What the launch of bitcoin futures ETFs means in the quest for a bitcoin spot ETF

The first bitcoin-based exchange-traded fund (ETF) finally got a green light from the US regulators to begin trading last week.

But it was only a milestone along a long and winding road that crypto advocates hope eventually ends with an actual bitcoin ETF — not just funds that hold bitcoin futures.

Since 2013, numerous companies have advanced proposals under the Securities Act of 1933 for ETFs that directly hold bitcoin. This led to an endless dance of submission, extension and eventual rejection between the industry and the securities regulator. 

So why is the SEC happy to let a futures ETF start trading but not a so-called spot ETF?

The agency has continuously cited concerns of price manipulation in bitcoin spot markets and the lack of sound custody options in its rejection orders. But the industry has grown since then and attempted to address these concerns, so much so that commissioner Hester Peirce even accused the SEC of moving the finish line after the most recent wave of rejections.

When crypto-savvy former Commodities Futures Trading Commission (CFTC) chair Gary Gensler took the helm at the SEC after the rejections, many wondered if he would herald a new era for the debate around a bitcoin ETF.

He has done that — but not in the way many had hoped.

Instead of making him more sympathetic to the industry, his background studying blockchain systems seems to have made him ask tougher questions about crypto investor protection — and that appears to be part of the rationale behind the continued resistance to a spot ETF. 

Meanwhile, the SEC has opened the floodgates for futures ETFs: already, two additional products — one from VanEck and another from Valkyrie — have been listed since ProShares listed the first one last week.

The sudden appearance of bitcoin futures ETFs raises important questions about the future of crypto ETFs in the US. First, how exactly are futures ETFs more protective of investors? And can the supposed investor protection gap between potential spot offerings and the newly listed futures offerings be closed?  

A different act

In August of this year, Gensler said he looked forward to reviewing crypto products under the Investment Company Act of 1940,  signaling what kind of standards the new guard wants in U.S. crypto ETFs. 

The name of the game seems to be investor protection. In an interview yesterday with Yahoo Finance’s Brian Cheung, Gensler responded to questions about whether a spot approval was on the horizon by saying that most of crypto has yet to come under the “investor protection remit,” leaving investors vulnerable to fraud and manipulation in these markets. 

Most spot ETFs have been filed under the Securities Act of 1933, which is a registration that allows shares to be made available to the public. It is a disclosure rule, meaning issuers have to register their offerings with the SEC, but they don’t necessarily agree to certain standards. 

Gensler’s August comments about the Investment Company Act of 1940 set off a flurry of submissions under that law, one that doesn’t clearly apply to the products but nonetheless might provide the protection that regulators are looking for.

Unlike the Securities Act of 1933, the Investment Company Act of 1940 has a framework of standards attached to it, including limits on leverage and requirements related to derivatives usage. It also requires an independent board and a daily net asset value calculation, as well as an assurance that any market-based price is fair value.

The two laws are “really focused on different cases,” said Ryan Louvar, general counsel for WisdomTree, which lists an ETF that holds some bitcoin futures and has a spot bitcoin ETF proposal before the SEC.

“The ’33 Act is focused on what is the fund disclosing for that prospectus, the ’40 Act is how the fund is operating and being overseen,” said Louvar. “So the SEC staff could then come in on an exam basis and say ‘is the fund operating and being overseen with this whole list of requirements under the ’40 Act,’ and they could enforce that.”

But due to the globally distributed nature of bitcoin trading, bitcoin spot products don’t inherently fit under the ’40 Act. The ’40 Act is for investment companies, subsidiaries created as investment vehicles. Mutual and closed-end funds fall under this law. An ETF wouldn’t normally go this route, since it incurs different tax burdens. 

Now that Gensler has signaled that it could be the road to an ETF approval, though, that leaves questions for issuers still hoping for the SEC to approve a spot ETF, according to Louvar. “What are the expectations for how you can translate what is in the ’40 Act to a product that, by its nature, doesn't fit under the 40 act? What will be necessary to get there?”   

“I think one starts with that pricing mechanism,” he added, pointing to “internal controls” in the ‘40 act that could potentially be applied to a spot ETF. “And will that be enough? I think that that's really the ultimate issue.”

The pricing problem

Most assets held in ETFs are traded on federally regulated marketplaces and in the name of the company that owns them. Bitcoin is different.

The price of bitcoin derives from thousands of marketplaces that lack federal oversight, so it’s relatively easy for a bad actor to open an account on a number of different platforms and circularly trade to manipulate the price.

If price manipulation occurs and U.S. investors are harmed, it’s unclear who the Commodity Futures Trading Commission (CFTC) — which has the authority to take enforcement action against manipulation on spot markets — can call to ask questions. 

Gensler hasn’t said if this is why he remains hesitant to approve a spot-based product, but the SEC has historically voiced these concerns in its rejection orders. For his part, he’s made it clear he trusts bitcoin futures contracts that trade on the Chicago Mercantile Exchange (CME). This is likely because CME is a federally regulated market, meaning the CFTC oversees its activity.

Gensler himself once chaired the commodities regulator, so he’s familiar with the process and protections in place on a CFTC-regulated exchange. 

In traditional markets, the exchanges where the underlying assets are originally traded to price futures also have some degree of surveillance through vendor agreements. They share data with futures exchanges that the exchanges can in turn share with the regulator. In its rejection orders, the SEC has consistently said it doesn’t understand how the crypto market could do the same since it’s traded in such a distributed manner.

To mitigate this to some degree, CME prices its bitcoin futures using an index that pulls from a number of trusted exchanges. Some, like Louvar, wonder why a spot ETF couldn’t use the same mechanism to assuage regulator concerns. The argument goes, if you’re comfortable with a derivative, you must be comfortable with the underlying asset, since any manipulation in the spot market would affect the pricing of futures. 

Chen Arad, COO of Solidus Labs, a crypto market surveillance and risk monitoring firm, said the futures ETF acts as a middle ground for now. “The compromise is there are more degrees of separation between bitcoin’s underlying market and an ETF itself through the futures market,” he said.

These additional regulated layers between the investor and the underlying give the SEC clear spaces to step in if something goes wrong. It can’t control the trading of bitcoin itself, but it can exert some control over the futures market, CME and how it prices its futures. 

“I think part of their concern is if there was a major global manipulation or price change in the bitcoin market, who do they go to?” said Arad. “They can go to entities regulated in the U.S., but the manipulation probably didn’t happen here because here entities have some of the most credible bitcoin volume.”

It shows the SEC is giving the industry something, according to Arad, as it continues to examine industry solutions for cross-market surveillance. But it also acts as something of a test run, he said: it pushes the industry to demonstrate more integrity.

“The moment the bitcoin futures ETF started trading doesn’t mean we made it,” said Arad. “It means there’s going to be more scrutiny, more responsibility to prevent market manipulation, so in a way, it also gives the SEC more justification for scrutiny and potential enforcement.”