One of the most discussed topics in the cryptocurrency market is the possible launch of a Bitcoin ETF. In this article, we will try to briefly understand what is an ETF and how it works, why the approval of a Bitcoin ETF would be important and what are the issues that are preventing its launch.
What is an ETF? How it works?
An ETF (literally “Exchange Traded Fund”) is a financial instrument that replicates the performance of another instrument, defined as “underlying”. It is divided in quotes: people who want to invest in it buy some ETF shares
For example, a Bitcoin ETF would be a financial instrument that replicates Bitcoin’s performance. So if the Bitcoin price goes up the ETF price goes up, and vice versa if the price goes down. To replicate the performance of the underlying, ETF managers buy that underlying. In our case, the fund managers would buy Bitcoin. This means that if one wanted to buy the ETF, he would get a share of the fund, and the fund manager would buy BTC to cover that share. ETFs are an extremely vast world: there are ETFs on many different financial instruments, such as gold and financial indices, or which replicate the performance of particular stocks. You can find HEREmore technical informations from US Security Exchange Commission (SEC)
Why is Bitcoin ETF so important?
In case of approval, a Bitcoin ETF would allow investors to bet on Bitcoin without buying physical Bitcoins. However, unlike futures, these investments would be “covered” by real bitcoins, and this would allow to create a lot of demand for “real” Bitcoins. In this way, if ETF is approved, several operators could invest in Bitcoin without bearing the risk of buying Bitcoins on the exchanges or of storing them: it would be a problem for those who manage the ETF (who would require a fee as compensation).
Because of these characteristics, the ETF approval could trigger a strong rise of the whole cryptocurrency market. At the same time, the Exchange would be listed on a regulated market, so it could be more difficult to manipulate. Furthermore, the presence of an approved Bitcoin fund listed on regulated markets would greatly improve the transparency and quality of the Bitcoin market (see a study HEREabout how an ETF improves the efficiency of the underlying market): this market would no longer be driven by a few whales, but it would become much larger and more complex. This would happen especially if the volumes of the ETF were very high, and therefore it was the ETF that influenced the “physical” market and not vice versa, as already happened in other cases).
As result of the approval, a Bitcoin ETF could be able to reach a larger group of investors and price volatility could decrease. This would be a great incentive towards Bitcoin adoption: many operators would have the opportunity to include it in their portfolio, leading to an increase in global demand.
What is preventing the launch of a Bitcoin ETF?
In our case, an ETF would be an important step in order to allow many operators to invest in the Bitcoin market. Because of these potentially great effects, its launch is subject to certain conditions. In fact, the ETF approval can create the possibility of investing in Bitcoin for a large number of operators, so its risk has to be limited. Because of this, the US financial authority SEC (Security Exchange Commission) has put some strict requirements:
For first, SEC states that the market in which the underlying is traded must be a non manipulated and transparent market. Otherwise, there may be very significant risks for managers and investors in the ETF, particularly if the price is manipulated. This is a weak hypothesis for the Bitcoin market, which is unregulated and subject to various distortion phenomena; for example, the asset management company “Bitwise” published last year a report which hypotesized that95% of the trading volumes we see are fake: certainly this not an encouraging circumstance, even if this proportion gives more importance to the regulated market of BTC futures (and SEC would appreciate the presence of a strong regulated market).
A further problem in the case of Bitcoin is the fact that the ETF manager must buy and store physical Bitcoins, bearing the risk of wallet hacks and similar issues. We imagine that every possible precaution would be taken, but anyway a series of appropriate measures should be adopted to minimize these risks.
Bitcoin Volatility and the ETF
Volatility could also be a problem in case of approval, since Bitcoin, if we look at price variability, is extraordinarily riskier than all the other assets on which ETFs exist (stocks, commodities, stock indices, etc.). This is also due to lower liquidity that makes possible greater price movements.
It is clear that allowing institutional investors to add Bitcoin to their portfolio would be a great risk for the entire financial system. We are not saying that in traditional markets there are no scams and “junk bonds”: Simply, Bitcoin is on average more risky than the other assets (as we have seen in the table before). So, the ETF approval can create great risk for traditional investors, while, on the other hand, it offers great earning opportunities. These are two sides of the same coin that must be carefully weighed when it comes to the stability of the financial system. The same considerations apply for other cryptocurrencies such as Ethereum.
The history of Bitcoin ETF is quite troubled: there have been many ETF proposals, all rejected, even relatively recently. In October 2019, the SEC rejected the request of the asset management company “Bitwise” to launch a BTC ETF. Among the reasons there was the fact that Bitcoin had a very small regulated market (futures) compared to the total market (exchanges): Therefore, it was difficult to prevent fraud and manipulation. For the more curious, here you can find the link with the complete SEC discussion
Some ideas about Bitcoin ETF approval
1) Behind the requests to create an ETF there is a real interest in managing such a product. Despite the high risk, it could lead to large profits (even just for the commissions that investors would pay to those who manage the ETF). In fact, the Bitwise company sent the request together with NYSE arca, which is the Chicago branch of the New York Stock Exchange (the New York Stock Exchange). This is an example of how there are many interests in the financial industry too for a bitcoin ETF.
2) The request was originally sent to SEC on January 28, 2019. Then, there was a long discussion between the proposers and the SEC, which ended ten months later, in October 2019. The approval of the ETF is a long and complex process; when you see hype for ETF arrival, don’t get anxious and always calmly evaluate your decisions. Over the past two years there have been dozens and dozens of announcements about the forthcoming approval. And none of them have been accomplished so far! This of course applies not only to the ETF or SEC, but also to many other issues related to Bitcoin and other cryptocurrencies. Chasing the news, acting instinctively, is dangerous and goes against every principle of prudence.
In conclusion, while there are many unknowns about the possibilities of approval and its effects for Bitcoin, it could represent a real revolution for the whole cryptocurrency market. We must not forget that, following this milestone, there could be also ETFs on other cryptocurrencies, leading to the evolution and – hopefully – the growth of the whole market.