Posted October 27, 2023 at 1:54 PM EST.
A federal appeals court on Monday finalized its decision to overturn the SEC’s earlier rejection of the Grayscale Investments application to convert its Grayscale Bitcoin Trust into an Exchange Traded Fund, or ETF, following the “spot” price of BTC. ETFs can be purchased and traded in traditional brokerage, retirement and institutional investment vehicles, and the ruling sparked a huge rally in bitcoin and crypto as a whole, in anticipation of a wave of new investors.
But the search for a spot Bitcoin ETF has always been controversial among crypto advocates. While this has many potential benefits for investors and the price of BTC, some have argued that this is not true to the spirit of crypto, as it relies heavily on third-party custody. Even leaving crypto ethics aside, there are other downsides to ETF approval, including the fact that the current rally could lead to another unsustainable, and ultimately damaging, crypto bubble.
Why is a BTC ETF making headlines again?
First, the basics.
Bitcoin (BTC) has soared more than 20% over the past week on growing expectations that the U.S. Securities and Exchange Commission (SEC) will begin approving Bitcoin “spot” ETFs, or traded funds in stock exchange. These stock-like assets would represent claims on the underlying Bitcoin holdings managed by ETF issuers and should therefore closely track the price of BTC. Bitcoin ETFs are legally different from directly holding BTC, allowing investors to effectively purchase Bitcoin, albeit indirectly, through conventional brokerage and retirement accounts.
Currently, with a few exceptions, investing in Bitcoin is more difficult than that. Either this requires buying and holding through an exchange like Coinbase, which is not allowed for many traditional asset management setups; or trading imperfect Bitcoin proxies such as shares of Michael Saylor’s Microstrategy, with its vast hoard of BTC. Opening up more direct and reliable exposure to bitcoin appears likely to have major long-term benefits for the price of BTC by increasing the base level of demand.
The ETF is now on the table because, after years of the SEC rejecting Bitcoin ETF applications, a recent court ruling appears to have forced the agency’s hand. The decision depended SEC Approval of a Bitcoin Futures ETF in 2021, when Chairman Gensler argued that the futures market offered more built-in investor protections than the spot market. This has always been a strange argument because Bitcoin futures, before the futures ETF was approved, were traded in huge volumes on lightly regulated international crypto exchanges.
In August, a court rejected Gensler’s distinction, ruling that the SEC had been “arbitrary and capricious” in failing to explain why the futures and cash markets for the same assets were so profoundly different that it had approved one ETF and not the other. This judgment was confirmed in a court order yesterday which officially referred the decision to the SEC for review.
Although nothing is guaranteed, observers including Nic Carter of Castle Island Ventures have estimated that it will take two to four months for approval and launch of at least some of the pending ETFs. The price of Bitcoin soared in anticipation of this approval.
The advantages of a Bitcoin ETF
The likely increase in demand for BTC is the most obvious benefit of approving a spot ETF – although this is only a “benefit” for current holders, and not necessarily for the system, which we will talk more about shortly. The official approval of one or more ETFs will likely be a “news sell” moment that produces a short-term rise in the price of BTC that quickly stabilizes.
But diamond enthusiasts will also likely benefit from a longer-term upside, not least because the approval of ETFs will turn large institutions into Bitcoin marketers. This already happened with Larry Fink of Blackrock. Fink may really think that Bitcoin is equal to “the value of human freedom” but he will be even more motivated to be bullish when he actively collects fees from Bitcoin ETF buyers.
More substantially, the creation of Bitcoin ETFs could help counteract the repeated fraud that the crypto industry has suffered. Over the years, huge amounts of Bitcoin on exchanges like Quadriga and FTX simply disappeared when those custodians proved untrustworthy – a phenomenon that sparked fears of large amounts of “paper bitcoin” that are not actually backed by the real on-chain thing. Regulated options managed by truly reputable entities like Blackrock could starve out more sketchy operations, thereby largely reducing fraud. This could trigger a longer-term “melting” of the perception of legitimacy of bitcoin and crypto in general.
Other benefits of ETFs are slightly more abstract. On the one hand, the court’s decision against the SEC looks bad for Gary Gensler, who, despite initial hopes when he took office, has proven not only hostile to crypto, but scattered and often seemingly uninformed in his opposition. The most dramatic illustration of this, of course, is his embrace of alleged fraudster Sam Bankman-Fried as an authority on crypto regulation – a topic the SEC has remained discreet on.
Finally, while it is undeniable that any third-party custodian represents a compromise on the ideals of Bitcoin, this is consistent with how some advocates have often presented BTC over the years: as “digital gold” and “a store of value “. While many “gold bugs” like to have physical gold on hand, it’s not at all strange to hold a gold ETF instead of actual gold. There would be nothing inherently wrong with Bitcoin having the same two-tiered market structure.
Bitcoin ETF Risks
For all its potential benefits, there are real downsides to approving a Bitcoin spot ETF – and often, they are almost the same as the upsides.
Clearly, while current holders will certainly benefit, price appreciation is not unambiguously good for the broader cryptocurrency ecosystem. I’ve been reporting on crypto for over a decade now (my goodness), and these things have had a generally predictable dynamic. The rise in the price of bitcoin, for both sentimental and technical reasons, drives up the prices of other cryptocurrencies, including riskier assets. I can already foresee the ETF becoming a catalyst for an unsustainable crypto bubble, either very soon or once it is actually approved – again, a possible reason to sell the news.
Although the safer and more reliable nature of regulated ETFs alone could avoid the worst impacts of such a bubble, these moments have undeniable negative effects. Cryptocurrency price appreciation almost inevitably attracts new waves of fraud, and even crime, as the growing pie becomes more attractive to bad actors. Even theoretically well-intentioned projects launched to take advantage of cryptocurrency bull markets can often be hastily designed and ultimately fragile.
It’s also not impossible that, while more reliable on their own, ETFs actually increase the overall volatility of the crypto market in some way. Although many Bitcoin ETF shares are likely to be intrinsically held for the long term, they will also be actively traded and, given the likely scale of institutional involvement, they could in the future become accelerators, rather than brakes, on the main news from the crypto market.
This is for both technical and social reasons: Right now, most large-scale Bitcoin holders, like MicroStrategy, are true believers with a developed thesis about long-term Bitcoin growth. The ETF will be held by many less committed investors. This means that more bitcoins will be available to liquidate almost instantly during market uncertainty.
Additionally, while largely aligning with the “digital gold” thesis for Bitcoin, ETFs could reveal a weakness in that thesis: Bitcoin as a “store of value” may ultimately depend of its daily use as a transactional support. The reality, extent, and persistence of this usage became blindingly obvious during the (now concluded?) bear market, as BTC trading volumes remained in a range of around 1 to 3 billion dollars per day.
These volumes ultimately generate fees for bitcoin, supporting the hashing power and security of the chain. If everyone just parked their Bitcoin in an ETF, Bitcoin itself could be at risk.
This naturally brings us to the ideological objections to an ETF. Bitcoin, after all, is supposed to be about financial autonomy, eliminating middlemen, and, in practical terms, self-custody. Buying a Bitcoin ETF stock does not require knowing how to use a Bitcoin wallet, or even a basic understanding of how the system works. This reality also comes at a financial cost: Bitcoin generates no native returns, so if you pay an ETF to manage your coins, you are entirely dependent on price appreciation to generate returns, and these must exceed the fees you pay.
A pessimist would argue that this is both detrimental to Bitcoin’s stated goals and the long-term health of the system, because it reduces overall engagement in an open source project that ultimately depends on the wisdom of the crowd. However, there is also a counterargument: Bitcoin ETFs will become something like the shallow end of the crypto pool, an easy first step that ultimately leads all the way to the bottom of the rabbit hole.
On this issue, only time will tell.