ETF issuers have a lot of questions to answer before the SEC will allow them to launch bitcoin exchange-traded products. That’s according to Jeremy Senderowicz, an attorney and expert on laws pertaining to ETFs and mutual funds.

He participated in a panel with ETF.com CEO Dave Nadig at the Inside ETFs conference in Hollywood, Florida, where the two discussed the prospects for bitcoin ETFs three days after the SEC released a letter that struck a skeptical tone about allowing cryptocurrency funds to trade on U.S. exchanges.

According to Senderowicz, the ball is in the industry’s court to try and assuage the SEC’s concerns. In its letter dated Jan. 18, titled “Engaging on Fund Innovation and Cryptocurrency-related Holdings,” the SEC hit on five broad issues that need to be addressed before bitcoin ETFs could become a reality.

Valuation

When it comes to ETFs and mutual funds, net asset value (NAV) is critically important. But with cryptocurrency markets being volatile, fragmented and unregulated, how can fund companies ensure they can adequately value cryptocurrencies and come up with an accurate “fair value?”

Liquidity

The SEC asked what steps funds would take to assure they have sufficient liquidity to meet daily redemptions. “Given the fragmentation and volatility in the cryptocurrency markets, would funds need to assume an unusually sizable potential daily redemption amount in light of the potential for steep market declines in the value of underlying assets?” the commission asked.

With regard to ETFs that want to hold bitcoin futures, the commission raised the question of what a fund would do if its holdings became a large portion of the underlying futures market and how that possibility would impact the fund’s portfolio management and liquidity analysis.

Custody

According to the SEC, there are currently no firms providing custodial services for cryptocurrencies, which is problematic for satisfying the 1940 Act requirement that sets standards regarding “who may act as custodian and when funds must verify their holdings.”

Additionally, the commission brought up several issues with regard to the safeguarding of private cryptocurrency keys and the potential of hacking cryptocurrency wallets.

Arbitrage

Given the fragmentation, volatility and trading volume of the cryptocurrency market, the SEC wonders whether the creation and redemption mechanism that keeps an ETF’s market price close to its NAV will be effective.

“How would volatility-based trading halts on a cryptocurrency futures market impact this arbitrage mechanism? How would the shutdown of a cryptocurrency exchange affect the market price or arbitrage mechanism?” the SEC asked.

Potential Manipulation

The SEC said bluntly that cryptocurrency markets have “substantially less investor protection than traditional securities markets” with “correspondingly greater opportunities for fraud and manipulation.”

Because of this, how can fund companies make the case that products tied to cryptocurrencies are appropriate “for the wide range of investors, including retail investors, who might invest in the fund?” questioned the SEC. “Would investors, including retail investors, have sufficient information to consider any cryptocurrency-related funds and to understand the risks?”

Additionally, “are there particular challenges investment advisors would face in meeting their fiduciary obligations when investing in cryptocurrency-related funds on behalf of retail investors?”

The Bottom Line

Senderowicz said that if you could boil down the SEC’s concerns to one thing, it would be the potential for these products to be offered to retail investors and the impact on them, a point corroborated by the multiple references to retail investors in the commission’s letter.

He said alternative product structures such as exchange-traded notes would also be met skeptically by the SEC until the aforementioned questions are sufficiently answered.

“Some of the questions that were raised by the SEC are answerable,” said Senderowicz. “The other part of it is what happens with the cryptocurrency market itself,” and that’s something that will develop over time, he says.

“I think it would be tough to see an exchange-traded bitcoin product in the next 12 months,” Senderowicz said. “There’s going to have to be a very robust response from the industry to the SEC’s concerns. The underlying market for bitcoin has to evolve.”

 

Contact Sumit Roy at sroy@etf.com. To get the latest ETF news in your inbox, sign up for the ETF.com Daily Newsletter.

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