Cryptocurrency ETFs – The New Investment Opportunity

Published on May 31, 2018 by Nikunj Shinghal

The year 2017 saw cryptocurrencies getting a lot of attention with its rising popularity among investors worldwide. Though Bitcoin – the first digital currency based on the block chain technology – is almost synonymous with cryptocurrency, there are several others such as Ethereum and Litecoin. Since Bitcoin’s inception in 2009, the number of cryptocurrencies has been increasing and newer ones are being introduced. The number stands at 1584 today with total market capitalization of more than $400bn. In recent times, although cryptocurrencies have cooled off from their highs after posting phenomenal returns for a substantial period, they are still sought after.

Innovative fund managers have shown keen interest in cryptocurrencies and are looking to capture this segment’s growth by launching new (Exchange Traded Funds) ETFs based on cryptocurrencies. The advantages of investing through ETFs far exceed the disadvantages. Primarily, the “security” of a cryptocurrency ETF is a major advantage. Various cases of theft or cryptocurrency wallet hacking are being reported on a daily basis. Investing through ETFs can protect investors from a direct exposure to cryptocurrencies, lowering chances of losing out their hard-earned money.

Bitwise Asset Management recently launched first cryptocurrency ETF – HOLD 10 Private Index Fund on November 22, 2017. This ETF tracks the cryptocurrencies in the HOLD 10 Index. The HOLD 10 Index is a market-cap weighted index and is rebalanced on a monthly basis. The index has consistently outperformed Bitcoin – one of the oldest and most popular cryptocurrencies.

Coinbase in California, one of the leading digital currency exchanges, launched its cryptocurrency fund Coinbase Index Fund as recently as March 6, 2018. This fund will be rebalanced on an annual basis. Both these funds are available only to qualified investors, considering the volatility and risk factors, but are first steps towards creating publicly traded cryptocurrency ETFs. However, there is a long way to go given the regulatory challenges surrounding cryptocurrencies.

The US Securities Exchange Commission (SEC) is yet to give the formal permission to launch public ETFs based on cryptocurrencies. The SEC had raised several valid concerns in a staff letter titled “Engaging on Fund Innovation and Cryptocurrency-related Holdings” while replying to some ETF sponsors who had approached the regulator for a no action letter, which was necessary for a new product launch on January 19, 2018. In the letter, the SEC had raised a series of questions, which were related to issues such as valuation, liquidity, custody of holdings, arbitrage for ETFs, potential manipulation and other risks.

In the letter, the SEC points out that because of very high volatility in cryptocurrency markets, their largely deregulated markets, and the early stage of their adoption, it is very difficult to ascertain the correct Net Asset Value (NAV) of a cryptocurrency ETF, which is essential for buying or selling ETFs. As liquidity is also important for an investment, classifying cryptocurrencies in four liquidity categories, as defined by the SEC, and maintaining the maximum 15% exposure to illiquid securities are daunting tasks, which are necessary under the fund liquidity rule 22e-4. The SEC also raised concerns about meeting daily redemptions and the contingency plan in case of an unusual surge in redemptions, which is very much possible due to the high volatility and fragmentation of the cryptocurrency markets. The 1940 Custody Act states that registered custodians should have the custody of assets and funds must verify their holdings. The SEC noted that, as per its information, currently none of the custodian is providing custodial services for cryptocurrencies, so it will be difficult to satisfy the custody requirements of the 1940 Act. Other issues that the SEC raised are related to existence validity, exclusive ownership, software functionality of private cryptocurrency keys, other ownership records, cybersecurity threats and the chances of digital wallet hacking.

One of the SEC’s important requirements is that an ETF’s traded price should be always near its net asset value to prevent any arbitrage trade. The SEC believes arbitrage trade can be a concern for crypto ETFs considering the volatility, fragmentation and trading volume of cryptocurrencies.The SEC also asked the fund sponsors on whether they had any discussion with the market makers and authorized participants to understand the feasibility of arbitrage trade in the cryptocurrency ETF and the impact of trading halts in cryptocurrency exchanges due to high volatility, considering the importance of both these issues on the functioning of ETFs.

Overall, the SEC believes that there is lower level of investor protection in cryptocurrency markets than traditional investment avenues, given the higher risk of price manipulation, fraud and liquidity related issues. However, the SEC has softened its earlier hard stance on public cryptocurrency ETFs, and, on March 23, 2018, it started formal proceedings to determine whether to approve a rule change that would allow NYSE Arca to list two ETFs: ProShares Bitcoin ETF and ProShares Short Bitcoin ETF proposed by ProShares. Both the ETFs will be based on the Bitcoin future contract listed on the Chicago Board Options Exchange (Cboe) and the Chicago Mercantile Exchange & Chicago Board of Trade (CME). One of the ETFs will take a long position and the other will take a short position. Cryptocurrency ETFs based on the bitcoin future contract listed on the Cboe and the CME will have lower risk because of measures taken by the Cboe to prevent and detect manipulation in the bitcoin future market (e.g. strict position limit requirements that help in preventing excessive manipulation). Replying to the SEC on its observations in the staff letter, Chris Concannon, president and COO of Cboe, said, “Cboe has entered into a comprehensive surveillance sharing agreement that allows Cboe access to order and trade detail information for the purposes of conducting cross-market surveillance and regulation is also working with various cryptocurrency exchanges”

This is definitely a step in the positive direction so far as cryptocurrency ETFs are concerned and paves the way for a possible launch of an entirely new segment in the hugely popular and growing ETF space. Considering the success of private cryptocurrency funds, ETFs will provide one more investment avenue to investors who want to bet on the decentralized currency regime.

Sources

https://coinmarketcap.com/all/views/all/

https://www.sec.gov/fast-answers/answersnoactionhtm.html

https://www.ccn.com/sec-quietly-puts-bitcoin-etf-proposals-back-on-the-table/

https://seekingalpha.com/article/4143066-4-new-cryptocurrency-etfs-consider-portfolio

https://www.cnbc.com/2018/01/26/investors-clamor-into-new-etfs-with-focus-on-blockchain.html

https://money.usnews.com/investing/cryptocurrency/articles/2018-01-29/cryptocurrency-etf-blok-blcn-gbtc

http://www.cboe.com/publish/ComLet/20180323.pdf

https://coinjournal.net/cboe-letter-to-sec-argues-industry-can-support-cryptocurrency-etfs/

https://www.bitwiseinvestments.com/

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