Bitcoin ETFs: Another step towards institutional mania

On 30 September the Securities and Exchanges Commission (SEC) is set to rule on a recent application, submitted by Cboe to trade Bitcoin exchange traded funds (ETFs); though there are already suggestions that any decision may now be postponed until next February.

An ETF would allow investors the opportunity to indirectly purchase Bitcoin as an underlying asset rather than having to purchase a physical Bitcoin, offering investors ‘institutional standard’ protection, which is a far more secure and user-friendly way to buy and sell digital currencies. Approval should bring much more affluent customers to the crypto marketplace, such as mutual funds and pension funds.

The crypto community, buoyed by the recent announcement from the SEC that Bitcoin will not be classed as a security, believes the Cboe application has a strong case for being approved. Indeed this belief was priced into Bitcoin throughout the month of July when the price increased by more than 40% across the month of July (when the application was originally set to be considered by the SEC). Price support has wavered during the month of August due to uncertainty as to when the application will now be presided over but those investing in this market should be aware of some key consideration points that the SEC will have to address before any decision is made.

We must first recognise that this is not the first time the SEC has presided over an application to allow the trading of Bitcoin ETFs. In February 2017, the SEC rejected an application from the Winklevoss brothers, basing their decision on a lack of regulation within the cryptocurrency industry. Undeterred, they submitted a second application during the first week of August 2018, though the SEC stood behind their decision, highlighting that their second application failed to demonstrate how Gemini would prevent fraudulent transactions and price manipulation.

With the SEC demonstrating such clear concerns over a lack of regulation what could possibly change between August and September in order to justify the crypto community’s belief that the SEC will approve the Cboe application? Also, why has the crypto community placed so much faith in the Cboe application being approved, when the Winklevoss Brothers have been less successful on more than one occasion?

To answer the later, we must consider the difference in the quality of the applications.

ETF applications: Devil in the details

The Winklevoss brothers proposed the trading of Bitcoin ETFs on their own trading platform – Gemini – and while both applicants are highly successful entrepreneurs it is my belief that the maturity of their exchange, which only opened for business in 2014, has been a point of consideration for the SEC across both applications. While not explicit in any meeting minutes, it is clear that there the SEC would be concerned over a lack of evidence to suggest that the Gemini exchange would be able to support such a huge surge of institutional money and transactions that the market believe would need to be supported off the back of a Bitcoin ETF being launched.

Furthermore; the Winklevoss brothers’ application intended to go far beyond the institutional investors as their application proposed issuing an EFT being priced from $0.01. The potential surge from retail and institutional investors simultaneously; with no protection in place, is, in my opinion, too much, too soon, for a government agency already struggling to keep up with the speed of change that crypto assets are bringing.

By comparison the Cboe application is a much more considered and far more mature in approach, demonstrating an inherent understanding and perhaps empathetic attitude towards the SEC; who clearly have a difficult job when it comes to balancing regulation with innovation suffocation.

The Cboe application provides the SEC with an opportunity for another trusted party to effectively manage risk and any uncertainty more effectively. Unlike the Gemini Exchange, Cboe has long-term, proven capability in handling mass volumes of trades and transactions. This makes them a far more appealing and safer exchange to launch Bitcoin ETFs; while the application itself only proposes offering Bitcoin ETFs to institutional investors and high net individuals, setting a minimum purchase price of $125,000 per share.

Furthermore; the Cboe application also proposes self-imposed regulation by offering their investors with insurance protection for loss and theft, up to the value of $125 million. With such guarantees in place, it is perhaps more obvious why the crypto community has attached far more hope to the Cboe application than they have done to any of the previous attempts.

The crypto community should be encouraged by just how far the largest options exchange in the world are prepared to go to in order to gain an approval to trade Bitcoin ETFs.

As of August 2018 there are more than 300 institutional funds worldwide focussing on crypto assets, while established institutions such as Nomura are introducing custodian solutions for their own corporate investors.

Cboe will have considered the way the market is moving and will have noted the revenues it has provided to both Coinbase and Binance. That they are willing to enter the market and provide their customers with the certainty of insurance demonstrates that the market is prepared to adapt and self-regulate the industry in order to play their part. This is something that the SEC should find encouragement from as it allows them to ‘sit-on-the-sidelines’ to some extent as established, cash-rich partners take the lead almost on their behalf.

The SEC approach to regulation

The SEC has expressed concern at the lack of regulation but they should recognise that the crypto industry has proven ability to self-regulate and mature, in many ways, without any intervention. Two of the top 20 projects by market capitalisation – EOS and VeChain, are two examples of self-governed projects that have investor protection at the core of their business models and are a clear indication as to the positive effects that the rhetoric from agencies like the SEC are having on the market and there should be no reason why the approval of Bitcoin ETFs will not lead to an even greater level of self-regulation in the future.

In terms of new market products, the SEC should also consider the success of Bitcoin futures, which have operated for a number of months without concerns; whilst simultaneously; since launching, much of Bitcoin’s volatility has actually been curbed. The market capitalisation has never fallen below the $100 billion mark with resilience maintaining a floor of $5800. Support for such assets is only going to increase; particularly when we consider such countries such as Venezuela and Turkey who have seen the value of their currencies demonstrate far more volatility than crypto-assets themselves; something that central bankers consistently highlight as being a negative for against all crypto assets.

One aspect of ETFs that is unclear to me at this time is how an ETF will work while retail exchanges remain open. The SEC has concerns about the lack of liquidity within cryptocurrency markets. Their fear is that it could prove to be extremely difficult to mitigate the risks’ of an ETF price suffering significant drops while the Cboe is closed.

In such circumstances, it is extremely difficult for their investors to hedge against such losses. Furthermore, if we consider a market with the volatility levels running through December 2017 to January 2018, then determining the Net Asset Value (NAV) of Bitcoin will become difficult to do when the prices across multiple exchanges can differ so much. Such things pose obvious causes of concern for the SEC given that such events and non-current trading hours can have disruptive consequences on the gap between the Bitcoin EFT price and the NAV; ultimately presenting arbitrage mechanisms for people to exploit.

While this is obviously a concern, the markets today do present some fantastic arbitrage opportunities; however, the market has always been about trial and error. And while nothing is perfect, in approving the Cboe Application the SEC will effectively give some control of this new product to an exchange that they can trust will do the right thing – particularly given the risk they are willing to take on should things go wrong.

It may add liquidity to the market but there is still a lack of knowledge and adoption for Bitcoin. Even with the launch of Bitcoin ETFs, I feel that smart money will still have more questions than answers, meaning the market may not rally as much as some expect it to.

Taking such things into consideration, therefore; I believe this is the right time to approve an ETF application. This is a view shared by the SEC Commissioner – Hester M. Peirce, who dissented the decision to block the Winklevoss Brothers’ application. In her dissent statement, she concluded that: “More institutional participation would ameliorate many of the Commission’s concerns with the Bitcoin market that underlie its disapproval order. More generally, the Commission’s interpretation and application of the statutory standard sends a strong signal that innovation is unwelcome in our markets, a signal that may have effects far beyond the fate of Bitcoin ETPs.”