According to every key benchmark, the new spot Bitcoin (BTC -2.35%) exchange-traded funds (ETFs) appear to be a remarkable success. In just the first few days, they attracted more than $1 billion in assets. Trading volume has been "insane," according to market participants. And even though Bitcoin actually fell 12% in the week after the introduction of these ETFs, investor appetite still appears to be very strong.
However, there are two Bitcoin ETF risks that you won't hear a lot of people talking about. And either could affect how well your investment performs over time.
Tracking error risk
The primary purpose of the new ETFs is to give you exposure to the performance of Bitcoin. If Bitcoin goes up by 10%, your ETF should go up by 10%. And if Bitcoin goes down by 10%, your ETF should go down by 10%. While it might be naive to expect an exact 1:1 match in price, the difference should be fairly negligible, right?
And yet, over the first week of trading, the performances of the different Bitcoin ETFs have sometimes been all over the place. I first noticed this when watching an analyst on CNBC explain why the price of Bitcoin was down while in the background, all the tickers for the Bitcoin ETFs were flashing different numbers!
For example, the new offering from BlackRock (BLK 0.69%), the iShares Bitcoin Trust (IBIT -1.47%), was down 6%. The new offering from VanEck, the VanEck Bitcoin Trust ETF (HODL -1.54%), was down 7%. And the WisdomTree Bitcoin Trust (BTCW -1.48%), was down 12%.
What concerns me is not that the ETFs are down. That's to be expected, with the price of Bitcoin down. What concerns me is that performance can vary so widely. Such discrepancies are known as tracking errors, and they highlight the potential difficulty of tracking Bitcoin. Keep in mind that Bitcoin is a truly global asset that trades 24 hours a day. That makes it harder to track than, say, the S&P 500 index, which trades during regular market hours.
Custodial risk
The other risk is called custodial risk. This is the risk of incurring a loss on your assets in the event of a custodian's insolvency, negligence, fraud, poor cybersecurity standards, or inadequate record-keeping.
This matters because the custodian for much of the Bitcoin held by the big Wall Street players will be cryptocurrency exchange Coinbase Global (COIN 5.68%). In fact, eight of the 11 Bitcoin ETFs have chosen Coinbase as their custodian.
Image source: Getty Images.
To conceptualize this, imagine Coinbase having a vast digital vault filled with safe deposit boxes where 70% of Wall Street's Bitcoin is being held. In this analogy, each safe deposit box would correspond to a different blockchain wallet and could be opened only with the right cryptographic keys.
This doesn't sound risky, but to understand what could go wrong, all you have to do is think back to November 2022, when cryptocurrency exchange FTX went belly up. As it turns out, the crypto exchange was commingling customer funds with funds from its own trading desk. And there are plenty of examples from the early days of Bitcoin, when cybercriminals specifically targeted large crypto exchanges such as Mt. Gox in order to steal Bitcoin.
This is not to say that there excessive risk right now with Coinbase Global. I'm sure that multiple layers of security protect the Bitcoin holdings. But articles musing about the potential for something to go very wrong have already appeared in financial media. What if, for example, cybercriminals decide to target Coinbase as part of some coordinated hacking exploit to steal Wall Street's crypto?
Understand what you're buying before you buy it
Perhaps the biggest takeaway here is that it's important to understand what you're buying before you buy it. You don't need in-depth knowledge of how the crypto market works or even how an ETF works, but you should have a basic understanding of the potential risks of buying Bitcoin via an ETF.
That said, I'm still long-term bullish on Bitcoin. But I'll definitely be keeping a close eye on how Wall Street deals with any potential risks unique to the new spot Bitcoin ETFs.
