Investors are eagerly awaiting the potential approval of a spot bitcoin exchange-traded fund (ETF) by the United States Securities and Exchange Commission (SEC). The excitement began in early June when BlackRock, the investment giant, filed for the product. Momentum increased after a court decision required the SEC to reconsider its rejection of Grayscale’s proposal to transform its Bitcoin Trust (GBTC) into a spot ETF.
The SEC’s objection to ETFs is due to Bitcoin’s trading in unregulated venues worldwide, which poses challenges in preventing fraud and price manipulation. To address this, surveillance-sharing agreements (SSA) with some cryptocurrency exchanges have been proposed. These agreements aim to identify bad actors attempting to manipulate the market. However, critics question the effectiveness of SSAs as they cannot cover the entire market. ETFs are based on previous decisions that allowed spot commodity ETFs based on the relevance of the underlying commodity futures markets.
The SEC has established that futures should lead the spot market in price formation to be considered a “regulated market of significant size.” This means that information from the futures market takes precedence over the spot market in the price discovery process. However, even if price discovery is led by the futures market, manipulation in the spot markets can still affect the ETF in some cases. The details, such as the price source for net asset value (NAV) calculation and the creations and redemptions method, play a significant role in this.
In scenarios where creations and redemptions are in-kind, an arbitrage opportunity arises between the ETF and the unregulated spot markets. This allows arbitrageurs to exploit the price difference by buying underpriced spot commodities, selling the corresponding amount of the ETF, and using the bought commodity to create new ETF units. The profitability of this trade continues until the spot commodity price and the equivalent amount of the ETF converge.
Similarly, if creations and redemptions are in cash and the NAV is calculated using commodity prices derived from unregulated spot markets, a similar arbitrage opportunity exists. The arbitrageur buys underpriced spot commodities, sells the ETF, uses cash to create ETF units to cover the short position, and sells the commodity to replicate the NAV calculation. The consequences of this trade are similar to the in-kind creation scenario.
To effectively shield the ETF from manipulation, using spot prices derived from the futures curve for NAV calculation, along with in-cash creations and redemptions, is the most promising alternative. This obstructs the arbitrage path between the spot price and the ETF price, making it difficult for manipulators to exploit the price difference. On the other hand, this setup allows for a straightforward arbitrage path between the ETF and futures, establishing a robust link between the ETF and the futures market.
Academics and practitioners have found evidence supporting the dominant role of CME Bitcoin Futures in Bitcoin’s price discovery. A spot Bitcoin ETF in the U.S. would be a positive development for both traditional markets and the crypto industry. By paying attention to detail and addressing potential manipulation risks, a Bitcoin ETF has the potential to be truly beneficial for investors.
Disclaimer: This article is for general information purposes only and should not be considered legal or investment advice. The views expressed here are solely those of the author and do not necessarily reflect the views of Cointelegraph.