoin.

If you believe bitcoin will clash with nation-states, a regulated security is not guaranteed to protect your bitcoin from that geopolitical threat because regulations can change.

Leverage: Bitcoin is designed as an asset without a liability, much like gold. But individuals and businesses can take on debt, and they sometimes run the risk of going bankrupt. This is true for crypto companies and for any business listed on traditional regulated exchanges. If you are exploring a bitcoin-related security, be mindful of its debt burden. Shares can be worthless if the investment proves to be the next Enron.

Custodial risk: The traditional financial system is architected on trust, and trusted third parties are security holes. Whether you leave bitcoin in the care of an exchange or if you own shares in a managed bitcoin trust, you are still relying on a third party to do their job.

While it could be argued that regulated entities are less likely to commit the sort of misconduct we’ve observed in the crypto industry, it is not outside the realm of possibility. Recently, Prime Trust, a qualified custodian regulated by the State of Nevada, farmed out custody to a vendor, subsequently lost access to customer assets and was placed into receivership.

Third-party involvement is rampant in the legacy financial system where you usually own stock certificates which are housed with brokerage firms. Writ large, this can make for a confusing ride for the individual investor trying to exercise full sovereignty over their wealth.

I had known all along that my broker was a trusted third party; what I didn't realize before this saga was how many points of failure existed in the system.

• The brokerage controls the stock certificates.
• The transfer agents are also a point of control for stock certificates.
• The markets control the price information.
• The regulatory agencies control the markets.

— Jameson Lopp, How the SEC Nearly Destroyed My Retirement Account

Dilution: One drawback of owning shares of a bitcoin-related security rather than bitcoin itself is the potential for your wealth to be eroded in BTC terms.

The amount of underlying bitcoin per share can fluctuate depending on management and any applicable fees. For instance, GBTC has a (relatively high) annual 2% management fee that reduces the amount of BTC held per share over time.

If you invest in company stock, the company can also issue more shares, which dilutes your ownership stake. This can be advantageous when the stock is overvalued, but dilution can add insult to injury during bear markets. There have been several instances where bitcoin-related companies have increased their shares outstanding or sold bitcoin to shore up their balance sheets. This happened a lot with bitcoin miners during the last bear market. Granted, miners typically sell some of the bitcoin they produce to pay their energy bills and fund their operations, but overdoing it in a bear market isn’t all that different for the shareholders from panic selling on an exchange.

These are just some of the risks to keep in mind. Be sure to consult any applicable prospectus or similar documents, and seek the guidance of a qualified professional before proceeding with an investment.

Why we believe in self-custody

Ultimately, the decision to hold bitcoin in self-custody and purchasing shares in a security has many factors, and there are many investors who own securities in addition to holding bitcoin in self-custody. Purchasing shares in bitcoin-related ETFs, trusts, and other financial products can be a helpful way to gain exposure to bitcoin’s price action, especially in tax-advantaged accounts with few alternatives. But these instruments are not a complete substitute for self-custody and bitcoin’s promise as trustless, self-sovereign money.

The creation of bitcoin ushered in a new era of property rights, and investors no longer have to rely exclusively on third parties to protect their wealth. By holding your keys, you preserve much of the optionality associated with peer-to-peer technology and a decentralized network. Whether you see bitcoin as a trade, investment, or a way of life, understanding these tradeoffs is key to understanding the opportunity of bitcoin itself.

Secure your bitcoin for real

Casa helps bitcoin investors take self-custody of their bitcoin with multiple keys for robust protection against hacks, theft, and custodial risk. With a Casa vault, you can be sure you own your bitcoin fair and square for full peace of mind.

Schedule a call with a Casa advisor to learn more.

Jameson Lopp

Jameson Lopp is co-founder and Chief Security Officer of Casa. He is passionate about creating tools to empower individuals; he has been building bitcoin wallets since 2015.