The price of Bitcoin has climbed since the SEC allowed new trading funds. Martyna Dudek explains what’s changed and the FCA’s own moves to allow crypto trading.
On 10 January 2024 the U.S. Securities and Exchange Commission (SEC) approved a number of Bitcoin (BTC) spot Exchange Traded Funds (ETF(s)) issued by BlackRock, Fidelity, Greyscale, and others.
The SEC made this decision against the backdrop of 46 enforcement actions brought against cryptocurrency market players in 2023, a record high comparing to previous years. The charges brought against Sam Bankman-Fried for defrauding investors in the trading platform FTX made the biggest headlines in the last year, followed by the high-profile fines issued by the Commodity Futures Trading Commission (CFTC) against Binance, currently the largest cryptocurrency exchange in the world, for failures in its anti-money laundering programme.
The approval of the ETF did not come lightly to the SEC. In 2022, attempts by Grayscale to issue the spot ETF were initially rejected. The regulator was pushed to reconsider when a ruling by the Court of Appeal in Washington in the summer of 2023 held that the SEC’s decision to reject the ETF applications was not sufficiently justified.
Despite the SEC’s eventual approval of the ETFs, the SEC Chair, Gary Gensler, made it very clear that the agency does not endorse or approve BTC itself. In the notice of approval, he stressed that BTC is “primarily a speculative, volatile asset that’s also used for illicit activity including ransomware, money laundering, sanction evasion and terrorist financing.”
Though the SEC continues to cast doubt on the future of cryptocurrencies, the market does not seem to share that scepticism. In early March, at the time of writing, BTC EFTs have seen trading volume surpass $10 billion. The price of BTC has also skyrocketed, reaching its all-time high on 8 March at $70,184, price levels higher even than those seen during the Covid-induced crypto frenzy, before the crypto winter.
How does it work?
A traditional ETF is a fund which invests in a pool of assets and issues corresponding securities to investors in the form of shares which subsequently trade on traditional exchanges. The approval of the BTC spot ETF has been called a milestone for the industry as the asset managers behind the ETF purchase BTC directly and hold it on trust for its investors. The number of shares in issue correspond to the BTC held by the ETF, if the shares trade at a premium to the amount of BTC held, the shares are redeemed in a rebalancing activity performed by authorised participants. This allows the fund to track the price of BTC, giving its investors direct exposure to the asset without having to purchase and custody the asset themselves.
This is a key distinction between the spot BTC ETF and futures BTC ETF. The BTF futures ETF has been around since October 2021 and is currently traded on serval mainstream US exchanges. The futures BTC fund invests in cryptocurrency-related assets but not in the cryptocurrency itself. The futures ETF is considered as much less volatile than its spot counterpart as its value, arguably, is derived from numerous factors beyond the spot price of BTC.
Honeypot
As ever, when cryptocurrency is concerned, security is one of the key risks associated with investment. Both retail and institutional investors have been subject to numerous hacking scandals in the crypto world. Perhaps the most famous was the hacking of Mt. Gox in 2014 which, at the time, handled 70% of all cryptocurrency trading activity. The concentration of trading on one venue made Mt. Gox a particularly attractive target for hackers, sometimes called a “honeypot”.
The security risks arise because BTC, like any other crypto asset, is held in digital wallets. Digital wallets, sometimes confusingly referred to as crypto’s equivalent of bank accounts, do not actually hold crypto balances but the user’s public and private keys. These key pairings are in turn used to access crypto assets which sit on the public blockchain network. The keys are strings of data used to initiate and accept transactions on the blockchain by signing and authorising transfers. To facilitate quick initiation of a transaction these collections of keys, or digital wallets, are usually held online and often directly with cryptocurrency exchanges.
In this case, ease of trading can translate to the ease of transfer when a user’s public and private keys are accessed by malicious actors who, often, through the use of special wallets known as “mixers”, can nearly entirely obliterate the trail of the funds. This, combined with the multijurisdictional aspect of public blockchains, poses a real challenge in terms of asset recovery.
While a vast number of security features are available to secure digital wallets, most prominently dual authorisation and cold (offline) or hardware storage, it is still very much an ongoing concern for cryptocurrency holders.
The investors in the BTC spot ETF are not immune to this risk even given that they do not hold cryptocurrency themselves. The scale of investment in the ETFs, and consequently amount of BTC held by the funds, makes it an attractive target. This risk is exacerbated as the majority of the asset managers offering the ETF chose to custody the underlying asset with one single custodian. Currently 8 out of 11 asset managers concerned, trade and hold BTC with Coinbase. Such a concentration of assets with a single entity is a prominent concern when considering the “honeypot” risk. It is also worth noting that Coinbase itself is subject to SEC enforcement action, albeit not related to its custody offering.
UK Outlook and change in FCA’s position
What looks like an overwhelming success of the BTC spot ETF in the US (and other countries around the world), was not lost on the UK watchdog, the Financial Conduct Authority (FCA). The FCA published a statement on 11 March confirming that it will not object to requests from recognised investment exchanges to create a UK listed market segment for cryptoasset-backed exchange traded notes.
Up until this decision, the FCA’s stance on crypto derivatives could be summarised as a “hard no”. Its ruling, originally made in 2021, banned the sale of derivatives and exchange traded notes that reference certain types of crypto assets to retail consumers. It cited the lack of inherent value, prevalence of market abuse and financial crime, and extreme volatility as key factors which make crypto derivates ill-suited for the retail consumer. These were similar sentiments to those shared by the SEC when publishing its decision on the approval of the ETF.
This position has attracted comments that the FCA appears increasingly isolated in its anti-crypto ETF stance, and that it excludes the UK consumers from investing in cryptocurrency products which benefit from significant regulatory compliance and scrutiny. The ban had the effect of leaving direct trading via cryptocurrency exchanges, arguably a riskier route, as the venue of choice for the UK retail investor.
While the recent announcement is a step towards loosening its position, and a small victory for crypto supporters, it comes with several caveats. The FCA noted that “these products would be available for professional investors, such as investment firms and credit institutions authorised or regulated to operate in financial markets only” making it clear that the initial ban remains in place for retail investors and that any product approved by the FCA will be subject to strict regulatory oversight.
Following the challenges encountered by asset managers in the US in securing SEC’s approval of the BTC spot ETFs, it remains to be seen how the FCA will approach similar applications and whether some of the risks emerging in the US market will be addressed by the UK regulator.
Martyna is a Trainee Solicitor at Mishcon de Reya. Prior to starting at Mishcon she worked in-house in an institutional cryptocurrency business providing custody and settlement services.
