Investors are eagerly awaiting the potential approval of a spot Bitcoin exchange-traded fund (ETF) by the U.S. Securities and Exchange Commission (SEC). The excitement began in early June when investment giant BlackRock filed an application for the product and gained further momentum after a court ruling required the SEC to reverse its rejection of Grayscale’s proposal to convert its Bitcoin Trust (GBTC) into a spot ETF. to reconsider.
The SEC’s objection to ETFs stems from the fact that Bitcoin (BTC) is traded in unregulated locations around the world, which poses a challenge in preventing fraud and price manipulation.
One attempt to address the issue was to enter into Surveillance Sharing Agreements (SSA) with some cryptocurrency exchanges. In theory, this would allow for the identification of bad actors attempting to manipulate the market. Critics question the effectiveness of these SSAs because they cannot cover the entire market. ETFs are based on precedents that enabled spot commodity ETFs based on the relevance of the underlying commodity futures markets.
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The SEC has determined that futures should be at the forefront of pricing to be considered a “regulated market of significant size.” In other words, information from the futures market takes precedence over information from the spot market when determining prices. However, even if price discovery is controlled by the futures market, there are still some cases in which manipulation in the spot markets can spill over into the ETF. The devil is in the details and in particular in the price source for calculating the net asset value (NAV) and in the method of creation and redemption (in cash or in kind).
Imagine a scenario where a manipulator successfully reduces the underlying commodity price by 5% on unregulated spot markets.
A 2019 Bitwise report on using volume-weighted median price to protect against net asset value manipulation. Source: Bitwise
When the creation and redemption occurs in kind, there is a simple arbitrage that acts like communication ships between the ETF and the unregulated spot markets. In this example, the arbitrageur can exploit this by simply purchasing an undervalued spot commodity and selling the corresponding amount of the ETF, then using the purchased commodity to create new ETF units and cover the short ETF position. The profitability of this trade will continue until there is a significant convergence of the spot commodity price and the corresponding amount of the ETF. How much each price moves toward convergence will depend on its liquidity, but some of the adjustment will come from the ETF price, meaning that spot market manipulation will extend, at least in part, to the ETF.
In a case where creation and redemption are in cash and the NAV is calculated using commodity prices derived from the unregulated spot markets, a very similar arbitrage is possible. The arbitrageur buys undervalued spot commodities and sells the ETF, creates ETF units with cash to cover the short position, and sells the commodity, attempting to replicate the pricing method used in the NAV calculation (which is the price paid for the creations certainly). Apart from poorer capital efficiency (due to the cash payout for creation) and low execution risk when replicating the NAV price, the trading is fundamentally the same as when creating in kind and the consequences are similar.
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Is there a mechanism that effectively protects the ETF from manipulation? The most promising alternative is the use of spot prices derived from the futures curve to calculate the net asset value in connection with cash creations and redemptions. If an arbitrageur tries to use the same method as in the previous case, there is no guarantee that he will sell the commodity at a price similar to the price used in the NAV calculation, especially if there is a manipulator in the spot market. Trading is no longer arbitrage. The lines connecting the spot price and the ETF price are blocked.
On the other hand, this setup allows for a straightforward arbitrage path between ETF and futures. Whenever the ETF price deviates from the spot price implied by the futures curve, an arbitrageur can execute a trade in the opposite position with perfect hedging of the futures, thus creating a robust connection between the ETF and the futures market. One can assume that an ETF with such characteristics would be as resistant to manipulation in unregulated spot markets as the futures contracts or a futures ETF.
Both academics and practitioners have already found some robust evidence supporting the idea that CME Bitcoin futures dominate in Bitcoin price discovery. Undoubtedly, a spot Bitcoin ETF in the US would be a good development for the traditional markets and the crypto industry. As American pastor Chuck Swindoll once said, “The difference between something good and something great is attention to detail.” By keeping the devils away, a Bitcoin ETF has the potential to be truly great for investors.
Joao Marco Braga da Cunha is the portfolio manager at Hashdex. He earned a Master of Science in Economics from Fundação Getulio Vargas before completing his PhD in Electrical Engineering and Electronics at the Pontifical Catholic University of Rio de Janeiro.
This article is for general information purposes and is not intended to constitute, and should not be construed as, legal or investment advice. The views, thoughts and opinions expressed herein are those of the author alone and do not necessarily reflect the views and opinions of Cointelegraph.