According to some experts, the introduction of bitcoin-tracking exchange-traded funds (ETFs) in the United States strengthens the connections between the volatile cryptocurrency market and the established financial system, possibly posing unanticipated risks.
This month, the SEC (Securities and Exchange Commission) approved eleven spot bitcoin ETFs from issuers, such as BlackRock and Invesco/Galaxy Digital. This was a landmark decision for the cryptocurrency industry, which has been plagued by fraud and bankruptcy. After losing Grayscale Investments’ legal challenge, the SEC was forced to reconsider its long-standing rejection of the products on the grounds of investor protection.
The products, according to cryptocurrency enthusiasts, will make it easier and safer for investors to invest in bitcoin. SEC Chair Gary Gensler cautioned investors to exercise caution as bitcoin is still a “volatile asset” while approving the products.
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With a combined asset value of about $21 billion, the ETFs may attract more as $100 billion in capital from institutional and retail investors this year alone, according to some analysts. After the products were introduced, bitcoin has decreased by over 6%.
According to some ETF experts, who cited data from prior ETF volatility events, if the products are widely adopted, they may increase the volatility of bitcoin prices or cause displacements between the cost of the ETF as well as bitcoin, which could be dangerous for other components of the economy throughout periods of market stress.
Some claimed that the turmoil in US banks last year demonstrated how risks can spread across the financial and cryptocurrency markets. For instance, cryptocurrency lender Silvergate Bank went bankrupt due to withdrawals triggered by the demise of cryptocurrency exchange FTX. Regulators claim that this further exacerbated panic and ultimately led to the collapse of Signature Bank. The USD Coin stablecoin experienced a run-on following the failure of Silicon Valley Bank.
“When investors pour capital into these products, you significantly raise the risk of much higher interconnection between the financial system’s core and the cryptocurrency ecosystem,” stated Dennis Kelleher, the chief executive officer of Better Markets, a lobbying organization that had pushed the SEC to reject bitcoin exchange-traded funds (ETFs), citing risks to investors as well as the financial system.
Initially designed as a substitute for cash transactions in 2009, bitcoin is primarily utilized for investment purposes. The Wells Fargo Funding Institute estimates that its daily average fluctuation is approximately three as well as a half period that of stocks.
The European Union’s economic watchdog, the European Systemic Hazard Board, principal economist Antonio Sánchez Serrano, stated that Bitcoin exchange-traded funds (ETFs) could “particularly worsen” that volatility during periods of market stress and other avenues through which ETFs can establish systemic hazards.
The separation of the ETF cost from the actual asset being traded is one of those other channels, and it can be stressful for institutions that have a significant exposure to the products or that depend on them for managing their liquidity.
In an email, Serrano stated, “The differences with a plain-vanilla stock ETF are simply too large in terms of embedded risks.” Serrano categorized bitcoin ETFs as complex. Complex, highly leveraged, and less liquid exchange-traded products have seen stress in the past.
During a spike in volatility in February 2018, an exchange-traded note that tracked volatility collapsed, costing traders $2 billion in the amount of losses.
2020 saw a sell-off in certain corporate bond ETFs due to COVID-19 shutdowns. The Federal Reserve’s emergency support, which included buying up shares of bond ETFs, prevented the stress from spreading to the larger fixed income market, according to the CFA Institute, a professional association for investors that has also researched the risks associated with ETFs. The argument that systemic risks are present in ETFs is generally refuted by the industry.
The issuers of bitcoin ETFs list a wide range of market, policy, as well as operational risks in their risk disclosures; however, they also note that because bitcoin is still in its infancy, some risks may be unpredictable. A request for comments was not answered by the SEC. “TOMORROW’S FAILURE”
Indeed, according to Serrano and other experts, the risks will mostly depend on how widely the ETFs are eventually adopted. “Size is the key factor in systemic risk… The head of advocacy and policy research for EMEA at the CFA Institute, Olivier Fines, wrote in an email that “we do not yet know enough about who is actually purchasing these and in what proportions.”
Executives in the cryptocurrency sector also indicate out that the industry has largely been immune to crises in cryptocurrencies, most notably the one in 2022 when they lost roughly two thirds of their original $3 trillion in value.
The financial system’s connectivity with cryptocurrencies is still “very limited,” according to S&P Global Ratings senior analyst Lapo Guadagnuolo. ETF issuers assert that they have put in place safeguards. For instance, there won’t be as many middlemen holding actual bitcoin because the items will be paid for with cash instead of bitcoin.
Steve Kurz, the global head of asset management at Galaxy Digital, which collaborated with Invesco on its ETF, stated, “I don’t see cataclysmic… dynamics in any of these products,” Nevertheless, a senior SEC official has raised some concerns.
In a statement, the Securities and Exchange Commission Commissioner Caroline Crenshaw claimed that the agency had not given any thought to the possibility that the ETFs would forge a connection with conventional markets that would “allow issues in mostly non-compliant digital currency markets to spill over” when she voted against approving the vehicles in January. In addition, Crenshaw expressed concern that the ETFs might open the door for riskier products; she did not reply to an inquiry for comment. “I fear that today we are setting ourselves up for tomorrow’s failure,” she said.
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