a bunch of market-manipulating hype or impending reality?
Special thanks to Joe McGinley, a third-year student at UCLA School of Law and Legal Analyst at Blockhead Capital, for conducting invaluable research in support of this article. You can connect with him on LinkedIn and harass him for being a no-coiner on Twitter.
Over the past 18 months, several Bitcoin (or crypto) ETFs have been proposed to the SEC. More recently, the proposition of an ETF approval has dominated the crypto market narrative and has had significant impact on price movements. The submissions most often propose tracking a Bitcoin-only price index composed of several U.S. based exchanges.
Why does the market care about a Bitcoin ETF approval?
First, in the unlikely case you aren’t aware, an “ETF” is an exchange-traded fund — which means that the product is available to be bought or sold just like traditional securities on easily accessible stock exchanges (such as the NYSE or Nasdaq) and through traditional brokerages. Because of this easier access, ETFs typically have higher daily liquidity. Additionally, a Bitcoin ETF would include a professional custodian solution (and quite likely insurance on holdings), vastly reducing the risk of financial loss due to corrupt, lost or stolen private keys. These factors make a Bitcoin ETF an attractive investment vehicle to gain exposure to the digital asset market for retail investors and traditional institutional investors alike.
The market has eagerly anticipated an ETF approval because increased demand from either retail or institutional investors should (absent mitigating factors) increase the price of Bitcoin. Further, regardless of direct impact on price action, many analysts view ETF approval as an important milestone in Bitcoin’s development as approval would recognize it and the rest of the industry as a legitimate new asset class.
What’s the process to get an(y) ETF approved?
ETF proposals are submitted to the SEC Division of Trading and Markets for review. Upon submission, the SEC will publish the proposal, request comments from the public and relevant regulatory bodies, and either make a determination or provide a notification requesting more time within 45 days. The SEC can delay making a determination up to three times, for a total review period of 240 days after publication. The burden is on the applicant to demonstrate compliance with all relevant securities regulations. After an approval or denial, the applicant or an SEC commissioner may file an appeal for reconsideration. There is no explicit timeline for a final decision following an appeal.
Why has every Bitcoin ETF application been denied thus-far?
As most market participants are aware, every Bitcoin ETF proposal that has received a final decision has been denied. More specifically, the SEC has recently ruled that these applications have failed to meet the requirements under Exchange Act Section 6(b)(5), meaning that the proposals have failed to demonstrate that they are designed “to prevent fraud and manipulative acts” and “to protect investors and the public interest.”
Special thanks to Jake Chervinsky of Kobre Kim, LLP for proving invaluable guidance on recent SEC decisions
Right about now, you might be asking yourself “I thought Bitcoin was designed to ‘protect investors and the public interest’ from ‘fraud and manipulative acts’ of central banks,” so…
What’s the SEC’s problem?
The SEC recently denied ETF proposals that were based on spot markets (Bats BZX / “Gemini” ETF) and derivative markets (Direxion, GraniteShares and Proshares). ETFs based on the spot markets are less complex to operate (as spot is the direct asset price) and arguably have less variability in pricing than derivative products, but the lack of even a single fully compliant U.S. exchange stands as a significant impediment to approval (more on how this is changing later). On the other hand, ETFs based on derivative markets benefit from the existence of CFTC approved and regulated exchanges that have seen increased (but thus far insufficient) trading volume.
Risk of manipulation because of insufficient regulated trading volume
In each Bitcoin ETF denial, the SEC has made clear that the largest impediment to approval is the lack of significant trading volume on any regulated exchanges (whether spot or derivative), which are subject to federal oversight for fraud or manipulation. While there is no explicit volume level which is considered “significant”, the general threshold is considered to be one which would either make it incredibly difficult, or outright impossible, to manipulate price via trading tactics on unregulated exchanges. The rationale is that if the volume requirement is met, the ETF sponsor will be able to properly monitor and prevent any attempts at price manipulation via a fraud monitoring agreement with the market exchange. This is an increasingly challenging burden for a sponsor to meet in the current Bitcoin climate because an overwhelming majority of the world’s Bitcoin trading volumeoccurs on exchanges outside direct SEC regulatory jurisdiction. Some might point to precious metals or traditional commodities (e.g., Gold or Crude Oil, which both have actively traded ETFs) as examples of assets classes that suffer from a very similar issue. While these asset classes do indeed have significant offshore trading volume, as Ari Paul noted the immaturity of the market and the “lack of a quantifiable fundamental value” makes it easier to manipulate Bitcoin than those with fundamental value.
Bitcoin futures began trading in January 2018 on CME and CBOE, two US-based regulated derivatives exchanges, but saw significantly lower transaction volume and open interest than other similar futures products. Please see the below charts which compare data as of Wednesday, September 26th.
Source: CME Research Group. Note that Bitcoin averages ~4,000 contracts traded per day.
Source: CME Research Group. Price estimates were taken via an average of contract quotations across active futures contracts.
When viewed from this perspective, it is clear that Bitcoin’s regulated derivative volume and open interest (on CME) falls well short of those of other assets. Arguably more relevant is how Bitcoin metrics compare to other commodities as of the date of their respective ETF approvals. Even from that perspective, Bitcoin open interest is multiple orders of magnitude below those of other commodities (as noted by the SEC in footnote 37 of the Direxion ETF denial).
Except for Bitcoin, all values were provided by the SEC in footnote 37 of Direxion ETF denial. Bitcoin values were gathered by Blockhead from (*) the CME group and (**) CBOE. Bitcoin annual volume numbers were annualized by Blockhead based on August 2018 trading levels on the respective exchanges.
In addition to the insufficient trading volume, the SEC recently noted that there isn’t sufficient trading history to make a determination regarding potential fraudulent CME or CBOE Bitcoin futures trading. While a concern today, a future CME or CBOE based Bitcoin ETF proposal could be viable once the two exchanges’ Bitcoin products mature.
A derivative product is only as good as its underlying spot market
Because a derivative product would be subject to the fluctuations and market behavior of the underlying spot market, the SEC seems to desire regulated exchanges of both spot and derivative markets with significant volume (comparable to the underlying products of other approved ETFs) before approving a derivative-based ETF.
Thus far, no US-based spot exchanges (including Gemini, Coinbase/Coinbase Pro, itBit, and Kraken) have been deemed in compliance with all relevant SEC regulations. Even if fully compliant, none of those exchanges rank in the top 5of worldwide Bitcoin volume, meaning that the overall market would still be susceptible to the trading mechanics of unregulated exchanges. Researchers have alleged that many of the top exchanges artificially inflate their transaction volume through wash trading and conduct other manipulative practices (such as trading against their own users). As such, federal oversight of exchanges may be necessary prior to the SEC’s approval of such exchanges to support underlying pricing of an ETF.
The SEC has reportedly sent notices to a number of cryptocurrency exchanges and suggested they may also register under an Alternative Trading System Form (“ATS”) but an August publication of approved ATS applicants does not list a single cryptocurrency exchange. Further, the New York Attorney General report on cryptocurrency exchanges indicated that none of the exchanges they studied were fully compliant (and many are not even taking the minimal initial steps — such as conducting low-level KYC/AML checks — required to be deemed the same). Once regulated exchanges come online and reach significant volume levels, much of the SEC’s concerns would be relieved.
Market risk because a handful of whales may be controlling the tides
Even if there were an exchange on which to rely, the SEC noted concerns regarding the structure of the Bitcoin market in general. Research has found that there may be a small number of people or organizations who hold a dominant share of Bitcoin. Academic research cited by the SEC found that when there is a small number of people who hold a dominant share of an asset, it is more easily manipulated. This aligns with intuitive conceptions of big-money market movers manipulating retail investors. This concern is exacerbated by the pseudonymous nature of Bitcoin — making it difficult (or nearly impossible) to identify these market participants or even the fact that a large number of apparent users are in actuality one participant. Thus, it is difficult to estimate the distribution of Bitcoin holdings and their effects on trading patterns. This uncertainty, in conjunction with large swings in daily valuations, and an air of seediness surrounding the Bitcoin marketplace (as explored in Nic Carter’s recent article) and its early uses (e.g. Silk Road), contribute to the SEC’s hesitance to approve a Bitcoin ETF.
And what’s going on with “anonymous” OTC exchanges?
Over the counter (OTC) markets have played a large role in Bitcoin and other cryptocurrency volume for years. Many OTC exchanges previously allowed users to transact anonymously and therefore attracted a large portion of Bitcoin trading activity. Eric Wall, citing a TABB Group report, recently suggested that OTC volume is at least two times the volume seen on exchanges.
Recently, ShapeShift, a pseudo-OTC marketplace, announced the implementation of Know Your Customer (KYC) and Anti-Money Laundering (AML) policies. These policies stem from obligations of trading platforms under the Bank Secrecy Act as a money services business (MSB) and require parties to disclose personal information in order to transact. While many industry veterans were displeased with the decision because it runs afoul of Bitcoin’s pseudonymous ethos, it is specifically these types of compliance efforts that will aid in legitimizing trading activity to the point where a retail Bitcoin ETF would be more palatable to the SEC.
A single point of failure in ETF pricing mechanism (decentralize pricing!)
As an example, let’s look at the Gemini/BZX proposed ETF, which proposed to use the Gemini Auction as the sole means by which to dictate the ETF’s net asset value (NAV). The SEC expressed concern that Gemini/BZX had not demonstrated that the Gemini exchange had sufficient volume to support accurate pricing or share redemption. This is similarly true of all U.S. exchanges if analyzed on an individual basis. An analysis of transaction volume across the world reveals U.S. exchanges, in aggregate, represent less than 5% of the world’s Bitcoin trading volume.
More recent applications have attempted to remedy this concern by pricing based on a composite of U.S. based exchanges. It seems to be a step in the right direction, and when combined with higher volume and regulatory compliance, might just be exactly what the SEC is looking for.
“But aren’t arbitrage bots keeping prices stable across exchanges?”
The SEC similarly indicated that Gemini/BZX failed to produce convincing evidence regarding how quickly or effectively price discrepancies between exchanges are arbitraged away (shout out to our friends at arbitraj.io — check out their site if you’re interested in a live view of arbitrage opportunities). Additionally, one public comment noted that arbitrage opportunities routinely remain, and became increasingly apparent as volume has decreased on the Gemini exchange and grew on international exchanges throughout the review period. As additional institutional investors and liquidity enter the market, we expect that these arbitrage opportunities are likely to diminish. As such, the SEC’s more recent decisions have not focused on these arbitrage concerns and instead on the liquidity and manipulation concerns discussed above.
Hope is on the horizon but is it what the market is looking for?
The VanEck/SolidX ETF proposal (which had its decision date recently postponed), is the most promising proposal on the market today. The ETF is targeted at institutional investors due to its high share price (25 Bitcoin per share or ~$165,000 at today’s Bitcoin pricing) and use of an OTC composite index for pricing. We believe it is likely to be approved because it is unlikely to pose a risk directly to retail investors due to its nominal share price and it avoids reliance on untrustworthy exchanges.
While likely to be approved, the proposal would not open the door to retail investors nor would its approval necessarily foreshadow approval of a retail Bitcoin ETF. There are significant, market-wide, hurdles left before the SEC is likely to approve a retail ETF application. Specifically, the need for Bank Secrecy Act compliant OTC trading venues, federal oversight of Bitcoin exchanges (through regulatory compliant exchanges), and increased liquidity on such regulatory compliant exchanges as a proportion of total global Bitcoin trading volume.
There are exciting projects on the immediate horizon which should begin to alleviate these specific concerns. Institutional investors may soon have a premier platform to trade digital assets (spot, derivatives and eventually options) on Seed CX, which is expected to launch on October 22, 2018, or (spot and derivatives) on Bakkt. While we are clearly still some time away, the SEC should begin to warm up to the prospect of a retail-facing Bitcoin ETF as volume increases on regulatory compliant exchanges (as a percentage of global volume).
Justin Yashouafar is a Managing Partner at Blockhead Capital, a Santa Monica based digital asset hedge fund. Previously, Justin attended UCLA School of Law and practiced law as a full-time attorney. You can connect with him on Twitter,LinkedIn or Telegram.