Author: Zou Chuanwei, Chief Economist of Wanxiang Blockchain

As a compliant bitcoin financial product that can reach general investors,Bitcoin ETFsHas been very concerned. Especially in the past period of ups and downs in the encrypted asset market, the shortcomings of other types of compliant bitcoin financial products have highlighted the advantages of bitcoin ETFs. However, after Canada approved multiple Bitcoin ETFs this year (the first is the Purpose Bitcoin ETF, which is listed on the Toronto Stock Exchange in Canada), the US SEC has recently postponed the decision on multiple Bitcoin ETF applications, including WisdomTree(until July 14),Kryptoin (until July 27),Valkyrie(until August 10) andVanEck(Under public comment).

Through Bitcoin ETF, ordinary investors can (indirectly) participate in Bitcoin investment in mainstream stock exchanges without managing private keys, with low fees and high transparency, and do not have to worry about compliance issues such as financial supervision and taxation.Bitcoin ETF is an important sign of mass investment. Because of this, the US SEC has adopted a more cautious attitude towards Bitcoin ETFs—this can be seen from the relevant statements of the US SEC.

Some concerns of the US SEC are very helpful for understanding the next development of the encrypted asset market.

This article is divided into three parts:

• The first part is aboutA General Introduction to ETFs, as a reference for understanding Bitcoin ETF;

• Part Two DiscussionTwo main design schemes of Bitcoin ETF and related difficulties

• The third part combingSeveral Obstacles to US SEC Approval of Bitcoin ETF。

What are ETFs?

ETFs asindexing investment tool, is the most successful financial innovation product in the global financial market after the international financial crisis. By the end of 2020, there were 7,527 ETFs listed and traded globally, with total assets exceeding$7.9 trillion, of which stock ETFs accounted for nearly 3/4, bond ETFs accounted for 19%, and commodity ETFs accounted for 3.4%.

The United States is not only the birthplace of ETF, but also the largest ETF market in the world. The US market is far ahead of other markets in terms of product quantity and asset size. At the end of 2020, the U.S. ETF market had assets of$5.49 trillion, accounting for global market share69.5%。

The establishment basis of the US ETF is "Investment Company Act of 1940", but the ETF's operating mechanism has many conflicts with the Act, such as physical subscription and redemption, only authorized participants (APs) are allowed to participate in subscription and redemption, and ordinary investors can only participate in transactions. Therefore, the issuance of each ETF requires a separate application to the US SEC for exemption.

In September 2019, the US Securities Regulatory Commission issued new ETF regulations (Rule 6c-11), which is the first systematic regulation for ETFs since the birth of ETFs. After the new regulations come into effect in November 2019 (the transition period is one year), general ETFs can be established by reporting to the US SEC, and there is no need to apply for a separate exemption order, which greatly simplifies the ETF creation process.

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(This picture is quoted from: Yu Zhaowei, 2019, "The Enlightenment of the Global ETF Development Wave to my country", "Tsinghua Financial Review", July 2019.)

APs can beMarket makers, professional institutions or other large financial institutions, designated by the ETF issuer, can change the supply of ETF shares in the market through physical subscription and redemption.

When an ETF issuer wants to expand the product scale, it will ask AP to buy the constituent securities of this ETF in the market according to the allocation weight, and deliver these securities to the ETF issuer. In exchange, the ETF issuer gives AP shares of an ETF of equal value, referenced to the ETF's net value (NAV). APs can then resell the ETF shares at a profit. This process can also be reversed: the AP redeems the basket of constituent securities from the ETF issuer, removing the ETF shares from the market.

The ability of AP to purchase and redeem ETF shares and the arbitrage mechanism make the market price of ETF approach the net value. When the ETF has a premium, the AP buys the underlying securities in the market to purchase shares from the ETF issuer; when the ETF discount occurs, the AP redeems the shares from the ETF issuer and sells the obtained underlying securities in the market.

Generally speaking, the more APs, the more likely competition between them will make the ETF market price close toFair value. This is one of the important features that distinguish ETFs from closed-end funds. For closed-end funds, no one can redeem shares. Because there is no arbitrage mechanism to adjust supply and demand, closed-end funds often trade at large premiums or discounts.

In the US, individual investors can buy and sell ETFs directly from brokerage accounts such as Charles Schwab and Merrill Lynch. ETF share transfers are similar to stocks. The intraday reference value is announced every 15 seconds, and the ETF share value is announced every day. It can be traded at any time when the market is open, and supports multiple buying and selling, short selling, and margin purchases on the same day. In contrast, regular mutual funds (ETFs can be considered a special class of mutual funds) can only be traded once a day (after the market is closed).

In summary, ETFs in general can be understood from the following points (these points are also the key to understanding Bitcoin ETFs):

• Portfolio characteristics: investment benchmarks, investment strategies;

• Features of the primary market: AP, share purchase and redemption mechanism, arbitrage mechanism;

Secondary market characteristics: investor groups, trading venues, trading methods, and price characteristics.

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Comparison with Grayscale Bitcoin Trust

To understand the significance of Bitcoin ETF, it is best to first communicate with the world's largest Bitcoin financial product——Grayscale Bitcoin TrustFor comparison.

The key features of Grayscale Bitcoin Trust are as follows:

• Asset Portfolio Characteristics: Directly hold Bitcoin, through holdingofof Genesis buy bitcoin byCoinbase Custody hosted.

• Features of the primary market: the trust share is GBTC, and each bitcoin corresponds to about 1,000 shares of GBTC; qualified investors can purchase GBTC with bitcoin or cash, but cannot redeem GBTC.

• Secondary market characteristics: GBTC has6 month lock-up period, OTCQX transactions in the over-the-counter market, ordinary investors can also participate; GBTC used to be at a premium to Bitcoin, but now it is at a discount.

first,

• first,GBTC cannot be redeemed, making the arbitrage mechanism unsmooth, the price of GBTC deviates from Bitcoin for a long time, and there is no inherent convergence power, so that investors cannot obtain good exposure to Bitcoin.

• Secondly, GBTC can only be traded in the over-the-counter market OTCQX,restricted mobility。

Therefore, a Bitcoin ETF has two key objectives: one is toBy perfecting the arbitrage mechanism, to better track the price trend of Bitcoin; the second isExpand secondary market investor groupssecondary title

Bitcoin ETF Based on Bitcoin Spot

Reference reading:

Reference reading:

《SECURITIES AND EXCHANGE COMMISSION 》https://www.sec.gov/rules/sro/cboebzx/2021/34-92196.pdf 

《UNITED STATES SECURITIES AND EXCHANGE COMMISSION》

3B2 EDGAR HTML -- c100811_s1.htm (sec.gov)

• Portfolio characteristics: Legally, the Bitcoin ETF is actually a commodity-based trust share (Bitcoin belongs to the category of commodities in the United States), and will directly hold Bitcoin and entrust it to a third-party custodian. This Bitcoin ETF generally does not hold cash or cash equivalents and invests against the MVIS ® CryptoCompare Bitcoin Benchmark Index less trust operating fees. This Bitcoin benchmark index combines Bitcoin prices on Bitstamp, Coinbase, Gemini, iBit and Kraken.

• Primary Market Features: The Bitcoin ETF will introduce Authorized Participants (AP). AP purchases and redeems trust shares through bitcoin transactions with bitcoin ETF issuers. Obviously, the purchase and redemption of trust shares is accompanied by the movement of bitcoins between the wallets of AP and ETF issuers, and these movements occur on the bitcoin blockchain. In this way, an arbitrage mechanism between trust shares and Bitcoin spot is established.

• Secondary Market Features: The trust share plan is listed on the Cboe BZX Exchange (formerly BATS, a non-traditional exchange with very high trading volume). During trading hours, the NAV of trust shares will be updated every 15 seconds.

secondary title

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Reference reading:

《UNITED STATES SECURITIES AND EXCHANGE COMMISSION》

https://www.sec.gov/Archives/edgar/data/1838028/000093041320002664/c100811_s1.htm

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The goal of this ETF is to make theThe ETF's total exposure to Bitcoin is approximately equal to the ETF's NAVtext

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To sum up, the ETF scheme does not involve the custody and wallet operations involved in Bitcoin, and is essentially closer tocommodity mutual fund: Obtain risk exposure through futures, and the main assets are invested in financial products with low risk and high liquidity, which are also used as futures margin. This mainly creates the following risks:

• Bitcoin futures deviate from the spot price (which is the norm until the futures expire). After the Bitcoin futures expire, it needs to be continued (Rollover), and there will be additional risks.

• The risk of poor leverage ratio control.

• The risk of poor leverage ratio control.

• When the encrypted asset market fluctuates violently, Bitcoin futures may suspend trading, based on the price of Bitcoin futures

It is more difficult for Bitcoin ETFs to track Bitcoin price movements. Canada HorizonsThis happened to the Bitcoin ETF on May 21, 2021.

The overall effect is that changes in the ETF's NAV can deviate significantly from Bitcoin's price action, and there is no arbitrage mechanism for the two to converge.

Hurdles Facing US SEC Approval of Bitcoin ETF

By combing the US SEC's statement on May 11, 2021 and the statement on June 16VanEck Bitcoin ETFReference reading:

Reference reading:

《Staff Statement on Funds Registered Under the Investment Company Act Investing in the Bitcoin Futures Market》 

https://www.sec.gov/news/public-statement/staff-statement-investing-bitcoin-futures-market

Bitcoin ETF Based on Bitcoin Spot

• Liquidity, transparency, and potential for manipulation (e.g. Elon Musk tweets) in the Bitcoin spot market.

• Possibility of manipulation of ETF shares, and exchange precautions.

• Whether listings of ETF shares meet the requirements of the Securities Exchange Act of 1934.

• secondary title

Bitcoin ETFs Based on Bitcoin Futures

• The liquidity and depth of the Bitcoin futures market, and whether it is suitable for mutual fund investment.

• Whether the mutual fund can liquidate the bitcoin futures position when faced with investor redemption, and the mutual fund's derivatives risk management and leverage management capabilities.

• The impact of mutual fund participation in the bitcoin futures market on futures pricing, and the impact of volatility in the bitcoin spot market on futures pricing.

• The liquidity management capabilities of mutual funds under normal market conditions and stress scenarios, whether they can meet the requirements of open-end funds (closed-end funds have lower requirements for liquidity management capabilities), and whether there are concentrated and large positions, etc.

• The potential for fraud or manipulation in the bitcoin spot market and the implications for the bitcoin futures market.

Based on an analysis of mutual funds investing in Bitcoin futures,US SEC to Evaluate Bitcoin Futures Market to Support ETF, because the ETFGreater challenges in liquidity management。

Overall, some barriers will tend to disappear over time and as the market evolves. However, the basic tendency of the current Democratic Party policy in the United States is to strengthen supervision, which adds to the approval of Bitcoin ETF.political uncertainty。