REGULATION

The Road to Mainstream: Understanding the Design Principles of Bitcoin ETFs and GBTC, Regulatory Challenges

2021/7/9

Understanding the principles of GBTC, the differences with Bitcoin ETF, and the design principles and challenges faced by Bitcoin ETF.

(This article is authorized to be reprinted from ChainNews, titled "The Inevitable Road to Mainstream Cryptocurrency: In-depth Understanding of Bitcoin ETF Design Schemes and Regulatory Challenges," original article here)

Bitcoin ETF has been a subject of great interest as a compliant Bitcoin financial product accessible to the general investors. Especially during the fluctuations in the cryptocurrency market in recent times, the shortcomings displayed by other types of compliant Bitcoin financial products have highlighted the advantages of Bitcoin ETF.

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However, after Canada approved multiple Bitcoin ETFs this year (the first being Purpose Bitcoin ETF, listed on the Toronto Stock Exchange, the U.S. SEC recently postponed the decision on several Bitcoin ETF applications, including WisdomTree until July 14, Kryptoin until July 27, Valkyrie until August 10, and VanEck seeking public feedback.

Through Bitcoin ETFs, general investors can participate (indirectly) in Bitcoin investments on mainstream stock exchanges without managing private keys, with low fees, high transparency, and without worrying about financial regulatory, tax compliance, and other issues. Bitcoin ETFs are a significant milestone towards mass investment. It is due to this reason that the U.S. SEC has taken a more cautious approach towards Bitcoin ETFs - as seen in the relevant statements by the U.S. SEC.

Some concerns from the U.S. SEC are very helpful in understanding the next steps in the development of the cryptocurrency market.

This article is divided into three parts:

The first part is a general introduction to ETFs as a reference for understanding Bitcoin ETFs;
The second part discusses the two main design schemes and related challenges of Bitcoin ETFs;
The third part summarizes several obstacles faced by the U.S. SEC in approving Bitcoin ETFs.

Table of Contents

What is an ETF?

ETF, as an index investment tool, is the most successful financial innovation in the global financial market after the international financial crisis. By the end of 2020, there were 7,527 ETFs listed for trading globally, with total assets exceeding $7.9 trillion, of which stock ETFs accounted for nearly 3/4, bond ETFs accounted for 19%, and commodity ETFs accounted for 3.4%.

The United States is not only the birthplace of ETFs, but also the largest ETF market globally. In fact, the U.S. market leads by a wide margin in terms of product quantity and asset size. By the end of 2020, the U.S. ETF market's asset size was $5.49 trillion, accounting for 69.5% of the global market share.

The establishment of ETFs in the U.S. is based on the "Investment Company Act of 1940," but the operational mechanism of ETFs conflicts with the Act in many ways, such as in-kind creation and redemption, allowing only Authorized Participants (APs) to participate in creation and redemption, and limiting regular investors to trade. Therefore, each ETF issuance requires a separate exemption application to the U.S. SEC.

In September 2019, the U.S. Securities and Exchange Commission (SEC) issued a new rule for ETFs (Rule 6c-11), which is the first systematic regulation specifically for ETFs since their inception. After the rule took effect in November 2019 (with a one-year transition period), regular ETFs can be established with a simple filing to the SEC without the need for individual exemption applications, significantly streamlining the ETF creation process.

ETFs have primary and secondary markets. In the primary market, Authorized Participants (APs) participate in the creation and redemption of ETF shares. Investors buy and sell ETF shares on stock exchanges, constituting the secondary market for ETFs. The following introduces Figure 1.

APs can be market makers, professional institutions, or other large financial institutions designated by the ETF issuer, and they can change the supply of ETF shares in the market through in-kind creation and redemption.

When an ETF issuer wants to expand the product size, they will ask APs to buy the constituent securities of the ETF in the market according to the weight allocation and deliver these securities to the ETF issuer. In exchange, the ETF issuer gives the AP an equivalent value of ETF shares based on the ETF net asset value (NAV). The AP can then resell the ETF shares for profit. This process can also be reversed: the AP redeems a basket of constituent securities to the ETF issuer, removing ETF shares from the market.

The ability of APs to create and redeem ETF shares, along with arbitrage mechanisms, helps keep the ETF market price close to the net asset value (NAV). In times of ETF premium, APs buy underlying securities in the market to create ETF shares with the issuer. Conversely, in times of ETF discount, APs redeem shares from the issuer and sell the acquired underlying securities in the market.

In general, the more APs there are, the more likely the competition between them will help the ETF market price approach fair value. This is one of the key differences between ETFs and closed-end funds. For closed-end funds, no one can create or redeem shares. Due to the lack of arbitrage mechanisms to regulate supply and demand, closed-end funds often trade at a high premium or discount.

In the U.S., individual investors can buy and sell ETFs directly from brokerage accounts (such as Charles Schwab and Merrill Lynch). ETF share transfers are similar to stocks, with the reference value updated every 15 seconds, daily publication of ETF share values, allowing trading at any time the market is open, supporting multiple daily buys and sells, short selling, and buying on margin on the same day. In contrast, regular mutual funds (ETFs can be considered a type of special mutual fund) can only be traded once a day (after the market closes).

In summary, ETFs in general can be understood from the following points (which are also key to understanding Bitcoin ETFs):

Asset portfolio characteristics: benchmark, investment strategy;
Primary market features: AP, share creation and redemption mechanism, arbitrage mechanism;
Secondary market features: investor groups, trading venues, trading methods, price characteristics.

Design and Challenges of Bitcoin ETF

Contrast with Grayscale Bitcoin Trust

To understand the significance of a Bitcoin ETF, it is best to compare it with the largest Bitcoin financial product globally - the Grayscale Bitcoin Trust.

The key features of the Grayscale Bitcoin Trust are as follows:

Asset portfolio characteristics: directly holding Bitcoin, purchasing Bitcoin through Genesis, which holds a BitLicense, and custody by Coinbase Custody.
Primary market features: Trust shares are GBTC, with approximately 1,000 shares of GBTC per Bitcoin; accredited investors can purchase GBTC with Bitcoin or cash but cannot redeem GBTC.
Secondary market features: GBTC has a 6-month lock-up period, trades on the OTCQX market, open to retail investors; GBTC previously traded at a premium to Bitcoin but is currently at a discount.

Although the Grayscale Bitcoin Trust has been very successful, its shortcomings are also evident:

Firstly, GBTC cannot be redeemed, hindering arbitrage mechanisms, leading to a long-term deviation of GBTC prices from Bitcoin, lacking inherent convergence forces, making it difficult for investors to obtain exposure to Bitcoin.
Secondly, GBTC can only be traded on the OTCQX market, limiting liquidity.

Therefore, a Bitcoin ETF has two key objectives: to improve arbitrage mechanisms for better tracking of Bitcoin prices and to expand the secondary market investor base, especially by listing on mainstream stock exchanges.

Bitcoin ETF based on Bitcoin Spot

The following introduces the Bitcoin ETF proposal submitted by VanEck to the U.S. SEC in March 2021, which the SEC has delayed the decision on and sought public opinion.

Bitcoin ETF based on Bitcoin Futures

The following introduces the Bitcoin ETF proposal submitted by VanEck to the U.S. SEC in June 2021 (submitted after the previous proposal sought public opinion).

Obstacles to U.S. SEC Approval of Bitcoin ETF

By reviewing the U.S. SEC statements on May 11, 2021, and the explanation seeking public opinion on the VanEck Bitcoin ETF on June 16, 2021, it is evident that two types of Bitcoin ETF proposals face obstacles in approval.