Bitcoin Spot ETFs: Why SEC Is Reluctant on Crypto

The US Securities and Exchange Commission (SEC) has so far rejected all the applications for Bitcoin spot ETFs submitted in the past by various investment funds. However, right now, the SEC is dealing with an unprecedented rush of new Bitcoin spot ETF submissions. Close to 10 traditional and crypto-focused fund managers, including the likes of Fidelity and BlackRock, have filed (or re-filed after past unsuccessful attempts) their submissions for a Bitcoin spot ETF approval. Given the massive tide of submissions, many observers believe that the SEC now has nowhere to hide and will need to either approve the first US Bitcoin spot ETFs or find some credible reasons to roundly reject the submissions.

The SEC’s stubborn position on Bitcoin (or in general crypto) ETFs looks unreasonable. However, there are concerns and nuances related to crypto that might provide at least some explanation for the regulator’s typical attitude towards this asset class. In this article, we review the major points of concern related crypto as a financial asset.

1. Custody Concerns

Custody of funds is a significant challenge in the cryptocurrency world. As cryptocurrencies are digital and exist solely on blockchain networks, secure storage and management of the underlying Bitcoin assets are essential. The SEC requires robust custody solutions that inspire confidence in investors and ensure the safety of their funds.

Some businesses, primarily centralised exchanges, keep some portion of crypto funds within their own systems and only transfer the assets to the underlying blockchain periodically. However, reputable exchanges nearly always maintain significant crypto reserves on a blockchain to ensure transparency and alleviate customer concerns.

Most importantly, the business model of crypto exchanges ensures an active flow of funds between their own systems and an underlying blockchain. The situation is different for the investment funds that offer Bitcoin-based products. They need a storage environment that is long-term, accountable, verifiable, and secure. The SEC has serious doubts that blockchain networks satisfy these requirements.

Additionally, the challenge lies in achieving a delicate balance between secure custodianship and accessibility. While stringent security measures are essential, they should not hinder the fund's efficient operations or delay withdrawals. ETF providers must demonstrate the ability to promptly process redemption requests while maintaining the highest levels of security.

2. Security Risks

The broader security landscape of the cryptocurrency market is a key concern for the SEC. Cybersecurity threats, including hacking attempts on blockchains and vulnerabilities in digital wallets, pose risks to investors' assets and sensitive information. Addressing security risks is vital to instill investor confidence and protect against potential vulnerabilities in the crypto ecosystem. ETF applicants must demonstrate robust security protocols. Here in lies the problem – no investment fund manager can vouch for the security of the Bitcoin blockchain or any other blockchain out there.

3. Market Manipulation

Market manipulation is a pressing concern within the cryptocurrency space. The decentralised and less regulated nature of the market creates opportunities for bad actors to engage in price manipulation, pump-and-dump schemes, and other fraudulent activities.

The challenge in combating market manipulation lies in identifying suspicious activities within a decentralised and pseudonymous environment. Traditional methods used in regulated markets may not be directly applicable to cryptocurrencies.

4. Volatility and Investor Protection

The significant price volatility of Bitcoin and other cryptos exposes investors to significant risks, especially in an ETF structure that allows easy access to the asset class.

While hedge funds and hardcore derivative traders might be accustomed to extreme price volatility in the products they use, these categories of investors aren’t the classical ETF customers. Many retail investors use ETF products, and the concern is that the volatility of crypto might expose countless less sophisticated investors to risk levels they wouldn’t normally expect from an ETF product.

5. Liquidity Considerations

Sufficient liquidity in the underlying Bitcoin market is crucial for the efficient functioning of an ETF. The SEC requires assurance that the market can support efficient ETF creation and redemption.

Unfortunately, the cryptocurrency market, even for Bitcoin, has liquidity levels that are considerably lower than those prevalent in the stock market. Most of that liquidity comes from centralised exchanges, whom the SEC (often rightfully) views with a degree of suspicion. Do we have to mention Sam Bankman-Fried and FTX again?

6. Anonymous Crypto Whales

The presence of large and anonymous holders (whales) in the cryptocurrency market raises concerns about their true identities. The largest Bitcoin owner in the world is the anonymous, and likely non-existent, Satoshi Nakamoto. “He” owns about 1.1 million BTC (valued currently at over $30 billion) spread over 22,000 Bitcoin addresses.

Who really owns that massive pile of money? Is it a single person or a group of people. Are any of them affiliated with groups involved in dubious activities? The SEC might want answers to these questions given that Nakamoto-san is in possession of 5% of all Bitcoin in circulation. Approving an ETF whose underlying asset raises so many questions might indeed be a brave move by the SEC.

The factors above all contribute to the SEC’s reluctant stance on Bitcoin ETFs. Some of these issues are serious and provide insight into why the SEC might have earned the reputation of an ardent crypto hater. However, the good news for crypto investors and enthusiasts is that the approval of the first US Bitcoin spot ETFs is nevertheless highly likely, at least by the estimates of some industry analysts.

Perhaps the powers that be at the regulator’s office are starting to realise that many of the concerns about crypto aren’t exclusive to this asset class. The stock market has more than enough issues related to excessive volatility, market manipulation, security breaches, or domination by powerful, even if not anonymous, whales. This hasn’t forced the SEC to shut down the stock market or banish traditional ETFs. At the end of the day, Satoshi Nakamoto, whoever he really is, might be at least as nice as George Soros.