This post originally appeared in Money Stuff.
“SEC Pours Cold Water on Prospect of Bitcoin ETFs” is the Wall Street Journal’s headline about this letter from the Securities and Exchange Commission’s Division of Investment Management to the Investment Company Institute and the Securities Industry and Financial Markets Association, two industry groups with some interest in getting cryptocurrency-backed exchange-traded funds approved for trading in the U.S. some day. It is true that the letter is bracing, but I am not sure that it is a hard no. The SEC is really just asking questions. Questions like:
What steps would funds investing in cryptocurrencies or cryptocurrency-related products take to assure that they would have sufficiently liquid assets to meet redemptions daily?
How would funds classify the liquidity of cryptocurrency and cryptocurrency-related products for purposes of the new fund liquidity rule, rule 22e-4? For example, would any of these products be classified as other than illiquid under the rule? If so, why? How would funds take into account the trading history, price volatility and trading volume of cryptocurrency futures contracts, and would funds be able to conduct a meaningful market depth analysis in light of these factors? Similarly, 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?
Those questions may be familiar from back when we used to talk every day about bond market liquidity. One strain of bond market liquidity worries is that bond market mutual funds offered a “liquidity illusion”: The funds let investors withdraw their money daily, but the funds may not be able to sell the underlying bonds on one day’s notice. Some people, for reasons that I don’t quite understand, worry more about this problem for ETFs than for regular mutual funds. Other people, though, argue that ETFS actually helpsolve the liquidity problem in bonds: If bond trading is illiquid and ETFs are liquid, you can get most of the benefits of bond trading through a liquid ETF instead. If I want to buy bonds and you want to sell them, the bond market may be an inefficient place for us to transact — but we can achieve almost the same thing if I buy a bond ETF from you.
One could pretty easily imagine the same argument with Bitcoin: If people want to trade Bitcoin with each other, and if Bitcoin markets are a horrible mess, why not let them trade Bitcoin in regulated exchange-traded fund form? The ETF could be liquid, and if you want a bit of Bitcoin you could buy the ETF and not have to worry about whatever horrors are going on in the underlying market.
Of course someone has to worry about those horrors, specifically the arbitrageurs who keep the ETF prices in line with the underlying prices. The SEC has questions about that too:
Have funds engaged with market makers and authorized participants to understand the feasibility of the arbitrage for ETFs investing substantially in cryptocurrency and cryptocurrency-related products? 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?
Elsewhere, Intercontinental Exchange Inc. is “joining with startup Blockstream to launch a data feed that would pull information,” including order-book information, “from more than 15 cryptocurrency exchanges around the world and deliver it to financial firms.”
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Philip Gray at philipgray@bloomberg.net