Academy Industry Analysis Article

Examining a Bitcoin ETF’s Regulatory Hurdles and Significance for Mainstream Investment

2020.06.17 OKEx

Following the United States Securities and Exchange Commission’s (SEC) latest rejection of a Bitcoin exchange-traded fund (ETF) application from Wilshire Phoenix in February 2020, the New York-based asset manager filed a new application for the publicly traded Bitcoin Commodity Trust last week. 

At the same time, the cryptocurrency community expressed excitement around the announcement that London-based ETC Group’s first crypto exchange-traded product (ETP) will be listed on Germany’s Xetra digital stock exchange in late June. 

Despite the positive developments surrounding cryptocurrency ETPs, the crypto community is still waiting for the launch of the first Bitcoin ETF. With that in mind, OKEx Insights examines the key differences between Bitcoin ETPs and Bitcoin ETFs while discussing the main obstacles preventing the latter from gaining approval from the SEC.

How is a Bitcoin ETP different from a Bitcoin ETF?

Listed on stock market exchanges, an ETP is an investment vehicle that tracks underlying securities, an index or other financial instruments. 

There are three main types of ETPs:

  • Exchange-traded funds 
  • Exchange-traded notes (ETNs) 
  • Exchange-traded commodities (ETCs)

ETFs are the most common type of ETPs and contain a basket of securities — including stocks, bonds or commodities. They are listed on exchanges and investors may trade them like ordinary shares. 

ETNs, meanwhile, are unsecured debt securities that track an underlying index of securities. Investors in ETNs receive their returns from the tracked index at the maturity date. 

Finally, ETCs track individual commodities or a basket of commodities — such as energy and livestock.

Richard Keary, the founder of Global ETF Advisors LLC, explained to OKEx Insights the differences between ETF, ETN and ETCs:

“An exchange-traded fund is an exchange-traded product. Most ETFs are based on an index, where other products like ETNs in the U.S. or ETCs in Europe are mostly physically-backed products — like the new Bitcoin Exchange Traded Crypto (BTCE) to be launched in Germany — and are referred to as ETPs and sometimes as ETFs.”

In the case of Bitcoin ETPs and ETFs, both track the price of Bitcoin (BTC) as the underlying asset. They offer exposure for traders and investors interested in cryptocurrencies without purchasing bitcoins directly from cryptocurrency exchanges. Once approved by regulators, both Bitcoin ETPs and ETFs are traded and quoted on stock exchanges.

It’s all about regulation

The primary difference between a Bitcoin ETP and Bitcoin ETF relates to how an ETF is regulated in certain jurisdictions. 

In the United States, additional compliance is required for ETFs when compared to ETPs. The latter are classified as ETFs if they are an investment company under the Investment Company Act of 1940. Because ETFs operate as open-end investment companies or mutual funds, the issuers need to obtain exemptive relief from the SEC in order to launch their ETFs. 

The SEC adopted Rule 6c-11 to provide exemptions of the exemptive relief in 2019, and eligible ETFs need to comply with additional procedures when compared to an ETP. The compliance procedures include daily portfolio transparency reports, written policies on customized baskets of assets, and disclosures of historical investment information such as premiums, discounts and bid-ask spreads.

What about Switzerland?

In Switzerland, ETFs are distinguished from ETPs by their fund structure. 

According to SIX Swiss Exchange, ETFs in Switzerland are funds that are subject to the Collective Investment Scheme Act (CISA) and are not supervised and regulated by the Swiss Financial Market Supervisory Authority (FINMA). 

Bitcoin ETPs, on the other hand, are debt securities issued by a Special Purpose Vehicle (SPV). An SPV is a subsidiary created by a parent company that has a separate legal status and is not liable for any financial liabilities of the parent company.

An additional difference between ETPs and ETFs in Switzerland is the storage of collateral. While both ETFs and ETPs are collateralized, the collateral in ETFs is stored in a segregated pool of assets that is subject to FINMA regulation. Collateral in ETPs, on the other hand, is deposited in a third party. 

On the SIX Swiss Exchange, ETPs on the market are named as ETNs or ETCs.

Key differences between ETFs and ETPs in Switzerland. Source: SIX Swiss Exchange

The United States ETF dominance 

While there are a number of ETPs listed in the U.S. and Europe, the crypto community is still waiting for the first Bitcoin ETF to be approved.

The U.S. has long been the leader in ETF trading. According to ETF data provider ETFdb.com, 60% of the top 30 ETFs in assets under management are based in the United States. 

The traditional market dominance of ETFs has made the U.S. the primary location to list a Bitcoin ETF. However, all applications in the country have thus far been rejected by the SEC, which is not convinced that the proposed Bitcoin ETFs are resistant to market manipulation.

Key Bitcoin ETF applications in the U.S. Source: SEC

Applicants must prove Bitcoin market is protected from manipulation

The SEC’s most recent denial of Wilshire Phoenix’s Bitcoin ETF application on Feb. 26, 2020, just as previous proposals, was on the grounds that it did not demonstrate an ability to comply with the market manipulation rule stated under Section 6(b)(5) of Securities Exchange Act of 1934. 

According to the rule, exchanges that list Bitcoin ETFs would need to set up preventative measures against fraudulent and manipulative acts to protect investors. The rule also requires exchanges to demonstrate a comprehensive surveillance-sharing agreement with “a regulated market of significant size relating to the underlying assets” — something that is seen as essential, as such agreements facilitate the sharing of information, such as market trading activity, clearing activity and customer identity. 

The SEC made reference to commodity-trust ETPs approved in the past, stating that there had been at least one significant and regulated market in futures trading of the underlying commodity in such cases. Moreover, exchanges listing ETPs have entered into surveillance-sharing agreements or held Intermarket Surveillance Group (ISG) memberships with the regulated markets. Therefore, the SEC reasons that the same standard should be applied to Bitcoin ETFs. 

In the latest rejection of Wilshire Phoenix’s Bitcoin ETF application, the SEC noted that previous applicants had attempted means other than surveillance-sharing agreements to prevent market manipulation. For instance, the applications for the Winklevoss Bitcoin Trust and Bitwise Bitcoin ETF Trust asserted that the Bitcoin spot market is “uniquely” and “inherently” resistant to market manipulation. The SEC rejected such claims, stressing that many Bitcoin spot markets are not regulated or supervised by a government agency and noting that there is a lack of customer protection in platforms offering BTC spot trading.

Nevertheless, the SEC offered an exemption for surveillance-sharing agreements if Bitcoin ETF applicants are able to demonstrate resistance to market manipulation beyond the existing protections in traditional commodity or equity markets. 

Bitcoin funds are not necessarily ETFs

NYDIG Bitcoin Strategy Fund deals in cash-settled futures

Despite the multiple rejections of Bitcoin ETF applications, the SEC has approved the NYDIG Bitcoin Strategy Fund (BTCNX.US) filed by Stone Ridge Trust VI in December 2019. The fund does not directly invest in Bitcoin. Instead, it invests in cash-settled Bitcoin futures contracts on exchanges registered with the Commodity Futures Trading Commission (CFTC).

The NYDIG Bitcoin Strategy Fund is not an ETF. As explicitly stated in its filing, “the Fund’s Shares are not listed and the Fund does not currently intend to list its Shares for trading on any national securities exchange.”

Grayscale Bitcoin Trust is traded over the counter

While the proposed Winklevoss Bitcoin Trust and VanEck SolidX Bitcoin Trust have been withdrawn or rejected by the SEC, they should not be confused with the similarly named Grayscale Bitcoin Trust (GBTC), which was launched in 2013. While these products are named as “Bitcoin Trusts,” it is important to note that the Grayscale Bitcoin Trust is not an ETF.

The main distinction between the Grayscale Bitcoin Trust and the proposed Bitcoin ETFs is that the former is traded over the counter (OTC), and it is available only to accredited investors. The Grayscale Bitcoin Trust is traded publicly on the OTC market OTCQX, which is under the Alternative Reporting Standard. Thus, it is not required to register with the SEC. 

To provide further transparency, the Grayscale Bitcoin Trust obtained approval from the SEC as a reporting company in January 2020, and the company’s shares are registered with the commission under Section 12(g) of the Securities Exchange Act of 1934.

SEC commissioner Hester Peirce — known as “Crypto Mom” among many in the cryptocurrency industry — has stated that a regulated Bitcoin ETF would help to price Grayscale’s Bitcoin Trust more fairly. She said during a Bloomberg interview:

“Recently, I issued a second dissent, saying: To me, it appears that the current commission is not interested in approving any exchange-traded product that’s available to a retail audience that has crypto underlying. […] The analysis that we’ve applied in preventing these products from trading in the United States is a uniquely tailored analysis that we only seem to use for these kinds of products, which suggests to me that we have one standard for crypto products and then another standard for other types of products. And I don’t think that’s right.”

Canadian “Bitcoin Fund” is actively managed

Canadian investment manager 3iQ Corp has listed The Bitcoin Fund (QBTC.U) on the Toronto Stock Exchange (TSX) as of April 9. The Bitcoin Fund obtained approval from the Ontario Securities Commission (OSC) on Oct. 29, 2019 — which showed that the OSC is seemingly supportive of the emerging asset class.

While QBTC.U is listed and traded on the TSX, it is a closed-end fund, as opposed to an ETF. One major distinction between a closed-end fund and an ETF is the activeness in fund management. ETFs are passively managed and are designed to track the performance of an index. This is contrary to QBTC.U, as the fund is actively managed by 3iQ Corp.

Japan’s FSA views cryptocurrencies as too volatile for an ETF

A Bitcoin ETF does not appear to be on the cards in Japan.

The Financial Services Agency (FSA) in Japan adopted “The Comprehensive Guidelines for Supervision of Financial Instruments Business Operators, etc.” on Dec. 27, 2019 — which states that the creation and sales of investment funds are approved for only specified assets. The FSA claimed that cryptocurrencies are not defined as specified assets. 

Additionally, the FSA cited the excessive price fluctuation of cryptocurrencies and concluded that it is not appropriate for accredited or institutional investors to invest in funds with crypto asset components. This implies that it is unlikely investors will see an approved Bitcoin ETF in Japan in the near future.

Do Bitcoin ETPs improve the probability of a Bitcoin ETF approval?

The launch of Bakkt’s Bitcoin futures and the recently announced ETC Group Bitcoin ETP serve as gateways for institutional investors looking to invest in BTC — but do these products lead us any closer to an approved Bitcoin ETF?

Bitcoin ETPs have seen strong demand from European investors, with 18 cryptocurrency ETPs listed in the SIX Swiss Exchange since 2018. Keary told OKEx Insights that BTC futures markets contribute to the increasing number of Bitcoin ETPs being launched:

“The improved probability of a Bitcoin ETP being launched comes from the futures markets. ETP market makers need to have the ability to hedge the ETP, that is usually done through a futures contract. The more liquidity in the futures products, the more likely an ETP can get launched.”

However, Keary believes that Bitcoin ETPs do not necessarily improve the probability of a Bitcoin ETF getting approved, due to different regulatory systems in Europe and the U.S. He explained:

“The U.S. has a very different regulatory regime than Europe. U.S regulators are concerned that they can not track Bitcoin trades to the original order entry and, thus, are concerned about inherent risks in trading Bitcoin — because there could be price manipulation exchanges and regulators cannot detect or police it in any way. The lack of surveillance of Bitcoin or other cryptocurrencies is a major roadblock to physically-backed crypto products being launched in the U.S.”

Keary’s view is shared by Lanre Ige, a researcher at 21 Shares and Amun Tokens, who told OKEx Insights that, according to his personal views and not those of the companies, Bitcoin ETPs are primarily listed in Europe and do not relate to any potential Bitcoin ETFs in the U.S. He explained:

“ETPs are different from ETFs because, in the European Union, ETFs are generally UCITS and so they have a diversification requirement, which makes them most inappropriate for something like gold or BTC as a stand alone. Given that most ETPs are listed and available in Switzerland and Europe, this does not directly relate to any efforts to list a Bitcoin ETF in the U.S.”

When will there be a Bitcoin ETF?

Bitcoin ETFs have been widely discussed since 2018 — and the SEC has rejected a number of high-profile applicants. While the launch of Bakkt’s Bitcoin futures captured the spotlight in 2019, the crypto community is still waiting in 2020 for the first Bitcoin ETF to be approved.

For retail investors, a Bitcoin ETF would provide more direct access than Bakkt’s Bitcoin futures by allowing for the purchase of cryptocurrencies from retirement accounts. Meanwhile, Bakkt is primarily targeted at institutional investors. Bakkt’s president, Adam White, however, claimed that its BTC futures are available to retail investors through retail brokerages.

In the United States, the approval of a Bitcoin ETF by the SEC would imply that any person with Roth IRAs, 401(k) retirement accounts and investment brokerage accounts could purchase BTC directly. By allowing investors to purchase Bitcoin via investment and retirement accounts, the funds held in those accounts are subject to protection under the Securities Investor Protection Corporation (SIPC), a federally mandated corporation overseen by the SEC. 

Ige told OKEx Insights that he believes that investing in Bitcoin through ETPs or ETFs enables tax benefits and removes the complexities of custody and trade execution for the users, explaining: 

“ETPs/ETFs would allow investors to invest in Bitcoin through the broker and take advantage of the benefits of their retirement or tax-advantaged investment accounts in any given jurisdiction where the product were to be listed. In addition, most institutional investors do not have mandates to invest directly in physical Bitcoin and do not want to deal with the hassle of custody and trade execution. On the other hand, an ETP or an ETF would make Bitcoin investing as easy as buying a stock for such investors.”

Bitcoin ETFs could bring convenience to investors, as they could use tax-advantaged retirement accounts for investment. Such tax benefits encourage mass investment, which gives Bitcoin the potential to tap into the enormous asset management industry that, in PwC’s estimates, is expected to reach $145.4 trillion by 2025. Ige explained:

“ETPs and ETFs for Bitcoin have the ability to widely increase the capital available to be invested in Bitcoin — which, to this point, has barely been available to institutional investors and many retail investors. This is significant, as the availability of an ETP and ETF across jurisdictions, especially in the United States, would likely be a key impetus behind future increases in Bitcoin’s price and help further institutionalize the industry.”

In terms of the global leaders in asset under management, BlackRock topped the chart with $6.5 trillion — followed by Fidelity, JPMorgan Chase and Goldman Sachs, which have seen active involvement in launching services related to digital assets.

2019: Global leaders in asset under management. Source: Statista

Keary told OKEx Insights that Bitcoin ETFs would broaden the scope of potential Bitcoin investors. He also highlighted that such ETFs could serve as a hedge when the equity market is highly volatile, explaining:

“From an investor perspective, the significance of the ETF is that it is a way to buy or invest in Bitcoin without having to get a wallet or go through a miner. It would broaden the breadth of investors in BTC. This is important because some investors view Bitcoin as a safe haven when equity markets become volatile and/or move into a bear market environment. A Bitcoin ETF would be an easy and inexpensive way to hedge various market conditions.” 

Ige also hinted that Bitcoin ETPs/ETFs enable investors to pay lower premiums for crypto asset exposure, noting:

“It’s important to remember that there are currently Bitcoin and Ether investment trusts available in the United States which, due to their inferior product structures, mean that retail investors who hold such products are drastically overpaying for crypto asset exposure. A, ETP or ETF would be a vastly superior vehicle for investors to get crypto asset exposure without paying large premiums.”

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