By Leon Yee, Yeo Ming Ze and Brian Sim
1. Navigating the Bitcoin Exchange-Traded Funds (“ETFs”) Landscape: A Comprehensive Overview
Introduction to Bitcoin ETFs in 2024
On 10 January 2024, the U.S. Securities and Exchange Commission (“SEC”) approved the listing and trading of 11 spot Bitcoin ETFs. This followed a case in the U.S. Court of Appeals District of Columbia where the court held that the SEC’s denial of Grayscale Investments conversion of its Bitcoin trust to an ETF was “arbitrary” and “capricious” given that the SEC had approved a futures-based Bitcoin product. The court found these futures-based ETFs to be materially similar to Grayscale’s Bitcoin ETF such that they should have received the same regulatory treatment. The court’s decision was based on two key points: the underlying assets (Bitcoin futures and Bitcoins) being closely related in that they both track spot Bitcoin market prices and the futures and Bitcoin exchanges having the similar controls in place for detecting fraudulent or manipulative market misconduct.
In the SEC’s approval order for 11 spot Bitcoin ETFs on 10 January 2024, the SEC relied on the exchanges’ data over the past 2.5 years and noted that there was a high correlation between the spot Bitcoin prices and Chicago Mercantile Exchange (“CME”) Bitcoin futures prices. The SEC then reasoned that manipulation in spot Bitcoin markets would similarly impact CME Bitcoin futures prices. As the CME surveillance would help detect any such manipulation, and due to the fact that the spot Bitcoin ETFs would be listed on exchanges that have a comprehensive surveillance-sharing agreement with the CME via their common membership in the Intermarket Surveillance Group, manipulation in the spot market would be avoided.
Significance of this Development in the Financial Landscape
This development marks a significant milestone in the financial landscape, as the approval of an SEC-sanctioned spot Bitcoin ETF would grant legitimacy to the cryptocurrency asset class. Currently, the SEC’s stance characterises cryptocurrency as speculative and lacking intrinsic value, prompting regulatory scrutiny, particularly towards assets deemed securities under the Howey test. However, by approving the listing of Bitcoin ETFs on regulated exchanges, the SEC is taking a strategic step to provide a pathway for greater acceptance and recognition of cryptocurrencies within the traditional financial system, potentially fostering a more regulated and mainstream market for these digital assets.
Beyond this, an approved spot Bitcoin ETF would bolster liquidity in the Bitcoin market, potentially influencing its price dynamics positively and fostering price stability. Additionally, the approval would broaden investment avenues, especially for retail investors, enabling them to access the Bitcoin market indirectly, circumventing restrictions in countries where direct Bitcoin purchases are prohibited.
2. Understanding Bitcoin ETFs: Decoding the Basics
Definition and Explanation of ETFs
An ETF is an investment fund that invests in a basket of assets or securities and is listed on a stock exchange. Typically, ETFs track or aim to outperform an index, sector, commodity, or other asset. Unlike mutual funds, where orders are executed after-market hours, ETF orders are executed throughout a trading day. By holding a bundle of assets or securities, ETFs aim to reduce market risks and exposure while diversifying the fund’s portfolio.
Overview of how Bitcoin ETFs Work
A Bitcoin ETF would be an ETF that invests in the asset class of Bitcoins. Generally, there are 2 types of Bitcoin ETFs: 1. Bitcoin futures ETF; 2. Spot Bitcoin ETF.
A Bitcoin futures ETF is a derivatives-based ETF where the underlying assets are Bitcoin futures contracts which reflect agreements to buy or sell Bitcoins at a specified price on a pre-determined future date. These contracts give subscribers a way to gain exposure to the crypto market indirectly. A spot Bitcoin ETF on the other hand is an ETF that invests in Bitcoins directly by buying and holding Bitcoins. This means that it tracks the price of Bitcoin directly. While the SEC has already approved a futures-based Bitcoin ETF, currently listed and trading, the approval of a spot-based Bitcoin ETF is a recent development, marking a departure from previous rejections by the SEC.
The Unique Aspects of the Recently Introduced Bitcoin ETFs
Firstly, while Bitcoin futures contracts are correlated with Bitcoin’s prices, they may not precisely reflect the spot price due to the nature of the underlying asset being futures contracts rather than Bitcoin itself. This distinction can introduce tracking errors, manifesting as the futures price diverging from the spot price. Consequently, futures-based ETFs tend to be more volatile due to basis risk, which is the difference between futures and spot prices, compounded by the leverage used in futures contracts. In contrast, a spot-based ETF offers a more straightforward and accurate approach to tracking Bitcoin prices, reducing such tracking errors and volatility.
Secondly, futures-based ETFs incur rollover costs as futures contracts have expiration dates, necessitating the sale and purchase of new contracts. These costs are absent in spot-based ETFs, making them more cost-effective in the long term.
Additionally, a spot-based ETF mitigates counterparty risks associated with futures contracts. In futures-based ETFs, the parties involved in the contracts have obligations to fulfill, and failure to do so can negatively impact the ETF holder and investors. Such risks are non-existent in spot-based Bitcoin ETFs, providing a more secure investment option.
3. Exploring the Advantages and Controversies
Advantages
Accessibility for Traditional Investors
The SEC’s approval of spot Bitcoin ETFs represents a significant shift in accessibility for investors, particularly retail investors. Traditionally, investors interested in Bitcoin needed to navigate cryptocurrency exchanges, which might pose challenges for those unfamiliar with the crypto space. These exchanges often require users to undergo a registration process, manage digital wallets, and navigate the complexities of trading pairs and order types. In contrast, the approval of spot Bitcoin ETFs means that investors can now buy and sell Bitcoin through their traditional brokerage accounts, just like they would with any other stock or ETF. This eliminates the need to interact directly with cryptocurrency exchanges, streamlining the process and making it more familiar and accessible to a broader range of investors.
Potential for Portfolio Diversification by Investors who Already Invest in Other Securities / Assets
Investors who have already allocated a portion of their portfolios to traditional assets like stocks and bonds may seek to further diversify their portfolios by adding alternative assets like Bitcoin. Bitcoin has shown low correlation with traditional asset classes, meaning its price movements may not align with those of stocks or bonds. Therefore, adding Bitcoin to a portfolio can potentially reduce overall portfolio risk through diversification.
By investing in a Bitcoin ETF, investors gain exposure to the price movements of Bitcoin without the need to directly purchase and hold the cryptocurrency themselves. This indirect exposure allows investors to benefit from potential Bitcoin price appreciation while mitigating some of the risks associated with holding Bitcoin directly, such as cybersecurity concerns or regulatory uncertainties.
3. Controversies
Concentration Risk in Relation to Custody of Cryptocurrency
Most newly approved spot Bitcoin ETFs have designated Coinbase as their crypto custodian. While custodians are meant to secure the Bitcoins, security concerns persist. With the substantial asset concentration in Coinbase, it becomes a prime target for hackers. The lack of asset dispersion among multiple custodians means that a single hack could cause significant damage to the crypto market.
Bitcoin ETFs, like any investment product holding digital assets, rely on custodians to securely store the underlying Bitcoin. However, the cryptocurrency custodian industry is relatively new and less regulated compared to traditional financial custodians. This presents inherent challenges and risks, especially regarding security and reliability. Thus, claims of being a qualified custodian may face scrutiny.
Though custodian concerns are significant, they are not inherently more dangerous than individual wallets. Both face similar security risks, including hacking and theft. However, custodians managing larger asset volumes for multiple clients may attract more attackers. Additionally, custodians may use hot wallets (connected to the internet for trading) or cold wallets (offline storage), each with its own risks and considerations.
Anticipated Fraud and Market Manipulation Risks
While a Bitcoin ETF may be subject to the listing rules of the stock exchange, it’s important to note that its underlying assets are Bitcoins, which are widely considered unpredictable, speculative, and susceptible to market manipulation. The SEC has emphasised that its approval of the 11 Bitcoin ETFs does not constitute an endorsement of Bitcoin as an asset class. In Singapore, the Monetary Authority of Singapore (“MAS”) has not authorised the offering of spot Bitcoin ETFs to retail investors. Although Singaporean investors can get exposure to the Bitcoin market by trading in Bitcoin ETFs overseas, MAS warned that they should exercise caution given the highly volatile nature of such an asset class.
Moreover, some Singapore brokerages only allow eligible investors who have the requisite knowledge and experience to trade in U.S. listed spot Bitcoin ETFs. Bitcoin ETFs are classified as Specified Investment Products (“SIPs”)¹ by the MAS which are financial products that have features and risks that are more difficult for retail investors to understand. Financial intermediaries like brokerage firms must assess if the retail investor has the relevant knowledge and experience before opening an account for him to trade the SIP. The financial intermediary would typically request for information like education qualifications, investment experience and work experience. If the investor does not have the requisite knowledge, he may be required to undergo learning modules on the particular SIP. The financial intermediary must also offer to provide the investor with financial advice on whether the SIP is suitable for him, taking into account his knowledge and experience in the product. MAS has also requested the financial intermediaries to ensure adequate risk disclosures.
4. Comparative Analysis: Bitcoin Ownership vs. Bitcoin ETFs
Ownership and Custody
Investing in a spot Bitcoin ETF involves purchasing shares in the ETF fund, where the fund itself owns the underlying Bitcoins, not the individual shareholder. Consequently, ETF shareholders do not directly own the Bitcoin units themselves but rather own shares in the fund. As a result, they cannot practically use the Bitcoins for transactions, such as paying for goods online, as they lack direct ownership of the Bitcoin units. In contrast, purchasing Bitcoins directly allows individuals to own the units of Bitcoin outright, enabling them to use the cryptocurrency for transactions or even leverage it as collateral if needed.
Regarding custody, ETF fund providers typically handle the custodianship of the Bitcoins. This often involves partnering with a third-party custodian, such as Coinbase Custody Trust Company, LLC, as seen with BlackRock’s iShares Bitcoin Trust ETF. This arrangement relieves individual investors of the responsibility of sourcing a custodian themselves or managing self-custody, which could expose them to risks such as hacking or loss of custodian keys due to inadequate IT security measures.
Liquidity and Trading
Bitcoin ETFs could be seen as the panacea to liquidity concerns which are commonly associated with crypto exchanges since it enables more investors especially retail investors to get exposure to crypto just by buying shares of the ETF instead of purchasing crypto directly which is banned in certain countries. Furthermore, the approval of Bitcoin ETF listings adds legitimacy to crypto as an asset class, potentially attracting more participants and further enhancing liquidity in the crypto market.
Regulatory Oversight
A Bitcoin ETF would bring about increased regulatory oversight, offering investors certain protections as highlighted by the SEC. Firstly, sponsors of Bitcoin ETFs would be mandated to provide comprehensive and transparent disclosure about the products through public registration statements and periodic filings.
Secondly, since the ETF would be listed on a regulated stock exchange, the rules and surveillance programs of the exchange designed to prevent fraud and manipulation would come into effect. For example, on the NYSE, listed companies are subject to robust market surveillance programs. These systems monitor stock price movements and volume changes, promptly flagging significant shifts for further investigation. If there are indications of information leaks regarding significant corporate transactions, the NYSE may suspend or delay trading in the security until the issue is publicly addressed.
In contrast, the direct buying and selling of crypto often occurs in unregulated environments in certain jurisdictions, where uncertainties persist regarding how to address bad actors in the crypto space due to its nascent stage. In Singapore, cryptocurrencies may be categorised as digital payment tokens (“DPTs”) if they exhibit certain characteristics subject to regulation under the Payment Services Act 2019 (“PSA”). Additionally, if a crypto asset displays characteristics of being a capital markets product, including securities, it would also fall under the regulatory purview of the Securities and Futures Act 2001 (“SFA”). However, aside from these regulations, there is relatively little legislation governing cryptocurrencies in Singapore.
MAS’ Response to Consultation Paper
The MAS also recently published its “Response to Public Consultation on Proposed Regulatory Measures for Digital Payment Token Services” elaborating on its proposed regulatory measures for licensed and exempt DPT service providers (“DPTSPs”) that carry on the business in DPT services.
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- Risk Assessment
For example, DPTSPs would have to conduct a risk assessment to assess whether a retail consumer has sufficient knowledge of the risks of DPT services. DPTSPs would have to enact internal policies to ensure that the assessment is fair and holistic. The risk assessment must not trivialise the risks involved or promote any product. For retail consumers with insufficient knowledge, DPTSPs should conduct a re-assessment. However, prior to such reassessment, DPTSPs should help enhance the customer’s understanding of DPT risks through methods such as providing educational materials.
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- Restrictions on Debt-financed and Leveraged DPT Transactions
MAS has also stipulated restrictions on debt-financed and leveraged DPT transactions. DPTSPs cannot: (i) provide to a retail customer any credit facility to facilitate retail customers’ purchase or continued holdings of DPTs; and (ii) enter into any leveraged DPT transaction with a retail customer or facilitate a retail customer’s entry into any leveraged DPT transaction with any other person. Such transactions would include margin trading, DPT futures, options and other derivative transactions. The reason for the above measures is to ensure that retail consumers do not exacerbate financial risks by taking on leveraged positions or debt given that DPTs are already highly volatile by nature.
Regarding credit card and charge card payments, MAS will not allow DPTSPs to accept credit card or charge card payments, except from foreign-issued credit cards or charge cards. The reason for the leeway for foreign-issued credit cards is that foreign retail consumers might have limited payment options compared to a local retail consumer.
Fees
Investors should consider their investment horizon and risk management strategies when deciding between a Bitcoin ETF and direct purchase. Long-term holders may prefer the convenience and oversight of an ETF, while active traders might choose direct purchase for short-term gains. Ultimately, the decision should align with individual investment goals and risk preferences.
5. Conclusion
The approval of 11 spot Bitcoin ETFs marks a significant milestone for the crypto industry, bestowing legitimacy and fostering wider investor participation. The introduction of Bitcoin ETFs could inject much-needed momentum into the beleaguered asset class, which experienced a significant reduction in total value locked across various DeFi blockchains. From November 2021 to December 2022, the total value locked plummeted from US$174.52 billion to US$38.42 billion, representing a staggering decline of approximately 78%. However, with the improvement of macroeconomic conditions following the cessation of Federal Reserve interest rate hikes (with the last hike being in July 2023) and the announcement of the Bitcoin ETFs earlier this year, Bitcoin’s price has seen a significant rise. From an average of US$16,950 in December 2022, it briefly surpassed US$50,000 on 13 February 2024, marking an impressive increase of over 195%. This increase was followed by a retreat due to higher-than-expected CPI numbers for January 2024.
Nonetheless, while enhancing access to the crypto market, investors must remain vigilant of inherent risks associated with crypto investments, whether through ETFs or direct purchases. Ultimately, investment outcomes hinge on the underlying asset’s performance, emphasising the importance of diligence and awareness.
It will be interesting to observe the effect of these Bitcoin ETFs on cryptocurrency exchanges in the near future. Undoubtedly, the introduction of such Bitcoin ETFs will intensify competition between cryptocurrency exchanges and traditional exchanges offering Bitcoin ETFs, potentially leading to cannibalisation. This occurs as investors, attracted by the convenience and regulatory oversight provided by ETFs, may shift their trading activity away from cryptocurrency exchanges to traditional exchanges. Despite the current market momentum, cryptocurrency exchanges could face challenges as they contend with this redirection of investor interest.
¹ Any investment product other than those listed as follows and any investment product that is only listed on an overseas exchange is classified as a Specified Investment Product: a) Shares; b) Fully-paid depository receipts representing shares; c) Subscription rights pursuant to rights issues; d) Company warrants; e) Units in business trusts; f) Units in real estate investment trusts; g) Debentures (other than asset-backed securities & structured notes); h) Life insurance policies (other than investment-linked life insurance policies); i) Contracts or arrangements for the purpose of foreign exchange trading (other than derivatives of foreign exchange contracts and leveraged foreign exchange trading).
For More Information
If you have any questions about this article, please contact Duane Morris & Selvam Chairman Leon Yee or Associates Yeo Ming Ze or Brian Yang if you would like to discuss this update.
About Duane Morris & Selvam LLP
Duane Morris & Selvam LLP is a joint law venture between international firm Duane Morris LLP and Singapore-based firm Selvam LLC. Duane Morris & Selvam runs a unique Latin American-Asian practice out of Singapore, with a team of international lawyers qualified in multiple jurisdictions including Singapore, the U.S., the U.K., Canada, Mexico and Colombia, with substantial experience in international transactions and disputes. Duane Morris & Selvam also has cooperative relationships with some of the best Latin American and Asian law firms.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm’s full disclaimer.