The ‘Bitcoin (Crypto) ETF’ Primer Series: PART II

By Rodrigo Zepeda, CEO, Storm-7 Consulting

Crypto Market Developments in Europe and the United States

In Part I of this Blog Series, readers were introduced to underlying financial market fundamentals relating to ‘exchange-traded funds’ (ETFs). It was identified that the United States (US) and Europe formed the top two markets for ETFs globally (Deutsche Asset Management (DAM) 2017, p. 5). Therefore, in theory, any regulatory and market developments in the US and Europe have the potential to catalyse the greatest change in global crypto ETF industry trends and practices. That is why the US and European markets matter. However, Europe currently represents the least viable option, in terms of speed of potential change.

This is because any developments pertaining to the regulation of crypto futures ETFs and crypto spot ETFs in Europe, would invariably be required to take place within the European Union (EU) regulatory framework, i.e., regional regulation across all 27 Member States. The legislative processes for enacting EU regulatory frameworks are much more protracted, owing to the need to achieve harmonisation across a larger number of EU Member States. As a result, enacting regulatory changes to facilitate and catalyse issuing and trading of crypto ETFs would take much longer, compared to the US.

The US also features the top worldwide Bitcoin (BTC) trading volume (n=$1,523.6 million in 2020) (Statista 2020). In addition, the 'U.S. Securities and Exchange Commission' (SEC), which regulates securities markets, and the 'U.S. Commodity Futures Trading Commission' (CFTC), which regulates derivatives markets, are viewed as two of the most, if not the most, advanced financial regulators in the world. If they are willing to accept the introduction of both crypto futures ETFs and crypto spot ETFs, this would send a clear and unmistakeable signal to crypto markets and regulators worldwide regarding their commercial viability.

Bitcoin (Crypto) Futures ETFs v. Bitcoin (Crypto) Spot ETFs

In Part I of this Blog Series, we saw that the main difference between a Bitcoin spot ETF and a Bitcoin futures ETF, is that spot ETFs track the price of real physical (digital) Bitcoins (i.e., direct price tracking), and futures ETFs track the price of Bitcoin futures (i.e., indirect price tracking) (Georgiev 2021). However, there are financial instrument characteristics and regulatory differences that may further distinguish investments in Bitcoin spot ETFs and Bitcoin futures ETFs. By analysing these, readers can become more knowledgeable about potential crypto investments.

To begin with, there are certain intrinsic characteristics that may detract from the overall investment proposition of Bitcoin futures ETFs. There are issues relating to underperformance, namely that Bitcoin futures ETFs can underperform the asset they are tracking (Bitcoin), as the contracts expire on a future date, and must be rolled over into new contracts (Stafford and Johnson 2021). Because the sale price of near-expiry futures contracts is below the price of future-expiry futures contracts (contango), traders must then either suffer a small loss, or pay a roll premium (to roll contracts from an expiry month to a future month) (CFTC 2022).

Investors may also be required to pay management fees and other expenses, e.g., subsidiary commodity pool management fees, parent investment company management fees (CFTC 2022). This means the crypto futures fund must potentially absorb transaction costs and management fees for thousands of new contracts (Stafford and Johnson 2021). Owing to the comparatively small size of the US Bitcoin futures ETF market there are structural challenges that may also arise.

For instance, the Chicago Mercantile Exchange (CME) Group had set down volume limits to restrict potential market volatility and manipulation – these are 4,000 contracts per entity for short-dated (November) contracts (Stafford and Johnson 2021). Thereafter, whilst investors could purchase an unlimited number of longer-dated futures contracts, these were more costly (Stafford and Johnson 2021).

In theory, a Bitcoin spot ETF would be based on more realistic market prices. This is because it would be based on the actual price of Bitcoin, which would reflect the prevailing global market price, as opposed to a Bitcoin futures ETF, which would be based on Bitcoin futures which represent a much smaller market (De 2022). This means Bitcoin futures market prices may not always accurately reflect prevailing global market prices for Bitcoin.

As was seen in Part I of this Blog Series, CME Bitcoin futures are based on the ‘CME CF Bitcoin Reference Rate’ (BRR), which is calculated on relevant Bitcoin transactions taken from only four Constituent Exchanges (Bitstamp, GDAX, Kraken, itBit) (CME Group 2020), i.e., value is representative of a smaller target population. This fact tends to somewhat call into question claims that there is more efficient price discovery for Bitcoin futures ETFs (Nasdaq 2021). In October 2021, the number of outstanding trades in Bitcoin futures trading on the CME was approximately $5 billion (Stafford and Johnson 2021).

However, this figure can be compared to the global market capitalisation of Bitcoin in June 2022, which was approximately $398.6 billion (n=$398,581,921,746) (CoinMarketCap 2022). Clearly, this is a big difference. As a result, Bitcoin futures ETF investors may therefore potentially be exposed to additional price volatility risk along with tracking discrepancies (Bitcoin v. futures prices) (Stafford and Johnson 2021). By way of illustrative example, in November 2021 the index provider ‘Solactive’ estimated that futures contracts had achieved a loss of 13 percentage points, compared to the 120% rise experienced by Bitcoin at that time (Stafford and Johnson 2021).

The regulation of ETFs is also a prime consideration in US markets. The default position at present seems to be that the SEC has rejected a number of applications since 2013 for Bitcoin spot ETFs, and it is unlikely to change its position in the short term (Blockchain Council; Gallagher 2021). I will analyse why this is the case below. Some market commentators believe that the clear difference that exists between crypto futures ETFs and crypto spot ETFs may explain this positioning (Blockchain Council; Gallagher 2021).

On the one hand, regulatory authorisation of physical asset ETFs (i.e., crypto spot ETFs) is governed by the US Securities Act of 1933 (1933 Act) process, which requires an exchange to file a Form 19b-4 which must demonstrate that the relevant underlying market is not subject to manipulation (Blockchain Council 2021; Gallagher 2021). On the other hand, regulatory authorisation of futures-based ETFs (i.e., crypto futures ETFs) is generally governed by the US Investment Company Act of 1940 (1940 Act) process instead (Blockchain Council 2021; Gallagher 2021).

Most ETFs are registered as investment companies with the SEC under the 1940 Act and offer public shares which are registered under the 1933 Act – purists consider these to be ‘true’ ETFs (WisdomTree Investments, Inc. 2018). In practice, the process for listing of ETFs in the US under the 1940 Act has been simplified. There are exchange rules that set out continued listing standards for all ETFs that mirror generic initial listing standards (Investment Company Institute (ICI) 2017, p. 6). This means that if index and actively managed ETFs can meet generic listing standards, no further SEC approval or relief under the 1934 Act will be required to initiate listing and trading of a new product (ICI 2017, p. 7).

It is only if a new proposed ETF cannot meet an exchange’s generic listing standards, that the exchange is then required to submit an individual ‘proposed rule change’ to the SEC (under Rule 19b-4), to then obtain formal listing approval (ICI 2017, p. 7). Not only can this process take a long time (i.e., more than one year), but it is procedurally and substantively complex (ICI 2017, pp. 8-9). To date, most accepted and listed Bitcoin futures ETFs have used the 1940 Act process.

So, for example, certain crypto ETFs listed in October 2021 were approved under the 1940 Act process, under which the investment fund was regulated as an ‘investment company’ and classified as ‘non-diversified’ under the 1940 Act (‘ProShares Bitcoin Strategy ETF (NYSE ARCA: BITO)’, ‘VanEck Bitcoin Strategy ETF (Cboe BZX: XBTF)’, ‘Valkyrie Bitcoin Strategy ETF (NASDAQ: BTF)’). Any type of futures, options, or derivatives instrument issued in the US is subsequently regulated by the CFTC pursuant to the US Commodity Exchange Act of 1934 (1934 Act). ETFs that invest in Bitcoin-related futures contracts are regulated by the CFTC.

However, the CFTC does not hold regulatory jurisdiction over spot markets, e.g., markets on certain digital cryptocurrency exchanges (Howell 2022). This underlying regulatory structure is therefore crucial to understanding precisely why crypto futures ETFs have been accepted by the SEC/CFTC to date, but crypto spot ETFs have not. Bitcoin futures ETFs are structured in a similar way to managed futures mutual funds and ETFs, as the ETFs hold at least 75% of assets in fixed income securities/money market instruments/cash, and up to 25% in shares of a wholly owned subsidiary (controlled foreign corporation (CFC)) (K&L Gates LLP 2020, p. 311).

The CFC is authorised only to invest in Bitcoin futures traded on the CFTC regulated CME, and so this structuring of the ETF allows it to fall within 1940 Act regulation (K&L Gates LLP 2020, p. 311). In this operational structure, the exposure of the fund to securities outweighs the actual indirect exposure to Bitcoin, which enables the ETF to be ascribed investment company status under the 1940 Act, and therefore able to rely on the SEC ETF Rule (Rule 6c-11 rescission of exemptive relief) (K&L Gates 2020, pp. 311-312; SEC 2019). This is crucial to the acceptance of such Bitcoin futures ETFs by the SEC. As noted by the US law firm K&L Gates LLP (2020, p. 312):

“The applicability of the 1940 Act to these ETFs was a key consideration of the SEC in not objecting to their listing”.

In distinct contrast, ETFs that offer spot exposures to Bitcoin are not subject to regulation under the 1940 Act, because Bitcoin is not a security (SEC v. W. J. Howey Co., 328 U.S. 293 (1946); Board of Trade of City of Chicago v. SEC, 677 F.2d 1137, 1142 (7th Cir. 1982)) (K&L Gates 2020, p. 312). Therefore, since the ETF portfolio in Bitcoin spot funds will not predominantly consist of securities, they will not be capable of registration under the 1940 Act (K&L Gates 2020, p. 312).  In principle, ETF registration under the 1940 Act offers investors a wide range of protections (e.g., conflict of interest provisions, governance requirements, fiduciary duties), therefore from the SEC’s viewpoint, these will not be made available for crypto spot ETFs (K&L Gates 2020, p. 313). 

SEC Decision: Bats BZX Exchange, Inc., 10 March 2017 

These underlying differences in the structuring of crypto ETFs and the regulatory approval procedures to be followed, are absolutely crucial to the overall probability of approval of a proposed crypto ETF in the US. Bitcoin futures ETFs that follow the 1940 Act approval process are likely to be approved, so long as they follow the same structural format as previously approved Bitcoin futures ETFs. However, because Bitcoin spot ETFs must generally follow a different approval process under the 1933 Act using Form 19b-4, at present it is very unlikely the SEC will approve such type of investment entity.

The rationale behind this is set out and exemplified in the SEC decision setting out an order disapproving of a proposed rule change with respect to the listing and trading of shares of the ‘Winklevoss Bitcoin Trust’ (WBT) commodity trust exchange-traded products (ETPs) on 10 March 2017 (Release No. 34-80206; File No. SR-BatsBZX-2016-30) (Bats Case 2017). In the Bats Case 2017, Bats BZX Exchange (BZX) filed a proposed rule change (PRC) to list and trade shares of WBT. The SEC stated that it was required to determine whether the PRC was consistent with statutory provisions, rules, and regulations applicable to a national securities exchange (NSE), and it was required to disapprove the filing if it did not make such a finding (Bats Case 2017, p. 1).

The SEC disapproved of the PRC because it did not find the proposal to be consistent with section 6(b)(5) of the 1934 Act, which required that the rules of a NSE be designed to prevent fraudulent and manipulative acts and practices to protect investors and the public interest (Bats Case 2017, p. 2). The SEC found that to meet the required standard, two requirements had to be met which were held to be dispositive of the matter:

(1) the NSE must have surveillance-sharing agreements (SSAs) with significant markets for trading the underlying commodity or derivatives on that commodity; and

(2) those markets must be regulated (Bats Case 2017, p. 2).

BZX represented that it had entered into a comprehensive SSA with the Gemini Exchange, however, the SEC found that the proposed SSA was not sufficient to justify the PRC (Bats Case 2017, p. 2). The SEC decision was based on very extensive evidence which included 59 comment letters that it had received regarding the PRC which the SEC analysed in depth. One of the key points made by the SEC, was that when a crypto spot market was unregulated (i.e., global decentralised unregulated Bitcoin markets), there had to be significant, regulated markets or derivatives markets related to the underlying asset (Bitcoin), with which BZX could enter into a SSA (Bats Case 2017, pp. 36-37).

Consequently, the SEC decision logic, was that a regulated exchange must meet its obligation under section 6(b)(5) of the 1934 Act, by implementing rules designed to prevent fraudulent and manipulative acts and practices, and to protect investors and the public interest (Bats Case 2017, p. 37). It found that global, decentralised, unregulated markets for Bitcoin existed around the world, and that in reality these were significantly exposed to a very wide range of fraudulent or manipulative acts and practices. In order to detect and deter manipulative conduct, an exchange must have SSAs in place with all significant, regulated, Bitcoin-related markets (Bats Case 2017, p. 37).

The SEC believed the majority of Bitcoin daily trading volume was conducted on unregulated exchanges situated outside the US. This meant BZX operations were potentially exposed to a wide range of fraudulent or manipulative acts and practices occurring on unregulated Bitcoin markets around the world. These were the relevant significant markets in Bitcoin. Since the relevant significant markets in Bitcoin were unregulated, in theory, BZX could not enter into SSAs with such significant markets. As a result, it was not possible for the SEC to approve the PRC. The SEC concluded:

“The Commission notes that bitcoin is still in the relatively early stages of its development and that, over time, regulated bitcoin-related markets of significant size may develop. Should such markets develop, the Commission could consider whether a bitcoin ETP would, based on the facts and circumstances then presented, be consistent with the requirements of the Exchange Act.” (Bats Case 2017, p. 38).

Overall, this no doubt seems to have cast somewhat of a death knell for proposed future Bitcoin spot ETFs in the US. In the next blogs, I will endeavour to summarise where the global crypto ETF landscape has developed to date. Most importantly, I will seek to venture further than previous crypto articles by providing readers with potential solutions to overcoming the crypto spot ETF problem that currently exists in US markets.

To be continued.