The New Year has seen the Securities and Exchange Commission break out its best Dikembe Mutombo finger wag impersonation for those seeking to list a Bitcoin related exchange traded fund (ETF). According to the SEC’s EDGAR database, seven different Bitcoin ETF proposals were withdrawn just this week at the request of SEC staff.
The SEC’s stance is disheartening to those who believed that the launch of Bitcoin futures contracts last month presaged a Bitcoin related ETF. After all, the logic went, if the CFTC was willing to sign off on Bitcoin futures contracts, how could the SEC possibly resist an ETF tied to regulated Bitcoin futures? But resist they have, and in so doing the SEC has implicitly rebuked the CFTC for authorizing Bitcoin futures.
Brief History of the Bitcoin ETF
Demands for a Bitcoin ETF have grown in lockstep with Bitcoin’s price. Retail and institutional investors, who may be unwilling or unable to invest directly in Bitcoin, view an ETF as an opportunity to gain exposure – in the form of a regulated and liquid instrument – to an asset that increased by over 1,300% in 2017.
The SEC first threw cold water on these demands last March, when they rejected a proposed rule change from the BATS BZX exchange that would have allowed them to list an ETF created by Tyler and Cameron Winklevoss that invested directly in Bitcoin (Winklevoss Bitcoin Trust.) The SEC was concerned that Bitcoin’s unregulated status made it susceptible to manipulation. They noted that any exchange seeking to list an ETF tracking the price of Bitcoin cannot “enter into the type of surveillance sharing agreement that has been in place with respect to all previously approved commodity-trust ETPs— agreements that help address concerns about the potential for fraudulent or manipulative acts and practices in this market.”
Investors’ hopes for an ETF were rekindled last month when the Chicago Board Options Exchange (CBOE) and the Chicago Mercantile Exchange (CME) launched separate Bitcoin futures contracts. Because the CFTC signed off on the contracts – a decision I’ve been highly critical of – investors now have the opportunity to gain exposure to Bitcoin, both long and short, through a regulated financial instrument.
Bitcoin Futures are Not Popular
Despite the hoopla surrounding the launch of Bitcoin futures, investor interest has been tepid to date. Open interest for the contracts currently stands at 1,258 at CME and 4,733 at CBOE. Such limited take-up can be partially attributed to the extraordinarily high initial margin requirements for these contracts. The CBOE futures contract requires initial margin equal to 44% of the daily settlement price; by comparison, margin for the S&P 500 futures contract is 5%. Therefore, if Bitcoin is trading at $15,000, an investor wishing to go long or short the CBOE futures contract will have to pony up $6,600 at contract initiation. Because the CME futures contract is based off of five Bitcoin, the required initial margin is even higher, which likely explains why open interest in CME’s contract is lower than CBOE’s.
Even if an interested futures investor has enough cash on hand to meet the initial margin requirements, their broker may not offer them access to the contracts. JPMorgan, Bank of America Merrill Lynch, RBC and Citigroup all refuse to offer their clients access to the bitcoin futures market, due to concerns that Bitcoin’s volatility make it an unsuitable investment for most of their clients.
Bitcoin Futures Change the Calculus
Investor demand for Bitcoin exposure was not satiated by the introduction of futures contracts. Hoping to harness the regulated status of Bitcoin futures contracts in order to satisfy the remaining demand, financial institutions flooded the SEC with new applications to list Bitcoin related ETFs. Investors are attracted to ETFs because of their low fees and the fact that they trade just like a common stock on a regulated exchange, thereby making them very easy to buy and sell.
The below link, titled “Bitcoin ETF Withdrawals,” summarizes the seven Bitcoin ETF applications that were withdrawn this week. You can see that most of these applications were filed around the time the CFTC approved Bitcoin futures contracts in early December. It is also critical to note that these ETFs differed from the original Winklevoss ETF in that they planned on investing primarily in Bitcoin futures contracts and not in actual Bitcoin. Clearly the driving force behind the surge in new ETF applications was the CFTC’s decision to allow Bitcoin futures contracts.
Bitcoin ETF Requires Exchange Rule Changes
Public stock exchanges in the U.S. are required to have dedicated rules governing the listing of new ETFs. In 2016, the SEC approved generic listing standards for actively managed ETFs that exchanges could adopt (Bitcoin ETFs would be actively managed .) These standards include provisions pertaining to “minimum market value, minimum trading volume, minimum diversification, and the minimum number of index components.”
Because of Bitcoin’s unique nature, the newly proposed ETFs do not meet the generic listing standards. When this happens, Section 19(b) of the Securities Exchange Act Of 1934 requires the exchange seeking to list the ETF to submit a proposed rule change to the SEC, which is then released for public comment. It was the SEC’s decision to reject a proposed rule change by the Bats BZX exchange that ultimately killed the Winklevoss ETF.
Most of the exchange rules that need to be changed in order to list a Bitcoin ETF are designed to guard against possible market manipulation by preventing an ETF from investing too heavily in less liquid instruments. For example, the CBOE BZX exchange requested the following rules be changed to allow for the listing of the REX Bitcoin Strategy ETF and the REX Short Bitcoin Strategy ETF:
- the aggregate gross notional value of listed derivatives based on any five or fewer underlying reference assets shall not exceed 65% of the weight of the portfolio (including gross notional exposures), and the aggregate gross notional value of listed derivatives based on any single underlying reference asset shall not exceed 30% of the weight of the portfolio (including gross notional exposures)
- the most heavily weighted Non-U.S. Component stock shall not exceed 25% of the equity weight of the portfolio, and, to the extent applicable, the five most heavily weighted Non-U.S. Component Stocks shall not exceed 60% of the equity weight of the portfolio
- where the equity portion of the portfolio includes Non-U.S. Component Stocks, the equity portion of the portfolio shall include a minimum of 20 total component stocks; provided, however, that there shall be no minimum number of component stocks if (a) one or more series of Derivative Securities Products or Linked Securities constitute, at least in part, components underlying a series of Managed Fund Shares, or (b) one or more series of Derivative Securities Products or Linked Securities account for 100% of the equity weight of the portfolio of a series of Managed Fund Shares
CBOE believes these rules are unnecessary in this instance because “the bitcoin market is generally less susceptible to manipulation than the equity, fixed income, and commodity futures markets.” To support this assertion, CBOE notes:
there is not inside information about revenue, earnings, corporate activities, or sources of supply; it is generally not possible to disseminate false or misleading information about bitcoin in order to manipulate; manipulation of the price on any single venue would require manipulation of the global bitcoin price in order to be effective; a substantial over-the-counter market provides liquidity and shock-absorbing capacity; bitcoin’s 24/7/365 nature provides constant arbitrage opportunities across all trading venues; and it is unlikely that any one actor could obtain a dominant market share.
I disagree, and in a previous post I highlighted several features of the Bitcoin market that make it highly susceptible to manipulation. But what I find most interesting about CBOE’s line of reasoning is that the same argument in defense of Bitcoin could have been made, and in fact largely was, when the original Winklevoss ETF proposal was submitted in 2016. When they denied the Winklevoss ETF last year, the SEC resoundingly rejected the notion that Bitcoin could not be manipulated, noting that the proposal was inconsistent “with Section 6(b)(5) of the Exchange Act, which requires, among other things, that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.”
Rather than emphasizing the characteristics of the Bitcoin market that shield it from manipulation, NYSE Arca decided to focus on the regulated status of Bitcoin futures when making their case to list the Direxion series of Bitcoin ETFs. Because the funds would be investing primarily in Bitcoin Futures, NYSE Arca wisely tried to focus the SEC’s attention away from the Bitcoin spot market and towards the regulated futures market. They note that because the futures contracts are centrally cleared, there is minimal counterparty risk. They also highlight the CFTC’s role in bring some order to the underlying spot market:
“the CFTC has noted that the U.S. futures exchanges that will trade bitcoin futures have agreed to significant enhancements to protect customers and maintain orderly markets, and announced its expectation that futures exchanges that list and trade bitcoin futures contracts will, through information sharing agreements, monitor the trading activity on the relevant cash platforms for potential impacts on the price discovery process for bitcoin futures contracts, including potential market manipulation and market dislocations due to flash rallies and crashes and trading outages.”
Ultimately, the SEC was unpersuaded by either exchange, and the REX and Direxion ETF applications were withdrawn. Although we don’t know all the reasons for the SEC’s decision, the withdrawal submission for the Direxion ETF noted that SEC “Staff expressed concerns regarding the liquidity and valuation of the underlying instruments in which the Fund intends to primarily invest.” Given that these ETFs would be investing primarily in illiquid futures contracts that track the price of an even less liquid and unregulated digital currency, I’d say the SEC’s concerns are justified.
The cryptocurrency market has changed in ways that nobody could have imagined since the Winklevoss ETF was proposed in the summer of 2016. At the time, Bitcoin was trading for $640, few people had heard of it, and initial coin offerings didn’t exist. Today, Bitcoin is worth over $13,500, everybody has heard of it, and initial coin offerings have become a preferred source of funding for many tech startups. The ways you can invest in Bitcoin have also changed dramatically, thanks to the introduction of cryptocurrency hedge funds, Bitcoin options, and Bitcoin futures contracts.
But what hasn’t changed is the unregulated and fragmented nature of the Bitcoin spot market. For the average person to purchase Bitcoin, they must go to one of many online exchanges, all offering a different price, and all requiring you to wait days to deposit or withdraw fiat currency. Furthermore, these exchanges are frequently down, be it for maintenance or because they’re defending against hacking attempts. Finally, trading volume on these exchanges is quite limited, thus making it possible for a large trade to move the price of Bitcoin dramatically.
The SEC recognizes that the Bitcoin market is ripe for fraud and abuse, and that the CFTC’s decision to authorize Bitcoin futures contracts does nothing to change this fact. Approving an ETF tied to the price of Bitcoin would be just as irresponsible now as it would have been last March. Thankfully, the SEC takes their mandate to protect investors seriously. I hope they continue to do so.
 See, e.g., Securities Exchange Act Rel. Nos. 78397 (July 22, 2016), 81 Fed. Reg. 49320 (July 27, 2016) (SR-NYSEArca-2015-110); 8396 (July 22, 2016), 81 Fed. Reg. 49698 (July 28, 2016) (SR-BATS-2015-100); 78918 (September 23, 2016), 81 Fed. Reg. 67033 (September 29, 2016).
 CBOE finalized its purchase of BATS on March 1, 2017