Moving Bitcoin ETFs Forward

News, Opinion, Regulation | January 24, 2020 By:

For years, digital market asset participants and US regulators have engaged in a dialogue around the approval of a Bitcoin Exchange Traded Fund (ETF). Nearly every attempt has been unsuccessful, either rejected outright by the Securities and Exchanges Commission or withdrawn by the applicant.

Each of these applications have taken their own approach towards satisfying the requirements demanded by the SEC of ETFs, from reliance on different underlying assets, like “physical” Bitcoin and futures traded on regulated exchanges, to different underlying index methodologies. Unfortunately, none of these combinations have yet to satisfy the regulator’s demands, which from our reading of regulatory filings as well as public comments from members of the SEC, continues to evolve as the asset class matures. 

We’ve been hard at work directly with regulators in the US and the UK, on understanding issues currently confronted by regulators. In this post, we explore why the history of the SEC’s ETF rejections, the current state of the conversation around Bitcoin prices, and what can be done to move the conversation forward.

Why the ETF structure appeals to investors

ETFs offer many advantages to traditional investment vehicles, like open and closed-ended funds. These include liquidity, access to unique asset classes and investment strategies, portfolio diversification, tax efficiencies, ability to margin, and low costs. Specifically, for a Bitcoin ETF, benefits include investor protections, tax benefits, and asset class access. 

A Bitcoin ETF would offer investors the protections and disclosures of federal securities laws that are not afforded through existing Bitcoin ownership options. Furthermore, ETFs bring with them transparency in underlying asset ownership through a NAV, intra-day liquidity, and simplicity in tax reporting. Finally, the US operates some of the most trusted and liquid markets in the world. As a globally respected regulator, the SEC’s approval could be viewed as a signal to other financial regulators around the globe.

The SEC’s concerns over the potential impacts of manipulation

In the disapproval orders for Bitcoin ETFs and in public comments, the SEC and its members have consistently cited several issues. These concerns largely focus on fraudulent activity and market manipulation in underlying markets. The SEC has said that these issues can be overcome by surveillance sharing agreements with a regulated market of significant size, or showing that the Bitcoin market is isolated from fraudulent and manipulative activity, which, to date, no applicant has successfully done. 

As a clarifying point, Bitcoin does not currently trade on a “national securities exchange”, an exchange registered with the SEC. In the US, Bitcoin currently trades on digital asset exchanges that are regulated by the Financial Crimes Enforcement (FinCEN), a division of the US Treasury, various states through Money Transmitter Licenses or a BitLicense by New York State Department of Financial Services. 

Bitcoin futures are listed and cleared on the CME, a US-registered designated contract market (DCM) and derivatives clearing organization (DCO). The trading and clearing of Bitcoin futures are regulated by the Commodity Futures Trading Commission (CFTC). The CME is regulated and engages in market surveillance and participates in market surveillance sharing agreements. 

To find a real price, you have to start by finding real volume

The concern over a reliable price has been a common refrain from the SEC. Speaking at Consensus: Invest in November 2018, SEC Chairman Jay Clayton stated that “The prices retail investors are seeing are the prices they should rely on, and free from manipulation – not free from volatility, but free from manipulation.” In order to arrive at a reliable price, you have to start with economic trading, between a real buyer and a real seller. 

In March of 2019, the SEC published a report from a meeting with Bitwise Asset Management, a sponsor of one of the Bitcoin ETFs, detailing the analysis of trading of Bitcoin on various digital asset exchanges.  As a result of their analysis, Bitwise alleged that 95% of reported trading volume was “fake” or the result of wash trading. The report offered that its ETF sourced prices from “real” spot markets, which exhibited certain characteristics indicative of markets that were free from manipulation or fraudulent trading practices. The SEC saw differently and disapproved of the proposed rule change in October.

Analysis and testing of exchange integrity has advanced since then, incorporating factors not contemplated in the original Bitwise report. Through vetting, we can identify spot markets that do not report fake volume, and that have the policies and procedures in place in order to prevent wash trading or other methods of price manipulation. 

Measuring price discovery: the ‘lead-lag’ relationship

In its disapproval notice of the Bitwise Bitcoin ETF Trust, the SEC brought up a new issue not addressed in previous ETF denials – the relationship between prices on digital asset exchanges with “real” volume and those that do not currently pass vetting standards,  i.e. “lead-lag” relationship. As stated in that denial, “ …mere belief that reported trading volume is questionable is no substitute for data-driven analysis of how other market participants would adjust their pricing in response to prices on other platforms, even if they agree that those platforms have predominantly – but not entirely – fake volume.” 

Price discovery is an important element in financial markets and becomes critical around the globally fragmented trading of Bitcoin. A lead-lag study might help determine whether Bitcoin markets are resistant to manipulation and which digital asset exchanges have market activity of real economic substance, and thus bring the market closer to a reliable Bitcoin price that can be trusted by regulators and investors. 

Lead-lag studies are well underway. In the coming months, regulators and market participants can expect greater clarity on whether venues that engage in questionable activity have a tangible impact on prices; if they don’t, this could be highly promising for ETF, product and index creators. 

Either way, a lead-lag analysis will help illuminate the current market structures of this asset class and further the discussion with the asset management industry, regulators, and crypto native investors not only in the US but around the world.