The Bitcoin ETF Is a Double-Edged Sword
Posted October 27, 2023 at 1:54 pm EST.
A Federal appeals court on Monday finalized its decision to overturn the SEC’s prior rejection of Grayscale Investments’ application to convert its Grayscale Bitcoin Trust into an Exchange Traded Fund, or ETF, tracking the “spot” price of BTC. ETFs can be bought and traded in traditional brokerage, retirement, and institutional investment vehicles, and the judgment has triggered a huge rally in bitcoin, and crypto as a whole, in anticipation of a wave of new investors.
But the quest for a spot Bitcoin ETF has always been controversial among crypto advocates. While it has many potential benefits for investors and BTC’s price, some have argued that it isn’t true to the spirit of crypto, since it relies deeply on third party custody. Even leaving crypto’s ethos aside, there are other downsides to the ETF approval – not least that the current rally could lead to another unsustainable, ultimately damaging crypto-bubble.
Why is a BTC ETF back in the headlines?
First, the basics.
Bitcoin (BTC) has shot up more than 20% over the past week because of rising expectations that the U.S. Securities and Exchange Commission (SEC) will begin approving Bitcoin “spot” ETFs, or exchange traded funds. These stock-like assets would represent claims on underlying holdings of Bitcoin managed by ETF issuers, and so should closely track the BTC price. Bitcoin ETFs are legally different from holding BTC directly, allowing investors to effectively buy bitcoin, albeit indirectly, under conventional brokerage and retirement accounts.
Currently, with some exceptions, investing in bitcoin is more difficult than that. It either requires buying and holding via an exchange like Coinbase, which isn’t allowed for a lot of traditional asset management setups; or trading imperfect bitcoin proxies such as the stock of Michael Saylor’s Microstrategy, with its vast trove of BTC. Opening more direct, reliable exposure to bitcoin seems likely to have major secular benefits for BTC’s price by raising the base level of demand.
The ETF is on the table now because, after years of the SEC rejecting bitcoin ETF applications, a recent court decision appears to have forced the agency’s hand. The decision hinged on the SEC approval of a bitcoin futures ETF in 2021, when Chair Gensler argued that the futures market had more built-in investor protections than the spot market. This was always a strange argument, since bitcoin futures, prior to the futures ETF approval, were traded in huge volumes on lightly regulated international crypto exchanges.
In August, a court rejected Gensler’s distinction, ruling that the SEC had been “arbitrary and capricious” in failing to explain why the futures and spot markets for the same assets were so deeply different that it had approved one ETF and not the other. That judgment was affirmed in a court order yesterday that officially returned the decision to the SEC for review.
While nothing is guaranteed, onlookers including Nic Carter at Castle Island Ventures have estimated a two-to-four month window for the approval and launch of at least some of the pending ETFs. Bitcoin’s price has spikedin forward-looking anticipation of that approval.
The benefits of a Bitcoin ETF
The likely increased demand for BTC is the most obvious benefit of a spot ETF approval – though this is only a “benefit” for current holders, and not necessarily the system, on which more shortly. The official approval of one or more ETFs is likely to be a “sell the news” moment that produces a short-term spike in BTC price that settles down rapidly.
But the diamond-hands crowd will also likely benefit from longer-term upside, not least because ETF approval will turn major institutions into bitcoin marketers. That has already happened with Blackrock’s Larry Fink. Fink may genuinely think Bitcoin equals “the value of human freedom,” but he’ll be even more motivated to be bullish when he’s actively collecting fees from Bitcoin ETF buyers.
More substantively, the creation of Bitcoin ETFs may help undercut the repeated frauds the crypto industry has suffered. Over the years, huge amounts of Bitcoin on exchanges like Quadriga and FTX have simply disappeared when those custodians proved untrustworthy – a phenomenon that has raised fears of large amounts of “paper bitcoin” that’s not actually backed by the real thing on-chain. Regulated options managed by genuinely reputable entities like Blackrock could starve sketchier operations, broadly reducing fraud. That could trigger a longer-term “melt up” in perception of the legitimacy of bitcoin, and crypto more broadly.
Other benefits of ETFs are slightly more abstract. For one, the court ruling against the SEC seems bad for Gary Gensler, who despite initial hopes when he took office has proven not just hostile to crypto, but scattershot and often seemingly ill-informed in his opposition. The most dramatic illustration of this, of course, is his embrace of alleged fraudster Sam Bankman-Fried as an authority on crypto regulation – a topic the SEC has remained tight-lipped about.
Finally, while there’s no denying that any third-party custodian represents a compromise on the ideals of Bitcoin, it’s consistent with how some advocates have often framed BTC over the years: as “digital gold” and “a store of value.” While many “gold bugs” like to have physical gold on hand, it’s not at all strange to hold a gold ETF instead of actual gold. There would be nothing inherently wrong with bitcoin having the same two-tiered market structure.
Risks of the Bitcoin ETF
For all its potential benefits, there are real downsides to the approval of a Bitcoin spot ETF – and often, they’re almost the same as the upsides.
Most obviously, while current holders will certainly enjoy it, price appreciation is not unambiguously good for the broader cryptocurrency ecosystem. I’ve been reporting on crypto for more than a decade now (my God), and these things have had generally predictable dynamics. The rising price of bitcoin, for both sentimental and technical reasons, pulls other crypto prices up – including riskier assets. I can already foresee the ETF becoming a catalyst for an unsustainable crypto-bubble either very soon or once it’s actually approved – again, a possible reason to sell the news.
While the more secure, trustworthy nature of the regulated ETFs might in itself stave off the worst impacts of such a bubble, these moments have undeniable negative effects. Appreciating crypto prices almost inevitably attract new waves of fraud and even crime, as the growing pie becomes more attractive for bad actors. Even nominally well-intentioned projects launched to capitalize on crypto bull markets can often be hastily conceived and ultimately fragile.
It’s also not impossible that, while more trustworthy in themselves, ETFs actually increase overall crypto market volatility in some ways. While many Bitcoin ETF shares are likely to be inherently long-term holds, they will also be actively traded, and given the likely scale of institutional involvement, they could in the future become accelerants, rather than dampeners, on major crypto market news.
That’s for both technical and social reasons: Currently most truly large-scale bitcoin holders, like MicroStrategy, are some variety of true believer with a developed long-term Bitcoin growth thesis. The ETF will be held by many less committed investors. That means more bitcoin will be available to be liquidated nearly instantaneously in moments of market uncertainty.
Further, while they align broadly with the “digital gold” thesis for Bitcoin, ETFs could expose a weakness of that thesis: That bitcoin as a “store of value” may ultimately depend on its daily use as a transactional medium. Just how real, widespread and persistent that use is, has become blindingly obvious during the (now concluded?) bear market, as transaction volumes on BTC held in a range around $1-3 billion per day.
Those volumes ultimately generate fees for bitcoin, supporting hashpower and the security of the chain. If everyone instead just parked their bitcoin in an ETF, Bitcoin itself could be threatened.
This leads neatly to the ideological objections to an ETF. Bitcoin, after all, is supposed to be about financial autonomy, the elimination of intermediaries, and, in practical terms, self-custody. Buying a bitcoin ETF share doesn’t require knowing how to use a bitcoin wallet, or even a basic understanding of how the system works. There’s also a financial cost to this reality: Bitcoin generates no native yield, so if you’re paying an ETF to manage your coins, you depend entirely on price appreciation to generate returns, and they must outpace whatever fees you’re paying.
A pessimist would argue that’s both harmful to Bitcoin’s stated goals, and for the long-term health of the system, since it reduces overall engagement in an open-source project that ultimately depends on the wisdom of the crowd. However, there’s also a contrary argument: that Bitcoin ETFs will become something like the shallow end of the crypto swimming pool, an easy first step that ultimately leads all the way down the rabbit hole.
On that question, only time will tell.
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