What are Bitcoin ETFs and Why are They Controversial?

Less than a month ago, the U.S. Securities and Exchange Commission (SEC) delayed a decision to approve a Bitcoin-based ETF. In a few days, it will decide on another proposed Bitcoin ETF. This article briefly explains what an ETF is, different types of Bitcoin ETFs, challenges to Bitcoin ETF approval, and which Bitcoin ETFs are likely to be approved first.

The SEC will decide the fate of Proshares’ Bitcoin ETFs on August 23, 2018

What is an ETF?

A lot of people have been talking lately about the creation of Bitcoin ETFs. An ETF (“exchange traded fund”) is a security that tracks some underlying assets. these assets could be equities, bonds, commodities, or cryptocurrency. An ETF takes custody of the underlying assets. A custodian (bank or other financial entity) is responsible for safeguarding the fund’s assets. Then it issues a number of shares that represent ownership of those assets.

Types of Bitcoin ETFs

There are two basic types of Bitcoin ETFs:

1. ETFs that “physically” hold BTC, for example, VanEck/SolidX (supported by the Chicago Board Options Exchange).
2. ETFs that purchase Bitcoin derivatives. These ETFs are not based on actual BTC holdings but on trading Bitcoin futures, options, swaps, money market instruments, and other investment vehicles. Two examples of Bitcoin derivative ETFs are the Direxion ETF and Proshares ETF

The SEC was set to decide whether to approve the VanEck/SolidX Bitcoin ETF in early August but delayed its decision. In a few days, it will decide the fate of Proshares. However, unlike with VanEck/SolidX, the SEC cannot delay this decision.

Concerns about Bitcoin ETFs

ETFs are traded on exchanges, which means they are traded in a way similar to public equities. The regulatory requirements to having an ETF approved are stringent because being listed on an exchange lets anyone invest in them. When the SEC evaluates a proposed ETF it is concerned with minimizing conflicts of interest, errors in tracking, manipulations, and that investment risks are reasonable and properly disclosed.

Custody Risk

One big worry about ETFs that hold Bitcoin is custody risk. Custody risk is essentially the risk that an ETF custodian might go bankrupt and no longer support the ETF. This is a particular concern with ETFs that hold physical Bitcoin. Bitcoin is largely traded on unregulated international exchanges that risk being hacked or going out of business. The value of Bitcoin is also highly volatile.

Non-transparent Data Sources

However, reducing custody risk is still easier than mitigating the risks of errors in tracking Bitcoin’s value. This concern applies to primarily to derivative Bitcoin ETFs. Compared to regulated equities, cryptocurrency markets are less transparent and more costly. Further, small price changes can have a huge impact on the ETF’s value because of leveraged trading. The result is investors need to have a lot of trust in a derivative Bitcoin ETF manager to properly track the performance of Bitcoin.

Conclusion

This year, there has been progress on custody solutions for cryptocurrency assets. The BTC in VanEck & SolidXs proposal are now insured, which may improve its chances of approval in the future. ETFs based on physical Bitcoin holdings are also the most transparent in terms of value-tracking. However, derivatives-based Bitcoin ETFs carry less custodial risk, which is a point in their favour. In any case, with the SEC having yet to approve any Bitcoin ETFs and cryptomarket volatility persisting, the upcoming decision on the Proshare ETF will be watched closely and will certainly have a impact on Bitcoin and the broader crypto market.

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What are Bitcoin ETFs and Why are They Controversial? was originally published in Hacker Noon on Medium, where people are continuing the conversation by highlighting and responding to this story.