A Significant Shift in the Crypto ETP Landscape
On July 29, 2023, the U.S. Securities and Exchange Commission (SEC) made a groundbreaking decision that could reshape the landscape of exchange-traded products (ETPs) in the cryptocurrency market. The SEC approved orders allowing for in-kind creations and redemptions for Bitcoin and other cryptocurrency ETPs, signaling a reversal of the cash-only requirements that had previously constrained the market. This shift has drawn considerable attention, not only for its immediate implications but also for its potential to streamline operations within the cryptocurrency investment realm.
The SEC’s Formal Statement
The SEC’s formal announcement highlighted that Bitcoin and ether ETPs will now be permitted to conduct transactions on an in-kind basis. This move aligns these instruments with the well-established mechanics traditionally utilized by commodity ETPs, such as those for gold or silver. Paul S. Atkins, the Chair of the SEC, heralded this change as a “new day” for the agency, emphasizing that it would lead to more efficient and less costly operations for crypto ETPs.
Implications for Authorized Participants
Bloomberg Intelligence’s senior ETF analyst, Eric Balchunas, echoed the significance of this policy shift on social media, underscoring the importance of allowing authorized participants (APs) to directly deliver or receive Bitcoin or ether. Previously, under the cash-only model, APs were compelled to purchase the needed cryptocurrencies from the market, often incurring additional costs in the process. Balchunas’s reflections encapsulated a sense of opportunity and relief within the crypto finance community.
Understanding In-Kind Redemptions
Teddy Fusaro, President of Bitwise, provided a detailed breakdown of how in-kind redemptions could alleviate various frictions that arose from the former cash approach. In essence, the cash-creation model required an ETF to buy Bitcoin on the open market whenever it faced inflows. This often came with a price premium, meaning that an ETF would purchase Bitcoin for slightly more than the market benchmark rate. For example, if an ETF paid a 0.02% premium on a $100 million purchase, that could equate to a $20,000 cost. Such expenses do not vanish—they are ultimately passed down to shareholders in the form of higher share prices.
In contrast, with in-kind operations, APs can deliver Bitcoin directly to the ETF, bypassing the cash transaction and the associated premiums. This process not only mitigates costs but also refines the market dynamics for investors.
The Mechanics Behind the Shift
For investors unfamiliar with the intricacies of ETF operations, the mechanisms behind AP activities may appear convoluted. In the primary market, APs create units of the ETF by exchanging Bitcoin for ETF shares. When transactions operate under a cash-only system, APs and the fund are forced to interact with the wider market, further complicating pricing and trade execution.
Fusaro’s technical insights emphasize that in-kind operational flows will help refine the trading process and reduce hidden costs that occur during peak demand for creations and redemptions. Over time, this should narrow spreads and enhance the tracking efficiency of the ETFs concerned.
Broader Regulatory Adjustments
The SEC’s orders included more than just the authorization for in-kind transactions. They unveiled a series of actions designed to promote a level playing field for crypto ETPs. These actions included approvals for listings of ETPs that hold both spot Bitcoin and ether, enhancements to options trading, and requests for comments on new proposals involving large-cap crypto ETPs.
Commissioner Mark T. Uyeda framed these modifications as a necessary correction to previous regulatory frameworks, which had unduly restricted crypto ETPs, in sharp contrast to their commodity counterparts. This alignment could significantly reduce the costs and challenges faced by ETF market-makers and APs, who have long argued for parity with established commodity funds.
Market-Structure Implications
The implications of these changes stretch well beyond theoretical discussions; they have real-world impacts on market structure and investor experience. In-kind mechanisms enable APs to manage Bitcoin inventories across various platforms, such as prime brokers and OTC desks, without requiring the fund to engage in last-minute transactions on the spot market. This capability is especially vital during periods of market volatility.
Moreover, these in-kind processes can help keep ETF prices tethered closely to their net asset value (NAV), thereby enhancing pricing efficiency and shielding investors from unnecessary price fluctuations during tumultuous market conditions.
Operational Adjustments Ahead
It’s essential to note that the speed at which these changes are implemented will vary among issuers. Each firm needs to adapt its operations, AP agreements, and custody systems to accommodate the new in-kind flow structure. However, the regulatory landscape has fundamentally shifted, setting the stage for a more integrated and efficient approach to cryptocurrency ETPs.
As the cryptocurrency market evolves, the SEC’s decision to embrace in-kind transactions marks a pivotal moment, promising a more streamlined and cost-effective avenue for investors looking to participate in this dynamic sector. The market is already responding, with Bitcoin values reflecting renewed investor interest and optimism.
