Retail Crypto: Investing in the approval of Spot Bitcoin ETFs

Written by Terence Ashforth

On January 10th, 2024, the Securities and Exchanges Commission (SEC) did something radical. Breaking a decade of precedent, the U.S. Market regulator approved the first exchange-traded fund (ETF) tracking Bitcoin (Lang & McGee, 2024). Upon casual reading, the event seemed unremarkable. ETFs comprise 12.7% of U.S. equities, and most are considered safe investment vehicles (Cohen, 2023) (Fidelity, n.d.). What’s remarkable, however, is the asset class these ETFs derive their value from Cryptocurrency. Crypto is a divisive topic. Many including the SEC are skeptical of crypto’s value, and the aftershocks of FTX’s bankruptcy scandal and other institutional crypto frauds have shaken public confidence (SEC, 2019). Additionally, the SEC has a long history of aggressive litigation with firms that sought to create similar financial products in the past (Nagi, 2024). Given this, more context is needed to understand why U.S. regulators approved bitcoin ETFs.

One of the many ambiguous aspects of cryptocurrency is their status as securities. Most people who own cryptocurrencies like Bitcoin see their tokens as investments and expect to see returns. As such, it would be easy to assume that all cryptocurrencies are securities. However, in the eyes of the law, it’s not so black and white. To differentiate between tokens that should be considered securities and those that shouldn’t, a method called the Howey test is used. Named after the 1946 SEC v. W.J. Howey Co supreme court case, this test defines what constitutes security in the United States. To meet its standard, an asset needs to fulfill multiple requirements. First, there needs to be an investment of money. Second, a common enterprise must exist where investor capital is pooled with the expectation of profits. Third, profits must be expected to come from the labor of others (Massari, 2022). By this definition, some cryptocurrencies such as tokens issued by startups in capital raises called initial coin offerings are considered securities, while other more decentralized tokens such as Bitcoin aren’t. This distinction is important because it means that while firms that facilitate Bitcoin transactions can be regulated, Bitcoin assets themselves fall outside the purview of securities law. Due to this legal distinction and the decentralized nature of the token, Bitcoin is inherently more vulnerable to market manipulation and fraud (SEC, 2024). As such, the SEC has resisted past attempts to create ETFs based on Bitcoin citing consumer safety. 

Despite safety concerns, legal challenges forced the SEC’s hand. In August of 2023, the D.C. Court of Appeals ruled that regulators were wrong to deny an ETF application from a crypto asset manager, Grayscale Investments (Lang, 2023). In their suit against the SEC, Grayscale argued that asset managers could adequately protect consumers through a market surveillance partnership with the Chicago Mercantile Exchange which transacts in Bitcoin futures contracts. In the wake of this, The SEC has been forced to change its position and approve 11 EFTs Bitcoin ETFs. 

The market effects resulting from this decision have been varied. When the SEC made its announcement, the price of Bitcoin initially spiked, then markedly declined. This seems counterintuitive as analysts expected that since ETFs would make investing in bitcoin more accessible, demand for the token would increase. However, what actually happened in the days following the listing of Bitcoin ETFs was an investor outflow from more restrictive and previously illiquid Bitcoin investment trusts. As such, the price of bitcoin actually decreased. However, as of March 16th, 2024, Bitcoin is at an all-time high (WSJ, 2024). This indicates that retail investors who previously weren’t investing in the token are now getting into the market. To some this is a positive, but this market action should be looked at with caution. Bitcoin and other crypto tokens are speculative asset, and due to their nature, risk is hard to calculate. Additionally, while the SEC doesn’t officially endorse Crypto, the approval of Bitcoin ETFs might be seen as a tacit stamp of approval. This normalization of assets with such undefined risk may one day pose a risk for institutional investors.

In conclusion, the SEC’s unprecedented nod to the introduction of Spot Bitcoin ETFs marks a new chapter in the relationship between traditional finance and the world of cryptocurrency. This decision reflects the growing acknowledgment of digital assets and a pragmatic response to the changing tides of investment trends and legal rulings. While retail crypto investors may see the entrance of Bitcoin ETFs into the market as a beacon of legitimacy and a simpler gateway into cryptocurrency investments, it comes with a dual-edged sword. The initial turmoil in Bitcoin prices post-approval presents a complex picture, suggesting investor ambivalence and shifting investment strategies around crypto assets.

The increased accessibility to Bitcoin via these ETFs has apparently broadened the investor base to include those cautious of direct involvement in the crypto market. This broadening, highlighted by Bitcoin’s new all-time high, captures a glimpse into a potential future where cryptocurrencies hold a more conventional position in investment portfolios. However, this surge also brings forth concerns about market volatility and the speculative nature of these assets.

The irony of regulatory bodies approving investment vehicles for assets they do not categorically endorse serves as a caution for institutional and casual investors alike. While the SEC’s seal on these ETFs may be misinterpreted as a blanket assurance, the onus remains on investors to conduct due diligence and approach these markets with the understanding that regulatory approval does not equate to risk elimination. In sum, the approval of Bitcoin ETFs signifies a maturing of crypto markets but equally highlights the need for investor caution in the face of difficult-to-quantify risks. As the financial ecosystem continues to evolve, the interplay of innovation, regulation, and market behavior will be key factors shaping the trajectory of retail investment in cryptocurrencies.

References

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Framework for “Investment Contract” Analysis of Digital Assets. (2019, April 3). SEC.gov.

Investor Alert: Watch Out for Fraudulent Digital Asset and “Crypto” Trading Websites. (2019, April 24). SEC.gov.

Johnson, S. (2024, January 28). UK looks increasingly isolated in its anti-crypto ETF stance. Financial Times.

Lang, H. (2023, August 29). Explainer: Understanding Grayscale’s victory in spot bitcoin ETF case. Reuters.

Lang, H., & McGee, S. (2024, January 11). US SEC approves bitcoin ETFs in watershed for crypto market. Reuters.

Massari, J. (2022, December 6). Why Cryptoassets Are Not Securities. The Harvard Law School Forum on Corporate Governance.

Nagi, C. (2024, January 10th). Stung by a Judge, SEC Rethinks View on Crypto Surveillance. Bloomberg.

SEC approves first spot bitcoin ETFs in boost to crypto advocates. (2024, January 11). Financial Times.

Statement on the Approval of Spot Bitcoin Exchange-Traded Products. (2024, January 10). SEC.gov.

Vereckey, B. (2018, May 4). Is a cryptocurrency a security? Depends. MIT Sloan.

What Are ETF Risks? – Fidelity. (n.d.). Fidelity Investments.