The US Securities and Exchange Commission has urged that Bitcoin exchange-traded funds have a material difference from large stock funds, and the impact of this decision on the way the funds are traded will only become clear over time highlight.
The Bitcoin funds, which launched on Thursday, use a stock redemption process that converts the underlying cryptocurrency into cash. Most ETFs primarily use an in-kind redemption process that does not require the underlying asset to actually be sold.
While the rules surrounding stock redemptions do not directly impact smaller trades that retail investors make in brokerage accounts, they do come into play when institutions execute larger trades.
There is concern that using the cash-only redemption model could impact the efficiency of the ETFs.
“It may be that certain funds are able to achieve better execution prices than others. The other thing is that those trading costs, whether they be transaction costs or the costs that impact the market that aren't necessarily quantifiable, are now being borne by investors,” said Bryan Armour, head of passive strategy research for North America at Morningstar.
In-kind redemptions are typically used by large equity funds and, as crypto asset manager Grayscale pointed out in a presentation to the SEC, commodities funds. Using cash-only redemption could result in ETFs having weaker liquidity and wider bid-ask spreads, Grayscale argued.
However, Steven McClurg, chief investment officer at Valkyrie, said the situation may be more akin to bond ETFs, where cash redemption is more common, as the authorized market participants working with the funds may be more familiar with that process.
“In this situation, there are many APs that are unable to transact in Bitcoin. If it were a tangible asset model, then it would provide great advantages to the APs who have this ability. … We.” “We want as many market makers and authorized participants in these products as possible because that leads to better markets,” McClurg said.
From a regulatory perspective, the decision to only allow cash redemptions simplifies the chain of custody for Bitcoin and eliminates broker-dealers from the process, said Jeremy Senderowicz, an attorney and shareholder at Vedder Price, a firm specializing in ETFs.
SEC Chairman Gary Gensler said in a statement Wednesday that broker-dealers will continue to be expected to comply with best-interest regulations regarding crypto products, a possible sign that the SEC is wary of letting these firms participate directly in this fund.
The good news for investors is that the cash redemption process shouldn't change the funds' tax treatment, even though cash redemptions are more commonly associated with mutual funds than ETFs. Many investors and financial advisors choose to use ETFs because the funds give them more control over when they initiate tax events.
“These things are taxed as grantor trusts. It is agreed that when an AP is redeemed for cash, the tax consequences apply only to that AP. So it's not like cash redemptions are happening to this extent in mutual funds and regular 40-Act ETFs.” “Because it's a cash transaction, taxable income from fund transactions is passed through to all shareholders,” Senrowicz said.
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