Research the dynamics of market manipulation before you jump in Bitcoin ETFs
Investors are eagerly anticipating the potential approval of a spot bitcoin exchange-traded fund (ETF) by the United States Securities and Exchange Commission (SEC). The excitement began in early June when the investment giant BlackRock submitted a filing for the product and gained further momentum after a court decision mandated the SEC reconsider its rejection of Grayscale’s proposal to transform its Bitcoin Trust (GBTC) into a spot ETF.
The SEC’s objection to ETFs is related to the fact that Bitcoin (BTC) is traded in unregulated venues around the world, which poses a challenge in preventing fraud and price manipulation.
One attempt to address the issue has included surveillance-sharing agreements (SSA) with some cryptocurrency exchanges. In theory, this would allow the identification of bad actors who attempt to manipulate the market. Critics question the efficacy of these SSAs given they cannot cover the entire market. ETFs are based on precedent decisions that allowed spot commodity ETFs based on the relevance of the underlying commodity futures markets.
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The SEC has established that the futures should lead the spot in price formation in order to be considered a “regulated market of significant size.” In other words, information from the futures market takes precedence over the spot market in the price discovery process. Yet, even if price discovery is led by the futures market, there are still some cases where manipulation in the spot markets can spread to the ETF. The devil is in the details, and more specifically, in the price source for the net asset value (NAV) calculation and in the creations and redemptions method (in-cash or in-kind).
Consider a scenario where a manipulator successfully drives the underlying commodity price down by 5% in unregulated spot markets.
A 2019 Bitwise report on using volume-weighted median price to protect against manipulation of the NAV. Source: Bitwise
If the creations and redemptions are in-kind, there is a straightforward arbitrage that acts like communicating vessels between the ETF and the unregulated spot markets. In this example, the arbitrageur can exploit it by simply buying underpriced spot commodity and selling the corresponding amount of the ETF, and then using the bought commodity to create new ETF units and cover the short ETF position. The profitability of this trade will last until there is a substantial convergence of the spot commodity price and the equivalent amount of the ETF. How much each price will move toward the convergence depends on their liquidity, but some of the adjustment will come from the ETF price, meaning that the manipulation in the spot market spreads to the ETF, at least in part.
In a case where the creations and redemptions are in cash and the NAV is calculated with commodity prices derived from the unregulated spot markets, a very similar arbitrage is possible. The arbitrageur buys underpriced spot commodity and sells the ETF, uses cash to create ETF units to cover the short position and sells the commodity trying to replicate the pricing methodology used in the NAV calculation (which determines the price paid for the creations). Apart from worse capital efficiency (due to cash disbursement for creation) and a small execution risk when replicating the NAV price, the trade is basically the same as with in-kind creation and the consequences are similar.
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Is there a setup that effectively shields the ETF from manipulation? The use of spot prices derived from the futures curve for calculating NAV, coupled with in-cash creations and redemptions, emerges as the most promising alternative. If an arbitrageur attempts to apply the same method as in the previous case, there is no guarantee of selling the commodity at a price similar to that used in NAV calculation, especially in the presence of a manipulator in the spot market. The trade is no longer an arbitrage. The pipes connecting the spot price and the ETF price are obstructed.
On the flip side, this setup facilitates a straightforward arbitrage path between the ETF and futures. Whenever the ETF price diverges from the spot price implied by the futures curve, an arbitrageur can execute a trade in the opposite position with perfect hedging on futures, establishing a robust link between the ETF and the futures market. It is reasonable to believe that an ETF with such characteristics would be as resistant to manipulation in unregulated spot markets as the futures contracts or a futures ETF.
Both academics and practitioners have already found some robust evidence supporting the idea that CME Bitcoin Futures are dominant in Bitcoin’s price discovery. Undoubtedly, a spot Bitcoin ETF in the U.S. would be a good development for the traditional markets and the crypto industry. As the American pastor Chuck Swindoll once said, “The difference between something good and something great is attention to detail.” By keeping the devils away, a Bitcoin ETF has the potential to be truly great for investors.
João Marco Braga da Cunha is the portfolio manager at Hashdex. He obtained a master of science in economics from Fundação Getulio Vargas before obtaining a doctorate in electrical and electronics engineering from the Pontifical Catholic University of Rio de Janeiro.
This article is for general information purposes and is not intended to be and should not be taken as legal or investment advice. The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.
