What Are the Advantages and Disadvantages of Bitcoin ETFs?

Since 2016, more than 10 applications to list Bitcoin ETFs (exchange-traded funds) have been made to the US Securities and Exchange Commission (SEC).

Bitcoin BTC
What Are the Advantages and Disadvantages of Bitcoin ETFs?

Since 2016, more than 10 applications to list Bitcoin ETFs (exchange-traded funds) have been made to the US Securities and Exchange Commission (SEC). Brothers Tyler Winklevoss and Cameron Winklevoss made the first application using their Gemini exchange as the broker through BZX Exchange, a subsidiary of Bats Global Markets, now part of Cboe.

Regulation Challenges

The SEC rejected their application in March 2017. The brothers appealed this decision and they have ultimately turned down again in July 2018. In August 2018, the SEC rejected a number of other Bitcoin ETF applications made through various stock and futures markets, including the New York Stock Exchange (NYSE).

The US regulator said the primary reason for the rejections was that the applicants lacked a sufficient surveillance-sharing agreement with other Bitcoin market players to prevent fraud and manipulation. Hester Peirce‏, an SEC commissioner, indicated in a recent tweet that the decision to reject the applications is ‘stayed pending review’.

It seems decentralization is going to be the biggest challenge for ETF approval. Bitcoin is designed to have no points of control. Regulators may have to realize that the platform is of a completely different design.

Forcing a new type of platform to fit conventional rules may not work—not because there is anything wrong with Bitcoin, but because the conventional rules were not designed to accommodate it.

What Is a Bitcoin ETF?

An ETF is a special type of security, financial instrument or share that is backed by an asset and can be bought and sold like stock. In the case of Bitcoin ETFs, the backing asset is most likely bitcoins stored in a cold wallet. An ETF may also be backed by a derivative such as Bitcoin futures.

A broker initiates the process of creating an ETF by reaching out to a stock exchange or a futures market and requesting a listing. On receiving the request and concurring that the proposed product is viable, the stock exchange applies to the regulator to be allowed to include the security in its listings. The request is often also accompanied by an application to change the rules to allow the inclusion of the new product.

The regulator will invite the public and any interested parties to make cases for and against the acceptance of the new ETF product. From the information provided by the submissions and through research undertaken by the regulator, the regulator then chooses to either approve or reject the application.

The regulator informs their decision according to whether the ETF provides protection for investors and whether measures have been put in place to prevent fraud manipulation.

If the regulator is satisfied that the applicant meets all necessary terms, approval is issued. The brokerage entity will then acquire the asset needed to back the ETF—in this case, bitcoins—and then issue shares to the public for purchase. Investors can then buy and hold ETFs as long-term investment tools, or trade them on margin, just like they would with company stock.

The Advantages of Bitcoin ETFs

Many in the Bitcoin community are excited at the prospect of ETF approval. They believe the cryptocurrency, the market and the technology that powers it would all benefit in several ways.

First, they believe it would legitimize Bitcoin and other cryptocurrencies. It would also bring in money from mainstream investors who would otherwise have to educate themselves before joining the Bitcoin market.

An ETF would make it easier for mainstream investors to put their money into cryptocurrencies and speculate on price movements without having to deal with the complexities of the technology, such as creating a wallet and securing private keys.

Second, it would give investors a way to invest in Bitcoin through regulated brokers, which would increase confidence. This form of investment would be insured against hacking and theft, therefore protecting investors from losses.

Finally, the legitimization of cryptocurrencies and the increase in money flowing in from mainstream investors could drive the price up dramatically and thus create more value for all bitcoin holders.

The Disadvantages

Many people see disadvantages to SEC approval. First, investing through an ETF goes against the essential principle of decentralization on which cryptocurrencies are built.

Buyers of bitcoins through an ETF would have no control over them. They’d have to rely on a custodian—a trusted third party—to hold and secure the coins. If ETFs are successful, they may create huge custodial systems that could become honeypots for hackers.

Second, approval would also mean that many owners of bitcoin would not have the rights and responsibilities envisioned in the Bitcoin white paper. By design, owners are supposed to have a sort of voting right over how the technology works.

With their bitcoins under the control of a separate entity, however, investors would lack a voice in the consensus and governance of the Bitcoin protocol. The fund manager would make critical decisions and speak on behalf of stakeholders, as the manager would hold the private keys.

For example, in the event of a fork, they could decide which chain to support. And when funds accumulate on two or more forks, they could decide to pocket the funds from the branch they do not wish to support. Shareholders would forfeit their right to such value.

Also, in the event of a soft fork, the manager would make the decision about whether to adopt the platform changes.

Finally, the US security commission gave fraud and manipulation as its reasons for declining to approve ETFs, but the opposite problem would be the case. Such instruments open the Bitcoin market to manipulation through activities such as shorting.

Perhaps worst of all, ETFs also encourage the adoption of cryptocurrencies as speculation assets, rather than as mediums of exchange, stores of value or units of account. In other words, they harm the ability of cryptocurrencies to act as currencies.

We have not seen the last of Bitcoin ETFs. More applications are likely on the way and we may witness eventual approval.

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