Why ETF investors should consider self-custody

The introduction of spot bitcoin ETFs represents a breakthrough in the mainstream adoption of bitcoin. But if you've spent some time studying bitcoin, you might wonder if this type of investment vehicle is the best way for you to hold bitcoin for the long term.

At Casa, we're not financial or investment advisors — we're security experts. We help our members take self-custody of their bitcoin, so they own it for all intents and purposes, protect it from third-party custodial risks, and keep it for the next generation.

Our team recently conducted a deep dive into ETFs and the risks associated with them. In this primer, we'll discuss some of the differences between owning shares in an ETF and holding bitcoin in self-custody, so you can make an informed decision.

What are bitcoin ETFs?

Exchange-traded funds or ETFs are securities that offer investors exposure to an underlying basket of assets, according to Investopedia.

For the purposes of this article, we will focus on spot bitcoin ETFs, which a third-party institution holds bitcoin in custody for a fee. In this type of offering, the basket of assets consists of one or more bitcoin addresses typically secured by a custodian, such as Coinbase. The collection of assets are packaged as shares that are traded on the public markets.

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ETFs are not all bad

There are many reasons why ETFs are popular with investors. They're a convenient, low-cost way to obtain indirect exposure in an asset without dealing with custody, and they're easy to buy and sell in a tax-advantaged retirement account.

Retirement is a big deal in the world of finance. Together, retirement assets represent nearly a third of all household financial assets in the U.S. as of September 2023, according to the Investment Company Institute.

It's possible to hold bitcoin in self-custody within a tax-advantaged account through a self-directed IRA, but this process can be costly and cumbersome for investors just getting started with bitcoin. 

So, there are a lot of incentives for owning shares of an ETF as a proxy for owning bitcoin, but these benefits come with trade-offs.

ETFs rely on trust

Owning shares in an ETF isn't the same as owning bitcoin directly. It has to do with how bitcoin is designed.

An ETF is essentially a collection of IOUs traded on the securities markets. When you own a share, you have a depository receipt, which is a claim to the fund's underlying assets. If you find yourself in a dispute with the ETF issuer, you become a creditor and that receipt becomes the basis for a series of legal proceedings. This system works reasonably well for real-world assets, but bitcoin is different on a practical level.

Unlike stocks, bonds, and other investment vehicles, bitcoin is the native token of a parallel, borderless system in cyberspace. It's a closed system with barely any knowledge of the outside world.

Ownership on the bitcoin network rests with keys. If you have the key to a bitcoin address, you can spend the bitcoin at that address. There are no do-overs with bitcoin transactions, which is why it's essential to keep your keys safe.

When a company issues a bitcoin ETF, they either custody the underlying bitcoin themselves, or they outsource that custody to a third party. So, they hold the keys or they pay someone else to hold the keys.

This creates a chain of trust that, if broken, can have disastrous consequences. We often advise our members not to leave bitcoin with an exchange or custodian because you never know what could happen with them. We've seen these companies go bankrupt and lose customer funds in hacks and accidents, such as Mt. Gox, FTX, and Fortress Trust in recent years.

Bitcoin ETFs have the potential to create the same scenario just on a much larger scale because these offerings rely on third-party custodians.

ETFs miss out on the broader bitcoin economy

There's a lot more to bitcoin than just buying and holding it. The bitcoin network enables peer-to-peer payments. Whether it's buying a pizza with bitcoin, buying a t-shirt at a conference, or minting an inscription, you need your own set of keys to send a bitcoin transaction.

When you own shares in a bitcoin ETF, you can't participate in the bitcoin network. If you're interested in the technology behind bitcoin or believe in its incorporation into everyday life, it's important to remember any underlying bitcoin in an ETF is boxed out from that world, at least for regular investors.

Owning bitcoin in an ETF is similar to owning shares of gold in a vault somewhere you can never lay eyes on. The price might go up but you're far from the action.

You can't get your BTC out of an ETF

Because it exists on a peer-to-peer network, bitcoin is one of the only assets you can transact with even if the traditional financial system is not operating. But if you're interested in bitcoin as a hedge against the financial system, a spot bitcoin ETF could work against you. 

At this point in time, the SEC has favored ETF filings with a "cash creates" redemption model, which means the authorized participants and market makers are using cash to create new shares in the traded product with the ETF provider. This arena is known as the primary market.

Retail investors participate in the secondary market. In between primary and secondary markets sit layers of exchanges and broker-dealers, which allow you to trade fiat currency for shares. This article has details about how ETFs are created and redeemed.

Spot ETFs are designed to maintain parity with the fair market value of an asset. If there's a significant difference between the underlying value of an ETF and the current spot price, institutions can typically engage in arbitrage in the primary market, which closes the gap in the secondary market.

This means if you purchase shares in an ETF, don't expect to trade your shares in for bitcoin anytime soon. You'd probably receive a cash redemption, similar to when you sell shares.

Why self-custody matters

Though it's part of the world we live in, the traditional financial system is a complicated web of trusted third parties. And it has let the general public down on more than one occasion.

Bitcoin was designed to take trust out of the equation. By holding your own keys, you can opt out of trusting third parties with your assets. And you ensure your bitcoin remains available for you to transact with as you see fit.

With the right tools, you can hold your bitcoin with peace of mind from hacks, accidents, and custodial risk. Casa vaults allow you to secure bitcoin with multiple keys and multiple devices to protect against single points of failure. This protocol, known as multisig, requires you to sign a transaction with more than one device. Learn more here.

Self-custody gives you greater control and freedom over your bitcoin than even the best custodian can provide.

Final thoughts

Spot bitcoin ETFs can be a compelling option for investors with tax-advantaged portfolios, but there is a lot of trust involved. Buying and selling an ETF is not all that different from trading bitcoin on an exchange, especially when most ETFs are using the same custodian.

If you choose to participate in such offerings, be sure to understand the trade-offs. Holding additional bitcoin in self-custody can be a smart way to diversify custodial risk and makes the most of bitcoin as a hedge against the financial system. If you want to own bitcoin, we would recommend having your own wallet in addition to any ETF holdings you may have.

It's one thing to buy bitcoin — it's another thing to keep it. Hold bitcoin in self-custody and you're much closer to unlocking bitcoin's true value.

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.