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Explaining ETFs: How does the SEC's preference for cash-settled ETFs differ from BlackRock's physically-backed Bitcoin ETF?

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Explaining ETFs: How does the SEC

Recently, Bloomberg ETF analyst James Seyffart referenced a presentation from BlackRock and the SEC, which introduced physically-backed and cash-settled spot Bitcoin ETFs. BlackRock and most issuers prefer physically-backed Bitcoin spot ETFs. However, the SEC seems to lean towards cash-settled models. What are the differences between the two?

What are the differences between in-kind redemption and in-cash redemption models?

As the in-cash redemption model is much more complex, involving transfer agents and cash custodians. However, the biggest difference lies in whether Bitcoin is settled in "spot" or "cash" after being sold! So, let's simplify it to help everyone understand the basic differences.

In fact, these differences do not affect investors at all.

In-Kind Redemption

First, let's look at the in-kind redemption model, where "In-Kind Redemption" refers to exchanging ETF shares with a basket of assets such as stocks or in this case, physical Bitcoin.

Traditional In-Kind Redemption Model
  • MM Market Maker buys ETF shares from the exchange and then transfers the shares to the Transfer Agent (TA). The registration is done at TA, but in reality, it is registered under the ETF issuer's name.
  • The ETF issuer instructs the Bitcoin custodian to deliver physical Bitcoin to MM, who can choose to sell the physical Bitcoin position on their own.

Note: The transfer agent is responsible for managing the fund's shareholder registry and handling the issuance, transfer, and redemption of fund shares. During the fund issuance process, the transfer agent usually collaborates with the fund manager to complete various tasks related to fund issuance. The transfer agent can be the fund manager itself or a third-party institution. A reputable transfer agent will help ensure the smooth progress of fund issuance, improve fund operational efficiency and returns. Grayscale has hired the professional bank of New York Mellon to act as the transfer agent.

In-Cash Redemption Model

The in-cash redemption model refers to using "cash" to exchange ETF shares. The conversion between cash and physical Bitcoin assets is instructed by the ETF issuer.

  • MM buys ETF shares from the exchange and then transfers the shares to the TA. The registration is at TA, but in reality, it is transferred to the ETF issuer, similar to the in-kind redemption model.
  • The ETF issuer instructs the Bitcoin custodian to move Bitcoin out of cold storage and then trade with MM to sell Bitcoin. The ETF issuer instructs to transfer cash to MM.

This method restricts the MM from selling physical Bitcoin at their discretion and the trade instructions are issued by the ETF issuer. This means the MM can no longer decide when and at what price to sell Bitcoin.

In-Cash Redemption Model

Advantages of the in-kind redemption model

James Seyffart believes that BlackRock seems to prefer issuing physical Bitcoin ETFs. Most Bitcoin ETF issuers also apply in this manner.

Seyffart believes:

Issuing in-kind may be the clearest structure for BlackRock and investors, and BlackRock's approach is reasonable.

Furthermore, this also involves issues of spreads and taxes. For instance, in the case of gold ETFs, most issuers choose the in-kind redemption model, which is a simpler process.

Why does the SEC insist on the cash redemption model?

For the SEC, using the cash redemption model may make it easier to regulate the Bitcoin spot market and integrate it into the traditional financial system. Market makers settle with cash, making each transaction transparent and unable to escape the scrutiny of tax authorities. The author speculates that the SEC can further restrict the list of entities trading Bitcoin spot, as market manipulation has always been a primary reason why the SEC is reluctant to approve Bitcoin spot ETFs.

However, once the cash model is established, will it make it easier for traditional financial institutions to enter this market? After all, the role of trading physical Bitcoin has been restricted, and arbitrageurs can use cash and ETF shares for trading arbitrage. Who will benefit the most from this?