Bitcoin ETFs are finally coming to the U.S. in 2024 and, by all indictions, the first ones will hit the market sometime in mid- to late-January. But now that the long-standing issues of if and when are resolved, the hot question surrounding Bitcoin ETFs is how exactly they will work—and, for now, the SEC is insisting on a process that doesn't make a ton of sense and will ultimately result in retail investors paying for added complication. More specifically, the agency wants to bar the would-be ETF issuers from using Bitcoin for in-kind redemptions, and instead carry out these transactions with cash.
To understand what this means, it's helpful to know how ETFs work in the first place. Recall that most ETFs hold a basket of shares in different companies, and that the issuer relies on deep-pocketed partners—market makers—to ensure the ETF's share price reflects the value of the underlying stocks. This occurs through an arbitrage system that lets the market makers turn up with a basket of stocks and redeem them for new shares in the ETF, which they can then sell at a profit. Or conversely, the arbitragers can turn up with shares of the ETF and ask for the underlying securities in return. In both cases, the transactions result in the price of the ETF shares aligning more closely with the underlying asset. It's a clever system that has made ETFs both inexpensive and widely popular.
Unfortunately, when it comes to the Bitcoin ETFs, the SEC is reportedly insisting that these transactions—the ones where market makers exchange the underlying asset for new shares or vice versa—be in cash and not "in-kind." This will likewise help ensure the ETF's share price closely tracks the underlying asset (Bitcoin in this case), but it will also be more expensive.
This won't be due to tax implications—as Grayscale gently pointed out to Bloomberg Intelligence following an inaccurate report last week—but because the ETF issuers will have to spend money exchanging Bitcoin for cash and vice versa. It would be simpler, of course, to just let the parties transact in Bitcoin, but here we are. In any case, it will be retail investors who be will paying for the additional transaction costs.
This is an odd decision by the SEC, especially as in-kind transactions are the norm with other ETFs. Indeed, when it approved a gold ETF in 2014—a novel concept at the time—the SEC issued an explanatory letter describing how the ETF issuer and its partners would conduct in-kind transactions involving bars of gold. This is obviously cheaper and more efficient than requiring a gold ETF issuer to go buy or sell new bars whenever there is a redemption. So why not do the same with Bitcoin, or at least permit both cash and in-kind redemptions? That is reportedly what both Fidelity and BlackRock—not exactly sketchy fly-by-night companies—are asking for.
The most charitable explanation is that the SEC views Bitcoin as a novel asset that could be cornered, and the agency wants to minimize the opportunities for mischief in the form of self-dealing on the part of market makers and ETF issuers. The chances of such manipulation occurring, however, seem unlikely—recall that a federal appeals court rejected this argument when it forced the SEC to stop blocking Bitcoin ETFs in the first place.
There is also another potential explanation for the SEC's move to block in-kind redemptions, one that is rooted in the fact that, in the words of a D.C. insider, that "Chair Gensler hates hates hates to lose." If that's the case, it's possible that the head of the agency—stung by his defeat in court—is going to allow Bitcoin ETFs, but on terms that will make them more expensive and less attractive to buy. That's an odd position for an agency chairman who claims his top priority is looking out for the little guy.
Jeff John Roberts
jeff.roberts@fortune.com
@jeffjohnroberts
