What Are the Differences Between Bitcoin ETFs and Trusts? Why Has the US SEC Been Hesitant to Approve Spot Bitcoin ETFs?

Abstract

ETFs allow specific assets to be securitized with physical guarantees, enabling investors to indirectly gain exposure to their invested underlying assets by purchasing fund shares issued by institutions. However, as of now, there are no real spot Bitcoin ETFs available.

Investment trusts are a type of closed-end investment fund listed on a securities exchange. Grayscale Bitcoin Trust (symbol GBTC) offered by Grayscale Investments is the most prominent Bitcoin trust product in the cryptocurrency market. It operates with a corporate structure, and the number of available shares is limited, which significantly influences their price through supply and demand dynamics.

ETFs and trusts differ primarily in their structure. ETFs are open-ended, allowing market makers to create or redeem shares at any time, while trusts are closed-end and typically more difficult to be created and lack an active redemption plan. Moreover, ETFs can be traded on a securities exchange throughout the trading day, similar to individual stocks.

The US SEC has consistently rejected Bitcoin ETF proposals, with reasons varying over time. Previously, the main issue was the classification of Bitcoin, while recently, the main concern has been potential market manipulation. Another major reason for the SEC's delay in approving a Bitcoin ETF is the lack of approval for the spot market under US federal regulatory standards.

If BlackRock's Bitcoin ETF application is approved, it would be a big win for investors. To stay competitive, Grayscale's GBTC may need to introduce daily redemptions and would charge lower management fees. Other Wall Street firms could swiftly follow suit to replicate BlackRock's success.

What is a Bitcoin ETF?

ETFs, or exchange-traded funds, allow specific assets to be securitized with physical guarantees, enabling investors to indirectly gain exposure to their invested underlying assets by purchasing fund shares issued by institutions. ETFs were first invented by John Bogle, the founder of Vanguard Investments. Bogle launched the world's first and still widely-known index ETF, the S&P 500 index ETF. Usually, ETFs are similar to mutual funds in that they are jointly managed by issuers and aim to track the performance of a specific market index, sector, or asset. When investors purchase an ETF, they buy shares of the underlying asset portfolio, such as stocks, bonds, or commodities, which grants them easy access to a diversified basket of securities. This is one of the benefits of investing in ETFs. Furthermore, ETFs typically boast lower costs compared to other types of investment tools.

ETFs play a significant role in the traditional financial system. When a commodity is offered as an ETF, it signifies that it complies with regulations and is well-established in the local market. Bitcoin ETFs, which track the price movement of Bitcoin, allow investors to benefit from the appreciation in Bitcoin's price without the direct purchase of Bitcoin typically involving registering for a trading platform and undergoing various verifications. The first-ever Bitcoin ETF created was a futures ETF named ProShares Bitcoin Strategy ETF (BITO). However, as of now, there is no real spot Bitcoin ETF available yet.

What is a Bitcoin Trust?

Investment trusts are a form of closed-end investment fund listed on stock exchanges. These trusts are managed by professional fund managers who are responsible for investing the funds held within the institution. They are invested to acquire assets such as stocks, bonds, or properties. An investment trust's share price is determined by the value of its held assets. In the field of cryptocurrencies, Grayscale Bitcoin Trust stands as a prominent Bitcoin trust product. Operating with a corporate structure, at least in regulatory terms, the Trust has a limited number of available shares, and its price is significantly influenced by the supply and demand of those shares.

Apart from Grayscale's GBTC, there are other alternatives available in the market. As early as 2017, Tobam, a French asset management company, launched the world's first Bitcoin mutual fund. In the same year, Swissquote Group introduced a Bitcoin exchange-traded certificate, and this exchange-traded product (ETP) has been listed on Six Swiss, Switzerland's largest stock exchange. Since then, Crypto ETPs have been issued in countries such as Germany, Sweden, and Austria. However, these products have similar drawbacks to Grayscale's GBTC and can only fulfill some of the functions of ETFs. This limitation arises because ETPs are essentially bonds and cannot be included in the regulatory framework of funds.

What are the differences between Bitcoin ETF and Trust?

One of the main differences between ETFs and investment trusts is their structure. ETFs are open-ended, which means that the number of available shares can be increased or decreased according to demand. Investment trusts, on the other hand, are closed-ended, which means that there is a fixed number of shares available. For instance, Grayscale's GBTC trust fund is more difficult to be created and does not have an active redemption plan, which can result in significant price differences from its net asset value. In contrast, ETFs allow market makers to create and redeem shares freely. Consequently, when there is sufficient liquidity, there is usually no premium or discount. ETFs are more readily accepted by mutual funds and pension funds because they carry much less risk than closed-end trust funds like GBTC.

In addition to differences in structure, ETFs and investment trusts also differ in their trading and cost structures. ETFs can be bought and sold on the stock exchange throughout the trading day, similar to individual stocks. On the contrary, investment trusts trade only once at the end of the trading day. Moreover, ETFs and investment trusts have distinct cost structures. ETFs are designed to track an index and require less active management, resulting in lower costs compared to investment trusts. Investment trusts, just the opposite, are actively managed, leading to higher management fees.

What are the reasons behind the repeated rejections of Bitcoin ETF proposals by the SEC?

The development of Bitcoin ETFs has had its twists and turns, with the SEC consistently rejecting their applications. However, the reasons for these rejections have varied significantly between the early days and more recent times.

In the early days, the SEC rejected Bitcoin ETF applications mainly due to their classification issues. During that time, cryptocurrency was considered neither a security nor a financial derivative by the SEC. Being a non-physical commodity, Bitcoin was theoretically not subject to regulatory oversight by the SEC or CFTC. Consequently, this became one of the primary reasons why Bitcoin ETF proposals were frequently rejected in the past.

With the launching of Bitcoin ETFs in other countries, the SEC has changed its stance and introduced futures Bitcoin ETFs to follow suit. In February 2021, the world's first Bitcoin ETF, Purpose BTC ETF, was approved in Canada. Just two months after its launch, three Ethereum ETFs were also approved for listing: Purpose Investments' Purpose Ethereum ETF (ETHH), CI Global Asset Management's CI Galaxy Ethereum ETF (ETHX), and Evolve Capital Group's Evolve Ethereum ETF (ETHR). The introduction of the futures Bitcoin ETF means that the SEC has officially brought Bitcoin under regulatory oversight. Additionally, the SEC is competing with the CFTC for regulatory jurisdiction over cryptocurrencies such as Bitcoin. Despite approving futures Bitcoin ETFs, the SEC has consistently rejected applications for spot Bitcoin ETFs.

On November 12, 2021, the SEC rejected the application for a spot Bitcoin ETF from the investment giant VanEck, citing seven reasons for the decision: 1. Wash trading; 2. Market manipulation by whales; 3. Security vulnerabilities of the Bitcoin network and trading platforms; 4. Malicious control of the Bitcoin network; 5. Potential insider trading based on non-public information, including false information; 6. Manipulation of prices by stablecoins such as Tether; 7. Fraud and manipulative practices by Bitcoin trading platforms.

However, it is essential to clarify that the SEC's rejections of the spot Bitcoin ETF filings are not primarily driven by concerns regarding trading volume and liquidity. This becomes evident when we observe that many corporate bond ETFs, like HYG, demonstrate a median daily trading volume in the single digits for their constituent stocks. The SEC has consistently rejected spot ETF filings, mainly due to the lack of approval from the US federal regulatory system for the spot market. This lack of approval is primarily attributed to three key factors. One of these factors lies in ETFs like EWJ (iShares MSCI Japan) including financial instruments that fall under regulations outside the US jurisdiction. Bitcoin is subject to regulation in many non-US jurisdictions and is traded on regulated exchanges in those locations. However, some ETFs, such as HYG (iShares High Yield Corporate Bond), include debt instruments that are not traded on any licensed exchange. Additionally, ETFs like FXE (Invesco Euro Trust) comprise fiat currencies that are not regulated by any market regulator.

What are the different approaches available for submitting a spot Bitcoin ETF filing?

Traditional ETF filing model: This type of application is similar to a regular ETF application. Back in 2013, the Winklevoss brothers unveiled their plans to launch a Bitcoin ETF. However, in 2014, the SEC rejected their application, marking the first setback. Undeterred, the Winklevoss brothers made several attempts to establish a Bitcoin ETF through various means, including changes in trading venues or locations. Despite numerous applications over the years, all their endeavors have proven unsuccessful, and the plan remains shelved to this day. In 2016, SolidX's application for a Bitcoin ETF was also rejected. The surge in institutional interest in Bitcoin ETFs became evident in 2017 when a total of six applications were submitted within a year. The applicants included BTC Investment Trust, VanEck, Exchange Listed Funds Trust, ProShares, REX BTC, and First Trust. Two additional companies, GraniteShares and Direxion, submitted their applications in 2018. Furthermore, VanEck and SolidX made a joint application for an ETF. However, all of these filings were ultimately rejected by the SEC.

Bitcoin Trust product transitioning to Spot Bitcoin ETF: Grayscale's GBTC stands as a prominent example of this approach. In October of the previous year, Grayscale applied to the US SEC via NYSE Arca to convert GBTC to a spot Bitcoin ETF. Nevertheless, the application was rejected by the SEC due to concerns about insufficiently addressed risks of fraudulent and manipulative behavior.

An alternative structure of ETF: Recently, the most typical example of this kind is BlackRock’s application. This type of ETFs is similar to other well-known funds like GLD and iShares managed by BlackRock. Unlike Grayscale’s GBTC, it offers greater flexibility and can be redeemed. However, due to the absence of a daily redemption mechanism that an ETF has, it will add and redeem in baskets of 40,000 Bitcoins from the trust. Meanwhile, it will generate similar premium and discount issues in net asset value as the GBTC.

How will Spot Bitcoin ETFs affect the cryptocurrency market?

BlackRock's recent application for an alternative structure of ETF has garnered a lot of attention in the market. Anthony Pompliano, an investor at Pomp Investments, believes its approval would be a big win for investors. To stay competitive, Grayscale's GBTC may need to introduce daily redemptions and possibly lower fees. Other Wall Street firms could swiftly follow suit to replicate BlackRock's success. The heightened media coverage may also attract new capital inflows into the Bitcoin market.

Some argue that BlackRock's Bitcoin ETF application still resembles more of a trust product. Despite having a redemption mechanism, its liquidity falls short compared to traditional ETFs, hindering its ability to fully utilize the unique advantages of ETFs like low fees and high intraday liquidity. The United States leads the world's ETF market, accounting for almost 75% (approximately US$5.6 trillion) of global assets under management (AUM) in 2020. Therefore, the approval of a spot Bitcoin ETF could make this crypto an appealing choice for both traditional institutional and retail investors, especially those seeking to mitigate legal risks or find cryptocurrency investments too complex. Undoubtedly, this would significantly bolster the long-term development of Bitcoin.