Regulation

Cryptocurrencies: 
An ETF can’t be far away now

This month we look at the concept of machine learning. It’s a topic that always reminds me of the Robert Harris book ‘Fear Index’ in which a machine called VIXAL is created to trade financial markets. The machine delivers enormous profits but is uncontrollable – even efforts to burn down the servers don’t work. One of the fascinating scenes in the book is when VIXAL sells short an airline just before a terror attack brings down one of the company’s aircrafts having scanned the Internet and found evidence of the planning of the attack on a terror-related website. 


Fiction aside, machine learning is something we have discussed in the past with the regulatory focus on algorithms. The concept of preventing harm to the market has become a key issue for regulators with algorithmic-driven events such as flash crashes having the potential to wipe billions off the market in a matter of seconds. In this month’s regulatory insight we return to a topic that never seems far from the news and is also a key bugbear of regulators – cryptocurrencies.


It’s been four months since we last updated you on the cryptocurrency debate, and there have been plenty of interesting developments during that interval. In my view, it’s the biggest technology-driven challenge for financial markets today. This month, we look at the latest on the Securities and Exchange Commission’s (SEC) decision on cryptocurrency ETFs, in particular the potential knock-on effect when it comes to a retail-focused product with bitcoin underlyings in the context of the new MiFID II age.


Ever traded fund?

The SEC’s position on ETF products containing cryptocurrencies has so far been somewhat intransigent, with the number of rejected ETFs now approaching double figures. It’s worth starting to question whether the SEC will ever approve one of them as fears over market manipulation and fraud continue to worry regulators. A number of well-known technology figures have been behind the spurned requests, including the Winklevoss twins. One of the reasons given for their failure to get approval was a concern over fraudulent market and manipulative practices. However, the SEC has since thrown a potential lifeline to the nine rejected funds by announcing that those decisions will be subject to a review. However, at the time of writing there is no timeline for that review.


VanEck, SolidX and CBOE ETF

Reviews aside, there’s a further development that might be of even more interest to those whose cryptocurrency applications were spurned. The SEC has now published a memorandum of its meeting with another of the parties looking to list an ETF, VanEck and SolidX, the intention being to list the product on CBOE1. The contents give a fantastic insight into VanEck’s plans because they include the presentation that the firm gave at the meeting. Highlights include the fact that the ETF is clearly being aimed at institutional clients with a price per share of USD 200,000. Also, VanEck claims that the previous rejections of the ETF used the phrase ‘significant size may develop’ in relation to bitcoin markets and said that should this happen then the Commission would look again at the applications. VanEck argued that as no guidance was given on what ‘significant’ meant it was possible for the SEC to move the goal posts to the extent VanEck would never be able to comply.

Other points to note included the commitment that all bitcoins held would be insured against loss and theft – hardly surprising considering the recent hacking incidents resulting in bitcoins being stolen – and it’s interesting to consider what the cost of that insurance would be. Finally the presentation suggests that CFTC would have jurisdiction over the bitcoin trading desks that the ETF would use for its pricing which adds an additional layer of oversight. The meeting occurred on 9 October, according to memorandum, meaning that any action from the meeting could still be a few months away. Still, in my view, meetings such as this make it clear: it is only a matter of time before an ETF is approved. A retail-focused product would, however, encounter significantly more hurdles.


Retail bitcoin products

Over the last 12 months, we have devoted a substantial amount of time in this series to covering MiFID II and the changes brought in by the KIDs for PRIIPs regulation when it comes to target markets and information for investors. If an institutional product is on the horizon, then it would be fair to consider how a retail-focused product would work and the main pitfalls and stumbling blocks around target markets.


From a regulator’s perspective it is highly unlikely that any retail product can make it to market within the next year, especially when you consider companies like VanEck going to great lengths to stress that their product would be institutional. That said, at some point the challenges do need to be considered.


Target markets, risk and investment

Firstly, the target market of such a product – where to start? A key category would be the knowledge and experience of the investors, but with bitcoin it has to be assumed that this kind of ETF would appeal to an entirely different class of investor than traditional investment products. Buyers might well be in their early 20s while traditional investment products are typically traded by investors aged 40+. Consequently, this category would be turned on its head. Would a 21-year-old investor with little experience of financial instruments but huge knowledge of bitcoin pass banks’ required checks? Simultaneously, would a more traditional investor with significant investing experience but little knowledge of the underlying cryptocurrencies be in a better position to invest? It’s possible an additional category would have to be created, one that reflects the unique nature of the product and its new target investors. 


Even once this minefield has been navigated, some of the other categories will still need addressing – risk for example. The current KIDs scale ranks an instrument’s risk on a scale from 1 to 7, a grade termed its specific risk indicator or SRI. I would be amazed if a bitcoin retail product would be graded at anything other than 7. Combine this with the knowledge and experience required and you already have quite a niche target market before even addressing the loss-bearing capacity of the investor. Could an attractive product include a capital protection element and therefore be able to limit any losses? This would certainly help from a target market perspective, as loss-bearing capacity would carve out the more risk-averse investors unless significant capital protection was given. Combine this with the swings seen in the bitcoin price, which this year has swung from as high as USD 20,000 to around USD 6,300 at the time of writing, and it’s clear that any product would need to be carefully constructed. Even then, it would face significant discussion with the regulators in the same way that the VanEck ETF has. It is highly unlikely that a regulator would be keen to see products offering leverage in bitcoin: given the huge swings in the price that we have seen over the last 12 months, any losses (or gains) would be significant.


Finally, we have the concept of purpose of such an investment: would bitcoin be suitable to hold for pension purposes? For asset accumulation? Or could it only be said that it offers disproportionate participation in price changes? At this nascent stage of bitcoin’s existence, the latter is the most likely, but in 20 years’ time attitudes could be very different with further growth in the market widening the appeal.

Conclusion – just a matter of time

In my opinion, an ETF referencing bitcoin is very likely to happen in the next 12 months, even if just as a test case for these type of products. The fact that the VanEck ETF has such a high initial price per share and will only be offered to institutional clients should give a certain amount of comfort to regulators. If the proposal was for a retail ETF product at USD 100 per share, regulators would be extremely unlikely to approve this product in the current environment. Indeed, it looks as though the regulator’s strategy will be to approve an institutional product where sophisticated investors can get exposure to bitcoin before thinking about whether it wishes to widen the approved product range. 


You can see from the above discussion on target markets that a cryptocurrency-focused retail product is not without additional challenges. However, from what I can see, none of these are insurmountable, and if an issuer were to engage with the regulator in the manner of VanEck they may find this approach easier than going it alone.