The prospect of a Bitcoin ETF has been widely discussed for the last few years, and despite all previous applications for a US-based fund being rejected or withdrawn, the latest rhetoric from the SEC appears to suggest the commission is ready to consult with industry stakeholders, who may be able to address their concerns such that a viable Bitcoin ETF can finally come to fruition in 2018.
The final quarter of 2017 saw the introduction of regulated Bitcoin futures products, via both the CME Group and Cboe Global Markets in the US, representing an increasing normalisation of Bitcoin as an asset within the framework of traditional finance, and an important new vector for fund providers to use in crafting a Bitcoin ETF. The Bitcoin futures contracts have now been trading for a number of months, and their early successes may have encouraged the latest dialogue from the SEC and the release of a document last month in which they have extended the consultation period of formal proceedings for a rule change to allow the NYSE to list Proshares Bitcoin ETFs. This appears to be in direct contrast to a staff letter penned by Director of the Division of Investment Management Dalia Blass at the SEC in January, which seemed to downplay the chances of an ETF being approved in 2018, citing “a number of significant investor protection issues that need to be examined before sponsors begin offering these funds to retail investors”.
The formal consultation process which was initially started at the end of 2017, is essentially a request for industry stakeholders to provide comments to address the handful of points of contention over Bitcoin ETFs, specifically regarding fair valuation, sufficient liquidity, effective pricing arbitrage and asset custody. These are reasonable considerations that have ultimately been the root cause of the stream of rejected and withdrawn Bitcoin ETP applications over the years. The document in March has been followed by further dialogue across April relating to similar ETF applications requiring rule changes, including a document released on April 23rd to extend the consultation period for similar proceedings related to both long and short leveraged Direxion Bitcoin ETFs.
Bitcoin is an asset which is unlike the vast majority of those the financial system is accustomed to engaging with, and has been treated with a tentative approach within traditional finance and banking circles. However, a response letter from Cboe president Chris Concannon, covers many of the concerns related to a Bitcoin ETF and points towards the growing maturity of the Bitcoin marketplace to suggest that the SEC take a “holistic approach”, similar to how it has historically engaged with commodity-related ETPs.
The Cboe letter acknowledges the additional considerations required for Bitcoin and cryptocurrencies but encourages an approach which doesn’t unnecessarily impede innovation. The document also points towards the growing maturity of the market, with the impressive “high-water marks” of December 2017, such as more than $5 billion in notional value of bitcoin transactions in a single day.
Applications for the Proshares Bitcoin ETF and Proshares Short Bitcoin ETF were originally filed in September 2017, but promptly withdrawn. Despite this, the latest document from the SEC appears to suggest that these proposals are now back on the table. The proposed Proshares ETFs and those presented by Direxion, would offer both long and short funds with exposure to Bitcoin returns using the cash-settled bitcoin futures contracts that are now available. This introduces potential liquidity problems due to the fact that the regulated futures contracts are yet to attract significant trading volumes. However, as stated in the CBOE letter:
“The nascent futures markets are developing quickly and, while the current bitcoin futures trading volumes on Cboe Futures Exchange and CME may not currently be sufficient to support ETPs seeking 100% long or short exposure to bitcoin, Cboe expects these volumes to continue to grow and in the near future reach levels comparable to those of other commodity futures products at the time that they were included in ETPs.”
There are notable differences in the CME and Cboe futures contracts currently trading, particularly in the size of the contract in relation to the underlying asset, and the pricing mechanisms used. However, rather than being a complication, this could perhaps simply offer flexibility for ETF providers and should be of no serious concern to the commission. The Cboe futures reached new record daily trading volumes last week on April 25th, with over 18000 of the May expiry contracts changing hands. This is likely still a fair way off the trading volumes required to sustain a large and popular ETF, but it shows there is growing interest in the bitcoin futures products across the handful of months following their launch.
As Cboe are keen to point out, the use of futures contracts to gain exposure to an asset isn’t uncommon in the world of ETFs, and is an approach often used in commodity ETFs, such as the United States Oil Fund (USO). A futures-based Bitcoin ETF could be more palatable to the SEC, as custody issues surrounding private keys are essentially eliminated, but if such a fund became wildly popular, it could wind up needing to sustain oversized positions and without underlying liquidity would be unable to easily unwind these positions upon redemption by fund investors. However, in the fullness of time, such an ETF could actually help to develop trading volume on the futures contracts too, as it is often the case that liquidity begets liquidity. Some more conservative industry stakeholders may also argue that a derivative-based ETF, built upon an already somewhat controversial new asset is a recipe for disaster, but this is most likely an overcautious approach centered on a lack of understanding of Bitcoin itself, as there are already far more complex leveraged commodity-based ETP instruments already available to investors.
The SEC should be encouraged by the success of a Bitcoin ETP currently available to investors in Europe. XBT Provider by CoinShares offers two Bitcoin Exchange-traded notes, or ETNs, which are traded via the Nasdaq OMX in Stockholm. An ETN differs structurally from an ETF as the former is primarily a synthetic debt-based instrument, usually underwritten by a bank. This allows for index tracking errors to be essentially eliminated, but relies on the creditworthiness of the underwriter as they’re ultimately responsible for redemption of the notes. The Bitcoin ETNs provided by XBT Provider are in the form of a certificate, and all the assets in the fund are held in the underlying Bitcoin or related derivatives, so these products are more similar to ETFs than the more complex ETNs, such as the inverse VIX instruments which recently caused upset.
Despite any and all concerns, there is a palpable enthusiasm for the cryptocurrency space and investors are clearly interested in gaining exposure to Bitcoin. Grayscale Bitcoin Investment Trust (GBTC) trades OTC in the US already, and regularly at a significant premium to NAV, indicating that certain investors are paying extra to gain exposure to Bitcoin through more traditional financial vehicles. Fund-type investment products are often suitable to be included within more tax-efficient wrappers, such as ISAs or IRAs, which is likely a factor involved in this interest.
It is clear that there is huge interest in bringing a Bitcoin ETF to market, and it is encouraging to see the SEC is clearly taking the more recent applications seriously. It is surely now only a matter of time before a futures-based Bitcoin ETF is approved, and it should inevitably be followed by a true Bitcoin ETF, wherein all assets are held in bitcoin, such that all suitable and willing investors can gain exposure to the nascent market. Institutional investor activity within Bitcoin and the wider cryptocurrency market has been largely avoided due to the unusual beginnings of the emerging market, which has lead to a somewhat inverse, retail-first development of the asset. However, despite unprecedented origins, Bitcoin should be treated no differently to any other commodity by the SEC when it comes to approval of an ETF, and with mainstream financial media continuing to cover Bitcoin and cryptocurrencies on an almost daily basis, there is a clear need for a more traditional investment vehicle offering Bitcoin returns to US investors.