The U.S. Securities and Exchange Commission (SEC) has given some guidance to exchanges that want to list spot Bitcoin ETFs, according to Bloomberg’s ETF analyst Eric Balchunas. In a tweet on Friday, Balchunas said that the SEC advised the exchanges to do cash creates for these products, which means that the ETFs would buy Bitcoin directly from the market instead of using a third-party custodian. Balchunas also said that the SEC asked the exchanges to file amendments in the next couple of weeks, indicating that the regulator is moving closer to approving spot Bitcoin ETFs.
ETFs, or exchange-traded funds, are investment vehicles that track the performance of a basket of securities, such as stocks, bonds, commodities, or currencies. ETFs are traded on stock exchanges, just like individual stocks, and offer investors exposure to a diversified portfolio of assets with low fees and high liquidity.
This is a significant development for the crypto industry, as spot Bitcoin ETFs would allow investors to gain exposure to the actual price of Bitcoin, rather than its futures contracts. Futures-based Bitcoin ETFs, such as ProShares Bitcoin Strategy ETF (BITO) and Valkyrie Bitcoin Strategy ETF (BTF), have already launched in the U.S., but they have some drawbacks, such as higher fees, tracking errors, and rollover risks. Spot Bitcoin ETFs, on the other hand, would track the spot price of Bitcoin more accurately and efficiently, and potentially attract more institutional and retail demand.
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However, spot Bitcoin ETFs are not without challenges either. The SEC has been reluctant to approve them due to concerns about market manipulation, fraud, custody, and liquidity in the crypto space. The SEC has also expressed doubts about whether Bitcoin is sufficiently decentralized and whether its price discovery is reliable. The SEC’s guidance to do cash creates for spot Bitcoin ETFs suggests that the regulator is trying to address some of these issues by ensuring that the ETFs have a direct connection to the underlying asset and do not rely on intermediaries.
The SEC’s guidance also implies that the regulator is not opposed to spot Bitcoin ETFs in principle, but rather wants to see more safeguards and transparency in their design and operation. This is consistent with the recent remarks by SEC Chair Gary Gensler, who said that he is open to considering spot Bitcoin ETFs if they meet the standards of the Investment Company Act of 1940, which governs mutual funds and ETFs. Gensler also said that he prefers that spot Bitcoin ETFs trade on exchanges that are registered with the SEC, rather than on platforms that are exempt from regulation.
One of the most popular types of ETFs are those that track the performance of a specific market index, such as the S&P 500, the Nasdaq 100, or the MSCI Emerging Markets. These are known as index ETFs, and they aim to replicate the returns of the underlying index by holding the same securities in the same proportions.
However, not all indexes are easy to replicate. Some indexes are composed of hundreds or thousands of securities, some of which may be illiquid, inaccessible, or subject to regulatory restrictions. For example, the MSCI China An Index includes over 4000 stocks listed on mainland China’s stock exchanges, which are subject to foreign ownership limits and capital controls. To overcome these challenges, some ETF providers use a technique called sampling, which involves selecting a representative subset of securities from the index that can capture its risk and return characteristics.
Another technique that some ETF providers use is called synthetic replication, which involves entering into a swap agreement with a counterparty, usually a bank or a broker-dealer, that agrees to pay the ETF the return of the index in exchange for a fee. The ETF does not hold any securities from the index, but instead holds a collateral basket of other securities that may or may not be related to the index. The swap agreement transfers the risk and return of the index from the counterparty to the ETF, without requiring the ETF to actually own the index securities.
Synthetic replication has some advantages over physical replication, such as lower tracking error, lower costs, and access to otherwise unavailable markets. However, it also introduces some risks, such as counterparty risk, collateral risk, and regulatory risk. Counterparty risk is the risk that the swap provider defaults on its obligation to pay the ETF the index return. Collateral risk is the risk that the collateral basket held by the ETF loses value or becomes illiquid. Regulatory risk is the risk that the rules governing synthetic ETFs change or become more restrictive.
In recent years, there has been a growing interest in launching spot ETFs, which are ETFs that track the spot price of commodities or currencies, rather than futures contracts or other derivatives. Spot ETFs aim to provide investors with a more direct and transparent exposure to the underlying asset, without the complexities and costs associated with futures trading, such as rollover, contango, backwardation, margin requirements, and leverage.
However, spot ETFs also face some challenges in obtaining regulatory approval and attracting investor demand. One of the main challenges is that spot ETFs may be considered collective investment schemes (CIS), rather than securities, under some jurisdictions.
CIS are subject to different and stricter regulations than securities, such as higher capital requirements, more disclosure obligations, and more investor protection measures. For example, in Hong Kong, spot ETFs are classified as CIS and require authorization from the Securities and Futures Commission (SFC), which imposes stringent criteria on their structure, operation, and risk management.
Another challenge is that spot ETFs may have difficulty in providing sufficient liquidity and efficiency for investors. Unlike futures contracts, which are standardized and traded on centralized exchanges with clearing houses and market makers, spot commodities and currencies are traded on decentralized and fragmented markets with varying degrees of liquidity and transparency.
Spot ETFs may rely on third-party providers to facilitate their creation and redemption processes, which may involve higher costs and operational risks. Spot ETFs may also face competition from other investment products that offer similar or better exposure to spot prices, such as exchange-traded notes (ETNs), exchange-traded commodities (ETCs), or physically backed ETFs.
The crypto industry and investors are eagerly awaiting the SEC’s decision on spot Bitcoin ETFs, which could come as soon as next month. Several applications are pending before the regulator, including those from VanEck, WisdomTree, NYDIG, Valkyrie, and Bitwise. If approved, spot Bitcoin ETFs could boost the adoption and legitimacy of Bitcoin and pave the way for more crypto-related products in the U.S. market.