Following the debut of two blockchain-based ETFs in the country, the U.S. Securities and Exchange Commission (SEC) has posed more concerns about the future of ETFs that are related to the industry of cryptocurrencies.
The concerns were highlighted by Dalia Blass, Director of the Investment Division of the SEC, in a staff letter that discussed the issues at length after the regulatory authority received several filings related to cryptocurrency-based ETFs.
The letter was addressed to the Investment Company Institute (ICI) and Securities Industry and Financial Markets Association (SIFMA), associations which represent entities including but not limited to investment funding, exchange-traded funds, securities, banking, and asset management.
The SEC also stated that until the concerns have been clarified, it has asked the current applicants of such products to withdraw their requests.
What does the letter say?
The letter refers to the fact of U.S. investment marketing being one of the most successful in the world and the attention that it gathers from both investors and commodity sponsors alike. It then points out how the same holds true for cryptocurrency-based products that are now turning towards the U.S. investment market for more exposure.
The letter explains that the SEC investment division is willing to discuss details on these proposed products with their investors, but also points out the “significant investor protection issues” needs to be looked into before such products are available to the public.
It identifies the advantages highlighted by the proponents of cryptocurrencies and related products, as well as the concerns from their critics. It also acknowledges that the “innovative” nature of cryptocurrencies and associated products makes them unlike any conventional product and the risks that this very evident fact proposes in the initiation and management of cryptocurrency related investment products.
The letter also presents a few questions related to five segments, these segments are summarized below.
The letter explains that one of the most critical requirements of funding opportunities such as ETFs, is that they need to value the assets in question each day for their net asset value (NAV), which is essential for various reasons such as determining what participants will pay for these ETFs, and what returns they can receive when they are redeemed or sold.
However, the letter points out that the volatility which cryptocurrencies and related products hold regarding daily valuation makes it challenging to maintain this requirement on a regular basis. It then poses questions related to this difficulty and asks for suggestions on how they can be tackled.
Another critical point that is highlighted pertains to the ability of these cryptocurrency-based products to be turned into liquid assets.
The letter mentions that due to specific rules, such funds need to ensure that they have the assurance of sufficient liquidity.
The letter then presents various questions about these products’ ability to do so and asks for answers to ensure that these requirements are met.
The letter mentions the safeguards currently in place to make sure that registered funds have maintained custody of their holdings to ensure that the investors and related authorities have a place to turn towards in the future and to verify the holdings if there is a need to do so.
While the letter acknowledges that the existing Bitcoin futures are “cash settled,” it also points out that other funds would need to provide derivatives for physical settlement.
It then poses several questions about the management of this requirement about cryptocurrency, asking what measures could be taken to “validate existence, exclusive ownership and software functionality of private cryptocurrency keys” against these funds.
4. Arbitrage for ETFs
The letter explains that ETFs receive Commission orders to “operate in a specialized structure” which enables their day to day share exchange trading (at market-based prices) as well as creation unit transactions (which are NAV based).
The letter then poses questions on the matter of compliance with this requirement, asking that given the volatility and other restrictions raised above, a fundamental question hinges on, how will ETF’s ensure that these guidelines are met.
5. Potential manipulation and other risks
In this section, the letter discusses various points that relate to concerns raised about the fraud-related instances noticed in the cryptocurrency industry. It refers to SEC Chairman Jay Clayton’s recent statement, which mentioned that “cryptocurrency markets, as they are currently operating, feature substantially less investor protection than traditional securities markets, with correspondingly greater opportunities for fraud and manipulation.”
It presents questions on how investors could be protected against increased chances of fraud and manipulation and what measures could be taken to ensure the prevention of these situations.
The letter concludes by stating that until the questions posed regarding the above points have been answered, the SEC investment management division does not think that sponsors should initiate registering for cryptocurrency based products.
It further mentions that all current applications have been asked to withdraw.
“Until the questions identified above can be addressed satisfactorily, we do not believe that it is appropriate for fund sponsors to initiate registration of funds that intend to invest substantially in cryptocurrency and related products, and we have asked sponsors that have registration statements filed for such products to withdraw them.”
It seems that cryptocurrency ETFs and related investment products have a long way to go before the industry could see them making their debut. It remains to be seen how the associations will be answering to these concerns and how soon can the process be completed.