Bitcoin ETFs — coming soon! But in cash only

By Amy Castor and David Gerard

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“It’s my turn, Sam.”

— Barry Silbert, Digital Currency Group, to Sam Bankman-Fried, November 23, 2021

The SEC is expected to rule on a spot bitcoin ETF by January 10 — the deadline to decide on the application from ARK 21Shares.

The SEC doesn’t like to be a kingmaker — so crypto is hoping the commission will approve a slew of bitcoin ETFs in one go.

The big institutional money will pour in and number will go up! Apparently. We’re not so sure.

 

SEC chair Gary Gensler with Zeke Faux’s Number Go Up

 

The long, sad story of bitcoin ETFs

An exchange-traded fund, or ETF, is a security that tracks a basket of underlying assets — commodities,  securities, or a mix of both. ETFs trade on securities exchanges like regular stocks. Ordinary mom-and-pop investors can buy them.

Coiners have long dreamed of bitcoin having a spot ETF. There’s a myth that the moment there’s a bitcoin ETF, the big institutional bucks will flood in!

Cameron and Tyler Winklevoss submitted the first proposal for a bitcoin spot ETF — the Winklevoss Bitcoin Trust — in July 2013. Bitcoin was trading at $90 at the time. The SEC shot them down twice, once in 2017 and again in 2018. 

On August 22, 2018, the SEC rejected nine bitcoin ETF applications in a single day. They were concerned about the “potential for fraudulent or manipulative acts and practices in this market” — particularly via Tether.

But then in October 2021, the SEC approved a bitcoin futures ETF, based on the Chicago Mercantile Exchange bitcoin futures. We were surprised they let this one through, as the bitcoin prices that CME was using were just as manipulated as any others. We suspect the SEC couldn’t really refuse the ETF — CME was already highly regulated, and its bitcoin futures product was fine with the CFTC.

Grayscale’s GBTC, which debuted in September 2013, was for many years the closest thing to a spot bitcoin ETF — only it wasn’t one. Unlike an ETF, GBTC is a closed-end fund. Once bitcoins went into the trust, there was no way to get them out.

Since Grayscale halted GBTC issuance in March 2021, they could have switched to redemption mode — but they chose not to. With GBTC’s ridiculously high 2% management fee, why would they?

Because it’s a roach motel for bitcoins, GBTC has never traded in line with the actual price of bitcoin. GBTC traded higher than BTC in 2020, because of shenanigans — but current holders are underwater. As of September 30, 2023, there are 622,657 BTC stuck in the trust — and a lot of angry GBTC holders.

Grayscale applied to convert GBTC into an ordinary two-way ETF in October 2021, in the hope of bringing the price of GBTC back up. The SEC rejected their application in June 2022. Grayscale appealed, on the basis that the CME bitcoin futures ETF was allowed — if their fraud prevention arrangements were OK, the same should hold for Grayscale’s proposal.

In August 2023, the appeals court agreed that the SEC had unfairly blocked the Grayscale bitcoin ETF. The panel called the order “arbitrary and capricious,” because the SEC never explained why it approved similar products. The SEC would need to further review Grayscale’s bid for an ETF. [Opinion, PDF]

The SEC decided not to appeal, and Grayscale issued a fresh filing in the form of an S-3, a shortened version of the typical S-1 filing used to offer new shares. [Grayscale S-3]

The SEC still has a low opinion of crypto. SEC chair Gary Gensler told CNBC that crypto was saturated with fraud — but on ETFs, he said, “We’re taking a new look at this based upon those court rulings.” [CNBC]

This year’s model: cash only

About a dozen companies have recently submitted filings for a bitcoin ETF. In addition to Ark 21Shares, there’s Grayscale, BlackRock, Bitwise, VanEck, Wisdomtree, Invesco and Galaxy, Fidelity, Valkyrie, Global X, Hashdex, and Franklin.

But here’s the catch: if the SEC is forced to approve a spot bitcoin ETF, it wants it to use in-cash creation. When new ETF shares are created or redeemed, that process would take place only in cash — and not in bitcoins. Only the company issuing the shares could touch a bitcoin.

Most ETFs of stocks allow in-kind redemption, where you put in or take out whatever asset the ETF is tracking directly. But the SEC doesn’t want broker-dealers to handle cryptos directly. So bitcoin ETFs will not allow in-kind creation or redemption — only cash will go in or out, and absolutely not actual bitcoins.

Valkyrie is the latest to agree to in-cash creation, following BlackRock, Fidelity Investments, Ark Invest, and Invesco. Grayscale doesn’t seem to have come to the party yet.

How in-cash creation works

Authorized participants (APs) — typically large financial institutions — create or redeem shares of an ETF based on demand from retail investors in the secondary market.

Like other single-commodity ETFs, such as gold, silver, or a currency, a bitcoin ETF would be structured as a grantor trust. The physical asset is stored in a vault — or, in the case of bitcoin, at a custodian. The trust issues shares representing beneficial interests in its net assets. Investors typically receive grantor trust letters with their tax information instead of it being included on their 1099.

When ETF shares are created or redeemed, the AP is the only one who can create and redeem shares directly with the issuer. APs make their money selling to retail investors — who buy through their brokerage on the secondary market.

In-kind ETFs are known for their tax efficiency for the APs. When an AP redeems shares, the ETF issuer simply pays the AP in assets from the underlying holdings of the ETF itself. Since the AP isn’t selling the underlying assets, there are no capital gains. They don’t have to worry about gains until they sell their actual shares.

A cash-create ETF erases most of that tax advantage. Creation or redemption in kind doesn’t create a taxable event, but doing it via cash does. So cash-based ETFs are less efficient for the APs. The ETF is also more complicated for the issuer to manage. [Bloomberg, archive]

So much for that GBTC premium

If the SEC does approve a cash-create ETF in 2024, we should expect the agency to provide reasoning on why it is not approving an in-kind ETF. We expect them to push back hard on in-kind ETFs — specifically because of odd behavior around Grayscale’s GBTC.

In the past, the only AP for Grayscale trust products was its fellow Digital Currency Group company Genesis.

A lot of the bitcoins flowing into GBTC via Genesis came from bitcoin whales who wanted to dump their coins for shares they could sell for cash, and from hedge funds, such as Three Arrows Capital, taking advantage of the lucrative GBTC arbitrage.

Until 2021, GBTC traded at a significant premium to NAV. The game was this: borrow BTC from Genesis, exchange it for GBTC directly from Grayscale, and sell the GBTC for 20% more to retail investors on the secondary market. It was an easy way to make 40% returns in a year. The GBTC arbitrage also contributed to the 2021 bitcoin bubble.

That arbitrage won’t be there this time. APs like Genesis won’t be able to exchange hard-to-track bitcoins for securities.  With a cash-create ETF, the AP would only be able to send cash to Grayscale for new GBTC, leaving an actual money trail. This may be why Grayscale hasn’t yet changed its ETF application to cash-create.

Who’s buying?

Even if the SEC is pressured to let through a bitcoin ETF, we still don’t think that just having a spot bitcoin ETF exist in the US is going to magic up fresh demand.

Bitcoin ETFs already exist outside the US — and they noticeably haven’t unleashed any pent-up demand for bitcoins. (Though the Purpose Bitcoin ETF in Toronto seems to be what sent GBTC underwater.) US dollars are somewhat special, but we don’t think they’re that special.

Investment firm Needham surveyed registered investment advisors and found that retail investor interest in crypto just wasn’t there — as Coinbase has already told us.

The advisors who Needham surveyed suggested that 5% to 10% of their clients might buy into a bitcoin ETF. But these clients were already crypto holders and would just be moving their holding around. “Any person that has not purchased bitcoin already is currently unlikely to buy a bitcoin ETF,” said John Todaro of Needham. [CNBC]

JP Morgan concurs that demand for a bitcoin ETF is likely to come from existing investors — holders of GBTC, CME bitcoin futures, or shares in bitcoin mining companies. And anyone buying into bitcoin miners deserves everything that follows. [Fortune, archive]

JP Morgan also suggests that GBTC holders are likely to cash out while they can, removing maybe $2.7 billion from the fund.

What happens next

We think the SEC hates crypto and considers it a hive of scum and villainy, and so doesn’t want to allow a bitcoin ETF.

If the SEC is forced to hold its nose and permit a bitcoin ETF, it will (a) make any bitcoin ETF cash-only and (b) approve multiple ETFs at once — meaning cut-throat competition on fees.

A bitcoin ETF will also drain institutional investors from exchanges such as Coinbase — because the fees will be so much lower.

The way to protect investors from dodgy bitcoin salesmen is to make the financial products suck. Fortunately, that only requires making them follow long-standing regulations.