In December last year the NYSE Arca Inc. filed a proposed rule change that would allow for the creation of Exchange Traded Funds investing in Bitcoin futures contracts, and, potentially, in other related Financial Instruments.

In January 2018 the U.S. Securities and Exchange Commission extended its review of this proposal. Also that month the director of the SEC’s Division of Investment Management outlined her concerns with the idea. These include valuation, liquidity, and transparency.

Most recently, on March 23, the SEC instituted a formal review of the proposal, soliciting comments from the public. Commenters have until April 19 to submit. Those who wish to rebut comments will have until May 3 to do so. The order is available here.

The investment objective of the proposed ProShares Bitcoin ETF will be to seek results that will mirror the performance of lead month bitcoin futures contracts listed and traded on either the CBOE Futures Exchange or the Chicago Mercantile Exchange’s Benchmark Futures Contract.

Comment Letters, and a Novelist

Before issuing the order the SEC had received one comment letter on the subject. This was from Abe Kohen of AK Financial Engineering Consultants LLC (December 27, 2017). It was a brief negative statement. Kohen called the idea of such an ETF a “house of cards” and said that “now mom and dad can lose money going long and short.”

Subsequent to the SEC’s request, three new comments were received on April 6. The most substantive of them is from Anita Desai, who writes that she believes such proposals are premature, since cryptocurrencies “are in their infancies with regard to the widespread understanding of even the fundamentals of what they are, which is a dangerous thing.”

Ms Desai doesn’t identify herself in the comment by any title or institutional affiliation, but there is a well-known Indian novelist of that name who teaches humanities at the Massachusetts Institute of Technology. The SEC’s commenter says, “A lot of people I personally knew lost their entire savings in places like India and Africa, when they drew their entire mutual funds out and plugged cash into ‘Ponzi’ schemes such as ‘Onecoin.’”

Ed Kaleda, of Charlotte, North Carolina, takes a more laissez-faire view. He asks the SEC to “please be open-minded and approve high quality Bitcoin ETFs, a new generation wants the product.”  

The third commenter of that day, Scott Moburg, also says that he supports a Bitcoin ETF.

The SEC’s Questions

The SEC’s order lists twelve questions that are especially on its mind, and on which it seeks some illumination from commenters,. The questions, somewhat abbreviated and paraphrased,  are as follows:

1. Has the exchange (NYSE Arca) sufficiently described “how the Sponsors will select the applicable Benchmark Futures Contract, given that the contracts trading on these these two bitcoin futures exchanges have different terms  … and trade at different prices?”
2. The second concern begins with the aspect of the proposed rule that stipulates that the Funds may invest in other financial instruments such as listed options and OTC swaps referencing Bitcoin Futures Contracts. The SEC asks, “What are commenters’ views on the ability of the Funds to invest in Financial Instruments in the event that position, price, or accountability limits are reached with respect to Bitcoin Futures Contracts? What are commenters’ views on the ability of the Funds to invest in Financial Instruments if the market for a specific Bitcoin Futures Contract experiences emergencies or disruptions?”
3. Would the Funds have the information necessary to adequately value the underlyings when determining an appropriate end-of-day NAV?
4. How great is the potential impact of manipulation of the underlying markets on the proposed ETF’s NAV? Specifically, the SEC wants commenters to weigh in on the potential impact of such manipulation on the financial instruments discussed in question two above.
5. How could the Funds’ valuation processes address the issue of a potential blockchain fork?
6. “What are commenters views on the price differentials and trading volumes across bitcoin trading platforms (including during periods of market stress) and on the extent to which these differing prices may affect the trading” both of the contracts and of the shares in the ETF?
7. The SEC asks about margin requirements and how might they affect the Funds’ ability to use available cash to achieve its trading strategy?
8. Also about whether the Funds development would lead to an excess concentration of holdings, that would in turn impact portfolio management, the liquidity of the Funds involved, and the pricing of the underlying contracts or the Financial Instruments?
9. What possible factors might impede the ability of arbitrage to keep the Funds’ NAV tied to the trading price of the shares? What is the impact on investors if the arb mechanism is impaired?
10. What is the likely impact of manipulation and fraud in the underlying trading platforms upon trading in the ETFs?
11. How may investors evaluate the price of shares in the Funds in light of the concerns alluded to above about arb and manipulation?
12. Finally, do the two bitcoin futures exchanges constitute a market of sufficient size to support an ETF?