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

By Rodrigo Zepeda, CEO, Storm-7 Consulting

Crypto Market Developments in Europe and the United States

In Part I of this Blog Series, I noted that crypto commentators such as Moeller (2022) had made statements such as:

“Enthusiasts view a spot ETF as a more legitimate method of investment because a spot ETF involves holding Bitcoin” and

“Crypto industry pundits often fight for a firm to establish a Bitcoin spot ETF as they believe that markets will take Bitcoin seriously after a spot ETF has been established”.

We can now see why such observations in relation to exchange-traded funds (ETFs) are elementary and misinformed. They are elementary because they are generalistic and are therefore prone to potentially mislead crypto investors. When we discuss crypto investments, we need precision. We need to identify which type of enthusiasts we are discussing. Are they crypto enthusiasts or financial investment enthusiasts, or a mixture of both? And we most certainly need to know which countries they represent.

Crypto investments in Europe, will be different to those in the United States (US), which will both be different to those in Vietnam, Singapore, or Hong Kong. Moreover, we previously saw that ETF investments can be undertaken with physical (full/optimised) replication or with synthetic replication (The Investment Association 2018, pp. 6-7). So, whether ETFs physically hold the underlying asset, or they replicate the asset synthetically, this in no way affects their legitimacy, as all such methods form completely legitimate ETF investment methodologies.

Therefore, in financial markets, speaking of the difference in legitimacy of ETF investment method in terms of physically holding an asset, or synthetically replicating the asset, is nonsensical. This is a misinformed view. The same can be said of any discussion concerning “Crypto industry pundits”, “markets”, and taking Bitcoin seriously. Which crypto markets, or financial markets are we talking about? We previously identified that the most relevant financial markets are the US and Europe (European Union (EU)). It was demonstrated that these are the ones that matter most.

Are these the markets under discussion? Or are they the Canadian markets? Because the ‘Purpose Bitcoin ETF (BTCC.Canada)’ commenced trading on the Toronto Stock Exchange on 18 February 2021 (Liu 2022). Does this mean that the “markets” that were referred to will now take Bitcoin (BTC) seriously, as this was a spot ETF now launched in Canada? Or, in actuality, will this only occur after Jacobi Asset Management launches its European spot Bitcoin ETF (BCOIN) this July 2022 on Euronext Amsterdam (i.e., the European markets) (Wright 2022)? As can be seen, this generic reference to “markets” is therefore confusing.

It may inadvertently mislead crypto investors to think that because many cryptocurrencies operate in a decentralised manner, that all cryptocurrency or Bitcoin markets are similar in nature. They are not. That is why when we talk about crypto ETFs, and principally Bitcoin futures ETFs and Bitcoin spot ETFs, what matters most is precision. That is, explaining issues and matters in ways that inform and empower crypto investors, rather than distorting their views and understandings via elementary and misinformed observations. Bearing this in mind, we will explore some of the theoretical benefits and problems that may arise with the launch of Bitcoin spot ETFs in the US financial market in more detail.

Bitcoin Spot ETFs: Theoretical Problems v. Theoretical Benefits

Investing in Bitcoin via a crypto exchange will not provide a crypto investor with any way to short Bitcoin. They will only be able to take a long position. This is problematic because given the volatile nature of Bitcoin, investors may either wish to speculate on a fall in the price of Bitcoin, or they may need to hedge their existing long position. Certain Bitcoin futures ETFs enable crypto investors to take short positions on the price of Bitcoin, which can be used for hedging or speculation purposes.

However, as was seen in Part II of this Blog Series, Bitcoin futures ETFs suffer from a number of intrinsic characteristics (e.g., asset tracking accuracy, underperformance, contango, roll premium, management fees and other expenses, small US market size, volume limits) that may detract from their overall investment proposition. So, at present, Bitcoin futures ETFs are still not attractive to all groups of crypto and financial investors, as they may not always be ideal financial instruments for Bitcoin hedging or speculation.

In theory, certain types of derivatives could address any residual market demand for alternative Bitcoin hedging or speculation instruments. For instance, a ‘Contract for Difference’ (CFD) is a financial derivative contract the value of which represents the difference between the agreed initial opening and subsequent closing price (at time of settlement) of an underlying asset. In theory, a Bitcoin CFD would enable an investor to directly speculate on, or hedge, the price movements of Bitcoin (long/short), without actually purchasing Bitcoin as an asset.

The inherent problem is that the use of CFDs has been effectively banned in the US for US residents and citizens. In the United Kingdom (UK), the Financial Conduct Authority (FCA) prohibited the sale to retail clients of investment products that referenced cryptoassets in 2020 (FCA 2020). This included CFDs, options, and futures that reference unregulated transferable cryptoassets such as Bitcoin (FCA 2020). This ban was based on the FCA’s belief that cryptocurrency CFDs represented an extremely high-risk, speculative investment, which would feature:

(1) extreme price volatility (e.g., >30% decline in value in a single day);

(2) massive risks from excessive available leverage (e.g., some firms were offering up to 50:1 leverage which would massively amplify potential losses);

(3) high charges and funding costs (e.g., spread, funding charges, commissions); and

(4) significant market risks relating to a lack of fair and accurate price transparency (FCA 2017).

The US ban on CFDs, along with the views of the UK FCA on cryptocurrency CFDs, has not changed. So, it it would seem to be the case that Bitcoin spot ETFs represent an alternative way to overcome existing bans on crypto and Bitcoin CFDs in the US. In practice, Bitcoin spot ETFs may be attractive to certain important groups of crypto and financial investors, and these are retail investors and institutional investors (e.g., mutual funds, pension funds, insurance companies.

They may be attractive to retail investors because Bitcoin futures ETFs may still present too many issues, Bitcoin futures ETFs may not directly reflect current Bitcoin market values, and also US/UK retail investors are banned from using Bitcoin CFDs. Institutional investors are typically prohibited by their investment mandates from directly holding a range of cryptoassets, including Bitcoin. In theory, Bitcoin spot ETFs would therefore provide a new way for institutional investors to diversify their portfolio holdings with exposure to a new asset class.

Institutional investors typically represent a very significant proportion of financial market investments. By providing access to Bitcoin investments in this way, Bitcoin spot ETFs hold the potential to significantly open up trading volumes and liquidity in US Bitcoin spot ETF markets. This is important because:

(1) the US is the largest ETF market in the world, with approximately $502 billion of Assets under Management (AuM) (Deutsche Asset Management (DAM) 2017, p. 5);

(2) 40% of retail investors use ETFs in the US compared to only 15-20% of retail investors in the EU, resulting in higher trading volumes and higher global impact (Wright 2022);

(3) the US features the top worldwide Bitcoin trading volume (n=$1,523.6 million in 2020) (Statista 2020); and

(4) the US financial markets feature two of the most, if not the most, advanced financial regulators in the world, namely the ‘U.S. Securities and Exchange Commission’ (SEC), and the ‘U.S. Commodity Futures Trading Commission’ (CFTC).

This means that the introduction of Bitcoin spot ETFs in the US could potentially catalyse the global acceptance of Bitcoin spot ETFs, as well as other crypto spot ETFs, by many more jurisdictions around the world. Overall, this could help to mitigate and stabilise the overall volatility of global Bitcoin prices in the long-term, which could in turn mitigate and stabilise the overall volatility of other correlated cryptocurrency prices. Lower volatility of Bitcoin could in turn increase its attractiveness as an investment asset, and its legitimacy as a cryptocurrency that holds its value.

At the same time, there are still a number of issues that can be identified that need to be addressed and potentially overcome. The first problem is identifying whether or not Bitcoin spot ETFs are actually the best way to open up and stabilise the volatility of Bitcoin markets, which raises the issues in question. In Part I of this Blog Series, we identified that the key ETF characteristics for investors were: (1) transparency; (2) cost-effectiveness; (3) diversification; (4) flexibility; and (5) liquidity (The Investment Association 2018, pp. 8-9).

However, crypto investors can already achieve flexibility by trading on a wide range of crypto exchanges. A Bitcoin spot ETF may provide transparency, but it is questionable whether one would immediately be cost-effective, as the benefits from scale management and lower transaction costs may only come about after a significant number of Bitcoin spot ETFs are available to competitively trade on the market. Furthermore, one of the most important objectives behind ETF investments is diversification.

Yet, Bitcoin spot ETFs in themselves provide no such diversification, as there is no securities basket which is replicated within the offering. The whole point behind many equity ETFs on US markets is replication of a diversified basket of underlying securities. In practice, such diversification reduces ETF investment risk. What this actually means, is that instead of the benefit of diversification, Bitcoin spot ETFs provide investors with concentration risk, as pricing is concentrated within a single asset.

There is also a significant challenge of liquidity that may arise. This is because traditional ETFs are structured in such a way as to ensure that large differences between share prices and the ‘net asset value’ (NAV) of the portfolio of securities are unlikely to persist (Investment Company Institute 2017, p. 7). As was seen in Part I of this Blog Series, the ETF creation/redemption mechanism is used by ‘Authorised Participants’ (APs) to provide liquidity within the relevant ETF ‘Primary Market’ and ‘Secondary Market’ (Deutsche Asset Management 2017, p. 11).

APs can therefore arbitrage any difference in an ETF’s intraday market price and its NAV by trading via the Primary and Secondary Markets (SEC 2012, p. 3). Theoretically, such arbitrage activities by APs will help to ensure that the ETF’s Secondary Market price falls back in line with its NAV (The Investment Association 2018, p. 11). However, Deutsche Asset Management (DAM) notes that:

“ETF arbitrage is possible only when the fund’s price moves by more than a certain amount above or below its NAV. The width of this so-called no-arbitrage or fair value band reflects the costs of creating or redeeming the ETF, including the bid-offer spreads on the underlying securi-ties, any creation or redemption fees set by the issuer, transaction taxes (where applicable) and hedging and inventory costs.” (DAM 2017, p. 11).

This underlying ETF arbitrage mechanism can actually fail in times of high market stress or panic, as market liquidity dries up which impacts bid-offer spreads, APs are not able to trade the funds’ underlying stocks and bonds, and ETF liquidity may evaporate (Kay 2009). Crypto and Bitcoin investors that believe this would never happen because of the global liquidity of crypto and Bitcoin markets would be wrong.

We need look no further than the Canadian listed 'Purpose Bitcoin ETF' which lost half its assets (24,510 Bitcoins - approximately $500 million) in one day in June 2022, likely because of a huge liquidation, to evidence such a potentiality (Sandor 2022; Pan and Hajric 2022). Added to this, in May 2022, the Canadian listed '3iQ CoinShares Bitcoin ETF' also suffered large investment outflows (7,401 Bitcoins) (Sandor 2022). Therefore, whilst I accept that US financial markets are significantly larger than Canadian financial markets, I am not convinced that similar market panics/shocks would not present themselves in US Bitcoin spot ETF markets, should they be approved by the US regulatory authorities.

Moreover, the latest decision by the SEC with respect to a pending Bitcoin spot ETF application by Grayscale Bitcoin Trust (Greyscale), would seem to confirm the SEC's continuing strong reluctance to provide such approval (see: SEC Release No. 34-95180; File No. SR-NYSEArca-2021-90 issued on 29 June 2022 (Greyscale Case 2022)). The Greyscale decision issued last week confirmed that the SEC disapproved the ‘proposed rule change’ (PRC) by Greyscale under NYSE Arca Rule 8.201-E (Commodity-Based Trust Shares).

The SEC held that the US electronic securities exchange ‘NYSE Arca’ had failed to demonstrate that the PRC was sufficient to prevent fraudulent and manipulative acts and practices (Greyscale Case 2022, p. 18). In Greyscale, the SEC received and acknowledged significant and extensive documentary evidence and assertions from market commentators. In summary, these asserted that:

(1) the SEC should approve the PRC as this would satisfy investor demand for a US regulated investment vehicle with direct exposure to Bitcoin;

(2) approval of a Bitcoin spot ETF would provide a simpler, safer, and more efficient way for retail investors to invest in Bitcoin (such as over-the-counter Bitcoin funds, Bitcoin futures funds, or foreign Bitcoin funds);

(3) approval of a Bitcoin spot ETF would reduce custody and cybersecurity risks for investors;

(4) approval of a Bitcoin spot ETF would facilitate lower costs and risks than Bitcoin futures ETFs;

(5) disapproving a Bitcoin spot ETF after approving Bitcoin futures ETFs would harm investors;

(6) Bitcoin futures ETFs present structural disadvantages over Bitcoin spot ETFs (e.g., monthly roll-costs and risks owing to position limits);

(7) approval of a Bitcoin spot fund would enhance efficiency, liquidity, and price discovery of the underlying Bitcoin markets; and  

(8) approval of a Bitcoin spot ETF would enhance investor choice, improve market structure and competition thereby benefitting investors, and would facilitate capital formation (Greyscale Case 2022, pp. 77-82).

Despite such wide-ranging arguments supported by market commentators, the SEC clearly disagreed with such views (Greyscale Case 2022, p. 82). Moreover, it confirmed that the test to be applied to such a PRC application, was inherently not a balancing test that could incorporate and take into account potential market and investor benefits (Greyscale Case 2022, p. 83). Rather, it was instead strictly limited to the specific legislative requirements set out in Section 6(b)(5) of the US Securities Exchange Act of 1934.

As such, the SEC found that the PRC did not sufficiently cover rules designed to prevent fraudulent and manipulative acts and practices, and to protect investors and the public interest. As the final Part IV of this Blog Series will show, the case was important because it provided a more detailed explanation as to how a Bitcoin spot ETF could be approved in the future in the US. Most importantly, it confirmed that there were other possibilities apart from surveillance-sharing agreements that could be used by exchanges to prevent fraudulent and manipulative acts and practices (Greyscale Case 2022, p. 9).

To be continued.