Market Commentary
Bitcoin Market Commentary: No Spot ETF
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Tuesday, November 16, 2021

Bitcoin experienced another week of consolidation with a 2.3% gain to close at $64,336, the highest weekly close in bitcoin’s history.

Both traders and investors focused on Wednesday’s headline CPI of 6.2% year-over-year for the month of October, which was both a 30 year high as well as the fifth straight month of headline CPI above 5%.

This news sent bitcoin to a new all-time intraday high of around $69,000 until risk assets across the board pulled back towards the end of the day. Bitcoin declined 5.1% on Wednesday, alongside a 0.8% loss in the S&P 500 and a 1.7% decline in the Nasdaq Composite.

Later last week, the SEC rejected the application for VanEck’s spot bitcoin ETF. The approval of futures-based ETFs has led to recent excitement around the potential for spot ETFs in the near-term, but this rejection outlined the SEC’s concerns with spot-based products.

This week, we take a deep dive into why the SEC continues to reject spot ETFs.

The SEC’s Reasoning for Another Spot ETF Rejection

The SEC has rejected spot bitcoin ETFs time and time again, not on the merits of the investment, but on the lack of “surveillance-sharing agreements with a regulated market of significant size.”

In the SEC’s view, these agreements are necessary to detect and investigate fraud, market manipulation, and violations of exchange rules. These agreements facilitate the availability of information related to market trading activity, clearing activity, and customer identity without the potential for impediment.

These agreements are in place for each and every commodity-ETP, such as those of gold, silver, platinum, and copper, but are not in place for the spot bitcoin market.

As a result, spot ETFs are a step behind in their approval requests.

Without a Surveillance-Sharing Agreement

Without these agreements, listing exchanges have proposed that bitcoin is inherently and uniquely resistant to fraud and manipulation. The SEC agrees that if this resistance can be proven, listing exchanges do not need surveillance-sharing agreements.

Most recently, BZX provided the following reasoning as to why spot bitcoin is resistant to fraud and manipulation, such as:

  • Geographically diverse, continuous trading
  • Fragmentation across exchanges, slow speed of transactions, and large capital requirements
  • Wash trading and/or similar activity intended to manipulate price is ignored by most participants
  • Arbitrageurs have significant funds on each exchange, and thus manipulators would have to overcome this liquidity supply

The SEC does not dismiss these claims but argues there is not enough evidence to justify the lack of surveillance-sharing requirements.

On Markets of Significant Size

When entering into a surveillance-sharing agreement, the agreement must be with a market of “significant size” – or one in which there is a reasonable likelihood that a person attempting to manipulate the ETP would have to trade on that market to do so.

The BZX argues that growth in volume, open interest, number of traders, and large open interest holders of CME bitcoin futures are reflective of the market’s growing influence on the spot price of bitcoin. However, the SEC believes 1) there is inconclusive evidence that futures prices drive price discovery, and 2) a manipulator of the proposed ETP might not need to trade on the CME futures market to achieve their goals.

Thus, the CME futures market is not of significant size in relation to the spot bitcoin market.

On Claims that Spot ETFs are Better for Investor Protection

BZX believes that spot ETFs would protect investors and public interest, as exposure through OTC funds and futures-based ETPs have respective risks, tracking errors, fees, and volatilities.

The SEC does little to argue these claims and agrees that a bitcoin-based ETP on a national securities exchange would provide additional protection to investors.

However, this reasoning alone is not enough to dismiss the surveillance-sharing agreement or the unique resistance to manipulation requirements.

Other Factors Cited by the SEC

The SEC also explains that BZX does not address risk factors specific to bitcoin, such as:

  1. Platforms are relatively new and sometimes unregulated, and therefore may be exposed to more fraud and security breaches than established, regulated financial exchanges
  2. Multiple trading venues that have various levels of regulation but are not regulated the same as traditional stock and bond exchanges
  3. Technical, security, or regulatory issues that could impact the ability of Authorized Participants to make markets, which could lead to significant premiums or discounts from the creation/redemption process
  4. The Bitcoin network is always at risk of a 51% attack
  5. Spot bitcoin is an appealing target for hackers and cybercrimes

Our View: Spot ETFs are Far Away

While the approval of a futures-based ETF created excitement for the potential of spot-based products, the SEC’s rejection outlines their many concerns with these vehicles. The SEC understands that futures-based ETFs and OTC trusts are not the best options for long-term investors, but this alone does not justify a spot ETF without sufficient analysis required to bypass surveillance-sharing agreements.

While many spot bitcoin exchanges are highly regulated such as Gemini, others are new and less regulated. The SEC, of course, has the strictest requirements in place for investor protection. The pricing mechanisms of these proposed ETFs utilize many exchanges to create a benchmark closing price, and thus, this must be taken into account.

If surveillance-sharing agreements with a market of significant size were to be made, this would be a step in the right direction. However, this has been SEC’s reason for rejection for many years now as these surveillance-sharing agreements are difficult to achieve.

Much needs to be hashed out (no pun intended) for spot ETFs to launch in the United States.

Even so, bitcoin does not need a spot ETF to be successful. Educated investors are interested in custody that allows them to own bitcoin directly, and platforms such as ours allow for full portfolio integration and daily liquidity.

Investors have already realized there are better options than waiting for a spot ETF approval and have begun to allocate accordingly.

As always, please reach out with any questions or comments.

Stay Tuned,

Joseph Orsini, CFA
Director of Research

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