Before jumping into Bitcoin ETFs, research the dynamics of market manipulation

Investors are eagerly awaiting the approval of the space bitcoin exchange-traded fund (ETF) by the United States Securities and Exchange Commission (SEC). The excitement began in early June when investment giant BlackRock filed an application for the product after a court ruling forced the SEC to reconsider its rejection of Greyscale's proposal to convert the Bitcoin Trust (GBTC) into a single FF.

The SEC's objection to ETFs is that bitcoin (BTC) is traded in unregulated locations around the world, which poses a challenge to preventing fraud and price manipulation.

One attempt to address the problem involves Security Sharing Agreements (SSA) with some crypto exchanges. In theory, this could identify bad actors trying to manipulate the market. Critics question the effectiveness of these SSAs because they cannot cover the entire market. ETFs are based on prior decisions that have approved spot commodity ETFs based on the relevance of the underlying commodity futures markets.

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The SEC has confirmed that futures must lead the position in price to be considered a “large-scale regulated market”. In other words, information from the futures market precedes the spot market in the price discovery process. However, while price discovery is driven by the futures market, there are still instances where manipulation in the spot markets can spill over into ETFs. The devil is in the details and especially in the source of value for the calculation of the net asset value (NAV) and in the method of creation and redemption (in cash or in kind).

Consider a situation where a regulator successfully lowers the price of a commodity by 5% in unregulated spot markets.

If the creations and redemptions are in kind, there is direct arbitrage between the ETF and the unregulated spot markets, acting as vessels. In this example, the arbitrageur could simply buy the undervalued spot commodity and sell the equivalent amount of the ETF, then use the purchased commodity to create new ETF units and cover the short ETF position. The profitability of this trade will last until there is a significant convergence between the spot commodity price and the ETF equivalent. How much each price moves to the index depends on their liquidity, but some of the adjustment comes from the ETF's price, meaning that the volatility in the spot market is at least partially transmitted to the ETF.

A very similar arbitrage is possible when the creations and redemptions are in cash and the NAV is calculated using commodity prices derived from unregulated spot markets. The arbitrageur buys the low-valued commodity and sells the ETF, uses cash to cover the short position of the ETF units, and sells the commodity, trying to replicate the pricing method used in the NAV calculation (which determines the price paid for innovations). With less capital efficiency (due to cash for creation) and less execution risk when repeating the NAV value, the business is basically the same as creating in kind, the result is the same.

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Is there a setup that prevents ETFs from being misused? Using spot prices from the futures curve, combined with cash creations and redemptions, emerges as a very promising alternative to calculate NAV. If an arbitrator tries to use the same method as in the previous case, there is no guarantee to sell the commodity at the same price as the NAV calculation, especially when there is a manipulator in the spot market. Business is no longer arbitrage. The pipes connecting the spot price and the ETF price are disrupted.

On the upside, this setup facilitates direct arbitrage between the ETF and futures. When the price of an ETF deviates from the spot price defined by the futures curve, an arbitrageur can create a strong connection between the ETF and the futures market by holding a perfect hedge on futures in the opposite position. It is reasonable to believe that an ETF with such characteristics would be resistant to fraud in unregulated spot markets such as futures contracts or futures ETFs.

Both academics and practitioners have found some strong evidence to support the idea that CME Bitcoin Futures dominate Bitcoin price discovery. Undoubtedly, the Bitcoin ETF space in the US will be a great development for traditional markets and the crypto industry. American pastor Chuck Swindoll once said, “The difference between good and great is attention to detail.” Keeping the devils away, the Bitcoin ETF has the potential to be truly great for investors.

This article is not intended for general information purposes and should not be construed as legal or investment advice. The views, ideas and opinions expressed herein are solely those of the author and do not necessarily represent the views and opinions of Cointelegraph.