Notable bitcoin investors Tyler and Cameron Winklevoss made headlines last week when they filed an initial registration for a bitcoin ETF. Each of the one million initial shares would represent 0.2 BTC, or a total of approximately $15 million of net asset value at current BTC exchange rates.
The planned ETF has been the subject of heavy criticism since the filing, but nearly all of the objections have been related to investing in bitcoin as an asset class, rather than the new instrument introduced by the Winklevoss Bitcoin Trust. Upon deeper analysis, it’s clear that a financial product like the one described actually has the potential to address a number of known market gaps, both for potential investors and the market as a whole.
Exchange-traded funds have become an integral part of the financial markets over the past 20 years because they allow investors to gain exposure to markets that may otherwise be unavailable. ETFs have been popular, for example, with those looking to invest in indexes or commodities, since such positions would historically require a trader to manage hundreds of positions or potentially accept physical delivery of gold, oil, etc.
Similarly, a bitcoin ETF would remove one of the most significant barriers to participation currently in the bitcoin market: access. If an investor today decides they want to take a position in bitcoin, they have to overcome the hurdle of funding an exchange account, which could require sending wire transfers and/or personal information to unfamiliar or overseas entities. An ETF makes entering and exiting a position in bitcoin as easy as any other trade from the comfort of a traditional brokerage account.
In addition to eliminating the hassles and uncertainties required to gain bitcoin exposure, an SEC-registered product could open investment to a world of important players who are currently unable to participate because of investment mandates.
When raising capital for a fund or planning the investment arm of an existing entity, nearly all fund managers are responsible for outlining a series of investment criteria to ensure the fund matches the risk profile and other interests of the fund’s stakeholders. These criteria could dictate acceptable asset classes, minimum credit ratings, allocation caps, etc. SEC registration is one of the most common of these criteria for large, institutional funds.
Most institutional players will likely still have qualms about market size, liquidity, regulations and a host of other issues, but having an SEC-registered vehicle opens the market to many of those players, should they choose to participate.
Current bitcoin enthusiasts love extolling the new frontier of wealth management where every person can be their own bank, safely storing their money with a few common security measures. As wonderful as that may be to some, is is simply not an attractive option for potential investors unwilling to dedicate the time and cost required to safely store large amounts of BTC.
Stefan Thomas, long-time bitcoin enthusiast and current Senior Developer at Ripple, recounted his experience losing $200,000 worth of bitcoin to the audience at the Bitcoin London last week. If the lead of Ripple’s development team is subject to a mistake like that, how confident should an investor be? A fund manager’s time is best spent focusing on investment strategies, leaving storage and other technical issues to those better equipped to handle them.
Repeated frequently so far during the discourse around the bitcoin ETF are points made about the costs associated with management fees. These arguments are based largely on a misunderstanding of current bitcoin enthusiasts and the next wave of investors.
While there are companies like Coinbase or BitInstant who sell bitcoins directly to end users, the amount a customer can purchase through these means is limited to approximately $1,000 per day. To obtain a larger position in bitcoin, one generally has to fund an exchange account. Sending fiat to a major exchange can cost 1-5% for a US resident after fees to payment processors and the exchange itself. With similar costs to return fiat back to an investor’s bank account, a few percent in fees (exact Sponsor’s Fee to be determined in later filings) becomes a reasonable substitute, particularly when adding additional value like safe storage and liquidity.
One of the most common features in articles about the proposed bitcoin ETF is the list of risks associated with an investment in this new financial instrument. For example, Abby Woodham from Morningstar writes,
“Indeed, one of the many risks listed in the proposed trust’s paperwork is the irreversible loss of the trust’s assets should a security breach occur. Considering bitcoins’ security track record, this risk is not insignificant.”
In addition to the factual inaccuracy of Ms. Woodham’s insinuations about bitcoin’s security history, she levies undue scrutiny for the potential loss of the underlying asset, a commonly-listed ETF risk factor. For context, the following is an excerpt from the SPDR Gold Trust (GLD), one of the top five largest ETFs with nearly $40B in AUM:
“There is a risk that part or all of the Trust’s gold could be lost, damaged or stolen. Access to the Trust’s gold could also be restricted by natural events (such as an earthquake) or human actions (such as a terrorist attack).”
Morningstar is not the only one to pull listed risks from the filing and describe them for the public without context. Mark Gongloff of the Huffington Post, for example, explained the following:
“A hacker or evil robot could grab control of more than half the processing power on the Bitcoin Network, the global system for producing and distributing bitcoins, which might adversely impact your investment just a touch.”
The most significant part of the risk Mr. Gongloff is describing, whether he knows it or not, is the possibility of a malicious double-spend – the bitcoin equivalent of counterfeiting. Once again we can look to the S-1 for GLD to see the same risk category explained in more familiar terms:
“The gold bullion allocated to the Trust by the Custodian in connection with the creation of Shares may be of a fineness or weight different from that reported to the Custodian or required by the Trust. If the Trustee nevertheless delivers the Shares, the Trust may suffer a loss.”
While still early in the process, important questions around the implementation of the ETF remain largely unanswered. As much as ETF participants may want exposure to an asset, educated investors will also consider their ability to exit a position before making a purchase.
Generally that liquidity will be provided by a market maker – a party that maintains both bids and offers in a security. This role ensures other participants can enter and exit a security easily, while also offering profit between the bid and offer prices as a profit to the market maker.
Tyler Winklevoss explained to the WSJ that he expects this role to be filled by “the usual suspects of banks, broker dealers and market makers.” With $15 million in assets under management in the ETF, it is highly unlikely to be worth the time of banks or any major broker dealer, but that does leave a window for smaller players to step in to fill the role.
On an ancillary note, the Winklevoss twins veered somewhat from the standard practice of most established VCs with this filing, given that a bitcoin ETF would compete directly with one of their portfolio companies.
In May, BitInstant raised $1.5 million in a round led by Winklevoss Capital. BitInstant addresses a market need of making bitcoins easier to access. To the extent any of BitInstant’s potential customers want to obtain bitcoin solely for investment purposes, the ETF described would likely cannibalize some of that business.
Regardless of your view on bitcoin as an investment, the product proposed by Tyler and Cameron Winklevoss would give a new world of potential investors the ability to make that decision for themselves – exactly as an ETF is intended to do.