Bitcoin Exchange - Traded Products (ETPs or ETFs)

Following the recently reported hack of the US Securities and Exchange Commission (SEC)’s social media account yesterday (10 January 2024), the SEC formally announced that it had approved the launch of 11 Bitcoin ETFs in the US.

As the announcement states, these approvals are not an endorsement of cryptocurrency as an “investment” or of any of the issuers of the ETFs themselves.

“It should in no way signal the Commission’s willingness to approve listing standards for crypto asset securities. Nor does the approval signal anything about the Commission’s views as to the status of other crypto assets under the federal securities laws or about the current state of non-compliance of certain crypto asset market participants with the federal securities laws.”

The Chair of the SEC went further and stated that (in contrast to assets such as metals, which have “consumer and industrial uses), “bitcoin is primarily a speculative, volatile asset that’s also used for illicit activity including ransomware, money laundering, sanction evasion, and terrorist financing.”

Those of you who have followed the SEC’s approach to cryptocurrency during under its current Chair’s tenure, will find it no surprise that the announcement also made clear that “the vast majority of crypto assets are investment contracts and thus subject to federal securities laws.”

It is difficult to avoid the conclusion that the reason the SEC finally approved bitcoin ETFs, is that it was forced to do so and that it is making the best of a difficult situation.

From 2018 to 2023, the SEC received (and refused) applications for the launch of 20 spot bitcoin ETFs. One of those filings was by Grayscale, which proposed converting its bitcoin trust into a ETF. When this application was refused, Grayscale appealed and the US Court of Appeals for the District of Columbia “held that the [SEC] failed to adequately explain its reasoning in disapproving the listing and trading of the Grayscale’s proposed ETP.”

The SEC was then in the position that it had to reconsider applications – and provide “adequate” reasoning for further approvals – or bring spot bitcoin into the ETF market where it would be subject to investor protection rules and transparency obligations. A ETF/ETP happens also to be a “security” which would satisfy the SEC Chair that he had brought crypto assets within his commission’s jurisdiction.

What is a ETF or ETP?

A ETF/ETP is a pooled investment vehicle which operates like a mutual fund. They track the price/value of an underlying asset (in this case, the price of bitcoin) without the investor needing to have direct exposure to the underlying. The “E” in ETF/ETP refers to the investment being exchange-traded. The price of the ETF’s shares will change during the day as its shares are bought and sold on the market.

How to ETFs and ETPs work?

ETFs benefit from a process called creation/redemption. Creation is the buying of the underlying asset (in this cash bitcoin) and wrapping them into the traditional exchange-traded fund structure. Redemption is the process by which the underlying assets are unwrapped from the structure.

The process for creation and redemption is controlled by the ETF sponsor and third parties which in other structures would be called market-makers but in the ETF context are called “authorised participants” (APs). APs create ETF shares by assembling blocks of the underlying assets and delivering them to the ETF sponsor/issuer. In return, the sponsor bundles the underlying into an ETF wrapper and delivers ETF shares to the AP. These newly-created shares are then introduced to the listed secondary market, where they can be bought and sold.

Redemption is the reverse of this process: ETF shares are bought by the AP (taking them out of the secondary market) and delivered to the ETF sponsor in exchange for the underlying of an equivalent value (i.e. the sponsor delivers bitcoin to the AP).

Why are bitcoin ETFs so important?

First, any ETF permits investors to gain some exposure to the market for the underlying without having to own the underlying itself. These approvals will permit institutions to gain exposure to cryptocurrencies and it will permit retail investors to gain exposure to cryptocurrencies with the protections afforded by the fact that they are buying/selling regulated securities on a regulated market.

What next?

Bitcoin is not the only cryptocurrency or crypto asset. The likelihood is that the next round of ETF applications will be for spot ether. We understand that major ETF issuers and sponsors have applied for ether ETFs in the last few months – the applications will be working their way through the SEC’s approval process. If those applications are approved (about which the industry is bullish), then the likelihood is that the next few years will see the launch of ETFs with a great variety of crypto asset underlyings.

The SEC’s approval of bitcoin ETFs also is likely to prompt other regulators around the globe to follow suit.