The Securities and Exchange Commission is Right on Bitcoin ETF

The SEC Rejects Bitcoin ETF Proposals.

The SEC has rejected nine more Bitcoin ETF proposals, one of them from a fairly well-established ETF distributor, ProShares.  The ProShares filing was due for comments on Thursday, but the SEC promptly responded a day early, as well as denying filings from Direxion that were due for comments at a later date.  All nine proposed products used Bitcoin derivatives in-place of Bitcoin to cunningly avoid the custody issues surrounding Bitcoin that the SEC might point to.

Instead, the SEC’s rejection was primarily attributed to potential manipulation of the Bitcoin market, which is not alleviated by trading futures, only amplified.  The SEC is right, not just on this point, but many others.

As background, I spent almost a decade of my career manufacturing many financial products, including ETFs – everything from product development, to writing indexes and methodologies, and portfolio management and portfolio construction.  I have seen much less esoteric ETF filings, such as investment grade bond portfolios, be rejected by the SEC or be approved after more than five years of comments.

An ETF’s Purpose

Bitcoin was created to decentralize and disintermediate.  ETFs are the opposite of that.  They centralize and intermediate.  However, the focus of this article is on the wrapper itself.  An ETF is not a suitable wrapper for a portfolio of Bitcoin. For context, ETFs are designed to give retail investors exposure to a broad, diversified investment strategy for a low fee.  They are also passively managed and based on an index that is rules-based.  These rules are not arbitrary, but due to the exemptive relief that give ETFs the right to be traded on an exchange and the special tax advantage given to ETF holders, which will be discussed later.  Most of the current Bitcoin ETF filings miss the point of what an ETF is, hence the rejection from the SEC.

#Bitcoin was created to decentralize and disintermediate. ETFs are the opposite of that. They centralize and intermediate. Click to Tweet

Portfolio Diversification

The goal of an ETF is to provide investors diversification in their portfolio. Generally, you can purchase an ETF that tracks broad indexes of a sector or market, not an individual security.    An ETF that only holds Bitcoin is as ridiculous as an ETF that only holds Apple stock. There is no point in purchasing a fund that gives the same exposure as the individual stock or asset that you can buy directly.  If the only portfolio position goes to zero, so does the ETF.  Diversification hedges the investor against potential downside.  The investor is actually worse off in the ETF due to the additional fees.  Instead of gaining exposure to a portfolio of stocks, you are exposed to only one stock and its daily price swings.  A meaningful ETF product would need to contain a basket of cryptoassets to attain the diversification mandate. The winner in a Bitcoin ETF: the ETF manager who charges you fees for the privilege of doing something you can do yourself.

An ETF that only holds #Bitcoin is as ridiculous as an ETF that only holds Apple stock. There is no point in purchasing a fund that gives the same exposure as the individual stock or asset that you can buy… Click to Tweet

Ease of Use

An ETF is used to conveniently purchase commodities or basket of securities that are normally difficult for an individual to purchase on their own, without incurring high fees. Buying an ETF of Bitcoin is not any easier than buying Bitcoin directly. In order to buy an ETF, one must go through the effort of signing up with an online brokerage such as Robinhood, Etrade or Schwab.  It is not exactly a simple process, but takes little skill to set up an account, fund it, and begin trading.

If you use Robinhood, you can buy Bitcoin and any ETF side-by-side with the same effort. Conversely, if a retail investor wanted direct exposure to Bitcoin, Coinbase and Gemini are also options that have an even easier setup than online brokerages since they are a money transfer agent, not a broker dealer.

Although many argue that you do not own your Bitcoin if it is in the custody of Gemini or Coinbase (because ownership of private keys is ownership of Bitcoin), but the same would be true if you owned an ETF of Bitcoin. A third-party would have custody of your private keys.  Ease of use is the argument for allowance of single commodities, such as gold, in an ETF.  It is difficult and expensive for an individual to purchase and store commodities.  An intermediary can purchase commodities in bulk closer to the spot price on behalf of their collective shareholders.  In an illiquid market like Bitcoin, with digital ownership and transactions, there is little benefit for an intermediary to consolidate investors to get a better transaction price.

Derivative Layers

ETFs also give an investor the ability to purchase options, both calls and puts, on the entire basket of underlying securities.  In addition, you may short an ETF on Margin.  The nine rejected ETF filings all proposed investing in derivatives of Bitcoin. This is beginning to look like a bad idea.

Take an asset (Bitcoin), create a derivative of that asset without owning the asset, only tracking the price (CBOE Bitcoin Futures), structure it in a vehicle that is offered to non-accredited retail investors (ETFs), then allow them to invest in derivatives based on that vehicle that holds the derivatives (options).  The concept sounds very familiar to a product called CLO Squared and CLO Cubed; these were derivatives of derivatives of mortgage loans created ahead of the Housing Crisis.  Aside from theoretical poor vehicles, this once again defeats the spirit and use of Bitcoin and Blockchain in general.

The beauty of Bitcoin is that it has a finite supply.  Derivatives create false supply, much like governments printing money with no gold in its coffers.

Market Manipulation

Though an ETF holding only Bitcoin, or ETH, or EOS, doesn’t make a lot of sense. An ETF that holds a basket of indexed cryptocurrencies conceptually makes more sense.  However, the biggest issue that the SEC referred to in its comments rejecting the nine proposals were all the same:

“…the Commission is disapproving this proposed rule change because, as discussed below, the Exchange has not met its burden under the Exchange Act and the Commission’s Rules of Practice to demonstrate that its proposal is consistent with the requirements of the Exchange Act Section 6(b)(5), in particular the requirement that a national securities exchange’s rules be designed to prevent fraudulent and manipulative acts and practices.”

It is still widely believed that there are fraudulent and manipulative acts and practices in the trading of Bitcoin.  The OTC equity markets are a great comparison, as they are so thinly traded, micro-cap public equities can be easily manipulated as well.

For this reason, the SEC has taken a hard stance on the liquidity and trading volume requirements on public equities in ETFs, making OTC markets unavailable in ETFs.  Until market manipulation in Bitcoin subsides, the SEC should hold off allowing it in an ETF.  As market cap, trading volume, and liquidity grow, those issues will go away.  But if Bitcoin has liquidity issues, altcoins have much more, making a portfolio of altcoins as unsuitable in an ETF as a Bitcoin ETF in the near future.

It is important to note, though, that SEC commissioners are actively reviewing the comments on the ProShares application rejection. Though I do not believe the SEC will or should overturn the decision, some of the other issues stated may be resolved, and a better understanding of how to treat cryptocurrencies will come out of it.

Until market manipulation in #Bitcoin subsides, the SEC should hold off allowing it in an ETF Click to Tweet

Latest Happenings

  • Ethereum had an important developer call on Friday regarding its system wide upgrade in October 2018. Three major points of contention for this call were difficulty bomb (increasing the difficulty of finding an ETH block), Ether issuance (amount of ETH issued) and ASIC resistance. Each one of these points have an immense amount of impact on the future of the Ethereum blockchain – as such, developers, large stakeholders, and miners were all in attendance, each with incompatible viewpoints. Arca Funds continues to be bearish on ETH.
  • On August 21, Bitmex closed for scheduled maintenance, leaving a window for Bitcoin bulls to push the price up 5% within an hour. Bitmex allows leveraged shorting (and leveraged long positions) of Bitcoin and other cryptocurrencies.  This spike certainly does not bode well for any argument against potential price manipulation of Bitcoin.
  • House Representative Tulsi Gabbard of Hawaii disclosed her crypto holdings of ETH and LTC this week, adding to a growing list US Congress members revealing holdings.  Hawaii has my vote for the next Crypto Island. The upcoming primaries also have many crypto-friendly candidates. I am watching US Senate candidate Deaglan McEachern in the New Hampshire primaries very closely.  He is pro-crypto, and is a former member of the US Rowing team.  Federal legislation is very important on how crypto will be handled.

Steven McClurg is a founding partner and CIO at Arca Funds, a full service asset management firm specializing in blockchain. Prior to Arca Funds, Mr. McClurg was a Managing Director and Portfolio Manager at Guggenheim Partners. Mr. McClurg holds an MBA and MS from Pepperdine University, where he has served as a guest lecturer.


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