The Securities and Exchange Commission (SEC) is dragging its feet in deciding whether it should approve the listing of a Bitcoin exchange-traded fund (ETF) proposed by VanEck Associates Group. While it is good to be cautious, speed and political decisiveness are equally important. Otherwise we risk the rise of a digital shadow finance industry.
Cryptocurrencies are here to stay. The opportunities brought about by the digitization of assets and new financial technologies make it challenging to reverse the course of financial innovation.
CoinMarketCap, a price-tracking website for crypto assets, registered 4,501 cryptocurrencies in February 2021, up from 66 in 2013. The total market capitalization is estimated to be more than $2 trillion, with daily trading volumes north of $100 billion. The growth in cryptocurrency derivatives, financial securities that depend on the value of cryptocurrencies, largely outstrips that of spot markets.
Initial interest in institutional cryptocurrency investing was met with skepticism. JPMorgan’s CEO Jamie Dimon called Bitcoin a fraud and threatened to fire any employee trading in it, while longtime Bitcoin skeptic Kenneth Rogoff from Harvard University considers Bitcoin only a “hedge against dystopia.”
However, an increasing number of institutional investors are expressing their support in the industry. The cryptocurrency firm Coinbase recently completed a whopping $76 billion listing on the Nasdaq stock exchange. Tesla’s Elon Musk took a $1.5 billion stake in Bitcoin. Meanwhile, Jamie Dimon reversed course on his anti-Bitcoin agenda, and CBOE Global Markets filed for approval to list a Bitcoin ETF.
In the past, the SEC has persistently rejected proposals for regulated crypto ETFs based on the value of cryptocurrencies. Concerns relate to high price volatility in cryptocurrencies, the risk of market manipulation and fraud, and redemption risk.
ETFs are financial securities that closely track the performance of another financial security, such as Bitcoin, or a broad-based market index. They invest in a basket of securities or financial derivatives to deliver their promised performance. Investors can buy the ETF shares that are traded on a regulated exchange, just like they would with any stock, to invest in the performance of the ETF’s underlying assets. This may be particularly appealing in the case of cryptocurrencies, which trade on mostly unregulated digital exchanges that can be accessed only through digital wallets. These wallets have to be set up with each exchange and, therefore, expose investors to the counterparty risk of these unregulated platforms.
There is an active debate whether ETFs impact the underlying market. It has been shown that ETFs can indeed increase the price volatility of the underlying assets. However, because ETFs need to synchronize their prices with the prices of their constituents, any trading at the ETF level may trickle down to underlying securities. Through that mechanism, ETFs can actually improve price efficiency and quality in the underlying asset market. Relatedly, recent research shows that the listing of Bitcoin futures by the CME and CBOE in December 2017 was beneficial to price efficiency, market quality, and liquidity of Bitcoin prices.
The SEC’s anxieties are valid. Concerns about systemic risk and financial fragility are especially important when new financial technologies lead to a democratization of finance, especially now that potentially misinformed retail investors are drawn into markets through the gamification of financial trading.
However, many of the concerns of market disruptions caused by ETFs are often linked to a buildup of market and risk concentration and leverage that goes undetected because of lack of disclosure and insufficient regulatory limits on leverage. These risks are the same for traditional and crypto ETFs and, therefore, require a uniform regulatory response for risk mitigation.
A much larger risk is the emergence of an unregulated digital shadow finance industry. The longer the SEC waits, the bigger the growth will be in unregulated cryptocurrency markets. Indeed, current growth in unregulated cryptocurrency markets is an order of magnitude larger than that in regulated ones.
The 2008 global financial crisis has shown the severe repercussions a major shock to the shadow banking system can have on the global economy. According to the International Monetary Fund, economic activity declined in half of all countries in the year following the crash, with possible long-term consequences for income inequality and migration. Shadow banking continues to be a concern for systemic risk, and there are concrete proposals for regulation.
The growing interest and applications for regulated investment products provide an opportunity to shape a safe and resilient digital financial system before it grows uncontrollably in unregulated markets. The U.S. already risks falling behind the curve, since neighboring Canada’s financial regulator approved its first Bitcoin ETF in February this year. In fact, Canada’s first ETF was launched a good three years before the introduction of the popular S&P 500 Trust ETF (or SPDR) in the U.S.
With the extreme pace that financial markets are moving these days, the SEC cannot afford to deliberate for three years. Thus, the leadership of newly appointed SEC chair Gary Gensler is needed to shape the future development of the industry.
The risk of the emergence of a digital shadow finance industry is real. Let’s not waste the opportunity to avoid mistakes from the past.
Patrick Augustin is an associate professor of finance at the Desautels Faculty of Management at McGill University.
