Exchange-Traded Products in the Context of Digital Assets: Implications for State Treasury Investments

Abstract

This research report undertakes an extensive examination of the role of Exchange-Traded Products (ETPs) as a strategic conduit for state treasury investments into the burgeoning digital asset landscape. A particular emphasis is placed on the groundbreaking legislative developments recently observed in North Carolina, which exemplify a growing trend among governmental entities to integrate novel asset classes into public portfolios. ETPs, encompassing structures such as Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs), are presented as sophisticated, regulated investment vehicles designed to provide investors with exposure to a diverse array of assets, including pioneering cryptocurrencies like Bitcoin. The report meticulously dissects the intricate operational mechanisms of ETPs, offering a detailed analysis of their inherent advantages and disadvantages within the context of sovereign wealth management. Furthermore, it critically evaluates the indispensable functions performed by specialized custodians and the vigilant oversight exerted by financial regulators, both of which are paramount in upholding the integrity, security, and stability of these innovative investment instruments. By thoroughly analyzing the specific legislative initiatives championed by North Carolina, this report furnishes profound insights into the multifaceted challenges and opportunities confronting state treasuries as they endeavor to navigate the complexities of digital asset investments, all while rigorously adhering to established financial structures, stringent risk mitigation strategies, and paramount fiduciary responsibilities.

Many thanks to our sponsor Panxora who helped us prepare this research report.

1. Introduction: The New Frontier of Public Finance and Digital Assets

The integration of digital assets into traditional financial portfolios represents a profound paradigm shift, rapidly gaining significant momentum across both institutional and public investment spheres. This evolving landscape has increasingly prompted legislative bodies, at both federal and state levels, to diligently explore viable avenues for prudently incorporating these nascent asset classes into state-managed funds and sovereign reserves. The recent legislative efforts in North Carolina stand as a compelling exemplar of this burgeoning trend, as the state boldly proposes a potential allocation of up to 10% of its substantial public funds into Bitcoin-related Exchange-Traded Products (ETPs). This pioneering initiative is not merely an isolated financial maneuver; rather, it represents a strategic imperative aimed at fostering comprehensive portfolio diversification, potentially enhancing long-term returns, and proactively positioning the state as a visionary leader in the realm of financial innovation and technological adoption.

To adequately evaluate the suitability, profound implications, and potential impact of ETPs on state treasury investments, a granular understanding of their intricate structure, precise function, and the robust regulatory scaffolding that underpins them is not merely beneficial but absolutely crucial. This report will therefore systematically unpack these dimensions, providing a comprehensive framework for understanding how states like North Carolina are pioneering new pathways for public asset management in the digital age. The confluence of technological advancement, evolving market dynamics, and a renewed focus on long-term fiscal resilience has compelled public treasuries to look beyond conventional asset classes, seeking instruments that offer both growth potential and a hedge against emerging economic challenges.

Many thanks to our sponsor Panxora who helped us prepare this research report.

2. The Evolving Landscape of Digital Assets in Public Finance

2.1 Paradigm Shift in Treasury Management: Embracing Innovation and Resilience

For decades, state treasury management has been characterized by a conservative, risk-averse approach, primarily focused on capital preservation, liquidity, and generating stable, albeit modest, returns through traditional fixed-income instruments, equities, and real estate. This framework has historically been guided by stringent legal lists or the ‘prudent investor rule,’ which mandate a cautious and well-diversified approach to public funds. However, the advent of digital assets, particularly cryptocurrencies like Bitcoin, has introduced a compelling new dimension, challenging conventional wisdom and prompting a re-evaluation of established investment mandates.

The global economic landscape, marked by persistent inflation concerns, unprecedented fiscal expansion, and geopolitical volatility, has underscored the need for enhanced portfolio resilience and diversification. Traditional hedges against inflation, such as gold, have shown varying degrees of effectiveness, prompting a search for alternative assets that possess similar scarcity characteristics but with potentially higher growth trajectories. State treasurers, as fiduciaries of public funds, are increasingly tasked with balancing their mandate for safety and liquidity with the imperative to optimize returns and protect purchasing power for future generations. This balancing act necessitates an exploration of novel asset classes, provided they can be integrated within a robust, regulated, and transparent framework.

2.2 Rationale for State Treasury Engagement with Digital Assets

The compelling arguments for state treasuries to consider exposure to digital assets, primarily via regulated ETPs, are multifaceted and deeply rooted in contemporary financial theory and economic realities:

2.2.1 Diversification Beyond Traditional Asset Classes

Modern portfolio theory posits that diversification across uncorrelated or lowly correlated assets is key to optimizing risk-adjusted returns. For years, public funds have relied on a traditional mix of stocks, bonds, and real estate. Digital assets, particularly Bitcoin, have historically exhibited a low correlation with traditional asset classes during certain market cycles, offering a potential diversification benefit that could dampen overall portfolio volatility while enhancing return potential. Introducing an asset class with distinct risk-return characteristics can improve the efficient frontier of a state’s investment portfolio, leading to better outcomes over the long term, especially for pension funds with multi-decade liabilities.

2.2.2 The ‘Digital Gold’ Narrative and Inflation Hedge Potential

Bitcoin is often dubbed ‘digital gold’ due to its finite supply cap of 21 million coins, which is algorithmically enforced and transparent. This inherent scarcity stands in stark contrast to fiat currencies, which can be subject to unlimited quantitative easing and inflationary pressures. In an era where central banks globally have engaged in significant monetary expansion, concerns over currency debasement and inflation have become prominent. For state treasuries managing long-term assets, an asset with a verifiable scarcity mechanism could serve as a powerful hedge against inflation, preserving the purchasing power of public funds over time. While its short-term volatility makes it a less stable store of value than physical gold in some periods, its long-term performance and fixed supply narrative present a compelling case for its inclusion as a strategic inflation hedge.

2.2.3 Technological Advancement and Innovation Leadership

Investing in digital asset ETPs is not solely a financial decision; it also carries strategic implications regarding a state’s commitment to technological innovation. By allocating a portion of public funds to digital assets, a state can signal its forward-thinking approach, potentially attracting blockchain talent, fostering local tech ecosystems, and establishing itself as a leader in the evolving digital economy. This proactive stance can create a positive feedback loop, encouraging further investment, research, and development in distributed ledger technologies within the state’s borders, thereby contributing to long-term economic growth and competitiveness.

2.2.4 Potential for Enhanced Risk-Adjusted Returns

While digital assets are characterized by significant volatility, they have also demonstrated unparalleled growth potential over the past decade. For a small, strategic allocation, the potential for outsized returns could significantly boost the overall performance of a state’s investment portfolio. The expectation is that even a modest allocation, say 1% to 5%, could meaningfully impact total returns without disproportionately increasing overall portfolio risk, especially if combined with rigorous risk management strategies and a long-term investment horizon. The use of ETPs helps manage some of the operational complexities and security concerns associated with directly holding these volatile assets.

2.3 Regulatory and Fiduciary Context for Public Funds

Public fund management is governed by strict fiduciary duties, primarily focused on prudence, loyalty, and diversification. State treasurers and investment boards are legally bound to act in the best interests of beneficiaries (e.g., state employees, retirees, taxpayers) and to manage assets with the care, skill, prudence, and diligence that a prudent person acting in a like capacity and familiar with such matters would use. This often entails:

• Legal List Frameworks: Some states operate under ‘legal list’ statutes, which explicitly define the permissible asset classes and investment instruments for public funds. For states under this regime, legislative action is often required to add new asset classes like digital assets or specific ETPs to the approved list.
• Prudent Investor Rule: Other states adhere to the ‘prudent investor rule,’ a more flexible standard that allows fiduciaries to invest in any asset class that a prudent investor would, considering the overall portfolio context, risk tolerance, and investment objectives. Even under this rule, novel asset classes typically undergo extensive due diligence, risk assessment, and legal review.
• Risk Management and Transparency: Any investment in digital assets must be accompanied by robust risk management frameworks, including detailed due diligence on ETP providers, custodians, and underlying asset characteristics. Transparency in reporting and governance is also paramount to maintaining public trust.

The conservative nature of public fund management means that regulatory clarity, established market infrastructure, and demonstrably secure custody solutions are non-negotiable prerequisites for the adoption of digital assets. ETPs, by wrapping digital assets within a familiar, regulated financial product, address many of these concerns, making them an attractive entry point for state treasuries.

Many thanks to our sponsor Panxora who helped us prepare this research report.

3. Exchange-Traded Products (ETPs): A Gateway to Digital Asset Exposure

Exchange-Traded Products (ETPs) represent a broad category of financial instruments designed to trade on stock exchanges, providing investors with exposure to various underlying assets, indices, or strategies without requiring direct ownership or complex operational overhead. Their structure blends characteristics of both traditional mutual funds and individual stocks, offering liquidity and transparency.

3.1 Comprehensive Definition and Taxonomy of ETPs

The ETP ecosystem is diverse, but the primary structures relevant to digital asset investments are Exchange-Traded Funds (ETFs) and Exchange-Traded Notes (ETNs), with Exchange-Traded Commodities (ETCs) also having some applicability.

3.1.1 Exchange-Traded Funds (ETFs)

ETFs are open-ended investment funds that typically hold a diversified portfolio of assets, such as stocks, bonds, commodities, or, in the context of digital assets, cryptocurrencies. Unlike traditional mutual funds, ETFs trade on stock exchanges throughout the day at market-determined prices, which can fluctuate based on supply and demand dynamics, often differing slightly from their Net Asset Value (NAV). ETFs can be passively managed, meticulously tracking specific indices (e.g., a Bitcoin spot index), or actively managed, where fund managers make discretionary adjustments to the portfolio composition.

• Spot vs. Futures-Based ETFs: This distinction is critical for digital assets.
  • Spot Bitcoin ETFs: These funds directly hold physical Bitcoin in secure cold storage with institutional custodians. Their performance is designed to closely track the spot price of Bitcoin. The U.S. Securities and Exchange Commission (SEC) notably approved several spot Bitcoin ETFs for trading in January 2024, a landmark decision that provided a regulated, accessible, and broadly accepted pathway for institutional investors, including state treasuries, to gain direct price exposure to Bitcoin. This approval signaled a maturity in the market infrastructure and regulatory oversight surrounding Bitcoin.
  • Futures-Based Bitcoin ETFs: These funds do not directly hold Bitcoin. Instead, they invest in Bitcoin futures contracts, primarily traded on regulated exchanges like the Chicago Mercantile Exchange (CME). While they offer exposure to Bitcoin’s price movements, their performance can diverge from the spot price due to factors like futures contract roll costs (contango or backwardation), which can erode returns over time. The SEC had approved futures-based Bitcoin ETFs earlier, viewing them as falling under the 1940 Investment Company Act, which provided greater investor protections than the 1933 Securities Act under which spot ETFs were initially proposed.
• Mechanism of Tracking: ETFs achieve their tracking objectives through two primary methods:
  • Physical Replication: The fund directly buys and holds the underlying assets in the exact proportions of the index or asset it aims to track. This is the preferred method for spot Bitcoin ETFs.
  • Synthetic Replication: The fund uses derivatives (such as swaps) with financial institutions to replicate the performance of the underlying asset or index. This introduces counterparty risk.

3.1.2 Exchange-Traded Notes (ETNs)

ETNs are unsecured debt securities issued by financial institutions (banks). Unlike ETFs, ETNs do not hold any underlying assets. Instead, their returns are linked to the performance of a specific index or asset class, such as Bitcoin. Investors essentially lend money to the issuer, and the issuer promises to pay a return linked to the performance of the specified benchmark, minus fees.

• Credit Risk: A key differentiator for ETNs is their inherent credit risk. Since they are debt instruments, their value is not only tied to the performance of the underlying asset but also to the creditworthiness of the issuing financial institution. If the issuer defaults, investors could lose their principal, even if the underlying asset performs well. This characteristic makes ETNs generally less favored for conservative institutional investors like state treasuries, especially when direct asset-backed ETFs are available.
• Lack of Direct Asset Ownership: Investors in ETNs do not own any part of the underlying digital asset, only a promise from the issuer. This distinguishes them significantly from spot Bitcoin ETFs.

3.1.3 Exchange-Traded Commodities (ETCs)

While often grouped with ETFs, ETCs specifically track the price of a single commodity or a basket of commodities, such as gold, silver, or oil. They can be structured either as ETFs (holding physical commodities) or ETNs (using derivatives). For digital assets like Bitcoin, which the U.S. Commodity Futures Trading Commission (CFTC) has classified as a commodity, an ETC structure (if it were to physically hold Bitcoin) would be conceptually similar to a spot Bitcoin ETF. However, in common parlance, especially in the U.S., the term ‘ETF’ is more frequently applied to digital asset products, even those tracking a single commodity-like asset, particularly after the SEC’s spot Bitcoin ETF approvals.

3.1.4 Other ETP Variants (Briefly)

Beyond these core types, other ETP structures exist globally, often tailored to specific market needs or regulatory environments. These can include Exchange-Traded Vehicles (ETVs) or more bespoke derivatives-based products. However, for the purpose of state treasury investment in digital assets, the regulated, physically-backed ETF structure remains the most pertinent and preferred option due to its transparency and risk profile.

3.2 Advanced Creation and Redemption Mechanisms: Ensuring Market Efficiency

The unique ‘creation and redemption’ mechanism is central to the efficient functioning and liquidity of ETFs, distinguishing them from traditional closed-end funds. This process is primarily facilitated by specialized financial institutions known as Authorized Participants (APs), typically large broker-dealers or market makers.

• Creation: When demand for an ETF exceeds its current supply, and its market price begins to trade at a premium to its Net Asset Value (NAV), APs step in. They acquire a specified ‘basket’ of the underlying assets (e.g., Bitcoin) in the open market and deliver this basket to the ETF issuer in exchange for new shares of the ETF, often in large blocks known as ‘creation units.’ These newly created ETF shares are then sold by the APs on the open market, increasing the supply and pushing the market price back down towards the NAV. This process ensures that the ETF can expand to meet investor demand without becoming significantly overvalued.
• Redemption: Conversely, when the market price of an ETF trades at a discount to its NAV, indicating excess supply or reduced demand, APs will purchase ETF shares from the open market. They then return these ‘redemption units’ to the ETF issuer in exchange for a corresponding basket of the underlying assets. The APs then sell these underlying assets in the market. This reduces the supply of ETF shares and pushes the market price back up towards the NAV, preventing the ETF from becoming significantly undervalued.

This continuous arbitrage mechanism, performed by APs, is crucial for two main reasons:

1. Price Efficiency: It ensures that the market price of ETF shares remains closely aligned with the fair value of its underlying assets (NAV), minimizing premiums and discounts.
2. Liquidity: It provides an additional layer of liquidity beyond simple secondary market trading. Even if trading volume in the ETF shares is low, APs can create or redeem shares, allowing investors to enter or exit positions efficiently, especially for large blocks.

3.3 ETPs vs. Direct Digital Asset Ownership vs. Other Indirect Methods

Choosing between ETPs, direct ownership, or other indirect methods for digital asset exposure involves a careful weighing of benefits and drawbacks for state treasuries.

3.3.1 Investing in ETPs (e.g., Spot Bitcoin ETFs)

Advantages:

• Regulatory Oversight: ETPs, particularly those approved by the SEC (like spot Bitcoin ETFs), operate within established regulatory frameworks (e.g., the 1933 Securities Act), offering a layer of investor protection, transparency, and reporting requirements that are familiar to state treasuries.
• Ease of Access and Familiar Infrastructure: ETPs trade on traditional stock exchanges, making them accessible through existing brokerage accounts and portfolio management systems. This avoids the need for state treasuries to develop new operational workflows or onboard specialized digital asset platforms.
• Professional Custody and Security: For physically-backed ETPs, the underlying digital assets are held by highly specialized, regulated institutional custodians, mitigating the significant security risks associated with direct private key management.
• Liquidity: ETPs generally offer high liquidity, allowing large blocks of shares to be bought and sold throughout the trading day at prevailing market prices.
• Diversification (for basket ETPs): While a single Bitcoin ETP offers exposure to one asset, future ETPs could offer diversified baskets of digital assets.
• Reduced Operational Burden: State treasuries avoid the complexities of directly acquiring, securing, and managing digital assets, including dealing with various exchanges, wallets, and blockchain protocols.
• Potential Tax Advantages: Depending on the fund structure and jurisdiction, ETPs may offer simplified tax reporting compared to direct ownership.

Disadvantages:

• Management Fees: ETPs charge expense ratios (management fees), which, over time, can erode returns, especially compared to holding the asset directly. These fees compensate for professional management, custody, and administrative costs.
• Tracking Error: While APs strive for price-NAV alignment, various factors (fees, expenses, rebalancing, market microstructure, futures roll costs for futures ETFs) can cause an ETP’s performance to deviate slightly from that of the underlying asset.
• Counterparty Risk (for ETNs or synthetic ETFs): As discussed, ETNs and synthetic ETFs carry the risk of the issuer defaulting on its obligations.
• Limited Utility Beyond Price Exposure: Investing in an ETP means a state treasury cannot directly participate in blockchain-native activities such as staking, decentralized finance (DeFi), or governance, which might offer additional yield or control for direct holders.
• No Direct Control: The state treasury does not have direct control over the underlying assets; decisions regarding custody, security upgrades, or forks are made by the ETP provider.

3.3.2 Direct Digital Asset Ownership

Advantages:

• Full Control and Self-Sovereignty: Direct owners control their private keys, offering ultimate autonomy over their assets.
• No Management Fees: Avoids ongoing fees associated with ETPs.
• Potential for Yield: Direct ownership allows participation in staking, lending, or DeFi protocols to generate additional yield (though this comes with its own set of complex risks).
• Access to All Blockchain Features: Ability to engage with smart contracts, governance, and other native functionalities.

Disadvantages:

• High Security Risk and Operational Burden: Managing private keys, securing wallets (hot/cold storage), and protecting against cyber threats is a highly specialized and complex task, often beyond the scope and expertise of state treasury departments.
• Regulatory Uncertainty: Direct ownership by a state treasury might face significant regulatory ambiguity and compliance challenges at both state and federal levels.
• Complex Tax and Accounting: Reporting and accounting for direct digital asset holdings can be intricate.
• Illiquidity for Large Positions: Executing large buy/sell orders directly on exchanges can be challenging and impact market prices.
• Steep Learning Curve: Requires significant technical expertise within the treasury department.

3.3.3 Other Indirect Methods (e.g., Private Funds, Corporate Exposure)

• Private Funds (Hedge Funds, Venture Capital): Some institutional investors access digital assets through private investment funds specializing in the space. These offer professional management but typically come with high fees, illiquidity, and less regulatory transparency than ETPs.
• Corporate Exposure: Investing in public companies that hold significant digital assets on their balance sheet or whose business models are tied to the crypto economy (e.g., MicroStrategy, Coinbase). This is an indirect play, and the primary business risk of the corporation remains a dominant factor.

For state treasuries, the ETP route, particularly physically-backed spot ETFs, offers the most pragmatic and compliant pathway. It effectively bridges the gap between the innovative potential of digital assets and the stringent requirements of public fund management by embedding these assets within a familiar, regulated, and professionally managed financial product.

Many thanks to our sponsor Panxora who helped us prepare this research report.

4. The Critical Nexus of Custodianship and Regulation in Digital Asset ETPs

For state treasuries to prudently invest in digital asset ETPs, the robustness of the underlying custodianship and the clarity and enforcement of financial regulations are paramount. These two pillars collectively ensure the integrity, security, and legitimacy of these novel investments.

4.1 Enhanced Role of Digital Asset Custodians

Custodians are financial institutions entrusted with the safekeeping of assets. In the traditional finance world, this involves holding physical securities or maintaining digital records. For digital assets, the role of a custodian is vastly more complex and critical, as it involves protecting cryptographic private keys that grant ownership of inherently digital, bearer instruments. For spot Bitcoin ETFs, the selection of a highly reputable and secure custodian is a fundamental component of the fund’s structure.

4.1.1 Defining Digital Asset Custody: Cold, Warm, and Hot Storage

Digital asset custodians utilize a spectrum of storage solutions, each with distinct risk profiles:

• Cold Storage (Offline): This involves storing private keys completely offline, disconnected from the internet. Methods include hardware wallets, paper wallets, or specialized hardware security modules (HSMs) in secure vaults. Cold storage offers the highest level of protection against online threats (hacks, malware) but can be less convenient for frequent transactions. It is the primary method for the vast majority of assets held by institutional custodians.
• Warm Storage: A hybrid approach, where keys might be semi-connected or require multiple layers of authorization and physical presence for transactions, offering a balance between security and accessibility.
• Hot Storage (Online): Private keys are stored on internet-connected devices or servers. This offers maximum liquidity and speed for transactions but is most vulnerable to cyberattacks. Institutional custodians use hot storage minimally, typically only for small operational floats or to facilitate immediate redemptions.

4.1.2 Advanced Security Protocols

Reputable digital asset custodians implement multi-layered, state-of-the-art security protocols:

• Multi-Signature (Multi-Sig) Wallets: Transactions require approval from multiple private keys, often held by different individuals or entities in different geographical locations. This prevents a single point of failure.
• Hardware Security Modules (HSMs): Tamper-proof physical devices that generate, store, and protect cryptographic keys within a secure, isolated environment.
• Air-Gapping: Completely isolating cold storage systems from any network connection.
• Geographical Distribution: Storing keys and backup data in multiple, geographically dispersed, high-security facilities to mitigate risks from natural disasters, political instability, or localized attacks.
• Physical Security: Custodial vaults often resemble military-grade bunkers, with biometric access controls, 24/7 surveillance, armed guards, and environmental controls.
• Operational Security: Strict internal controls, segregation of duties, background checks for personnel, and audit trails for all key management processes.
• Penetration Testing & Bug Bounties: Continuous external security audits and ethical hacking programs to identify and rectify vulnerabilities.

4.1.3 Operational Resilience and Compliance

Beyond security, custodians must demonstrate operational resilience and rigorous compliance:

• Business Continuity & Disaster Recovery: Comprehensive plans to ensure uninterrupted service and asset recovery in the event of unforeseen disruptions.
• Regulatory Compliance: Adherence to Know Your Customer (KYC), Anti-Money Laundering (AML) regulations, and sanctions screening. Custodians operating for U.S. ETFs must be regulated entities, often chartered as trust companies or state-licensed entities.
• Segregation of Client Assets: Legally and operationally separating client assets from the custodian’s own assets to protect investors in case of custodian insolvency.
• Third-Party Audits and Insurance: Regular independent audits of security practices, financial statements, and internal controls are crucial. Furthermore, many institutional custodians secure specialized crime insurance policies to cover potential losses due to theft, cyberattacks, or employee malfeasance, providing an additional layer of protection for fund assets.

4.2 The Evolving Landscape of Financial Regulation for Digital Assets

Financial regulators play an indispensable role in providing the legal certainty, investor protection, and market integrity necessary for institutional adoption of digital assets. The regulatory environment for digital assets has been dynamic and fragmented, but recent developments, especially in the U.S., are fostering greater clarity.

4.2.1 U.S. Regulatory Framework

• U.S. Securities and Exchange Commission (SEC): The SEC is the primary regulator for securities markets. Its classification of a digital asset significantly impacts its regulatory treatment. The SEC’s landmark approval of spot Bitcoin ETFs in January 2024 marked a pivotal moment, as it applied its rigorous standards under the 1933 Securities Act (governing public offerings) to these products. For years, the SEC had expressed concerns about market manipulation and inadequate investor protection regarding spot crypto markets. The approval indicated the SEC’s increased comfort with the surveillance sharing agreements and robust custody solutions proposed by applicants, acknowledging that the underlying Bitcoin markets had matured sufficiently to allow for a regulated ETP.
  • 1933 Act vs. 1940 Act: The SEC initially approved Bitcoin futures ETFs under the 1940 Investment Company Act, which regulates mutual funds and traditional ETFs and provides comprehensive investor protections. Spot Bitcoin ETFs, however, were filed under the 1933 Act. The SEC’s approval of the latter was a significant shift, indicating its view that the underlying spot market for Bitcoin had become resilient enough to support a retail investment product, despite its previous stance.
• Commodity Futures Trading Commission (CFTC): The CFTC regulates futures and derivatives markets. It has consistently classified Bitcoin and Ethereum as commodities, placing Bitcoin futures contracts under its jurisdiction. This distinction influences which regulatory body has primary oversight over certain digital asset products.
• Office of the Comptroller of the Currency (OCC): The OCC, which charters, regulates, and supervises all national banks and federal savings associations, has provided interpretive letters and guidance, allowing federally chartered banks to provide cryptocurrency custody services for clients, including ETPs. This institutional endorsement further strengthens the custody framework for digital assets.
• State-Level Regulation: Individual states also impose their own regulations. Many require ‘money transmitter licenses’ for entities dealing with digital assets. States like New York have established comprehensive ‘BitLicense’ frameworks. North Carolina’s HB 92 itself is an example of state-level legislative engagement with digital assets.

4.2.2 International Regulatory Approaches

Globally, regulatory frameworks are evolving. The European Union’s Markets in Crypto-Assets (MiCA) regulation, for instance, aims to provide a harmonized framework for crypto-asset issuance and services across all member states, covering aspects from consumer protection to market integrity. Other major jurisdictions like the UK, Singapore, and Japan are also developing their own comprehensive regulatory regimes, generally moving towards a balance of fostering innovation while mitigating risks.

4.2.3 Challenges in Digital Asset Regulation

Challenges remain, including:

• Jurisdictional Clarity: The fragmented nature of digital asset regulation, with different agencies asserting jurisdiction, can create ambiguity.
• Rapid Technological Change: The pace of innovation in the crypto space often outstrips the ability of regulators to formulate timely and appropriate rules.
• Market Manipulation Concerns: Regulators historically worried about the potential for market manipulation in unregulated spot crypto markets, though surveillance sharing agreements with regulated exchanges have been key to recent ETF approvals.

4.2.4 Impact on State Treasuries

For state treasuries, this evolving regulatory clarity, especially the SEC’s approval of spot Bitcoin ETFs, is transformative. It provides a formal stamp of approval from a leading financial regulator, signaling that these products meet established investor protection standards. This significantly lowers the legal and fiduciary hurdles for state investment committees considering digital asset exposure, as it demonstrates that a robust, regulated pathway now exists.

Many thanks to our sponsor Panxora who helped us prepare this research report.

5. Comprehensive Analysis of Advantages and Disadvantages for State Treasury Investments

Integrating ETPs into state treasury portfolios presents a unique blend of strategic advantages and inherent risks. A thorough understanding of both is essential for responsible public fund management.

5.1 Strategic Advantages

5.1.1 Enhanced Liquidity and Market Access

ETPs, by trading on major stock exchanges, offer unparalleled liquidity compared to direct trading on less regulated cryptocurrency exchanges. State treasuries can buy and sell ETP shares throughout the trading day at transparent, real-time market prices, facilitating efficient entry and exit from positions. This accessibility means treasuries can quickly adjust their exposure in response to changing market conditions or liquidity needs, a critical consideration for public funds.

5.1.2 Professional Management and Oversight

Investing in ETPs delegates the complexities of digital asset management to specialized fund providers. These providers employ teams of experts to handle trading, custody, compliance, and administration. This professional oversight significantly reduces the operational burden and expertise requirement for state treasury staff, who may lack specific experience in blockchain technology or digital asset security.

5.1.3 Regulatory Comfort and Compliance

One of the most significant advantages of ETPs, particularly SEC-approved spot Bitcoin ETFs, is their alignment with existing financial regulations. They fit seamlessly into traditional investment mandates and audit frameworks. This regulatory comfort addresses a major barrier for public funds, enabling them to invest in digital assets while adhering to their fiduciary responsibilities and legal constraints without requiring extensive retooling of their compliance departments.

5.1.4 Cost Efficiency (Relative to Direct Ownership)

While ETPs charge management fees, these are often significantly less than the costs associated with setting up and maintaining a direct digital asset custody operation. Directly managing private keys, implementing enterprise-grade security, ensuring regulatory compliance, and hiring specialized personnel for a state treasury would entail substantial upfront and ongoing operational expenses. ETP fees essentially cover these outsourced, complex functions efficiently.

5.1.5 Ease of Integration into Existing Systems

Since ETPs are traded like conventional stocks, they can be easily integrated into a state treasury’s existing portfolio management, trading, and accounting systems. This avoids the need for costly and time-consuming overhauls of IT infrastructure or the adoption of new, unfamiliar software platforms.

5.1.6 Risk Mitigation Through Structure

Physically-backed ETPs offer several layers of risk mitigation. The use of institutional-grade custodians protects against theft and loss of private keys. The transparency and reporting requirements imposed by regulators reduce the risk of fraud. For basket ETPs (should they emerge for digital assets beyond Bitcoin), the inherent diversification within the fund can further reduce asset-specific risk.

5.2 Inherent Disadvantages and Risks

5.2.1 Management Fees and Expense Ratios

The ongoing management fees charged by ETP providers, while covering essential services, can accumulate over time and detract from overall returns. For large, long-term investments, even seemingly small percentage points can translate into substantial amounts. State treasuries must carefully compare the expense ratios of various ETPs and weigh them against the value provided, acknowledging that these fees are generally higher for niche or novel asset classes compared to broad market index funds.

5.2.2 Tracking Error and Basis Risk

Tracking error refers to the deviation between an ETP’s performance and that of its underlying asset or index. Factors contributing to tracking error include management fees, operational expenses, cash drag (uninvested cash held by the fund), rebalancing costs, and for futures-based ETPs, the costs associated with rolling over futures contracts (basis risk). While sophisticated ETPs strive to minimize tracking error, it is an unavoidable reality that the ETP’s performance may not perfectly mirror the underlying asset’s performance.

5.2.3 Counterparty Risk (Especially for ETNs and Synthetic ETFs)

As previously discussed, ETNs are debt instruments and carry the credit risk of the issuing financial institution. If the issuer defaults, investors could lose their capital. Similarly, synthetic ETFs use derivatives (like swaps) with counterparties, introducing counterparty risk. While physically-backed spot ETFs mitigate this by directly holding the asset, state treasuries must perform rigorous due diligence on the ETP’s structure and the financial health of its issuer and custodians.

5.2.4 Market Volatility and Price Risk

Digital assets, especially Bitcoin, are characterized by significantly higher price volatility compared to traditional asset classes. While this presents opportunities for substantial gains, it also entails the risk of significant drawdowns. For public funds, which often prioritize capital preservation and stable returns, managing this inherent volatility is a critical challenge. Risk mitigation strategies, such as strict allocation limits (e.g., North Carolina’s proposed 10% cap), rebalancing rules, and a long-term investment horizon, are essential.

5.2.5 Ongoing Regulatory Uncertainty

While significant progress has been made, the regulatory landscape for digital assets is still evolving and subject to change. New regulations, enforcement actions, or shifts in governmental policy could impact the legal status, market dynamics, or operational viability of digital assets and ETPs. State treasuries must remain vigilant and adaptive to potential regulatory shifts that could affect their investments.

5.2.6 Custody Risk (Even with Institutional Custodians)

While institutional custodians offer vastly superior security compared to individual self-custody, no system is entirely impervious to risk. Potential threats include sophisticated cyberattacks, insider fraud, operational errors, or even unforeseen technological vulnerabilities. Although highly mitigated, residual custody risk remains a factor that state treasuries must acknowledge and continuously monitor through due diligence on their chosen ETP providers and their custodians.

5.2.7 Concentration Risk (for Single-Asset ETPs)

An ETP focused on a single digital asset, such as Bitcoin, introduces concentration risk specific to that asset. While Bitcoin is the largest and most established digital asset, its performance is still subject to idiosyncratic factors, technological shifts, and market sentiment specific to its ecosystem. Diversifying across a basket of digital assets (if such ETPs become available and approved) could mitigate this, but for now, treasuries must acknowledge the single-asset focus of most approved digital asset ETPs.

5.2.8 Lack of Direct Ownership Benefits

As previously noted, by investing in an ETP, state treasuries forgo the potential to engage directly with the underlying blockchain technology. This means they cannot participate in activities like staking (earning yield for supporting network operations), contributing to decentralized autonomous organizations (DAOs), or leveraging assets in DeFi protocols. While these activities carry their own complex risks and operational burdens, they represent potential revenue streams or strategic engagements that are unavailable through ETPs.

In conclusion, ETPs provide a structured and regulated bridge to digital assets, addressing many of the formidable operational and regulatory challenges of direct ownership. However, state treasuries must approach these investments with a clear-eyed understanding of the associated costs, market risks, and ongoing need for rigorous oversight and due diligence.

Many thanks to our sponsor Panxora who helped us prepare this research report.

6. In-depth Case Study: North Carolina’s ‘Digital Assets Investments Act’

North Carolina’s House Bill 92, the ‘Digital Assets Investments Act,’ represents a pivotal moment in the ongoing integration of digital assets into state-managed financial portfolios. This legislative initiative underscores a growing recognition among state policymakers of the potential benefits, particularly diversification and innovation, that digital assets can offer within a structured and regulated framework.

6.1 Detailed Examination of House Bill 92

House Bill 92 was introduced in February 2025 by North Carolina House Speaker Tim Moore and Representative Matthew Humphrey. The bill proposes to amend the existing General Statutes governing the investment of state funds, specifically by adding a new section that authorizes the State Treasurer to invest a portion of state-managed funds into digital asset exchange-traded products. This move places North Carolina among a select group of pioneering states actively exploring or proposing such investments, demonstrating a proactive stance on fiscal innovation.

6.1.1 Legislative Journey and Key Provisions

Upon its introduction, HB 92 would typically proceed through various legislative stages: committee review (e.g., Finance, Appropriations), floor votes in both the House and Senate, and finally, gubernatorial assent. The legislative process allows for public debate, expert testimony, and potential amendments to refine the bill’s provisions.

The core stipulations of House Bill 92 include:

• Investment Authorization: The bill explicitly authorizes the State Treasurer to invest funds and accounts under their control in qualifying digital asset ETPs.
• Allocation Limit: A crucial provision caps the maximum allowable allocation at 10% of the total assets under the State Treasurer’s management. This conservative limit is designed to mitigate risk exposure to the volatile digital asset market while still allowing for meaningful diversification and return potential. It reflects a prudent approach, acknowledging both the opportunities and the inherent risks.
• Definition of ‘Digital Assets’: The bill broadly defines ‘digital assets’ as a ‘digital representation of value that is recorded on a cryptographically secured distributed ledger or any similar technology.’ This broad definition accommodates future innovations within the digital asset space while maintaining the foundational requirement of cryptographic security.
• Eligibility Criteria for ETPs: To qualify for investment, ETPs must meet stringent criteria. Specifically, the underlying digital asset or assets tracked by the ETP must have had a market capitalization of at least $750 billion over the preceding 12 months. This high market capitalization threshold serves as a de facto filter, ensuring that only the most established, liquid, and systemically significant digital assets are considered for public investment. As of the bill’s introduction, this criterion is uniquely met by Bitcoin, effectively limiting initial investments to Bitcoin-related ETPs. This demonstrates a cautious, ‘crawl, walk, run’ approach, focusing on the most mature digital asset first.
• Regulatory Compliance: The bill implicitly requires that eligible ETPs comply with all relevant state and federal securities regulations, including those established by the U.S. Securities and Exchange Commission (SEC). The SEC’s recent approval of spot Bitcoin ETFs in January 2024 is a significant enabler for this bill, providing a direct, regulated, and institutionally palatable investment vehicle that meets high standards of investor protection and market integrity.

6.1.1 Rationale Articulated by Proponents

The proponents of HB 92, including Speaker Moore and Representative Humphrey, have articulated a clear rationale for this initiative, emphasizing fiduciary duty and fiscal prudence. While direct quotes may be scarce in a preliminary bill, the underlying arguments often revolve around:

• Fulfilling Fiduciary Duty in a Changing Economic Climate: Advocates argue that treasurers have a fiduciary responsibility to explore all prudent investment opportunities to maximize risk-adjusted returns and preserve the purchasing power of state funds, especially amidst inflation and evolving economic landscapes. As Speaker Moore might suggest, ‘It is our duty to ensure that North Carolina’s public funds are managed with an eye toward both stability and strategic growth, adapting to the modern financial world.’
• Diversification for Enhanced Portfolio Resilience: The bill’s emphasis on digital assets, particularly Bitcoin, is presented as a means to diversify portfolios beyond traditional asset classes, potentially reducing overall portfolio risk and improving long-term returns. Representative Humphrey might assert, ‘Bitcoin’s unique characteristics offer a valuable diversification tool for our state’s investment portfolio, protecting against risks inherent in traditional markets.’
• Positioning North Carolina as an Innovator: By being among the first states to formally authorize such investments, North Carolina aims to foster an image of financial innovation and leadership, potentially attracting technology companies and talent to the state. This forward-thinking approach can contribute to long-term economic development.

6.1.2 Comparison to Other States

North Carolina’s initiative is not entirely isolated. It is reported to be the 20th U.S. state to introduce legislation related to Bitcoin reserves or digital asset investments. While each state’s approach varies, a common thread is the exploration of Bitcoin as a potential reserve asset or a component of broader investment portfolios. States like Rhode Island have passed legislation to study blockchain technology and digital asset integration, while others, like Kentucky, have considered broader regulatory frameworks for digital assets. The North Carolina bill is notable for its specific allocation limit and market capitalization threshold, providing a clear and cautious pathway for immediate implementation once enacted.

6.2 Strategic Implications for North Carolina’s Public Funds

The enactment of HB 92 would have several profound implications for the management of North Carolina’s public funds:

• Potential Portfolio Impact: A 10% allocation to a high-growth, high-volatility asset like Bitcoin could significantly alter the risk-return profile of the state’s portfolio. While it introduces additional volatility, it also offers the potential for substantial long-term gains, contributing to overall fund growth. Investment models would need to be recalibrated to account for this new asset class.
• Alignment with Fiduciary Responsibilities: The bill’s cautious design, with its specific allocation limits and market capitalization requirements, aims to ensure that the investment aligns with the State Treasurer’s fiduciary duties. It frames digital asset investment as a prudent diversification strategy rather than a speculative venture, leveraging regulated ETPs to manage operational and security risks.
• Public Perception and Economic Development: By taking a pioneering stance, North Carolina could enhance its reputation as a financially innovative state, attracting blockchain-related businesses and talent. This could spur economic development, job creation, and technological advancement within the state, creating a virtuous cycle of growth and innovation.
• Operational Readiness: The State Treasurer’s office would need to ensure operational readiness, including internal training, updates to investment policies, and collaboration with chosen ETP providers to ensure seamless integration and oversight of these new investments. While ETPs simplify direct management, due diligence and ongoing monitoring remain critical.

6.3 Foreseen Challenges and Mitigation Strategies

While promising, the initiative is not without its challenges, requiring proactive mitigation strategies:

• Political and Public Acceptance: Introducing a novel and often misunderstood asset class like Bitcoin into public funds can face skepticism from politicians and the general public, particularly given its historical volatility.
  • Mitigation: Transparent communication, public education campaigns explaining the rationale (diversification, inflation hedge, innovation), and highlighting the conservative limits and regulatory compliance measures will be crucial to building trust and support.
• Ongoing Market Volatility Management: Bitcoin’s price fluctuations can be extreme. Even with a 10% cap, significant swings could impact portfolio valuation.
  • Mitigation: Implementing strict portfolio rebalancing rules to maintain the target allocation, setting clear risk limits, utilizing dollar-cost averaging for initial investments, and adopting a long-term investment horizon to ride out short-term market cycles are essential. The 10% cap is itself a primary risk mitigation strategy.
• Future Regulatory Shifts: The digital asset regulatory landscape is still evolving. Potential changes at the federal or state level could impact the permissibility or operational aspects of these investments.
  • Mitigation: Maintaining close liaison with regulatory bodies, actively monitoring legislative and policy developments, and building flexibility into investment mandates to adapt to new rules will be necessary.
• Operationalizing Custody and Security: While ETPs rely on professional custodians, the state treasury must conduct thorough due diligence on the chosen ETP provider and its underlying custodial arrangements to ensure the highest standards of security and operational resilience.
  • Mitigation: Mandating independent third-party audits of ETP custodians, ensuring robust service level agreements, and internal risk assessments will be vital.
• Performance Measurement and Reporting: Developing new metrics and reporting frameworks for digital asset performance within public funds will be important. Traditional performance benchmarks may not fully capture the unique characteristics of these assets.
  • Mitigation: Establishing clear performance objectives and reporting standards that integrate digital asset performance transparently within the overall portfolio context.
• Exit Strategies: Prudent financial management requires clear exit strategies. If market conditions fundamentally change, or the investment thesis for digital assets shifts, the state treasury must have a predefined plan for unwinding positions without significant market disruption.
  • Mitigation: Establishing liquidation protocols, understanding market depth for large sales, and considering staggered divestment strategies.

North Carolina’s House Bill 92 exemplifies a thoughtful, albeit cautious, step towards modernizing state investment portfolios. By embracing regulated ETPs and setting clear guardrails, the state seeks to harness the potential of digital assets while upholding its paramount fiduciary responsibilities.

Many thanks to our sponsor Panxora who helped us prepare this research report.

7. Broader Policy Implications and Future Outlook

North Carolina’s legislative efforts, alongside those of other pioneering states, carry significant broader policy implications, signaling a trajectory towards mainstream integration of digital assets within public finance. The future outlook for this convergence is dynamic, requiring adaptability and foresight from policymakers and investment managers alike.

7.1 The Precedent Set by Pioneering States

States like North Carolina that actively pursue legislative pathways for digital asset investments are setting crucial precedents. Their actions demonstrate that such allocations can be approached through a responsible, regulated framework, potentially inspiring other states to follow suit. The success or challenges encountered by these early adopters will serve as invaluable case studies, influencing the pace and nature of digital asset integration across other state and municipal treasuries. This ‘demonstration effect’ is critical in fostering wider acceptance and legitimization of a nascent asset class within the traditionally conservative public finance sector.

7.2 Evolving Landscape of Digital Asset ETPs

The current focus for state treasuries, as seen with North Carolina’s bill, is predominantly on Bitcoin ETPs due to its market dominance, liquidity, and recent regulatory clarity from the SEC. However, the ETP landscape is continually evolving:

• Ethereum ETPs: Following Bitcoin, Ethereum is the second-largest cryptocurrency by market capitalization, boasting a robust ecosystem and significant utility (e.g., smart contracts, DeFi). The approval of spot Ethereum ETFs by the SEC, which is currently under review, could open the door for state treasuries to diversify their digital asset exposure beyond Bitcoin.
• Basket ETPs: As the market matures, ETPs that track a diversified basket of cryptocurrencies (e.g., an index of top-performing digital assets) may emerge. These could offer broader market exposure and further diversification benefits, aligning more closely with traditional fund-of-funds strategies.
• Thematic ETPs: ETPs focused on specific blockchain sub-sectors (e.g., DeFi, metaverse, Web3 infrastructure) could also arise, offering more targeted exposure to the digital economy.

As more diversified and regulated ETPs become available and gain regulatory approval, state treasuries will have more sophisticated tools to manage their digital asset allocations, potentially moving beyond single-asset exposure to more diversified strategies.

7.3 Role of Education and Awareness

For the successful and sustainable integration of digital assets into public funds, widespread education and awareness are paramount. This extends beyond investment managers to policymakers, legislators, and the general public. Misconceptions about digital assets, often fueled by sensationalist media or past market excesses, can create significant hurdles. Clear, factual communication about the technology, market mechanics, regulatory safeguards, and the strategic rationale for investment is essential to build trust and foster informed decision-making. Educational initiatives can demystify digital assets, presenting them as legitimate, albeit volatile, components of a diversified portfolio within a carefully managed risk framework.

7.4 Balancing Innovation with Fiscal Prudence

The ongoing challenge for states will be to strike a delicate balance between embracing financial innovation and upholding their fundamental duties of fiscal prudence and capital preservation. Digital assets, by their nature, are disruptive and carry inherent volatility. While offering diversification and growth potential, they also necessitate heightened due diligence, rigorous risk management, and a long-term perspective.

Policy frameworks, like North Carolina’s HB 92, exemplify an attempt to achieve this balance by:

• Limiting Exposure: Capping the allocation to a conservative percentage (e.g., 10%) mitigates overall portfolio risk.
• Focusing on Established Assets: Requiring high market capitalization for underlying assets ensures investment in the most mature and liquid digital assets.
• Leveraging Regulated Products: Utilizing SEC-approved ETPs provides a layer of regulatory oversight and professional management.

This careful approach allows states to explore the new frontier of digital finance incrementally and responsibly.

7.5 The Long-Term Vision for Digital Assets in Public Finance

Looking further into the future, the interaction between state treasuries and digital assets could extend beyond simply holding ETPs:

• Tokenized Assets: The digitization and tokenization of traditional assets (e.g., real estate, private equity, infrastructure projects) could revolutionize liquidity and fractional ownership. States might invest in or even issue tokenized assets to raise capital or manage specific funds.
• Blockchain Infrastructure Investments: Beyond direct asset exposure, states might explore investments in the underlying blockchain infrastructure, such as venture capital into blockchain startups or partnerships with technology providers developing public sector applications of distributed ledger technology.
• Digital Currencies: The potential for central bank digital currencies (CBDCs) or state-issued digital currencies could fundamentally alter treasury operations, payment systems, and fiscal policy.

The trajectory is clear: digital assets and their underlying technologies are poised to become increasingly intertwined with traditional finance. State treasuries, as stewards of public wealth, are at a critical juncture, tasked with navigating this evolution to ensure long-term fiscal health and competitiveness.

Many thanks to our sponsor Panxora who helped us prepare this research report.

8. Conclusion

Exchange-Traded Products offer a structured, regulated, and increasingly accepted avenue for state treasuries to prudently gain exposure to digital assets. The recent legislative initiatives, particularly North Carolina’s proposed ‘Digital Assets Investments Act’ (House Bill 92), underscore a growing imperative among governmental entities to diversify investment portfolios, enhance resilience against macroeconomic pressures, and embrace financial innovation. By leveraging ETPs, state treasuries can bridge the gap between the novel opportunities presented by digital assets and their stringent fiduciary responsibilities, which prioritize capital preservation, liquidity, and risk management within a transparent framework.

The detailed examination of ETP mechanisms, their advantages such as enhanced liquidity, professional management, and regulatory compliance, and their disadvantages, including management fees and market volatility, highlights the careful balance required. Furthermore, the critical roles of institutional custodians in securing digital assets and financial regulators, particularly the SEC, in establishing robust oversight frameworks, are indispensable to the legitimacy and safety of these investments. The SEC’s landmark approval of spot Bitcoin ETFs in early 2024 has significantly de-risked the operational and regulatory landscape for institutional adoption, paving the way for initiatives like North Carolina’s.

North Carolina’s House Bill 92 exemplifies a pioneering yet cautious approach, with its strategic 10% allocation cap and stringent market capitalization requirements ensuring a focus on the most established digital assets through regulated products. While challenges such as market volatility and the need for public education persist, robust mitigation strategies—including diversified investment mandates, ongoing due diligence, and adaptive regulatory monitoring—are essential for success.

Ultimately, the integration of digital assets into state treasury strategies is not merely a fleeting trend but a reflection of the inevitable convergence of traditional finance with the burgeoning digital economy. States that proactively develop well-defined legislative and operational frameworks for engaging with digital assets, while maintaining an unwavering commitment to fiscal prudence, are poised to enhance their long-term financial health, stimulate economic innovation, and lead the way in modernizing public asset management for the 21st century.

Many thanks to our sponsor Panxora who helped us prepare this research report.

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