Exchange-traded funds are among the simplest and most popular financial instruments. For many retail investors, if they trade only one instrument, it is likely to be an ETF. Various entities have been pitching the idea of a bitcoin ETF to the US Securities and Exchange Commission for several years with no success.
The SEC’s objection has historically been that cryptoassets, which are traded on exchanges that the SEC does not yet regulate, are open to manipulation. To give the SEC its due, that’s most likely true. Research from Solidus Labs found that, of all the crypto transactions in 30,000 liquidity pools since September 2020, some 13% were wash trading. By the report authors’ estimation, the figure for the whole market may be ‘an order of magnitude higher’.
But the tricky thing for the SEC is that bitcoin futures do have an ETF. Bitcoin futures are contracts to buy bitcoin on a specific date. Since these contracts pay out the value of bitcoin when they mature, a rolling stock of bitcoin futures should roughly track the price of bitcoin. Because the futures market is regulated by the Commodities and Futures Trading Commission and bitcoin futures trade on the Chicago Mercantile Exchange, the SEC is happy for them to back an ETF.
But while the futures market may not be manipulated, the underlying asset is still bitcoin, which the SEC says is open to manipulation. A court ruled that this distinction was arbitrary and capricious, and it now seems more likely than ever that the SEC will have to license BlackRock, GrayScale or one of the other applications on which the SEC is presently sitting.
While it appears that the SEC is in no rush to approve any of the applications it has received, bitcoin ETFs are beginning to look like an inevitability. That’s good news for bitcoin holders. Given the convenience and popularity of the ETF format, bitcoin ETFs could sizeably increase the amount of money allocated to bitcoin. The simple fact that BlackRock is pursuing an application suggests there is material demand for the instrument. Accordingly, the price of bitcoin jumps following the announcement of positive news like the recent court verdict.
Elsewhere in financial markets, businesses are working to create tokenised versions of ETFs. The idea is that creating a blockchain token representing a share of an ETF or other financial asset means that it can be traded more efficiently.
For the retail investor, tokenisation shouldn’t matter much. Whether their broker (or their broker’s custodian) is holding a blockchain token or is entered on a centralised ledger somewhere as the owner of an asset is not important. But it might lower their fees. If tokenisation is able to reduce the risks and costs of settlement, bringing down the number of failed trades and the capital required to offset the risks, the fees charged to the consumer should be lower too.
There are challenges – developing the infrastructure necessary to interact seamlessly with blockchain tokens and manage the risks appropriately is not easy. Tokenised assets are pretty thin on the ground as yet. For all its faults, the cryptoasset market is a place where investors can get their feet wet, holding and exchanging blockchain tokens, interacting with decentralised finance protocols and building expertise and technical capacity.
But bitcoin ETFs are pushing market participants in the other direction. They give investors the opportunity to take exposure to the volatile world of cryptoassets, without exposing themselves to the challenges of interacting with the digital asset ecosystem.
Cryptocurrencies may yet carve out a vital economic niche for themselves but, whether they do or not, the proliferation of distributed ledger technology looks set to continue. It is entirely possible that DLT becomes the underpinning of our financial system, but cryptocurrencies themselves remain curiosities and collectibles.
Bitcoin ETFs give exposure to the performance of the asset class, but slow down progress towards realising the potential of the technology.
Lewis McLellan is Editor of the Digital Monetary Institute, OMFIF.
This topic will be further explored in OMFIF’s ‘Digital assets: building the markets of the future’ report. Register to attend the launch on 28 September.