The launch of U.S. exchange-traded funds (ETFs) tracking bitcoin strengthens ties between the volatile world of cryptocurrencies and the traditional financial system, potentially introducing new risks, according to some experts.
The Securities and Exchange Commission (SEC) approved 11 spot bitcoin ETFs this month from issuers including BlackRock (BLK.N) and Invesco/Galaxy Digital, marking a watershed moment in a crypto industry plagued by bankruptcies and crime.
The SEC had previously rejected the products, citing investor protection concerns, but was forced to reconsider after losing a court challenge brought by Grayscale Investments.
Crypto enthusiasts believe the products will make it easier and safer for investors to gain exposure to Bitcoin. However, when approving the products, SEC Chair Gary Gensler warned that bitcoin remains a “volatile asset” and that investors should exercise caution.
The ETFs have a combined asset value of around $21 billion, and some analysts predict that retail and institutional investors will invest up to $100 billion this year alone. Bitcoin has fallen by more than 6% since the products’ launch.
If widely adopted, the products could pose risks to other parts of the financial system during times of market stress by exacerbating bitcoin price volatility or causing price dislocations between the ETF and bitcoin, according to some ETF experts, citing previous ETF volatility events.
Others claimed that last year’s banking crisis in the United States demonstrated how financial and cryptocurrency markets can spread risk. Crypto lender Silvergate Bank, for example, liquidated following withdrawals triggered by the collapse of crypto exchange FTX, which stoked panic and contributed to Signature Bank’s failure, according to regulators. Meanwhile, the collapse of Silicon Valley Bank triggered a run on the stablecoin USD Coin.
“As investors pour money into these products, you substantially increase the risk of much greater interconnection between the core of the financial system and the crypto ecosystem,” said Dennis Kelleher, CEO of Better Markets, an advocacy group that had urged the SEC to reject bitcoin ETFs, citing risks to investors and the financial system.
Bitcoin was created in 2009 as an alternative payment mechanism, but it is now primarily used as a speculative investment. The Wells Fargo Investment Institute reports that its daily average volatility is roughly three and a half times that of equities.
According to Antonio Sánchez Serrano, principal economist at the European Systemic Risk Board, the European Union’s financial risk watchdog, Bitcoin ETFs may “particularly exacerbate” volatility during times of market stress, as well as other channels through which ETFs can create systemic risks.
Other channels include the decoupling of the ETF price from the underlying asset, which can cause concern for institutions that are heavily exposed to the products or rely on them for liquidity management.
“The differences with a plain-vanilla stock ETF are simply too large in terms of embedded risks,” Serrano said in an email to Reuters, referring to bitcoin ETFs, which he classified as complex.
Exchange-traded products that are complex, less liquid, and highly leveraged have historically been stressed.
In February 2018, a volatility-tracking exchange-traded note failed amid a surge in volatility, costing investors $2 billion.
In 2020, COVID-19 shutdowns caused a sell-off in some corporate bond ETFs. The CFA Institute, an investment professional organization that has also studied ETF risks, argues that if the Federal Reserve had not provided emergency support, including buying shares of bond ETFs, that stress would have spread to the broader fixed income market.
The ETF industry generally denies that their products pose systemic risks.
Bitcoin ETF issuers list a slew of market, policy, and operational risks in their risk disclosures, but acknowledge that because bitcoin is still in its early stages, some hazards may be unpredictable.
The SEC did not respond to a request for comments.
To be sure, Serrano and other experts believe the risks will be largely determined by how widely adopted the ETFs become.
“Systemic risk is all about size… We do not yet know enough about who is actually purchasing these and in what proportions,” Olivier Fines, head of advocacy and policy research, EMEA, at the CFA Institute said in an email.
Crypto industry executives also point out that crypto crises, such as the loss of roughly two-thirds of cryptocurrencies’ $3 trillion value in 2022, have primarily affected the crypto sector.
Connectivity between cryptocurrencies and the financial system still remains “very limited,” said Lapo Guadagnuolo, senior analyst at S&P Global Ratings.
ETF issuers claim to have put in place safeguards as well. For example, the products will be redeemed in cash rather than bitcoin, reducing the number of intermediaries who physically store the cryptocurrency.
“I don’t see cataclysmic… dynamics in any of these products,” said Steve Kurz, the global head of asset management at Galaxy Digital, which collaborated with Invesco on the ETF.
However, at least one top SEC official has expressed concerns.
When voting against approving the ETFs in January, SEC Commissioner Caroline Crenshaw said in a statement that the agency had not considered whether the ETFs would create a nexus with traditional markets that “allows crises in largely non-compliant crypto markets to spill over.”
Crenshaw, who did not respond to a request for comment, expressed concern that the ETFs would pave the way for riskier products.
“I fear that today we are setting ourselves up for tomorrow’s failure,” she said.