The U.S. Securities and Exchange Commission has pushed for bitcoin exchange-traded funds to be fundamentally different from large equity funds, and the impact of that decision on how the funds will be traded remains to be seen.
Bitcoin funds, which launched on Thursday, use a share buyback process that turns the underlying crypto into cash. Most ETFs primarily use an in-kind redemption process where the underlying asset does not have to be actually sold.
While the share buyback rules do not directly affect the smaller trades that retail investors make in brokerage accounts, they come into play when larger trades are made by institutions.
There is some concern that using a cash-only redemption model could reduce the efficiency of the ETF setup.
“It could be that certain funds are able to get better strike prices than others. The other thing is that those trading costs, whether they’re transaction costs or market impact-type costs that aren’t necessarily quantifiable, those costs are now investors,” said Bryan Armour, director of passive strategies 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, commodity funds. Using only cash redemptions could result in ETFs that have weaker liquidity and wider bid-ask spreads, Grayscale said.
But Steven McClurg, chief investment officer at Valkyrie, said the situation may be more analogous to fixed-income ETFs, where cash redemptions are more common because authorized market participants working with the funds may be more comfortable with the process.
“In this situation, there are a lot of access points that don’t have the ability to transact in bitcoin. If it was a peer-to-peer model, then it would bring a big advantage to the access points that have that ability. … we want as many market makers and authorized participants in these products because it leads to better markets,” McClurg said.
From a regulatory standpoint, the decision to allow only cash redemptions simplifies the process of managing bitcoins and removes broker-dealers from the process, said Jeremy Senderowicz, a lawyer and shareholder at Vedder Price, which specializes in ETFs.
SEC Chairman Gary Gensler said in a statement Wednesday that broker-dealers are still expected to follow best-interest rules with respect to crypto products, a potential sign that the SEC is wary if these firms don’t directly engage with these funds .
The good news for investors is that the cash redemption process shouldn’t change the tax treatment of the funds, 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 to create tax events.
“These things are taxed as grantor trusts. The trade-off is that when an AP is exchanged for cash, the tax consequences accrue only to that AP. So it’s not like cash redemptions in mutual funds and regular 40-share ETFs, where to the extent that it is a cash transaction, the taxable income arising from the transactions of the funds passes to all shareholders,” said Senderowicz.
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