With Facebook signalling its intent to use digital currencies, the world is getting a fresh reminder that crypto is here to stay.
Digital currencies have unquestionably brought in new technology – distributed ledger – which has enormous potential benefits. While at the moment it is mostly being used for speculation, in future it could be used for more valuable “tokenised” transfers like property.
In the future too – and perhaps the near future – it could also include crypto ETFs, which for too long have been turned down by regulators, who fear the worst.
In the United States, the biggest market, the SEC has expressed two major reservations about allowing crypto to trade on exchange.
First, custodial arrangements are inadequate. A bitcoin wallet is not a bank account. I know who I can sue if the custodial firm gets hacked and loses whatever stocks I buy. With bitcoin you only have a bitcoin wallet, with a “private key” and no recourse. As with old school Swiss Bank accounts, if your private key gets discovered, your wallet can get emptied with so much savoir faire.
Second, market manipulation is rife and exchange quality is low. Crypto exchanges have everything: fraud, wash trades, IEO scams, fake data, insider whales, pump and dumps, front running, theft. Crypto ETPs will take pricing from crypto exchanges, which are hot beds of fraud. And the SEC worries that permitting them will provide a channel for investors to get fleeced.
While other regulators globally have not publicly spelt out their qualms, one imagines them similar or the same.
Regulators are certainly right to have concerns. Beyond the technical problems above, crypto trading is a limited exercise in its own right. Trading cryptos in aggregate is a zero-sum game. As they have no internal rate of return, one investor’s gain is an equal and offsetting loss. Nor are they currencies, like the term “cryptocurrency” would suggest: currencies place claims on states and taxation ensures demand (and therefore value).
Yet for all the weaknesses, it is a good idea for regulators to greenlight crypto ETPs. Why?
For one, while distributed ledger technology has a lot to offer, the people creating and maintaining (mining) it need to be rewarded for their efforts. And unless you have crypto coins to pay for it, they won’t get rewarded. Crypto ETFs could help be part of this cycle of reward and help incentivise this continuing innovation.
For two, current regulatory hesitation ignores an important fact: digital assets are already trading on OTC markets, and retail investors are buying crypto every day, just on venues less secure than major exchanges.
Regulators appear to worry that if crypto is on exchange, then mums and dads might buy it and get swindled. Yet this line of argument provides little help to those who are trading them in dark venues. There is little logic in saying no to crypto ETPs but saying yes to Bitfinex and other less reputable trading venues.
The third is the inconsistency in having all kinds of leveraged and inverse ETPs on exchange – but not bitcoin trackers. Inverse VIX ETPs simply broke in 2017 and investors got burnt. While the compounding of the daily resets on 3x leveraged and inverse ETPs mean they go to zero long term. (And are constantly needing reverse stock splits). While these ETPs might not be “manipulated” like crypto often is, the danger of losing a lot of money very quickly is the same.
Finally, there is always a risk with regular stocks that they too get manipulated and go to zero. Biotech lottery tickets are one example; the winners in biotech investing are often those with “a finger in the pie”. Countless tech companies went boom then bust during the dotcom bubble. Trading on exchange is never a silver bullet.
In sum, the picture with crypto ETPs looks a lot like self-driving cars. There’s new technology with a lot of promise and a lot of potential dangers. Yes, it is likely that there will be accidents at the beginning – there have been with both. But by bringing crypto on exchange, trading will step out of the dark and into the light and help create a positive cycle of reward.
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Disclosure: The author does not own any crypto currency.
