Bitcoin spot ETFs now hold over $100 billion under management. Here’s why they could cause a financial crisis.
Let’s begin by clarifying some fundamental principles around the banking system that are often misunderstood. Imagine that you open a checking account and deposit one dollar. The bank records and maintains your balance of one dollar. Commercial banks in the United States are regulated entities; they are bound by U.S. laws and must adhere to rules laid out by regulatory authorities. The Federal Reserve Board, serving as the central bank, plays a key role in this regulatory framework.
All dollars in circulation are accounted for by a bank in the United States, or a foreign bank which clears transactions through a U.S. bank. This is precisely why the U.S. was able to freeze approximately $300 billion in central bank reserves from Russia back in June 2022. The majority of the frozen reserves were dollars that were accounted for by the U.S. banking system, which, upon instruction, froze the relevant accounts. If U.S. dollars or regulated securities are stolen or misappropriated in the eyes of the regulators, the regulators have an ability to resolve the situation in a way they see fit, in accordance with U.S. law.
An Exchange-Traded Fund (ETF) mirrors the performance of a group of assets and is available for trading on stock exchanges. The U.S. Securities and Exchange Commission (SEC) has previously greenlit Bitcoin futures ETFs on regulated U.S. exchanges, with the debut product being the ProShares Bitcoin Strategy ETF (BITO) which was listed on the Chicago Mercantile Exchange (CME) back in October 2021. This particular fund invests in futures contracts and does not directly invest in BTC (Bitcoin) itself. The settlements of these Bitcoin futures contracts are conducted exclusively in U.S. dollars, rather than in BTC. Consequently, the risk exposure for both the ETF provider and the investor is strictly confined to the stipulations of the legally binding futures contracts.
A spot ETF operates differently in that it directly corresponds to actual purchases of the underlying asset. In the case of a Bitcoin spot ETF, when shares are bought, the ETF provider receives payment in U.S. dollars and then instructs a designated custodian to acquire BTC from the market in a capacity that allows the custodian to accurately represent the fund’s holdings. Unlike futures contracts, the purchased BTC originates from sources that fall outside the regulatory purview of the Federal Reserve or the SEC, as the asset itself is not issued by a U.S. government-regulated entity.
In granting approval for a spot ETF, the SEC essentially endorses it as a sound investment choice. Should the custodian lose the BTC, there is no mechanism for freezing or recovering the digital assets through a regulated system, unlike U.S. dollars or regulated securities.
While the U.S. authorities might be capable of tracking down who controls the lost BTC in such a scenario, they may lack the jurisdiction or means to seize those assets. Shareholders of the ETF might as well be trading blank paper and everyone is held to ransom by the market for potentially trillions of dollars. Neither the custodian, the ETF provider, the SEC nor the Federal Reserve can fix the problem. Do regulators allow shareholders to lose it all? What counterparty risk exists in the system? One option that the Federal Reserve would have is to inject liquidity into the banks, so that out-of-pocket shareholders would be bailed out, preventing a systemic collapse. It’s 2008 all over again.