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Could Bitcoin ETFs create volatility in cryptocurrency markets?


Bitcoin ETFs have disrupted the market, but there are fears over how much they'll disrupt crypto prices.

The arrival of the first US Bitcoin ETF couldn't have come at a better time, with the price of Bitcoin hitting a new record high just a day after listing.

The ProShares Bitcoin Strategy ETF (BITO) launched onto Wall Street in late October 2021 and was soon followed by the second crypto ETF, the Valkyrie Bitcoin Strategy ETF (BTF) two days later.

But despite a happy start, the price of Bitcoin would quickly reverse course. Just one week after BITO's listing, Bitcoin had plunged by more than 11% from US$66,000 to US$58,000 in days.

The volatility surrounding the ETF listings raised alarm bells over how much influence these crypto funds might have over the market and shed some light on why regulators may have pushed back for so long.

Why are regulators worried?

Fund managers have been trying to launch physical Bitcoin ETFs in the US for years.

The first application for a US physical Bitcoin ETF was filed in 2013 by the the Winklevoss twins who you probably remember from the film The Social Network. And numerous other applications have been submitted and rejected by the SEC since then.

The reason the ProShares and Valkyrie Bitcoin ETFs were able to cross the line is because, unlike the failed listings on the past, there is no physical Bitcoin involved. Instead they trade in Bitcoin futures contracts.

Futures indices attempt to deliver the same performance as the physical asset they're tracking. The big downside is that on the whole they tend to underperform.

For instance, Horizon’s Front Month Rolling Futures Bitcoin Index has returned 530% in 2 years, while Bitcoin itself returned 660% over the same period, according to Bloomberg.

Which begs the question - why has the SEC refused to allow physical Bitcoin ETFs?

What's driving prices?

The SEC is wary about giving the green light to an ETF whose underlying value is influenced by prices on unregulated crypto exchanges.

BITO and BTF passed the test because futures exchanges, like the Chicago Mercantile Exchange (CME), are governed by the SEC.

The other big question mark is around what kind of influence physical crypto ETFs themselves will have over crypto price discovery.

Price discovery is all about what is influencing asset prices the most.

If one or a few Bitcoin ETFs become very popular, they could reasonably become the dominant driver of price discovery.

In an extreme case, some analysts fear this could result in a Bitcoin bubble. The theory goes that if enough funds pour into physical Bitcoin ETFs, it could drive up prices across the market.

Essentially, you’d have a perpetuating cycle where Bitcoin prices go up, simply because more funds are poured into index funds.

Cryptocurrency exchanges

Bitwise Asset Management, a US cryptocurrency index and fund provider, argues that the futures exchange Chicago Mercantile Exchange (CME) is actually the dominant source of price discovery.

To back that theory, it looked at previous overseas listings of cryptocurrency ETFs, such as Canada’s Purpose Bitcoin ETF, BTCC.

It concludes: "The data shows, at least in an anecdotal fashion, that even substantial inflows into newly launched ETPs have not correlated with changes in the price of Bitcoin in a statistically significant fashion."

If CME is proven to be the dominant force in price discovery, it would give the SEC and other regulators more reason to approve physical Bitcoin ETFs.

Of course, this view benefits fund managers like Bitwise, who are attempting to launch their own cryptocurrency ETFs.

Other studies say just the opposite. In a report titled Price discovery in Bitcoin: The impact of unregulated markets from the University of Sussex, researchers concluded that CME far from dominates price discovery, attributing it instead to activity on unregulated exchanges like Huobi, OKEx, BitMEX.

It says: "The CME futures have a very minor effect on price discovery, even less than the spot exchanges Bitfinex, Bitstamp and Coinbase. Our findings highlight the persistent problems stemming from inconsistent regulation in Bitcoin spot and derivatives markets, including insufficient price stability and lack of resistance to manipulative trading."

Lack of regulation

Cryptocurrencies are undoubtedly here to stay in some form.

The problem we now face is a lack of consistent regulation that has left authorities uncertain of the path forward.

Unlike assets such as gold or cash currencies, there is no agreed-upon rule book from authorities around the world. The same year that China banned Bitcoin, El Salvador made it the country’s legal tender.

This has confused the view of whether something like a Bitcoin ETF is a reasonably safe vehicle for investors or unpredictable and easily manipulated.

The exciting part of this is that we’re at a crossroads. What happens over the next few months in the ETF space could have a massive impact on how cryptocurrencies are adopted and even regulated in the future.

The good news is, where there is volatility and uncertainty, there can also be big opportunities if you’re willing and able to take on the risk.

As for the feared bubble, well there’s a very real possibility we’re in one. But like Montgomery says, bubbles come and go: "Like the stock market, there will be many bubbles that inflate and explode along the way."

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