The real implications of creating cash instead of in kind




The SEC has been busy meeting with all potential Bitcoin spot ETF issuers with active applications in December. These meetings have resulted in the universal adoption of a cash creation methodology by those issuers rather than “in-kind” transfers, as is typical of other ETFs. Much has been said about this change, from the absurd to the serious. However, the TLDR has minimal overall impact for investors, relatively significant impact for issuers, and does not reflect well on the SEC overall. To provide context, it is important to describe the basic structure of exchange-traded funds. All ETF issuers interact with a group of authorized participants (APs) who have the ability to exchange a predefined amount of the fund’s assets (stocks, bonds, commodities, etc.) or a defined amount of cash or a combination of both, for a fixed number of ETF shares for a predetermined fee. In this case, if “in-kind” creation were allowed, a fairly typical creation unit would have been 100 Bitcoin in exchange for 100,000 ETF shares. However, with the creation of cash, the Issuer will need to post the cash amount, in real time as the price of Bitcoin changes, to acquire, in this example, 100 Bitcoin. (They must also publish the cash amount that 100,000 shares of the ETF can be redeemed for in real time.) The issuer is then responsible for purchasing those 100 Bitcoin for the fund to comply with its agreements or selling the 100 Bitcoin in the event of a redemption. This mechanism is valid for all exchange-traded funds and, as you can see, means that claims that cash creation means the fund will not be 100% backed by Bitcoin holdings are wrong. There could be a very short delay, after creation, in which the Issuer has not yet purchased the Bitcoin he needs to acquire, but the longer that delay, the more risk the Issuer is taking. If they need to pay more than the quoted price, the Fund will have a negative cash balance, which would reduce the fund’s Net Asset Value. Of course, this will affect their performance, which, considering how many issuers are competing, would likely hurt the issuers’ ability to grow their assets. If, on the other hand, the issuer can purchase Bitcoin for less than the cash deposited by the APs, then the fund would have a positive cash balance, which could improve the fund’s performance. Therefore, one could assume that issuers will have an incentive to quote the cash price well above the actual trading price of Bitcoin (and the lower redemption price for the same reason). The problem with this is that the larger the spread between the creation and redemption cash amounts, the larger the spread APs would likely price into the market to buy and sell the ETF shares. Most ETFs trade on very tight spreads, but this mechanism could well mean that some of the Bitcoin ETF issues have wider spreads than others, and generally wider spreads than they might have had upon creation. “in species”. Therefore, issuers have to balance the objective of quoting a narrow spread between creation and redemption cash amounts with their ability to trade at or better than the quoted amounts. However, this requires access to sophisticated technology to achieve. As an example of why this is true, consider the difference between trading 100 Bitcoin based solely on Coinbase liquidity, versus a strategy that uses 4 exchanges that are regulated in the US (Coinbase, Kraken, Bitstamp and Paxos) . This example used the CoinRoutes Cost Calculator (available via API) which shows the trading cost of a single exchange or any custom group of exchanges based on the entire order book data stored in memory. In this example, we see that a total purchase price on Coinbase alone would have been $4,380,683.51, but the purchase price on those 4 exchanges would have been $4,373,568.58, which is $7,114.93 more expensive. That equates to 0.16% more spending to purchase the same 100,000 shares in this example. This example also shows the technological hurdle issuers face, as the calculation required traversing 206 individual market/price level combinations. Most traditional financial systems do not need to look beyond a handful of price levels, as the fragmentation in Bitcoin is much greater. It is worth noting that it is unlikely that major issuers will choose to trade on a single exchange, but it is likely that some will do so or choose to trade over-the-counter with market makers who will charge them an additional spread. Some will choose to use algorithmic trading providers like CoinRoutes or our competitors, who are able to trade at a price below the average quoted spread. Whatever they choose, we don’t expect all issuers to do the same, which means there will be potentially significant variations in prices and costs between issuers. Those with access to superior trading technology will be able to offer tighter spreads and superior performance. So, considering all of these difficulties that will fall on issuers, why did the SEC effectively force the use of cash creation/repayment? Unfortunately, the answer is simple: APs, as a rule, are broker-dealers regulated by the SEC and an SRO like FINRA. So far, however, the SEC has not approved regulated broker-dealers to trade Bitcoin spot directly, which they would have had to do if the process were “in kind.” This reasoning is a much simpler explanation than several conspiracy theories I have heard that do not deserve to be repeated. In conclusion, spot ETFs will be a big step forward for the Bitcoin industry, but the devil is in the details. Investors should research the mechanisms each issuer chooses to list and negotiate the origination and redemption process to predict which might work best. There are other concerns, including escrow processes and fees, but ignoring how they plan to operate could be a costly decision. This is a guest post by David Weisberger. The opinions expressed are entirely their own and do not necessarily reflect those of BTC Inc or Bitcoin Magazine.

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