Yesterday’s “crypto crash” has likely forced the SEC to once again reject a bitcoin ETF.  Before the crypto crash, there was momentum gaining in the crypto community that a bitcoin ETF was finally going to be approved.  The main reason for this hope was the crypto background of new SEC Chair Gary Gensler. Crypto hopefuls pointed to the blockchain courses that Mr. Gensler taught at MIT and felt that his crypto knowledge would surely put him in the bitcoin ETF approval camp.

While it’s true that Mr. Gensler is an expert on the blockchain and cryptocurrency markets, it’s also true that he holds investor protection as a top priority. When asked about a bitcoin ETF by Congress at the third Gamestop hearing, Mr. Gensler had this to say:

“It’d be good to consider whether to bring investor protection to the crypto exchanges…And I think if that were the case—because right now the exchanges trading in these crypto assets do not have a regulatory framework, either at the SEC or our sister agency, the Commodity Futures Trading Commission—that could instill greater confidence.” 

“Right now, there’s not a market regulator around these crypto exchanges and thus there’s really no protection around fraud or manipulation.”

That statement alone tells us that it it likely that Mr. Gensler intends to be on the side of previous SEC bitcoin ETF rejections. In these past rejections, the SEC clearly told the ETF sponsors that unless there was a robust, cross-market surveillance system put in place to monitor the underlying exchanges, then they would not approve the ETF filing. Since then, industry groups like the Virtual Commodity Association have formed in hopes of creating a FINRA-like self-regulatory association but these groups still fall short of what the SEC has requested.

Why did crypto crash yesterday?

How could this have happened? Did the bitcoin market makers walk away? Were crypto derivatives the cause? Were there margin calls which forced liquidation of highly leveraged positions? Were HFT proprietary traders playing some of their usual predatory games? We don’t know and we doubt regulators know.  And that is precisely why a bitcoin ETF will not be approved. 

A recent academic paper titled “Decentralized Finance: Regulating Cryptocurrency Exchanges” also questions what is happening on some of these underlying crypto exchanges.  The author comments that “these platforms face many of the risk-management threats that have plagued conventional financial institutions as well as a host of underexplored threats. Automated or algorithmic trading strategies, accelerated high frequency trading tactics, and sophisticated Ocean’s Eleven-style cyberheists leave crypto investors vulnerable to predatory practices.”

What is the case for a bitcoin ETF? 

We took a look at the one of the current ETF filings, the Kryptoin ETF, to find out why they think a bitcoin ETF should be approved.  The sponsor of the Kryptoin ETF filing tries to support their proposal by noting that bitcoin futures now trade actively on major exchanges and they believe that “bitcoin futures lead the bitcoin spot market in price formation”.  The sponsor also notes public companies have even started to hold bitcoin on their balance sheets which further proves bitcoin is a legitimate asset (we think recent tweets by Mr. Musk pretty much negates that position). In addition, the sponsor notes that other benefits of a bitcoin ETF include:

-exposure to bitcoin through the elimination of significant and prolonged premiums and discounts

-significant premium/discount volatility

-the reduction of management fees through meaningful competition

-the avoidance of risks associated with investing in operating companies that are imperfect proxies for bitcoin exposure

-protection from risk associated with custodying spot bitcoin by providing direct

While these are all interesting points, the filing doesn’t address the SEC’s main concern about having a surveillance sharing agreement in place for the underlying spot market exchanges. The SEC has said that “it is essential for an exchange listing a derivative securities product to enter into a surveillance- sharing agreement with markets trading underlying securities for the listing exchange to have the ability to obtain information necessary to detect, investigate, and deter fraud and market manipulation.”

Additionally, the Kryptoin ETF filing actually notes deficiencies at some crypto exchanges which still exist:

“By contrast, an individual retail investor holding bitcoin through a cryptocurrency exchange lacks these protections. Typically, retail exchanges hold most, if not all, retail investors’ bitcoin in “hot” (Internet-connected) storage and do not make any commitments to indemnify retail investors or to observe any particular cybersecurity standard.”

Final Thoughts

While it’s clear to us that the crypto crash has all but killed the current bitcoin ETF filings, there was one very popular money manager, Cathie Wood, that actually thought yesterday’s crash will help the ETF filing:

All we could do was shake our heads at that quote. The mission of the SEC is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. We don’t see how a crypto crash currently fits into this mission statement. Until the proper surveillance measures are put in place, we believe any bitcoin ETF applications will continue to be rejected.