The Bitcoin ETF Is a Double-Edged Sword

A federal appeals court on Monday finalized its decision to overturn the SEC's previous rejection of Grayscale Investments' application to convert its Grayscale Bitcoin Trust into an exchange-traded fund, or ETF, that tracks the "spot" price of BTC. ETFs can be purchased and traded in traditional brokerage, retirement and institutional investment vehicles, and the ruling has triggered a huge rally in bitcoin and cryptocurrencies as a whole, in anticipation of a wave of new investors.

But the search for a Bitcoin spot ETF has always been controversial among cryptocurrency advocates. While it has many potential benefits for investors and the BTC price, some have argued that it is not true to the spirit of cryptocurrencies as it relies heavily on third-party custody. Even setting aside the spirit of cryptocurrencies, ETF approval has other downsides, among them that the current rally could lead to another unsustainable and ultimately harmful crypto bubble.

Why is a BTC ETF making headlines again?

First, the basics.

Bitcoin (BTC) has soared more than 20% over the past week on growing expectations that the US Securities and Exchange Commission (SEC) will begin approving Bitcoin "spot" ETFs, or exchange-traded funds. bag. These stock-like assets would represent claims on underlying Bitcoin holdings managed by ETF issuers and should therefore closely track the price of BTC. Bitcoin ETFs are legally different from holding BTC directly, allowing investors to effectively purchase bitcoin, albeit indirectly, through conventional brokerage and retirement accounts.

Currently, with some exceptions, investing in bitcoins is more difficult than that. It requires buying and holding through an exchange like Coinbase, which is not allowed for many traditional asset management setups; or trade imperfect bitcoin substitutes, like Michael Saylor's Microstrategy stock, with its vast hoard of BTC. It seems likely that opening more direct and reliable exposure to bitcoin will have significant secular benefits for the BTC price by raising the base level of demand.

The ETF is on the table now because, after years of the SEC rejecting bitcoin ETF applications, a recent court decision appears to have forced the agency's hand. The decision depended on SEC approval of a bitcoin futures ETF in 2021, when Chairman Gensler argued that the futures market had more built-in protections for investors than the spot market. This was always a strange argument, as bitcoin futures, prior to the approval of the futures ETF, were traded in large volumes on lightly regulated international crypto exchanges.

In August, a court rejected Gensler's distinction and ruled that the SEC had been “arbitrary and capricious” by failing to explain why the futures and spot markets for the same assets were so profoundly different that it had approved an ETF and not the other. That ruling was confirmed in a court order yesterday which officially returned the decision to the SEC for review.

While nothing is guaranteed, observers, including Nic Carter of Castle Island Ventures, have estimated a two- to four-month window for the approval and launch of at least some of the pending ETFs. The price of Bitcoin has skyrocketed in anticipation of that approval.

The benefits of a Bitcoin ETF

The likely increase in BTC demand is the most obvious benefit of the approval of a spot ETF, although this is only a "benefit" for current holders, and not necessarily for the system, which we will discuss later. The official approval of one or more ETFs is likely to be a “sell the news” moment that results in a short-term rise in the price of BTC that quickly stabilizes.

But diamond supporters will also likely benefit from long-term advantages, not least because ETF approval will turn major institutions into bitcoin traders. That already happened with Larry Fink from Blackrock. Fink may actually think Bitcoin is the same “the value of human freedom” but you will be even more motivated to be bullish when you are actively collecting fees from Bitcoin ETF buyers.

More substantially, the creation of Bitcoin ETFs can help undermine the repeated frauds that the crypto industry has suffered. Over the years, huge amounts of Bitcoin on exchanges like Quadriga and FTX have simply disappeared when those custodians proved untrustworthy, a phenomenon that has raised fears of large amounts of "paper bitcoins" that are not actually backed by something real on the chain. Regulated options managed by genuinely reputable entities like Blackrock could starve more sketchy trades, greatly reducing fraud. That could trigger a long-term "meltdown" in the perception of the legitimacy of bitcoin and cryptocurrencies in general.

Other benefits of ETFs are a little more abstract. On the one hand, the court ruling against the SEC looks bad for Gary Gensler, who despite initial hopes when he took office has proven not only hostile to cryptocurrencies, but also scattered and often seemingly ill-informed in his opposition. The most dramatic example of this, of course, is his acceptance of alleged fraudster Sam Bankman-Fried as an authority on crypto regulation, a topic the SEC has remained silent on.

Finally, while there is no denying that any third-party custodian represents a commitment to Bitcoin's ideals, it is consistent with how some advocates have often framed BTC over the years: as "digital gold" and " a store of value." While many “gold fans” like to have physical gold on hand, it is not at all unusual to have a gold ETF instead of real gold. There would be nothing inherently wrong with Bitcoin having the same two-tier market structure.

Bitcoin ETF Risks

For all its potential benefits, approving a Bitcoin spot ETF has real disadvantages, and they are often almost the same as the advantages.

Most obviously, while current holders will certainly enjoy it, price appreciation is not unequivocally good for the cryptocurrency ecosystem as a whole. I've been reporting on cryptocurrencies for over a decade (OMG), and these things have had a generally predictable dynamic. The rise in the price of bitcoin, for both sentimental and technical reasons, drives up the prices of other cryptocurrencies, including riskier assets. I can already foresee the ETF becoming a catalyst for an unsustainable crypto bubble, either very soon or once it is approved; again, a possible reason to sell the news.

While the safer and more reliable nature of regulated ETFs could alone avoid the worst impacts of such a bubble, these moments have undeniable negative effects. Cryptocurrency price appreciation almost inevitably attracts new waves of fraud and even crime, as the growing pie becomes more attractive to bad actors. Even nominally well-intentioned projects launched to capitalize on cryptocurrency bull markets can often be hastily conceived and ultimately fragile.

It is also not impossible that, although more reliable on their own, ETFs actually increase the overall volatility of the crypto market in some way. While many Bitcoin ETF shares are likely to be inherently long-term holdings, they will also be actively traded and, given the likely scale of institutional participation, could become accelerators, rather than brakes, of major news stories in the future. crypto market.

This is for both technical and social reasons: currently, most of the true large-scale bitcoin holders, like MicroStrategy, are sort of true believers with a developed thesis of long-term Bitcoin growth. The ETF will be in the hands of many less committed investors. That means more bitcoins will be available to liquidate almost instantly during times of market uncertainty.

Furthermore, while broadly aligning with the “digital gold” thesis for Bitcoin, ETFs could expose a weakness of that thesis: that Bitcoin as a “store of value” may ultimately depend on its daily use as a transactional medium. . How real, widespread and persistent that usage is has become blindingly obvious during the (now concluded?) bear market, as trading volumes in BTC remained in a range of about Between 1,000 and 3,000 million dollars a day.

Those volumes ultimately generate fees for bitcoin, supporting the hash power and security of the chain. If, instead, everyone simply parked their bitcoins in an ETF, Bitcoin itself could be threatened.

This clearly leads to ideological objections to an ETF. After all, Bitcoin is supposed to be about financial autonomy, eliminating middlemen, and, in practical terms, self-custody. Buying a bitcoin ETF share doesn't require knowing how to use a bitcoin wallet, or even a basic understanding of how the system works. This reality also has a financial cost: Bitcoin does not generate native returns, so if you pay an ETF to manage your coins, you are completely reliant on price appreciation to generate returns, and these must exceed any fees you are paying.

A pessimist would say that's detrimental to Bitcoin's stated goals and the long-term health of the system, as it reduces overall participation in an open source project that ultimately depends on the wisdom of the crowd. However, there is also a counterargument: that Bitcoin ETFs will become something of the shallow end of the cryptocurrency pool, an easy first step that ultimately leads down the rabbit hole.

On that question, only time will tell.