We have been writing a lot lately about the potential for a bitcoin ETF because we think this is another pivotal market structure issue. Our position is clear: we think approval of a bitcoin ETF would be a mistake since many of the underlying exchanges where bitcoin trades are unregulated and not under the jurisdiction of US regulators. We have followed this story closely, not because we are cryptocurrency experts, but because we see a disaster in the making and we want to make our voices heard before it’s too late.
Apparently, the SEC agrees with many of our bitcoin ETF concerns and yesterday they took a sledgehammer to the numerous bitcoin ETF proposals. According to letters from four ETF sponsors, the SEC staff requested that they withdraw their bitcoin ETF proposals. Specifically, Direxion noted in their withdrawal letter that liquidity and valuation were a cause of concern for the SEC staff. Direxion wrote:
“On a call with the Staff on January 5, 2018, the Staff expressed concerns regarding the liquidity and valuation of the underlying instruments in which the Fund intends to primarily invest and requested that the Trust withdraw the Amendment until such time as these concerns are resolved.”
The SEC seems to be concerned about what types of instruments will be held in the bitcoin ETF. Last week, we pointed out that Cboe was requesting some exemptions for the bitcoin ETF issuers including an exemption for the maximum levels of derivatives and non-US stock holdings . Also, according to the Cboe filings for two bitcoin ETF issuers (REX and First Trust), the funds may contain some illiquid assets, specifically “each Fund may hold up to an aggregate amount of 15% of its net assets in illiquid assets (calculated at the time of investment) deemed illiquid by the Adviser under the 1940 Act.” After reading this, we were immediately reminded of the Level 3 assets that were held by banks during the financial crisis and the problems that they caused because of the valuation methods that were used by the banks. The SEC obviously does not want to see that problem occur again and likely made it clear to the ETF issuers that they were not going to allow illiquid assets in a bitcoin ETF.
So what happens now? We expect that these bitcoin ETF issuers will go back to their financial labs and try to cook up a new formula to replicate a bitcoin price that does not include illiquid assets. They probably will consult with their stock exchange friends, namely the Cboe (BATS) and the NYSE, to figure out a new plan. But before they resubmit their proposals, they should be prepared for more intense scrutiny from the SEC which has now slapped them down twice in the last year.
Exchanges and ETF issuers stand to reap millions from a bitcoin ETF since retail investors and some institutions would most likely jump on the opportunity to speculate on the price of bitcoin without going through the onerous process of buying bitcoin from a bitcoin exchange. But it’s the job of the SEC to protect these investors from themselves and not allow an exchange to list a product that has substantial underlying risk. We applaud the SEC for protecting investors and standing firm in the face of constant pressure from the exchanges and the bitcoin ETF issuers.
Below are the original bitcoin ETF filings and the withdrawal letters from four ETF issuers: