A Bitcoin ETF Would Be Good for Investors and Regulators

The Securities and Exchange Commission faces an important decision about cryptocurrency: Whether to approve a Bitcoin exchange-traded fund. Although it would be best to see such ETFs approved only after Congress has strengthened crypto regulation generally, the likelihood of that happening in the near future is low. The next best thing, then, is for the SEC to approve an ETF conditionally in a way that would enhance transparency and integrity in the industry. 

A Bitcoin ETF would be a way for retail investors to invest in cryptocurrency without having to actually purchase it and deal with the complexities of custody. There have been several applications to create Bitcoin ETFs pending with the SEC for years. To determine the price of shares of the ETF, they would rely on indices of Bitcoin prices derived from trading on crypto exchanges. 

The problem is that those crypto exchanges are unregulated, and former SEC Chairman Jay Clayton was apparently unwilling to move forward on any ETF application because of well-founded concerns about the risk of fraud and manipulation in the underlying cash market. The SEC does not have the authority to regulate these exchanges, because it can only regulate exchanges that trade securities, and Bitcoin and the other widely traded tokens are not securities. The Commodity Futures Trading Commission does not have the power, either. It regulates derivative exchanges. 

This means neither agency has the authority to set standards for Coinbase, Kraken and other U.S.-based crypto exchanges. And it means investor protection is weak. There are no rules to prevent fraud, manipulation and other abusive practices. There are no disclosure or reporting requirements. There are no prohibitions of conflicts of interest — some exchanges have proprietary trading operations that can compete against customer trades, and some have financial interests in the crypto assets they list. 

Many who believe that Gary Gensler, the new SEC chairman, should approve an ETF argue that the market has grown so big today that it is difficult to manipulate. Some also point out that there are now Bitcoin futures that lead price discovery, and those trade on CFTC-regulated exchanges. 

Those two developments are helpful but not sufficient.

The SEC could use the ETF approval process to improve transparency and integrity of trading on crypto exchanges. The approval would be granted on the condition that the ETF price be based on an index of exchanges meeting certain prescribed standards, similar to those for securities and derivatives exchanges.

These could include standards on reporting and disclosure, prevention of fraud, governance, prohibition on conflicts of interest, risk management, operational security and so forth. This would create a market incentive for exchanges to adopt such standards and for trading to flow to them. And it could create a blueprint for future legislation.

The CFTC, for its part, could incorporate similar standards into its approval process for crypto-derivatives, which can involve examining the risk of manipulation in the underlying cash market.

This approach could also draw on the work over the last decade to improve financial benchmarks for commodities, something that Gensler is quite familiar with from his tenure a decade ago as CFTC chairman and bringing enforcement cases for manipulation of the London interbank offered rate. Those cases led the International Organization of Securities Commissions to develop its Principles for Financial Benchmarks, which set standards for integrity and transparency that widely followed price indices must meet, such as those used in the oil industry.

This approach could also provide an incentive for decentralized exchanges to develop ways to meet such standards. DeFi is an increasingly important part of the crypto ecosystem, and this would avoid the common problem that regulations often favor the largest and best capitalized players in an industry. 

Some might say approving an ETF only further legitimizes an industry that we should be trying to contain. But the traditional approach to financial market regulation is to refrain from such judgments, and instead to require transparency and integrity in markets and let investors make their own decisions. 

So, if it’s unlikely that Congress will act to improve crypto regulation, let’s create market incentives for better self-regulation. This type of conditional approval would be a way to increase the industry’s transparency, integrity and investor protection, not just its mass appeal. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Timothy Massad is a research fellow at the John F. Kennedy School of Government at Harvard University. He served as chairman of the Commodity Futures Trading Commission from 2014 to 2017 and was the U.S. Treasury Department's assistant secretary for Financial Stability and oversaw the Troubled Asset Relief Program.

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