Price discovery research seeks to move the needle forward on a bitcoin ETF

The Securities Exchange Commission (SEC) has been wary of a crypto-based exchange traded fund (ETF), shooting down every proposal that’s come under its purview.

As industry players begin the work of answering regulatory concerns, Digital Asset Research has begun the work of investigating price manipulation in crypto – and what’s more, the SEC is paying attention. 

In September, SEC chair Jay Clayton said there was still work to be done to advance a bitcoin ETF, calling on industry players to answer “hard questions” on the road to approval. These hard questions primarily center on combating fraudulent activity and market manipulation around cryptocurrencies. 

Price manipulation occurs when entities interfere with a market by artificially driving a security’s price higher or lower. The SEC's top concern, as indicated by its past rejections of ETF proposals, is that price manipulation in the underlying markets will negatively affect any listed products. Wash trading, churning and other efforts to fake volumes have further fueled concerns about a crypto ETF.

In sum, the issues present significant roadblocks to the launch of a true crypto product on an SEC-registered exchange. 

Digital Asset co-founder Lucas Nuzzi pointed out that the concerns about manipulation aren't directed towards all corners of the market. The current approach by advocates of a crypto ETF is to demonstrate that manipulation isn’t happening at "trustworthy" venues, but the SEC concerns extend further than that, according to Nuzzi.

Regulators, he contended, are looking for assurance that activity in the Wild West parts of the crypto space isn't influencing market prices. 

Nuzzi said lead-lag analysis, which examines where price discovery is happening, can provide some answers. Indeed, the SEC itself called for more information on lead-lag relationships in its rejection of Bitwise.

“Without data to show the lead-lag relationship between prices on the two sets of platforms or any evidence about the directionality of the lead-lag relationship — which might indicate that changes in prices on platforms with fake volume are or are not leading to changes in prices on the ‘real’ platforms — the Commission has no basis on which to conclude that prices on the ‘real’ platforms are insulated from prices in the rest of the market,” the SEC said in its rejection letter. 

The regulator initially denied Bitwise’s ETF proposal in October – what some saw as a last hope – on the basis that the firm hadn’t sufficiently established that bitcoin was free from fraudulent activity and manipulation. But the regulator later moved to reconsider its rejection, though in the end Bitwise moved withdraw its application and asserted that the move represented a formality on the road to refiling. 

Digital Asset examined more than 100 events across 76 exchanges, including those that made its “vetted,” “watch” and “disqualified” lists, to measure lead-lag relationships. Disqualified exchanges seem to simulate volume, while vetted ones have passed a variety of qualitative and quantitative internal tests. Nine of the 10 price leaders, or those exchanges that led events, came from the “vetted” or “watch” lists. 

“We believe this shows that in the time period analyzed, activity on digital asset exchanges that fail to pass our vetting process have a limited impact on price discovery,” Greg Cipolaro, co-founder of Digital Asset, detailed in a version of the report.

The firm's researchers contend that price discovery mostly takes place on exchanges deemed trustworthy and that the risk of price manipulation by less-solid exchanges may be lower than some have thought. Cipolaro called the initial findings a positive development in the quest for a bitcoin ETF.

“It’s preliminary, but it is a very positive development because it does show that these disqualified exchanges that come and go reporting insane volume figures – at times we've identified trades of over 10 million bitcoins in one trade, which is absurd... that has a very limited impact on price discovery,” said Nuzzi

The SEC has seen these findings, according to Digital Asset, with Cipolaro and Nuzzi meeting with members of the office earlier this month. The SEC declined to comment on the meeting.

As The Block's Larry Cermak pointed out, the SEC lacks insight into venues that operate without much regulatory oversight. Even though Digital Asset has found that most of the venues leading price discovery are trustworthy, this may mean little to the SEC since these are still venues outside of its direct purview. 

Still, Nuzzi said Digital Asset is seeing continued interest in the space from the SEC. While there may be skepticism, there is an obvious interest in education, according to Nuzzi.  

“There is clear interest in understanding market structure, specifically something that they’ve publicly and in some of these meetings they’ve alluded to something that's key to regulating is just understanding the market structures, but it's an ongoing conversation,” said Nuzzi.

Ultimately, Nuzzi said the industry is inching closer to an approval – though, to date, the regulator has denied 12 of 26 total bitcoin ETF proposals, with the remaining 14 applications were withdrawn by the applicants, according to Cermak's research.

As of now, the Wilshire Phoenix and Kryptocoin ETF applications remain the only two in front of the SEC.