This piece originally appeared in FIN, James Ledbetter’s fintech newsletter.
March 2021 has been the month when a US-sanctioned exchange traded fund (ETF) focused on Bitcoin and/or other cryptocurrencies turned the corner from prohibited to inevitable. This week, a division of Fidelity filed an S-1 to launch an ETF to track the performance of Bitcoin. Earlier in the month, VanEck, which has tried for years to convince the Securities and Exchange Commission (SEC) to allow a Bitcoin-based ETF, made another attempt. Commenting on that effort, John Davi, CEO and chief investment officer at Astoria Portfolio Advisors, told CNBC: “It’s just a matter of time.” That sounds right, and when SEC approval comes it will be less because of a paradigm shift caused by incoming Biden regulators, and more because most of the earlier SEC objections have been resolved or at least addressed.
Several financial outfits, including the Winklevoss twins and VanEck, have tried more than once to create crypto-based ETFs, only to be shot down by the SEC. Some of the earlier efforts hit notes of naive bluster that were bound to land badly in regulatory ears. For example, in a 2018 proposal, the Winklevosses suggested that Bitcoin markets, such as their own Gemini exchange, are “uniquely resistant to manipulation.” The SEC unsurprisingly disagreed. True, there may be a chicken-and-egg dynamic at work here: cryptocurrency markets are subject to manipulation because they’re not well-regulated, but they’re not well-regulated because they’re subject to manipulation. But you don’t have to look very far to find evidence that the Winklevoss assertion was risible.
Beyond market manipulation, which is always going to be a regulatory concern, what exactly does the SEC object to? Crucially, regulators have largely avoided the argument that Bitcoin and cryptocurrency are worthless. Instead, they have focused on details that stem from the innovative nature of crypto. In a December 2017 statement, then-SEC chair Jay Clayton posited a series of questions which would-be crypto ETF investors should ask themselves, and which recent events have shown to be relevant; they include:
- If a digital wallet is involved, what happens if I lose the key? Will I still have access to my investment?
- If a blockchain is used, is the blockchain open and public? Has the code been published, and has there been an independent cybersecurity audit?
Subsequent SEC utterances have focused on valuation: How, exactly, does a Bitcoin-based ETF determine what the value of Bitcoin actually is at any given moment? Another issue—which institutional investors also raise—is liquidity. A 2018 letter from an SEC official asked:
How would a fund prepare for the possibility that funds investing in cryptocurrency-related futures could grow to represent a substantial portion of the cryptocurrency-related futures markets? How would such a development impact the fund’s portfolio management and liquidity analysis?
Yet another concern is custody: the Investment Company Act of 1940 requires that registered funds must retain custody of their holdings. How, regulators have asked, do you maintain custody of something that doesn’t physically exist, and how can you guarantee that a cyber-based security can’t be hacked and stolen?
Accepting that these are legitimate concerns, they don’t seem insurmountable. To put it bluntly, if Canada can pull it off, why can’t the US? (Brazil, too, has approved a Bitcoin ETF.) Between the broad growth of Bitcoin in recent years and the lessons learned internationally, it seems like most of the SEC concerns can be addressed. For example, here is how Canada’s Purpose Investments’ ETF addresses the storage question:
The Bitcoin in the ETF is held in secure, offline storage, which is also known as “cold” storage because it is not actively connected to the internet. We do use an online or “hot” wallet, but only for transitory purchases when the ETF is buying and selling Bitcoin. The ETF only invests in and holds 100% physically settled Bitcoin.
And here is how Fidelity’s proposed ETF addresses the valuation question:
The Trust’s investment objective is to seek to track the performance of bitcoin, as measured by the performance of the Fidelity Bitcoin Index PR, adjusted for the Trust’s expenses and other liabilities. The Index is constructed using bitcoin price feeds from eligible bitcoin spot markets and a volume-weighted median price (“VWMP”) methodology, calculated every 15 seconds based on VWMP spot market data over rolling 5-minute increments.
Perhaps these are not perfect answers to SEC concerns, and perhaps US law imposes stricter requirements. But enough evolution and innovation has taken place that we will see at least a pilot Bitcoin-based ETF in the US within the next year or two.
This piece originally appeared in FIN, James Ledbetter’s fintech newsletter. Ledbetter is Chief Content Officer of Clarim Media, which owns Techonomy.