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Bitcoin ETFs Guide: Bringing Institutional Investors to Crypto

Bitcoin advocates really really want to see shares of Bitcoin exchange-traded funds (ETF) launch on the world’s major stock exchanges. Tapping into the $4 trillion ETF market would bring credibility to crypto trading — and might give bitcoin prices a bump.

Unfortunately, regulators aren’t as excited. They have shot down every Bitcoin ETF proposal thus far. CoinIQ’s Bitcoin ETFs 101 will guide you through the complex world of ETFs and why regulators give them such a hard time.

This goal of this article is to help you understand a complicated issue facing the crypto community. It is not investment advice. Even fiat-world ETF trading carries risks. Bitcoin ETFs would have risks of their own that you should discuss with a financial advisor.

Exchange-Traded Funds Explained

Trading on an exchange
Source: Pixabay

The first ETF hit the markets in the early 1990s. Twenty-five years later, ETFs have become a huge part of institutional investment strategies in the fiat world. Individual investors can take advantage of ETFs as well, whether for long-term gains or short-term profits.

The advantage of investment funds

In some respects, ETFs resemble mutual funds. They both pool money from outside investors. They both invest in a defined list of assets like the companies in the Dow Jones Industrial Average (DJIA). Some mutual funds specialize by holding stocks in specific industries or in specific countries. Other types of mutual funds don’t purchase stocks at all– just currencies or commodities.

Affordable diversification is one advantage both mutual funds and ETFs offer. They let you invest in particular categories without having to spend the money on individual assets.

Let’s say you want your investments to track the DJIA. Buying a share of each company listed on the Dow would cost you more than $26,000. Fidelity’s Rydex Dow Jones Industrial Average Fund Class A, on the other hand, recently cost only $73.49 per share. The fund is a more affordable way to invest in the Dow.

Professional management is another benefit of investment funds. Buying and selling assets to keep the fund balanced takes time, resources and talent. Individual investors and institutions alike prefer to outsource that day-to-day management.

Limitations of mutual funds

Mutual funds can’t compete with ETFs for liquidity or flexibility. It all comes down to the fine print that regulators impose on mutual funds. Getting out of a mutual fund, for example, doesn’t happen right away. The fund sets its share price, the net asset value or NAV, only once a day regardless of volatility. In addition, US fund managers have 7 calendar days to transfer the funds to you.

Regulations also prevent traders from using tools like short selling or margin. This makes speculative trades or hedging strategies more difficult to put in place.

ETFs don’t have these restrictions. They’re no different from shares in a company. You can buy and sell ETF shares as quickly as quickly as any stock. You can also use the full range of investment tools to maximize your returns or hedge other investments.

Creating an exchange-traded fund

Like a mutual fund, an ETF invests in a basket of assets. Unlike a mutual fund, an ETF only deals directly with large institutions. These tend to be regulated financial institutions who play one of two roles: Authorized Participants (APs) and Official Liquidity Partners (OLPs).

Authorized Participants

The APs are the only ones that invest in the ETF. These are large financial institutions that can afford the fund’s price of entry. For example, an ETF may set its “creation unit”, the minimum transaction size, at 50,000 shares. This could easily mean the AP must make multi-million dollar transactions each time it trades with the ETF.

The NAV of the fund’s asset portfolio determines the price of the creation unit. However, the AP does not necessarily hand over a pile of cash. The ETF may instead require a basket of securities that matches the fund’s assets. When the AP sells a creation unit back to the ETF, the AP gets a similar basket of securities.

Dealing with a handful of APs who make large transactions makes ETF management more efficient than mutual fund management. For example, an ETF’s underlying assets get bought and sold in much larger volumes. This is easier and cheaper than the many small transactions a mutual fund makes. As a result, an ETF’s management fees can be much less than a mutual fund that holds similar assets.

Official Liquidity Partners

Even though the APs are the ones that receive and return the ETF’s shares, it’s the OLPs that actually bring the shares to market. As a condition for its listing, the ETF must have at least one OLP authorized to trade on the stock exchange. The OLP is a market maker that buys and sells the ETF’s shares. Its trading must have a specific spread and quote size, adding liquidity to the market in the process.

Trading ETF shares

Once the APs buy their creation units, they sell their shares into the secondary market. There the shares trade just like any other stock. Exchange-trading gives ETFs several advantages over mutual funds.

Investors buy and sell ETF shares at the market’s spot price rather than the mutual fund’s once-a-day NAV. Just as importantly, there’s no 7-day wait to get the proceeds of the sale. As soon as the trade clears, the money is in your account (minus any exchange fees, of course).

ETF share prices, however, don’t track exactly with the price its underlying assets. The ETF price will rise or fall with the market expectations for the asset’s price. For this reason, some investors treat ETF markets as cheaper and easier alternatives to futures markets.

Investors also get to profit from price variability by using the full range of investment tools, from short-selling to margin trading, that they use for stocks and other traditional equities. Investment strategies like high-frequency trading or hedging become much easier when dealing with ETFs.

There’s a lot more to ETFs than we can cover here. Fortunately, the Central Bank of Ireland has a 100-page discussion paper on exchange-traded funds. It’s a long, long read but you’ll come out of it with a solid understanding of fiat-world ETFs and the debates about them within the financial industry.

How Bitcoin ETFs Work

Bitcoin exchange-traded funds will work much like fiat-world ETFs. APs transfer large amounts of bitcoin to the fund manager in exchange for creation blocks of the ETF. Market-making OLPs provide liquidity on the listing stock exchange where prices would rise and fall alongside, but not in lockstep with, bitcoin’s market price.

In addition to all of the benefits of a fiat-world ETF, a Bitcoin ETF lets investors trade in the growth of the cryptocurrency industry without having to buy and hold any bitcoin. This is of particular concern for institutional investors whose management cannot accept the risks that come with investing in largely unregulated crypto markets.

In fact, bitcoin advocates see ETFs as a way of jump-starting the cryptocurrency’s price growth. If and when institutional investors from the fiat world start buying large quantities of bitcoin, the advocates argue, bitcoin’s prices will skyrocket again.

Attempts to create Bitcoin ETFs

Securities and Exchange Commission
The Securities & Exchange Commission hasn’t been too friendly to Bitcoin ETFs. Source: SEC

The crypto industry has tried for years to create Bitcoin ETFs that regulators will approve. Right now, your only options are ETFs that track aspects of the crypto economy. The Toronto Stock Exchange, for example, lists the Horizons Blockchain Technology and Hardware Index which hold stocks in companies like crypto miners and other cryptocurrency industry related businesses.

Closer to the ideal is Bitcoin Tracker One, an early “clean” bitcoin-based derivative. Created in 2015, it’s an exchange-traded note (ETN) that’s listed on the stock exchange in Sweden. An ETN tracks the price of an asset like bitcoin like an ETF, but is riskier since it is not backed by any actual bitcoin holdings.

Bitcoin ETFs: 0 for 14

The absence of Bitcoin ETFs from the world’s stock markets is not for lack of trying by the crypto and fiat financial industries. So far this year, the SEC has rejected 14 Bitcoin ETFs. A fifteenth proposal is still under review.

All of the rejected Bitcoin ETF proposals suffered from the same flaws. They failed to show that bitcoin futures markets are big enough to prevent fraud, that their methods to prevent fraud would work and that regulated bitcoin markets are large enough to make surveillance sharing agreements effective.

Since they all shared the same fate, we’ll do a deep dive into one of the proposals later on. For now, here’s a quick rundown of the Bitcoin ETF proposals to date.

Winklevoss Bitcoin Shares – rejected

The first attempt to create a Bitcoin ETF in the United States came from New York-regulated Gemini Exchange and the national stock exchange Bat BZX. They filed in 2016, got rejected in 2017, appealed the rejection and got rejected again this year.

GraniteShares – rejected

While the Winklevoss appeal was still under review, the BZX Exchange submitted another application to list 2 Bitcoin ETFs called GraniteShares Bitcoin ETF and GraniteShares Short Bitcoin ETF. This time, the exchange partnered with Bank of New York Mellon.

ProShares – rejected

In late 2017, the New York Stock Exchange Arca exchange applied to list 2 Bitcoin ETFs, the ProShares Bitcoin ETF and ProShares Short Bitcoin ETF in partnership with one of the world’s largest ETF managers, ProShares Group.

Direxion funds – rejected

In early 2018, NYSE Arca partnered with Direxion Asset Management, US Bancorp Fund Services and Bank of New York Mellon to list 9 Bitcoin ETFs. Besides taking long and short positions, some of the ETFs would use leveraged positions to generate returns at multiples of a benchmark’s returns.

VanEck SolidX – under review

In June 2018, BZX was at it again. This time the exchange partnered with crypto startup SolidX Management and Bank of New York Mellon to offer the SolidX Bitcoin Shares ETF. More than 1,400 comment letters arrived during the public comment period.

Bitwise HOLD 10 – submitted

Bitwise Asset Management operates private crypto investment funds. In July it announced the HOLD 10 Cryptocurrency Index Fund ETF. The proposed fund would track the performance of a basket of 10 cryptocurrencies.

Regulators’ Concerns with Bitcoin ETFs

The SEC’s dim view of Bitcoin ETF proposals stems regulations requiring America’s national securities exchanges to write rules that “prevent fraudulent and manipulative acts and practices” and “protect investors and the public interest.”

Surveillance-sharing

No matter what asset an ETF holds, the SEC expects the listing exchange to have “surveillance-sharing agreements” with large, regulated markets trading that asset. If an ETF trading on the New York Stock Exchange holds platinum, the SEC expects the NYSE to have surveillance-sharing agreements with large, regulated commodities markets.

Through surveillance-sharing agreements, fiat-world exchanges share reports of suspicious behavior with each other. For example, the International Surveillance Group is a network of 50 global financial institutions that share “fraudulent and manipulative activities.” The information sharing serves two purposes: it helps exchanges understand and recognize patterns of fraud and it helps exchanges and law enforcement track down market manipulators after the fact. Along the way, surveillance-sharing helps deter fraud by making it more difficult.

Regulators like regulated markets

The problem Bitcoin ETFs face is that few crypto exchanges are subject to any regulation at all. Even the Gemini Exchange, which received New York’s BitLicense, is not a nationally-regulated exchange. With so many unregulated exchanges accounting for most of the bitcoin trading volume, an exchange has few options for surveillance-sharing agreements to oversee Bitcoin ETFs.

Related: What is the BitLicense? Understanding New York’s Crypto Laws

A large, regulated derivatives market is another way to deter market manipulation of an ETF. Futures and other derivatives signal when an asset’s prices are not in line with market realities.

Unfortunately, the largest crypto futures exchange, BitMex, operates without any regulation in Hong Kong. One of the few US-regulated bitcoin futures contracts is run by the parent company of the Chicago Mercantile Exchange, the CBOE. Its trading volume pales in comparison to the bitcoin market.

Regulators want liquidity

The final area of concern for the SEC is the liquidity of a Bitcoin ETF’s shares as well as of the underlying bitcoin market. The sheer number of bitcoins hodlers keep stashed on the blockchain works against the ETFs. Regulators fear that a bitcoin whale could potentially manipulate bitcoin prices. High liquidity in the bitcoin market, on individual exchanges and in the trading of an ETF’s shares makes manipulation more difficult.

Deep dive: Winklevoss Bitcoin Shares

Source: Gemini Exchange

Since the SEC rejected all of Bitcoin ETFs for the same reason, we’ll use the Winklevoss Bitcoin Shares application to explain the SEC’s reasoning.

If the name Winklevoss sounds familiar, it’s because brothers Cameron and Tyler Winklevoss sued Mark Zuckerberg for stealing their software when he created Facebook. The brothers went on to become bitcoin entrepreneurs and founded the crypto-based Gemini Exchange. Openly advocating cooperation between the crypto industry and regulators, Gemini is one of the few exchanges to receive New York State’s notorious BitLicense.

Gemini worked with national stock exchange Bats BZX (BZX), now a CBOE subsidiary, to list its ETC, Winklevoss Bitcoin Shares (WBS). The request to the SEC has to come from the listing exchange, so BZX submitted its application in 2016.

Structuring Winklevoss Bitcoins Shares

In order to give WBS traders up-to-date price references, BZX and Gemini planned to set the NAV based on Gemini’s Daily Bitcoin Auction.

APs had to be regulated institutions like banks or broker-dealers and the OLPs (called Market Makers in the application) had to be registered with BZX.

The APS would buy WBS creation units in blocks of 10,000 shares. Even today, that would be cost $60 million to $70 million per unit. Of course, the purchases would be transfers of bitcoins into Gemini’s cold storage system.

BZX on bitcoin resilience

In BZX’s opinion, all of the many ways to trade bitcoin creates a highly liquid market that is resistant to manipulation. It did admit that arbitrage between global bitcoin exchanges was less efficient than between stock exchanges. However, BZX didn’t think it was important since the price differences between exchanges had fallen to “less than 1.30%” by mid-2016.

Despite the emphasis that the SEC places on the role of regulated derivatives markets, most of BZX’s discussion focused on the CFTC’s enforcement actions against companies that violated trading regulations. The one positive example, the TeraExchange swap execution facility, later became a target of a CFTC investigation.

Addressing market manipulation

In BZX’s opinion, all of the many ways to trade bitcoin creates a highly liquid market that is resistant to manipulation. It did admit that arbitrage between global bitcoin exchanges was less efficient than between stock exchanges. However, BZX didn’t think it was important since the price differences between exchanges had fallen to “less than 1.30%” by mid-2016.

In addition, the proliferation of bitcoin exchanges following Mt Gox’s collapse prevented, in BZX’s view, any one exchange from significantly affecting bitcoin prices. It also made manipulation more difficult by forcing traders to keep large deposits on many different exchanges.

BZX also claimed Gemini’s position in the crypto industry provided a check against market manipulation. Citing data from bitcoinity.org, BZX claimed Gemini had the size and liquidity to make its spot price (later its auction results) an accurate measure of bitcoin’s market price.

Despite the emphasis that the SEC places on the role of regulated derivatives markets, most of BZX’s discussion focused on the CFTC’s enforcement actions against companies that violated trading regulations. The one positive example, the TeraExchange swap execution facility, later became a target of a CFTC investigation.

Surveillance of bitcoin trading

BTX argued that its existing surveillance measures, its surveillance-sharing agreements with other exchanges as well as its relationship with the Gemini Exchange and the Intermarket Surveillance Group would be enough to deter market manipulation.

Public comments

The SEC received more than 120 comment letters during the review process. Only a few addressed the concerns leading to the SEC’s rejection, some of them supporting BTX’s case and others warning the SEC of potential risks.

On the critical side, commenters pointed out that most bitcoin trading happens outside the United States on undercapitalized and unregulated exchanges. Commenters observed that Gemini is one of the smallest American exchanges and even less of a player on the global stage. Given how much bitcoin is not in circulation, commenters warned, tight liquidity opens bitcoin markets to manipulation.

Supporters of BZX’s application pointed the US crypto market is regulated since the Commodities Futures Trading Commission (CFTC) ruled bitcoin a commodity and has prosecuted crypto companies. Commenters cited Gemini’s BitLicense as another example of regulated markets. They also supported BZX’s claim that the Bitcoin distributed ledger is inherently resistant to manipulation.

March 2017 rejection

The SEC rejected BZX’s application because the Commission did not believe BZX, Gemini or the regulated bitcoin markets could provide the required surveillance to prevent manipulation.

Bitcoin surveillance cannot protect investors

Even in the US, the SEC reported, no bitcoin exchanges are fully-regulated. The CFTC only registers exchanges that let retail investor trade on margin. New York’s BitLicense only includes a subset of the regulations required by the SEC or CFTC.

The globally “significant” bitcoin exchanges like Huobi or OKEx are neither regulated nor members of surveillance-sharing networks like the Intermarket Surveillance Group.

Given this state of the regulated bitcoin market, the SEC found BZX’s existing surveillance agreements “necessary, but not sufficient.”

Gemini is too small to resist manipulation

The SEC believes the Gemini Exchange is too small to set the NAV of a Bitcoin ETF. Using the bitcoinity.org link BZX provided in its application, the SEC found that Gemini only had a 0.07% of the bitcoin market.

In addition, the number of shares traded in Gemini’s daily auction, the number of shares in a typical trade on the exchange’s and the number of shares in the ETF’s creation unit were roughly the same. This further exposes the ETF to manipulation

Bitcoin is too undeveloped

The SEC rejected claims that bitcoin trading is inherently manipulation-resistant by pointing out that manipulation can happen off the blockchain. People could profit, for example, from inside knowledge of an ETF’s stance on a hard fork.

The SEC did not believe that regulated bitcoin derivatives markets are large enough to detect market manipulation. Even BZX admitted that bitcoin futures markets were “nascent” and that most are not available to Americans.

Appeal and August 2018 rejection

BZX appealed the SEC’s decision, prompting another round of applications, public comment and SEC review. As far as the Commission was concerned, BZX failed again to make its case. The other 13 requests to create Bitcoin ETFs failed for the same reasons.

What Will It Take To Get Approved?

In its rejection rulings, the SEC goes out of its way to say that it is not ruling against bitcoin itself. The SEC has been equally clear about what it needs from exchanges to approve their Bitcoin ETFs.

Just as with traditional ETFs, attempts to manipulate Bitcoin ETFs must be difficult, easily spotted and traceable. That requires, in the SEC’s view, enough liquidity to prevent owners of large bitcoin holdings from manipulating the market as well as regulated bitcoin markets large enough to:

  • Signal abnormal pricing through derivative prices.
  • Avoid the impact of manipulation on unregulated markets.
  • Make surveillance-sharing agreements effective deterrents to manipulation.

Unfortunately, not much has changed to give the next proposal in the queue, the VanEck SolidX Bitcoin ETF, much of a chance in its review at the SEC. The crypto industry may still have some growing up to do before Bitcoin ETFs trade freely on traditional stock exchanges.

Christopher Casper

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