Cryptocurrency and Exchange-Traded Products: Will we see a Cryptocurrency ETP?04.04.18
The rise of cryptocurrencies and the accompanying spike in interest from investors has led to a proliferation of investment opportunities based on cryptocurrencies.
One proposed vehicle is an exchange-listed Cryptocurrency Fund (Cryptocurrency ETP) that would operate in a manner similar to other exchange-traded products.
Earlier this year, the Securities and Exchange Commission (SEC) issued a staff letter voicing concerns about proposed Cryptocurrency ETPs and raising questions pertaining to issues of (1) valuation, (2) liquidity, (3) custody, (4) arbitrage and (5) manipulation and other risks.
Cboe Global Markets, Inc., a leader in the operation of national securities exchanges and a proponent of bitcoin-related ETPs, submitted a letter to the SEC addressing concerns about Cryptocurrency ETPs. The letter explained how they fit within the current framework used for other exchange-traded products and how the framework can continue to be replicated to apply to other cryptocurrencies as the ecosystem grows and evolves.
Here is a summary of the SEC's concerns and the responses:
One of the main issues identified by the SEC related to cryptocurrency assets is valuation and its impact on the net asset value (NAV) calculation and all the downstream processes affected by NAV. Cryptocurrencies pose a challenge to NAV calculations, because of their unique methods of distributing tokens. However, there are now numerous indices that have been tracked by Cboe and others in the market that help to provide reliable price information, including futures prices.
Data on pricing for bitcoin and several other cryptocurrencies are available 24 hours a day from a variety of trading platforms around the world. Cboe believes that the breadth and variety of pricing sources available would allow Cryptocurrency ETPs to create “reliable and robust valuation methodologies for bitcoin and potentially for other cryptocurrencies.”
For a Cryptocurrency ETP, the liquidity of the underlying cryptocurrency-related asset is of paramount importance.
As a new, digital asset, the liquidity evaluation for cryptocurrencies is and must be different from traditional assets, but should be done in a manner similar to other commodities like spot, over-the-counter and commodities futures markets, which are done on a case-by-case basis. The futures market for bitcoin, while young, is growing quickly and is expected to reach a level comparable to other commodity futures products, eventually allowing ETPs to cover long or short exposure to bitcoin, as well as use futures contracts as a reference asset. The market for cryptocurrencies is booming with the three largest U.S.-based exchanges having a combined daily volume of almost $950 million. This volume is expected to grow, especially on regulated U.S. markets, creating a spot bitcoin market that should have sufficient liquidity for a bitcoin ETP.
Cryptocurrency ETPs based on cash-settled futures contracts should be treated like other commodity futures contracts used in other ETPs. If they are treated the same way, regulated AAA credit-rated clearinghouses would be allowed to serve as custodians for Cryptocurrency ETPs based on cash-settled futures contracts. If a Cryptocurrency ETP plans to hold cryptocurrencies directly, there are a number of companies that are regulated custodians and can offer custodial services. As a digital currency, cryptocurrencies may be subject to — and are often associated with — cybersecurity issues. However, the SEC has never dictated standards for custodians or specifically evaluated the security of custody arrangements for a commodity-related ETP instead of relying on the standards of other regulators. Numerous regulators have weighed in on the issue of cybersecurity as it pertains to cryptocurrency, so the application of those regulations should suffice to control custody.
Arbitrage for Cryptocurrency ETPs can and should be treated like existing ETPs that hold commodities or associated futures contracts. With the growth of the cryptocurrency spot and over-the-counter markets, as well as the price limits on bitcoin futures on U.S. exchanges, the arbitrage mechanism for Cryptocurrency ETPs would operate similarly to other commodity-related ETPs by providing strong economic incentives to market participants to take advantage of arbitrage opportunities, which will help control pricing.
5. Manipulation and Other Risks
The arbitrage mechanism above, as well as the liquidity in the bitcoin and ETP markets, should encourage market participants to take advantage of arbitrage opportunities in both markets, which will keep the price of the ETP in line with the price of bitcoin and limit opportunities for manipulation. Additionally, as a global, distributed currency, bitcoin is very interconnected and manipulation would require a manipulation of the entire bitcoin marketplace, not just a local venue. The global connection also creates cross-market arbitrageurs, which minimizes the risk of manipulation.
Cboe, in addition to promoting the above mechanisms, has entered into a comprehensive surveillance sharing agreement that allows it to view and access order and trade details for cross-market surveillance and regulation. Together with other cryptocurrency exchanges, Cboe is working to put in place other surveillance-sharing agreements to broaden the scope of surveillance and increase access to information that can be used to curtail manipulation.
Another risk, and one of the most important issues to the SEC, is the appropriateness of Cryptocurrency ETPs for investors and how broker-dealers would analyze suitability.
Clearly, Cryptocurrency ETPs are not appropriate for all investors. Like other ETPs, investors must be provided comprehensive risk disclosure, and broker-dealer should evaluate the suitability of the investment for each investor. However, they do not warrant disparate treatment from other commodity-related funds. Application of the current regulatory framework for ETPs which requires comprehensive disclosure of risks and for broker-dealers to perform comprehensive analysis about suitability will provide sufficient investor information and protection while giving investors “exposure to cryptocurrency-related assets through well-regulated and transparent vehicles.”
Cboe argues that the application of the current framework for ETPs would address many of the concerns raised by the SEC, while the continued growth and the evolution of the spot and derivatives markets should make it even easier to fit cryptocurrencies within the existing framework.
While Cboe presents a compelling argument, recent comments by the SEC on cryptocurrencies, in general, suggest that additional scrutiny will be applied to any product related to cryptocurrency given the volatility of cryptocurrency markets, the boom in investor interest and the potential for abuse and manipulation.
While Cryptocurrency ETPs could be a strong product to help grow the cryptocurrency markets, it is unlikely to be approved under the SEC’s general framework for such financial products until the market has become more developed and accustomed to the volatility of cryptocurrencies.