It was thought that with the installation of the Biden administration we'd be looking at a more regulatory-friendly environment for cryptocurrencies. Multiple appointees to his staff have openly expressed at least a willingness to allow for greater acceptance of cryptocurrencies.
It looks like we may not be any closer after all.
On Tuesday, the SEC's Division of Investment Management issued a statement regarding mutual funds taking positions in bitcoin futures. Keep in mind that this is the same bitcoin futures market that many thought was going to clear the path for an eventual bitcoin ETF approval since dozens of ETFs already invest in futures contracts.
In the statement, the SEC makes pretty clear that its concerns over a lack of oversight and the potential for investors to be damaged are still very much alive.
The Division of Investment Management (“IM”) staff strongly encourages any investor interested in investing in a mutual fund with exposure to the Bitcoin futures market, as discussed below, to carefully consider the risk disclosure of the fund, the investor’s own risk tolerance, and the possibility, as with all investing, of investor loss. Among other things, investors should understand that Bitcoin, including gaining exposure through the Bitcoin futures market, is a highly speculative investment. As such, investors should consider the volatility of Bitcoin and the Bitcoin futures market, as well as the lack of regulation and potential for fraud or manipulation in the underlying Bitcoin market. As with any fund investment, investors should focus on the level of risk they are taking on, and the level of risk they are comfortable taking on, prior to making an investment.
One could argue that the statement calling bitcoin a "highly speculative investment" is more legal jargon than taking a potshot at cryptocurrencies. The fact that the statement specifically calls out the "lack of regulation" and the "potential for fraud of manipulation" seems like more than just prospectus-speak. It sounds more like the SEC making its opinion of bitcoin quite clear.
But the letter goes on to detail some of the reasons behind the group's thinking, which is actually a pretty interesting read. For example:
The areas identified related to substantive requirements regarding valuation, liquidity, custody, arbitrage mechanisms for exchange traded funds (“ETFs”), as well as potential manipulation and other risks associated with cryptocurrency-related markets.
It turns out that fraud isn't their only concern. It's primarily liquidity. My take is that when/if a bitcoin ETF is launched, there's inevitably going to be a huge flow of assets into it. Despite the interest in bitcoin at a high level, bitcoin futures is actually not a heavily traded market.
The May bitcoin contract has only averaged about 6000 contracts traded daily. I think the SEC's main concern is that if a bitcoin futures ETF is approved, demand will surge and you could run into a situation where the fund literally overwhelms the market and you're facing potentially significant price disconnects. That would lead into the other fear of "manipulation", although not quite in the same nefarious sense that I think the SEC is referring to.
The Bitcoin futures market has developed since then, with increased trading volumes and open-interest positions. In addition, the Bitcoin futures market consistently has produced a reportable price for Bitcoin futures. The Bitcoin futures market also has not presented the custody challenges associated with some cryptocurrency-based investing because the futures are cash-settled.
This is an interesting nugget in that the SEC is admitting that the current bitcoin futures market functions fairly well. The SEC has a bit of a blueprint to work with in Canadian bitcoin ETFs, which also seem to be operating just fine. Overall, this should calm some fears about the markets running into significant operational issues.
Consider whether, in light of the experience of mutual funds investing in the Bitcoin futures market, the Bitcoin futures market could accommodate ETFs, which, unlike mutual funds, cannot prevent additional investor assets from coming into the ETF if the ETF becomes too large or dominant in the market, or if the liquidity in the market starts to wane.
It sounds like the SEC wants to use bitcoin futures investment in mutual funds as a test case for how they might operate within an ETF structure. As the passage notes, mutual funds can close if there's too much money coming in too fast or the managers feel they can't effectively put new capital to good use. ETFs don't have that same feature and there isn't a similar mechanism for turning off the spigot if money comes in too fast.
Among open-end funds, IM staff believes at this time that investment in the Bitcoin futures market should be pursued only by mutual funds with appropriate strategies that support this type of investment and full disclosure of material risks. The staff welcomes further input from ETFs and other market participants, particularly input that focuses on efforts to ensure compliance with the Investment Company Act and its rules and promote investor protection. Because closed-end funds do not provide for daily redemption of their shares, they do not present the same types of liquidity challenges as open-end funds. Therefore, staff encourages any closed-end fund that seeks to invest in the Bitcoin futures market to consult with the staff, prior to filing a registration statement, about the fund’s proposed investment, anticipated compliance with the Investment Company Act and its rules, and how the fund would provide for appropriate investor protection.
This seems to be the SEC's official position on bitcoin: it's OK for mutual funds, probably OK for closed-end funds, but it's a no-go for ETFs.
As many have noted on Twitter already, this is probably a chance for the SEC to give itself more time to make a decision. They've kicked the can down the road on a number of bitcoin ETF filings already including the VanEck filing just recently. This is probably an extension of that trend.
As has also been noted, the latest bitcoin ETF filings are proposing the use of physical bitcoin, not bitcoin futures. Does that change the SEC's thinking at all? Probably not in the short-term as many of their concerns would apply to both physical and futures. At a high level, the SEC is essentially saying their uncomfortable still with how a bitcoin ETF may play out in practice. The million dollar question is when will the SEC get comfortable? If not now, when? These core issues they cite aren't going away. Is there a chance we simply never see a bitcoin ETF?
Either way, it seems nearly certain that we won't be seeing a bitcoin ETF in 2021.