The road to a Bitcoin ETF

The race is on. Currently, there are several bitcoin ETFs under review by the SEC. The Winklevoss twins recently had their application rejected for the second time after spending more than five years in the process. Undeterred, Cameron had this to say:

Despite today’s ruling, we look forward to continuing to work with the SEC and remain deeply committed to bringing a regulated bitcoin ETF to market and building the future of money.
— Cameron Winklevoss, Gemini President

So what exactly is an ETF and why are so many trying to bring one to market?

All Kinds of Funds

An Exchange Traded Fund or ETF is just a special type of fund. Funds are pooled investment vehicles where investors combine their assets for investment purposes. All funds involve an issuer or investment manager directing investments on behalf of the fund owners.

Since funds involve an issuer raising capital from investors to pursue a strategy for profit, they are deemed securities, and thus regulated by the SEC. The hallmark of a security is the investment of capital with the expectation of profit based on the efforts of others, or the “common enterprise.” Depending on the nature of the security, there are restrictions on how they can be marketed and transferred.

There are many kinds of funds suited for different audiences. Here are some examples roughly ordered from least regulated to most:

The reasons for purchasing a fund vary, but usually it’s a matter of investors wanting to benefit from the manager’s expertise, scale and access. Funds are convenient and investors benefit from shared expenses and effort.

Hurdles to an ETF

As the name implies, ETFs are traded on exchanges, which means they are traded similar to public equities. Being listed on an exchange allows anyone in the general public to invest, so the requirements are stiff.

Funds implement a variety of investment strategies. Hedge fund managers are afforded great flexibility, while mutual funds and ETFs face more rules and scrutiny. A typical ETF strategy is to mimic an index or asset performance, such as the S&P 500, gold or oil. Regardless of the strategy put forth in the prospectus, ETFs currently require the SEC to approve their listing on an exchange. The SEC is concerned with making sure the general public is protected from possible fraud, manipulation, and malfunctioning markets.

While creating a fund that tracks bitcoin’s price movement sounds relatively simple, the truth is that many players are required. The SEC evaluates the proposed investment objective and the operational strategy to determine whether the risks are appropriate and adequately disclosed. They are concerned with minimizing any sources of conflict, tracking error, or manipulation. The list of entities involved will look something like:

Sponsor: The issuer / fund manager of the ETF. Chooses the investment strategy and drafts the prospectus. Responsible for overseeing and marketing the fund

Authorized Participants: The market makers for the ETF. Unlike mutual funds, ETFs are not sold directly from the issuer to the public. Instead a select group is responsible for creating and destroying shares depending on market conditions

Administrator: Keeps formal records and financial books for the ETF

Prime broker: Responsible for sourcing counter-parties in the market for the fund to transact with

Custodian: Responsible for safeguarding the fund’s assets

Data Sources: Provide pricing data for marking fund value for share creation and redemption

In the case of the Winklevoss ETF, one concern is that the Winklevoss twins are involved in too many aspects of the fund potentially creating conflicts of interests. Their exchange, Gemini, is proposed as both a data source and brokerage, while the Winklevoss twins also act as the fund sponsor. Additionally, the Winklevoss twins propose holding “physical” BTC, which is largely traded in unregulated international exchanges. These concerns along with a conservative posture towards the industry have led the SEC to disallow the ETF for now.

Why does it matter?

Most people and institutions are not cryptocurrency investors. Despite companies like Coinbase making it relatively easy to participate, it is an intimidating market to get into. The real world applications are still being built, and while people may want financial exposure, getting past the hurdles to enter the market is often seen as not worth it.

What most people and institutions do have is access to traditional brokerage accounts. American brokerages firms are home to tens of trillions of dollars worth of assets. An ETF would act as a literal bridge between these markets, putting bitcoin in a place where investors can get exposure in a manner that is very familiar and comfortable to them. Purchasing shares via a ticker symbol with a broker is not foreign to most of us.

Beyond placing bitcoin in a familiar form nearer to where the retail money is, an ETF enables many institutions an avenue to enter the market. Most institutions have strict mandates and guidelines outlining the universe of investable assets. Compliance is serious at institutions, and direct cryptocurrency investing doesn’t yet have enough clarity for them. Investing a fund traded on major equities exchanges makes the compliance challenges much simpler.

Current Contenders

At the time of this writing there are four issuers with an active application for a crypto ETF. An additional three have either been rejected or withdrawn, but they may re-enter the process at any time.

Active applications

Direxion: This firm specializes in ETF creation, especially leveraged. They have five Bitcoin ETF applications in the works ranging from 2x Bear to 2x Bull. These products are based on futures and will not hold physical bitcoin.

Note: Bull ETFs track the asset while Bear ETFs track the inverse of the asset. 2x Bull and 2x Bear use financial leverage to provide amplified exposure to the underlying asset. As a rough example, if Bitcoin were to increase 2% in a day, the 2x Bull ETF should increase by 4% and the 2x Bear should decrease by 4%.

GraniteShares: A newer firm aiming to create a Bitcoin Bull ETF and Bear ETF. These funds are also based on the futures markets and will not hold physical bitcoin.

Van Eck: SolidX teamed up with the fund giant Van Eck to lend credibility ot their offering. This ETF aims to assuage regulator concern for retail investors by having an initial share price of $200,000. The Van Eck ETF will hold physical bitcoin, resulting in custody challenges to overcome.

ProShares: Another futures based ETF offering. ProShares aims to bring both a Long and Short product to market.

Withdrawn/Rejected

The Winklevoss Bitcoin Trust, a physical bitcoin ETF, has been rejected twice now. The Bitcoin Investment Trust, another physical bitcoin fund, led by Barry Silbert’s Digital Currency Group, has withdrawn its application. Rex Shares, an issuer of a pair of bitcoin futures based ETFs, has also withdrawn its application.

Conclusion

Investing in cryptocurrencies remains foreign for many involving friction, compliance and technical challenges. An ETF provides investors with a familiar and convenient way to invest. While they may not benefit from the censorship resistant properties of crypto, they can participate financially in this transformative technology. The beauty of decentralized systems is that they are open to participation in many forms, and not everyone has to participate the same way.

Disclaimer: Jordan Clifford is a managing director of Scalar Capital which holds bitcoin. This post is not investment or legal advice.