Bitcoin exchange-traded fund (ETF) continues to be the most eagerly awaited decision from the U.S. SEC. In the U.S., eight firms have tried without success since 2013 to create a bitcoin ETF. SEC has been hesitant to approve the Bitcoin ETF, while other countries have embraced and launched it. Recently, Canada’s securities regulator has given a go-ahead for a publicly-traded bitcoin exchange-traded fund (ETF). Today more than 20 cryptocurrency ETFs already exist outside the U.S., mostly in Europe.
If President Joe Biden’s nominee – Gary Gensler is chosen to lead the Securities and Exchange Commission, Gensler should act swiftly toward approving a Bitcoin exchange-traded fund and put the country on a level playing field with the rest of the world.
Gensler once taught a class at MIT’s Sloan School of Management called “Blockchain and Money.” But he has also acknowledged industry issues with fraud and light regulation.
Much of the previous Bitcoin ETF attempts from sponsoring firms have been on securing approval for the futures-backed offerings given the complexations of the safe storage of the cryptocurrency. However, this has much changed in recent years with regulated financial institutions such as Fidelity, ING, Bakkt, etc. launching digital assets custody solutions. BitWise and VanEck, the leading front-runners for Bitcoin ETF are betting on a physical-backed bitcoin ETF.
On Physical Versus Futures-Backed Bitcoin ETFs
Physical-backed Bitcoin ETF shares reflect actual Bitcoin price movement while Future-backed Bitcoin ETF share prices deviate to a larger degree compared to the actual bitcoin prices.
In the case of a physical-backed Bitcoin ETF, the sponsor – investment or asset management firm will purchase and hold the actual bitcoins in the wallet. Once purchased, it can create smaller-sized shares, which can then be sold and traded on stock exchanges.
Such physical-backed bitcoin ETFs are better for investors who want to take exposure in bitcoins without actually holding them. The investment management firm will be responsible for securely storing Bitcoins in their wallet, which in the past was a concern for the SEC due to the lack of proper custody solutions.
A futures-backed bitcoin ETF will base the shares in the fund by taking positions in bitcoin futures contracts instead of holding real bitcoins. Since futures are speculative instruments that may trade at a premium or at a discount, it is possible that the share price of a futures-backed bitcoin ETF may deviate to a larger degree compared to the actual bitcoin prices.
In futures-backed bitcoin ETFs, sponsors don’t have to worry about secure storage or thefts of bitcoins, however, they increase trading overheads. Since futures contracts come with expiry dates, sponsors need to roll over their underlying holdings.
“Rollover” occurs when an existing futures contract is about to expire and is replaced with another futures contract representing the same underlying but with a later expiration date. It often involves buying a longer-term futures contract at a higher price and selling the underlying holdings at a loss at the time of expiry of the contract. Additionally, it increases the operation cost.
Reason for not approving Bitcoin ETF in the past
Volatility, Liquidity, and Price manipulation. In today’s scenario, is that still justifiable?
#1. Volatility and liquidity:
For a physically-backed Bitcoin ETF, the sponsor has to physically control that much Bitcoin and is therefore limited to how many ETF shares can be circulated in the market. If the interest in the ETF holdings continues to increase, it could be a challenge for the sponsor to continue floating new shares without disrupting the trading mechanism given that liquidity is scattered across several exchanges. This could make Bitcoin more volatile than it is already.
A similar challenge can be experienced by the futures-backed Bitcoin ETF wherein a rise in the interest on the futures market could increase trading activity in the spot market, making Bitcoin price more volatile.
The SEC has approved vehicles that are arguably more dangerous in terms of volatility. There are many ETFs that are more volatile than Bitcoin. For example, Triple-leveraged (3X) exchange-traded funds (ETFs).
Leveraged exchange-traded funds (ETFs) come with considerable risk and are not appropriate for long-term investing. This is because they use financial derivatives and/or debt to amplify the performance of the underlying asset, some as much as 5x. And eventually, face complete collapse if the underlying index declines more than 33% on a single day. Some of the leveraged ETFs have a 60-day standard deviation between 100% and 200%.
#2 Price manipulation:
Another reason for rejecting Bitcoin ETFs (both physical and futures) in the past is the failure to convince the SEC of the Bitcoin efficient price discovery mechanism. The price discovery mechanism basically means deriving the price of an asset within a market based on the buyer and seller interactions.
Most of the Bitcoin ETF sponsors have proposed the Bitcoin ETF share price discovery based on the top-ten exchanges considered to be trustworthy. But this approach had a problem. In the past, most of the crypto exchanges used wash trading, one form of market manipulation to falsely articulate high trading volumes so as to gain new users.
However, this trend has changed with leading Cryptocurrency data providers like CoinMarketCap and CoinGecko changing their metrics. Now crypto data providers report top exchanges based on liquidity spread instead of volumes. This has helped to subside the wash trading practices.
Second, the broader Bitcoin market, which the SEC has previously said is prone to manipulation is becoming more efficient with bigger institutional players participating.
Why there is high interest in Bitcoin ETF
Much of the broader investor class does not buy Bitcoin. With Bitcoin ETF approval, the product can be traded on a stock exchange like buying a stock.
Bitcoin ETF is more likely to be bought by the very users of the durable and efficient ETF structure. It could bring accessibility and additional liquidity to the market. Much of the broader investor class could not buy Bitcoin, given the risk of betting on an unregulated asset, acquisition risk, and complex storage methods. It can be said it is really a market for specialists.
The introduction of the Bitcoin ETF can provide people with access to the Bitcoin market in an equity form, traded just as easily as buying shares of any stock. Investors don’t have to worry about losing keys to digital wallets. They just need to be able to log into a brokerage account. It could allow anyone seeking a safe vehicle to invest in Bitcoin to opt for ETF.
Unlike Grayscale Bitcoin trust shares that price at a premium rate – as high as 15-20% more than the actual Bitcoin price, ETF prices closely resemble the underlying asset.
But ETFs are also known for contributing more volatility, similar to gold. Since the launch of Gold ETF, interest in gold grew astronomically. The prices jumped to around $1,600 an ounce from about $332 at the time of the launch.
