What is the real impact of launching a spot Bitcoin ETF using cash creation methods?

Author: David Weisberger, Bitcoin Magazine; Compiled by: Songxue, Golden Finance

The SEC has been very busy, meeting with all potential issuers of spot Bitcoin ETFs with valid applications in December. These meetings have resulted in theseissuers generally adopting a method of cash creation rather than the “in-kind” transfer typically employed by other ETFs. There’s a lot to be said for this change, ranging from the ridiculous to the serious. Overall, however, the impact on investors will be minimal, relatively significant to issuers, and overall damaging to the SEC's image.

To provide background, it is important to describe the basic structure of an exchange-traded fund (ETF). ETF issuers work with a group of authorized participants (APs) who have the ability to exchange a predetermined number of fund assets (stocks, bonds, commodities, etc.) or a predetermined amount of cash, or a combination of both, for a fixed number of ETF shares. Cooperation is carried out, the fee is predetermined. In this case,if "physical" creation was allowed, a fairly typical unit of creation would be 100 Bitcoins in exchange for 100,000 ETF shares. However, with cash creation, the issuer will be required to acquire the amount of cash in real time as the price of Bitcoin changes, in this case 100 Bitcoins. (They must also publish in real time the amount of cash that 100,000 ETF shares can be exchanged for.) The issuer is then responsible for purchasing those 100 Bitcoins to bring the fund into compliance with its covenants, or selling those 100 in the event of a redemption Bitcoin.

This mechanism applies to all exchange-traded funds, and as can be seen, this means that claiming cash creation means that the fund will not be backed by 100% Bitcoin holdings The statement is wrong. After creation, there may be a very short delay before the issuer has purchased the required Bitcoins, but the longer the delay, the greater the risk the issuer takes. If they need to pay a higher price than the quoted price, the fund will have a negative cash balance, which will reduce the fund's net asset value. This will of course impact its performance, and given how many issuers are competingit could hurt an issuer's ability to grow its assets. On the other hand, if the issuer is able to purchase Bitcoin for less cash than the AP deposits, then the fund will have a positive cash balance, which may improve the fund's performance.

Thus, it can be speculated thatissuers will have an incentive to quote cash prices higher than Bitcoin’s actual trading price (for the same reason redemption prices are lower) . The problem is that the greater the difference between the cash amounts, the greater the difference the AP may quote when buying and selling ETF shares in the market. Most ETFs trade with very tight spreads, butthis mechanism likely means that some Bitcoin ETFs may have wider spreads than others, and overall spreads may be wider than they would have been if they were created using "physical" means.

Accordingly,issuers must balance the goal of maintaining a small spread between quoted cash amounts with the ability to transact at that quoted amount or better. However, to achieve this goal, advanced technology is required. The difference between a quote for 100 Bitcoins based on liquidity on Coinbase and a strategy using 4 exchanges regulated in the United States (Coinbase, Kraken, Bitstamp and Paxos) can serve as an example. This example uses the CoinRoutes Cost Calculator (available via the API), which displays the cost of trading for a single exchange or any custom group of exchanges based on full order book data held in memory.

In this example we see total purchases on Coinbase only The price will be $4,416,604.69, while the purchase price on these 4 exchanges will be $4,402,623.42, which is $13,981.27 more expensive. This equates to paying 0.32% more to purchase the same 100,000 shares in this example. This example also shows the technical hurdles faced by issuers, as the calculation requires traversing 206 individual market/price level combinations. There is a greater degree of fragmentation than Bitcoin, so most traditional financial systems do not need to look beyond a few price levels.

It is worth noting that it is unlikely that the major issuers will choose to trade on a single exchange, but it is possible that some will do so, or choose to trade with market makers who will charge them additional spreads OTC transactions. Some may choose to use algorithmic trading providers such as CoinRoutes or our competitors who are able to trade at lower than average quote spreads. Whatever they choose, we don't expect all issuers to approach it the same way, which means there can be considerable variation in pricing and costs betweenissuers.

Those with advanced trading technology will be able to offer tighter spreads and superior performance.

So,why is the SEC effectively mandating the use of cash creation/redemptions, given all the hardship the issuer will endure? Unfortunately, the answer is simple: AP (Authorized Participants), according to regulations, are brokers regulated by SROs such as SEC and FINRA. However,so far, the SEC has not approved regulated broker-dealers to directly trade spot Bitcoin, which they would be required to do if the process were to be “physically delivered.” This explanation is much simpler than the various conspiracy theories I hear that don’t need to be repeated.

Overall, spot ETFs would be a big step for the Bitcoin industry, but it’s the details that matter. Investors should study the mechanics of each issuer's selection of quotes and the deal creation and redemption process to predict which one is likely to perform best. There are other concerns, including the escrow process and fees, but ignoring how they plan to trade can be a costly decision.