Investors are eagerly anticipating the possible approval of a spot Bitcoin exchange-traded fund (ETF) by the U.S. Securities and Exchange Commission (SEC). The excitement began in early June, when investment giant BlackRock filed for the product, and followed a court ruling requiring the SEC to reconsider rejecting Grayscale’s proposal to convert its Bitcoin Trust (GBTC) into a spot ETF. Gained further momentum.
The SEC’s opposition to ETFs is related to the fact that Bitcoin (BTC) is traded in unregulated venues around the world, which poses challenges in preventing fraud and price manipulation.
One attempt to address this problem includes entering into surveillance sharing agreements (SSA) with some cryptocurrency exchanges. In theory, this would help identify bad actors trying to manipulate the market. Critics question the effectiveness of these SSAs because they fail to cover the entire market. ETFs are based on precedent decisions that allow for physical commodity ETFs based on correlations with the underlying commodity futures markets.
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The U.S. Securities and Exchange Commission requires futures to lead spot prices in price formation to be considered a “larger regulated market.” In other words, information from the futures market takes precedence over the spot market in the price discovery process. However, even if price discovery is dominated by the futures market, in some cases manipulation in the spot market can still spill over to ETFs. The devil is in the details, and more specifically, the source of price and the method of creation and redemption (cash or in kind) for net asset value (NAV) calculations.
Consider a situation where a manipulator succeeds in driving down the price of an underlying commodity by 5% in an unregulated spot market.
If both creation and redemption are physical, there is direct arbitrage, as is the case with communication vessels between ETFs and the unregulated spot market. In this example, an arbitrageur could exploit it by simply buying an underpriced spot commodity and selling the corresponding amount of ETF, then using the purchased commodity to create new ETF units and cover the short ETF position. The profitability of this trade will continue until spot commodity prices converge significantly with equivalent ETF prices. The extent to which each price converges depends on its liquidity, but part of the adjustment will come from ETF prices, meaning manipulation in the spot market will at least partially spill over to ETFs.
A very similar arbitrage may occur if both creation and redemption are cash and the NAV is calculated based on commodity prices in unregulated spot markets. Arbitrageurs buy underpriced physical commodities and sell the ETFs, use the cash to create ETF units to cover the short position, and then sell the commodities in an attempt to replicate the pricing method used in the NAV calculation (which determines the price paid to create ETF units). Trading is essentially the same as physical creation, with similar consequences, except for being less capital efficient (due to the cash required to create) and less execution risk when copying NAV prices.
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Is there a setting that effectively protects ETFs from manipulation? Using spot prices derived from the futures curve to calculate NAV, coupled with cash creation and redemptions, emerged as the most promising alternative. If an arbitrageur attempts to adopt the same approach as in the previous case, there is no guarantee that the commodity will be sold at a price similar to that used in the NAV calculation, especially if there are manipulators in the spot market. Trading is no longer about arbitrage. The pipeline connecting spot prices and ETF prices is not smooth.
On the other hand, this setting facilitates a direct arbitrage path between ETFs and futures. Whenever the ETF price deviates from the spot price implied by the futures curve, arbitrageurs can execute the opposite trade, perfectly hedging against futures, thus creating a strong link between the ETF and futures markets. There is reason to believe that ETFs with such characteristics will be as resistant to manipulation in unregulated spot markets as futures contracts or futures ETFs.
Academics and practitioners alike have found some strong evidence to support the view that CME Bitcoin futures dominate Bitcoin price discovery. There is no doubt that the launch of a Bitcoin spot ETF in the United States will be a good development for traditional markets and the crypto industry. As American pastor Chuck Swindoll once said: “The difference between something good and something great is attention to detail.” By keeping the devil away, Bitcoin ETFs have the potential to truly Bring benefits to investors.
Joao Marco Braga da Cunha Is a portfolio manager at Hashdex. He received a Master’s degree in Economics from Fundação Getulio Vargas and then a PhD in Electrical and Electronic Engineering from the Pontifical Catholic University of Rio de Janeiro.
This article is for general information purposes only and is not intended to be, and should not be construed as, legal or investment advice. The views, thoughts, and opinions expressed here are solely those of the author and do not necessarily reflect or represent the views and opinions of Cointelegraph.
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