Why the Winelvoss Bitcoin ETF Was Rejected and How to Create a Regulated Vehicle That Passes Muster

I’m considering putting together an institutional digital asset (bitcoin and blockchain related assets) investment vehicle. The SEC has clearly delineated what they felt were the deficinecies wee in the Winkelvoss application, to wit:

• Several commenters note that the majority of bitcoin trading occurs on exchanges outside the United States. One commenter claims that most daily trading volume is conducted on poorly capitalized, unregulated exchanges located outside the United States and that these non-U.S. exchanges and their practices significantly influence the price discovery process. Another commenter states that the biggest and most-influential bitcoin exchange is located outside U.S. jurisdiction.

To my knowledge, the bitcoin exchanges abroad aren’t heavily capitalized, but the amount of capitalization needed should be minimal if the exchange is structured properly. Here”s a snapshot of the global bitcoin exchange landscape. Most of the exchange trading is done in USD but the exchanges are domiciled outside of the US (likley due to onerous SEC regulatory requirements). Be aware that I believe most of the institutional trading (in aggregate) is done OTC, and in the US.

• One commenter states that, since 2013, the price of bitcoin has been defined mostly by the major Chinese exchanges, whose volumes dwarf those of exchanges outside China. According to the commenter, those exchanges are not regulated or audited, and are suspected of engaging in unethical practices like front-running, wash trades, and trading with insufficient funds. The commenter interprets pricing data from these Chinese exchanges to mean that the price of bitcoin is defined entirely by speculation, without any ties to fundamentals.32 Another commenter also observes that Chinese markets drive much of the volume in the bitcoin markets and that the bitcoin/Chinese Yuan (BTC/CNY) quote is apt to trade at a significant premium to the bitcoin/U.S. dollar (BTC/USD) quote. The commenter points out that large arbitrage opportunities would not exist for long in efficient markets, but they do persist in bitcoin markets. One commenter claims that a sizeable number of traders and owners of bitcoin do not desire to trade in a well-regulated environment for reasons including tax evasion, evading capital controls, and money laundering. This commenter also states that U.S. exchanges do not offer products such as fee-free trading, margin trading, or options, which drive traffic to the top nonU.S. exchanges. The commenter claims that, because trade is now sparse on regulated U.S. exchanges including Gemini, arbitrage will not occur efficiently or proportionally to mitigate.manipulation from the dominant unregulated bitcoin exchanges. This commenter also claims that several Chinese exchanges actively engage in bitcoin mining operations, creating a conflict of interest, and notes that these exchanges are unaudited and unaccountable.34 Another commenter also claims that the Chinese exchanges that account for the bulk of trading are subject to little regulatory oversight and that existing know-your-customer or identity-verification measures are lax and can be easily bypassed

This is no longer the case. The PBOC (Chinese Central Bank) has cracked down signficantly on Chinese bitcoin exchanges, ending fee free trading, unregulated margin lending and enforcing AML/KYC procedures. Reference:

1. Chinese Bitcoin Exchanges Suspend Client Withdrawals. I Warned You About Heteronomous Wallets!
2. Will Japan’s Declaration of Bitcoin as Legal Tender Accelerate Cryptocurrency Mainstream Adoption?
3. Revisiting the Breakdown of the Macro Drivers Behind Bitcoin’s Price Spike, Exactly As I Foretold 30 Day Ago
4. China’s Central Bank Eliminates Margin Trading of Bitcoin
5. The Macro Truth About The Big Bitcoin Pop and Drop: The Mainstream Media Doesn’t Have A Clue

The result is a signficant drop in bitcoin trading volume in China, passing the crown first to Japan (who just passed heavy bitcoin regulation, while declaring it legal tender) and then to the US – in direct contravention to said commenter’s claim. Take note that once the free trading was halted and central bank regulation took hold, trading volumes in China collapsed in line with the ROW.

 

•  One commenter states that the market for bitcoin, by trade volume, is very shallow. This commenter notes that the majority of bitcoin is hoarded by a few owners or is out of circulation. The commenter also notes that ownership concentration is high, with 50 percent of bitcoin in the hands of fewer than 1,000 people, and that this high ownership concentration creates greater market liquidity risk, as large blocks of bitcoin are difficult to sell in a timely and market efficient manner. This commenter claims that daily trade volume is only a small fraction of total bitcoin mined. 36 This commenter also states that several fundamental flaws make bitcoin a dangerous asset class to force into an exchange traded structure, including shallow trade volume, extreme hoarding, low liquidity, hyper price volatility, a global web of unregulated bucket-shop exchanges, high bankruptcy risk, and oversized exposure to trading in countries where there is no regulatory oversight.37 This commenter believes that lack of regulation and consumer protection also increase the chance and incentives for market price manipulation and states that approving the ETP before structural protections and controls are firmly in place would put investors at undue risk.

 This was actually countered by the authors of the ETF application, to wit:

The Exchange, in its comment letter, asserts that bitcoin is resistant to manipulation, arguing that the increasing strength and resilience of the global bitcoin marketplace serve to reduce the likelihood of price manipulation and that arbitrage opportunities across globally diverse marketplaces allow market participants to ensure approximately equivalent pricing worldwide.39 The Exchange further asserts, in its comment letter, that the Commodity Futures Trading Commission (“CFTC”) has designated bitcoin as a commodity and is “broadly responsible for the integrity” of U.S. bitcoin spot markets.40 The Exchange acknowledges that the CFTC has not yet brought any enforcement actions based on the anti-manipulation provisions of the Commodity Exchange Act, but notes that the CFTC has issued orders against U.S. and non-U.S. bitcoin exchanges for engaging in other activity prohibited by the Commodity Exchange Act. The Exchange’s comment letter states that a regulatory framework for providing oversight and deterring market manipulation therefore currently exists in the U.S.41

Another response went as follows:

…Bitcoin is relatively uncorrelated with other assets, enabling investors to construct more efficient portfolios,43 and that, as a general matter, the underlying market for bitcoin is inherently resistant to manipulation.44 The author of the paper posits that the underlying bitcoin market is not susceptible to manipulation because (a) there is no inside information related to earnings, revenue, corporate actions, or new sources of supply; (b) the asset is not subject to the dissemination of false or misleading information; (c) each bitcoin market is an independent entity, so that a demand for liquidity does not necessarily propagate across other exchanges; (d) a substantial over-the-counter (“OTC”) market provides additional liquidity and absorption of shocks; (e) there is no market-close pricing event to manipulate; (f) the market is not subject to “spoofing” or other high-frequency-trading tactics; (g) order books on exchanges worldwide are publicly visible and available through APIs (application program interfaces); and (h) it is unlikely that any one person could obtain a dominant market share.45 The author also asserts that listing the shares on a national securities exchange and a shift from OTC trading to trading on exchanges would make the overall bitcoin market more transparent.

 There were also public comments deriding the Gemini exchange, directly. While I don’t, personally, care for the Gemini exchange, some of the issues taken with it were impractical. For instance:

• One commenter states that the Gemini Exchange Auction could be an improvement over other bitcoin pricing mechanisms, but asserts that the auction has not improved volume. The commenter claims that the Gemini Exchange has the lowest liquidity of the three exchanges in the United States and is one of the least-liquid of all exchanges that trade bitcoin for U.S. dollars.56 The commenter observes that the auction data show that traders in the auction are taking advantage of the discounted auction price. The commenter notes that the daily two-sided auction process was designed to maximize price discovery and reduce price volatility that could be the result of momentum pricing, but asks what measures have been put in place to address traders who take advantage of the discounted auction price. The commenter also notes that while other financial products sometimes have auctions to determine price, an auction on a stock exchange does not require money to be deposited in advance with the exchange to be in the auction. The commenter notes that, by contrast, the Gemini Exchange requires dollars or bitcoin to be deposited before participation. The commenter believes that this is a problem because the Gemini auction is limited and “warped” and has failed on at least two occasions.

Listen, no market is perfectly efficient, and early markets are likely to be particularly inefficient. That’s one of the main reasons to introduce an ETF, to inject liquidity and efficiency. Even the largest and most efficient market in the world has trade failures, as has been noted by Bloomberg:Failed Trades in 10-Year Treasury Soar as Note Stays `Special’:

The shortage of benchmark 10-year Treasury notes in the market for borrowing and lending U.S. government debt has become so pronounced that uncompleted trades are soaring. Such trades, known as fails, surged into the billions of dollars in recent days for the newest 10-year note, and may have been in the range of $6 billion to $12 billion, according to Treasury market participants familiar with the matter who requested anonymity because the figures aren’t public. While uncompleted trades occur daily, sometimes because of computer glitches, it’s unusual for the level to be so high. There were $132 million in failures for all 10-year Treasuries in the week ended Feb. 24, the latest data from the Federal Reserve Bank of New York show.

 I can go deeper into the SEC declination analysis for insitutional subscribers who may be interested in creating or partipating in an institutional vehicle to access bitcoin exposure. Email me via reggie @ boombustblog.com.