Is Bitcoin ready to be structured as an ETF?
Bitcoin ETFs have been catching people’s eyes. Currently, there are around 25 Bitcoin ETF applications on the market, none of which are officially approved and few are rejected recently. However, the emergence of the Bitcoin ETF concept represents a further step toward the recognition of crypto currencies as a legitimate asset class (especially by regulators). However, there is a considerable way to go before a crypto ETF proposal could get approved. Two ProShares Bitcoin ETFs, a GraniteShare ETF and five Direxion ETFs, for example, were rejected by the SEC (Securities Exchange Commission) on August 22 . The SEC also announced that the VanEck ETF decision would be delayed to September 30. Although I am an enthusiast for Bitcoin, I still have one question: is the SEC ever going to approve an ETF application?
Traditional ETF
First, we need to fully understand the definition of an ETF and its pricing mechanism to understand the basic requirements for Bitcoin ETF approval.
The full name of an ETF is Exchange Traded Fund. An ETF tracks an index, a commodity, bonds, or a basket of assets. An ETF is a special open-ended fund that can be traded on a stock exchange, like a common stock.
Only authorized participants (APs) can create or redeem units of an ETF. APs are large financial institutions, such as banks or investment companies. To create an ETF, an AP assembles the required portfolio of underlying assets and turns that basket over to the fund in exchange for newly created ETF shares. For redemptions, APs return ETF shares to the fund and receive the basket consisting of the underlying portfolio. The fund’s underlying holdings are disclosed to the public every day.
An ETF has a net asset value (NAV), which is a value per share of an ETF on a specific date or time. An ETF calculates NAV at the end of each day. The formula for the NAV is as follows:
NAV = (assets-liabilities) / number of outstanding shares
They are many advantages of a traditional ETF: diversification (BTC ETF alone offers no diversification benefit), as well as the ability to short and to buy on margin.
Bitcoin ETF and its influence if approved
There are some differences between the Bitcoin ETF and traditional ETF in addition to the underlying asset. First, a Bitcoin ETF does not have as much diversification benefit. Bitcoin ETFs can track two types of assets: physical Bitcoins and derivatives based Bitcoins. If it tracks the physical Bitcoins, a Bitcoin ETF has a much narrower underlying asset class than a traditional ETF since it only invests in one type of asset — Bitcoin. As such, an ETF that tracks Bitcoin does not offer, if any, diversification benefit. The positive is that investors could hold the corresponding security and do not need to deal with Bitcoin storage buying and selling. The other type is Bitcoin derivative backed ETF, or a futures-based ETF since the only crypto derivative existing on the market is Bitcoin futures. The underlying asset class is also simpler than that of traditional ETFs.
The approval of Bitcoin ETF by the SEC will make a great difference. So far, Bitcoin and other cryptocurrencies are not considered “mainstream”. Cryptocurrencies are listed on exchanges operated by private companies, and carries the stigma of “high risk, high volatility, and lack of security over the warehousing”. However, if a Bitcoin ETF were to be listed on a regulated U.S. exchange, it could pave the way for participation by mainstream investors, potentially pushing Bitcoin toward mass adoption and broader recognition on Wall Street. What is more, it makes it easier for an investor to buy Bitcoin: he or she would only need a brokerage account.
Is Bitcoin ready to be structured as an ETF?
The following list provides details of 25 Bitcoin ETF proposals filed by various institutions. Some of them are “physically” backed, but most of them are backed by crypto derivative.
Winklevoss’s application was rejected on July 26th. The SEC explained its decision in a 92-page report . One of the arguments reads:
“The arguments submitted in support of this claim are incomplete and inconsistent, and are unsupported or contradicted by data.”
Citing similar reasons (e.g. fraud and manipulation concern), the SEC rejected two ETFs filed by ProShares that tracks ETF futures, another from GraniteShares and five inversed and leveraged ETFs proposed from Direxion on August 22, 2018. The recent rejection can be founded in 26-page report (https://www.sec.gov/rules/sro/nysearca/2018/34-83904.pdf). SEC argued that the ProShare applications:
Still have not met the essential requirement “that a national securities exchange’s rules be designed to prevent fraudulent and manipulative acts and practices. Among other things, the Exchange has offered no record evidence to demonstrate that bitcoin futures markets are ‘markets of significant size.”
CBOE-VanEck-SolidX Bitcoin ETF has created a stir since its application seems to fix all the points that SEC flagged on other applications and is in the best position to be approved. VanEck wrote a supplemental letter to SEC that covers five points: valuation, liquidity, custody, arbitrage, and potential manipulation. According to VanEck, (1) prices from CBOE (Chicago Board Option Exchange) and CME (Chicago Mercantile Exchange) are sufficient to determine a Bitcoin ETF’s NAV, and (2) the bitcoin market is a very liquid one citing the existing combined Bitcoin futures volume of close to $150 million to $200 million, with an average trading spread of less than five basis points. Most of the letter addresses the market manipulation risks, which is SEC’s major concern. VanEck argued that the Bitcoin futures market is already regulated, and manipulation risks of Bitcoin ETF are significantly mitigated by its nature as a regulated product traded on U.S. exchanges.
VanEck’s argument on manipulation risk does not seem very sound. The Bitcoin future helps because it creates a capacity to short Bitcoin, reducing the possibility for price manipulation. However, the idea that the ETF nature mitigates manipulation risk remains to be seen. Although the most promising application, I do not think the VanEck’s proposal will be approved in the next 30 days and SEC might further delay the decision,. Before accepting a Bitcoin ETF, SEC needs to be very cautious and conservative and ETF market still needs to mature. In sum, it is unlikely that SEC will approve a Bitcoin ETF soon.
Pros and cons of Bitcoin ETF
However, as a Bitcoin enthusiast, I believe that all Bitcoin ETF needed is time. The approval of a Bitcoin ETF will surely be a turning point for the whole industry, but will you invest in Bitcoin ETF if it gets approved? Here are the pros and cons:
Pros
1. Easy to invest. People have been complaining about the complexity of exchanging cryptocurrencies on private exchanges. With Bitcoin ETFs, one can let the ETF managers worry about this issue. At the same time, you do not need to be approved to trade futures, since an ETF can be easily traded in a brokerage account.
2. New asset class for existing investors. One of the biggest pros of Bitcoin ETF is that it adds an asset class to the market. Besides, it encourages investors who were not interested in investing cryptocurrencies to be involved in the market.
3. Arbitrage opportunities. For traditional ETFs, the arbitrage opportunity exists, since both ETF and the basket of underlying assets are tradeable during trading hours. Arbitrage opportunities also exist for Bitcoin ETF, offering more trading options.
4. More possibilities. Currently, Bitcoin ETF only invests in Bitcoin. However, we could see that there are infinite possibilities with cryptocurrencies: one can invest in new digital currencies and their derivatives as the industry grows and matures. Cryptocurrency ETFs can track more assets in the future. Besides, investors will be able to short and buy on margin.
Cons
1. Volatility. The volatility of Bitcoin is one of the reasons why most people choose to be a spectator instead of an investor. Cryptocurrency market in general is beloved by risk-takers, but it is not for those who are risk-averse.
2. Potential manipulation. Bitcoin ETF creators alleged that ETF’s nature will reduce manipulation risk, but the market still needs to grow and mature. Besides, market sentiment on cryptocurrency is very skeptical, and it depends heavily on regulator actions.
3. Audit. The auditing process will be tricky, as it is challenging for an ETF manager to verify that the underlying asset is present and secured.
In conclusion, the future of Bitcoin ETF is promising given it is easy to invest, gives investors more options like diversification, arbitrage, short and buy on margin, but the market needs more time. A bitcoin ETF still will be highly volatile and has manipulation and auditing risks. Postponing the approval of Bitcoin ETF is actually a good sign, since the SEC is serious about Bitcoin and other cryptocurrencies instead of rejecting the application outright in July and August. From an investor’s perspective, it is better to be more prepared instead of recklessly entering the market. In addition, the first movers bear more risks but potentially more returns. So it really comes down on your risk tolerance. Although I don’t think SEC will approve Bitcoin ETF at this point, I am still positive about its future.
Bio of the author:
Amber Li, Research Lead, KoinEra
Amber Li is a Johns Hopkins alumnus with a Master’s degree in Finance. Prior to KoinEra, she worked at PNC Bank (New York) in trans-border transactions with deals over 100 million dollars. She also worked in a hedge fund deal that successfully shorted a publicly listed company and made 50% return within two days. She noticed the trend of blockchain and hopes to leverage her finance background in this field. Currently, she is the Research Lead at KoinEra, a New York-based blockchain think tank.
Disclaimer: This article is not meant to give financial advice. Any opinion herein should be taken as is. Buying and trading cryptocurrencies should be considered a high-risk activity. Please carry out your own research before investing in any of the numerous cryptocurrencies available. Finally, KoinEra takes no responsibility should you lose money trading cryptocurrencies.
