A critical view on cryptocurrency spot ETFs by the Korea Institute of Finance

The Korea Insitute of Finance (KIF), in its periodical “Financial Brief”, has published research by Bomi Lee, outlining “Considerations on the Approval of Overseas Virtual Asset Spot ETFs”. As the document is also highly relevant to the discussions in Japan on the same topic, here is an English translation of the key points.

Recently, the approval of ETFs based on cryptocurrencies like Bitcoin and Ethereum in the US and other countries has sparked significant interest. While the issuance and trading of cryptocurrency-linked products offer advantages such as investor protection under regulatory frameworks and potential profits for financial institutions, they also pose risks, including: resource misallocation, increased exposure of financial markets to cryptocurrency-related risks, and potential threats to financial stability. The debate on introducing cryptocurrency-linked products necessitates thorough research and understanding of the potential benefits and drawbacks. At this juncture, the potential downsides appear to outweigh the benefits.

An Examination of Cryptocurrency Spot ETF Approvals Abroad

The Securities and Futures Commission (SFC) of Hong Kong approved the issuance of both Bitcoin and Ethereum spot ETFs on April 15, 2024, marking the world’s first approval for Ethereum spot ETFs.

The UK’s Financial Conduct Authority (FCA) approved both Bitcoin and Ethereum spot ETFs on May 22, 2024.

US

The approval of cryptocurrency spot ETFs in the US was facilitated by the effective implementation of a surveillance-sharing agreement between the exchanges seeking to list these ETFs and regulated exchanges where the underlying cryptocurrency spot market operates.

• The SEC had previously required exchanges seeking to list Bitcoin spot ETFs to establish a surveillance-sharing agreement with a regulated market where Bitcoin, the underlying asset, is traded in significant size*.
• This requirement is intended to comply with Exchange Act Section 6(b)(5), which mandates that exchange rules be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.
• At the time of the SEC’s rejection in 2022, exchanges aiming to list spot ETFs had established surveillance-sharing agreements with the Chicago Mercantile Exchange (CME), where Bitcoin futures are traded. However, the SEC argued that the CME was not a market where Bitcoin was traded in significant size and that futures and spot products are distinct, thus not meeting the listing requirements.
• Following the court’s decision to overturn the disapproval, the SEC changed its stance, asserting that the high correlation between Bitcoin spot prices and futures prices traded on the CME indicated that the surveillance-sharing agreement with the CME was sufficient to prevent fraud and manipulation in the Bitcoin spot market (SEC Release №34–99306).
• Similarly, in the case of Ethereum spot ETFs, the approval was facilitated by the surveillance-sharing agreement between the exchanges seeking to list the ETFs and the CME, where Ethereum futures are traded (SEC Release №34–100224).

Hong Kong & UK

Hong Kong and the UK were influenced by the US approval of Bitcoin spot ETFs. Hong Kong took a more progressive approach, driven by its crypto-friendly policies, while the UK adopted a more cautious stance, limiting access to institutional investors.

• Hong Kong has demonstrated its ambition to become a hub for the Asian cryptocurrency market. Following the approval of Bitcoin and Ethereum futures ETFs in December 2022, the introduction of licensing for cryptocurrency exchanges in June 2023, and the establishment of regulations for cryptocurrency-related financial products and institutions, Hong Kong became the first jurisdiction to approve Ethereum spot ETFs and permitted in-kind creation and redemption mechanisms. In-kind creation and redemption allows for the direct exchange of ETFs for Bitcoin and Ethereum, contrasting with the US SEC’s approach of only permitting cash settlement for Bitcoin spot ETFs.
• Joint Circular on intermediaries’virtual asset-related activities established regulatory measures for financial institutions handling cryptocurrency-related products. Circular on SFC-authorised funds with exposure to virtual assets set regulatory guidelines for the approval of funds investing in cryptocurrencies.
• In March 2024, the UK’s FCA indicated its willingness to approve Bitcoin spot ETFs targeting institutional investors, citing the accumulation of data from prolonged cryptocurrency trading. Subsequently, Bitcoin and Ethereum spot ETFs were listed on the London Stock Exchange for institutional investors at the end of May.
• The FCA banned the sale of cryptocurrency-related derivatives and ETFs to retail investors in January 2021, citing concerns such as the lack of reliable valuation standards for cryptocurrency-based ETFs, high price volatility, and limited investor understanding.

Cryptocurrency Exchanges

Considering that most countries permit cryptocurrency investments through exchanges, the authorization of cryptocurrency spot ETFs signifies the integration of cryptocurrencies into the regulated financial system rather than a mere expansion of investment assets.

• The argument that cryptocurrency-based ETFs enhance investor access to otherwise inaccessible assets holds less weight since individual investors in most countries that do not permit cryptocurrency ETF trading can readily trade cryptocurrencies through exchanges*.
• For instance, ETFs based on commodities like gold or crude oil, which are difficult to trade directly, or foreign currency ETFs, where direct investment may be cumbersome due to regulations, genuinely enhance investor access to those specific assets.
• As cryptocurrencies, previously traded outside regulatory frameworks, enter regulated markets through ETFs, they become subject to regulatory oversight and investor protection measures.
• Notably, cryptocurrency spot ETFs necessitate cryptocurrency spot trading by financial institutions, signifying that cryptocurrencies are becoming a target for active investment by these institutions.

South Korea

South Korea permits the brokerage of Bitcoin futures ETFs but prohibits the issuance and brokerage of spot ETFs.

• When the US approved Bitcoin spot ETFs, South Korean financial authorities maintained that issuing and brokering Bitcoin spot ETFs contradicted existing regulations that prohibit financial institutions from holding, purchasing, taking cryptocurrency as collateral, or making equity investments in them. They also questioned whether Bitcoin met the requirements for underlying assets of ETFs under the Capital Market Act*.
• According to Article 4 (10) of the Capital Market Act, underlying assets of ETFs should include financial investment products, currencies, commodities, credit risks, or other risks related to natural, environmental, or economic phenomena that can be calculated or evaluated through reasonable and appropriate methods.
• However, brokering Bitcoin futures ETFs is permitted because the underlying assets are Bitcoin derivatives rather than Bitcoin itself.

Some argue that South Korea should also allow the issuance and trading of cryptocurrency-linked products, such as Bitcoin spot ETFs, citing potential benefits for investors and financial institutions.

• Allowing the trading of cryptocurrency-linked products in regulated markets would require regulatory authorities to monitor the spot and futures prices of the underlying cryptocurrencies, oversee unfair trading practices, and provide investor protection. Financial institutions would be obligated to comply with legal requirements applicable to capital markets, creating a safer investment environment for investors.
• Financial institutions could generate profits through brokerage, issuance, and liquidity provision for cryptocurrency-linked products and enhance their competitiveness in developing and managing cryptocurrency-based products.

Conversely, the introduction of cryptocurrency-linked products could have negative consequences for the economy, financial markets, and financial stability.

• Allowing the issuance and trading of cryptocurrency-based ETFs could lead to a significant flow of South Korean capital from productive investments, such as corporate investments that generate future cash flows, towards cryptocurrencies, resulting in resource misallocation. This effect could be exacerbated if financial institutions directly manage cryptocurrency spot ETFs, leading to increased capital flows to the cryptocurrency market through their spot trading activities.
• While shifting capital to non-cash-flow-generating assets might diversify individual investment risk, it can lead to inefficient resource allocation at a national economic level.
• Introducing cryptocurrency-linked products could increase the exposure of financial markets to cryptocurrency-related risks through financial institutions that manage, broker, or invest in these products. A decline in cryptocurrency prices might force financial institutions and pension funds invested in related positions to liquidate their holdings and sell traditional assets to secure liquidity, potentially triggering a decline in traditional asset prices and propagating risks throughout the financial system.
• If individual investors lacking sufficient understanding of financial market mechanisms and cryptocurrencies invest heavily in cryptocurrency-linked products, shocks originating from the cryptocurrency market could trigger bank runs, undermining the stability of the financial system. Failure to implement adequate investor protection measures could severely erode investor confidence in the financial market, exacerbating these issues.

The debate surrounding the introduction of cryptocurrency-linked products requires thorough research and a comprehensive understanding of the potential benefits and drawbacks. At present, the potential downsides appear to outweigh the benefits.

• If the value of cryptocurrencies as financial assets becomes more evident and they demonstrate the ability to generate unique returns not replicable by traditional assets, they could serve as valuable tools for diversifying individual investment risks.
• However, introducing products based on cryptocurrencies into the regulated financial system at this stage, characterized by limited understanding of their intrinsic value and high price volatility, could create a false sense of legitimacy among market participants, potentially amplifying the aforementioned risks.
• Mitigating the risks associated with cryptocurrency-based ETFs necessitates robust regulatory frameworks. However, the evolving nature of the cryptocurrency market, characterized by its growing size and the emergence of new products, creates uncertainty regarding its impact on investors and the financial system. This uncertainty poses challenges in developing comprehensive regulatory frameworks and investor protection mechanisms.

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