Crypto Exchange Traded Products - Check the Structure before You BuyCrypto exchange traded products (ETPs) have become increasingly popular. The crypto asset class is a budding asset class. Therefore, the sector’s infrastructure has not met the same standards as the traditional exchange-traded fund (ETF) and ETP markets.

The growing popularity of crypto ETPs

Crypto ETPs are a go-to investment vehicle for investors seeking exposure to the prices of cryptocurrencies like Bitcoin (BTC) and Ether (ETH). As of February this year, Europe had 73 crypto ETPs, with $7 billion in assets under management. It equates to more than half of the global ETPs.

A report by Bloomberg Intelligence in December 2020 revealed that crypto ETPs had surpassed 1 billion euros, adding that the figure was proof of the crypto industry’s growth.

In February last year, another report by CryptoCompare’s Digital Asset Management Review said that the global AUM for crypto ETPs had hit $44 billion. Bloomberg Intelligence has also predicted that the global AUM for crypto ETPs could hit $120 billion over the next six years.

Structure of crypto ETPs

The risk investors face depends on how the issuers of these crypto exchange traded products have structured their products. Issuers are mandated to file a prospectus and the final terms of the product with the local market regulator. After approval, investors can assess the prospectus to show the security they are exposed to, how it works, and its details.

One main thing to consider is whether the crypto ETP is lending out the underlying securities, in this case, crypto assets like Bitcoin or Ether. This is dubbed “sweating assets,” where the issuers extract the most value from the AUM by using the assets to generate additional yield.

Investors can check whether the ETP provider allows an ETP or ETF to lend the underlying asset to understand the degree of risk they are exposed to. Lending out underlying assets introduces counterparty risk if the party that borrowed the assets fails to meet its obligations.

The risk of defaulting hinders institutions from investing in crypto-based products. Moreover, counterparty risk is higher in crypto because crypto lending platforms have few risk control measures compared to equity lending.

The cryptocurrency market is notoriously volatile. For instance, the price of Bitcoin has plunged by around 65% since reaching an all-time high in November last year. Therefore, loans issued in the space are usually overcollateralized.

While over-collateralized loans could be deemed safe, there is still the risk of the borrower defaulting, especially if cryptocurrency prices steadily decline. An example is the latest collapse of Three Arrows Capital, which defaulted on a $680M loan provided by Voyager Digital. The two firms have since filed for bankruptcy because of the credit crunch created after cryptocurrency prices started declining.

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