How to prevent ETFs from being affected by manipulation in the spot Bitcoin market?

Protecting ETFs from Manipulation in the Spot Bitcoin Market Prevention Strategies

Author: João Marco Braga da Cunha, Portfolio Manager at Hashdex; Translation: Song Xue, LianGuai

Investors are eagerly awaiting potential approval from the U.S. Securities and Exchange Commission (SEC) for a physically-backed Bitcoin exchange-traded fund (ETF). This excitement began in early June when investment giant BlackRock filed for the product and was further amplified by a court decision requiring the SEC to reconsider its rejection of the proposal to convert the Grayscale Bitcoin Trust (GBTC) into a physically-backed ETF.

SEC’s opposition to ETFs is related to Bitcoin.

One attempt to resolve this issue includes the signing of Surveillance Sharing Agreements (SSAs) with some cryptocurrency exchanges. In theory, this would allow for the identification of bad actors attempting to manipulate the market. Critics have questioned the effectiveness of these SSAs as they cannot cover the entire market.ETFs are built on precedent decisions that allow for the trading of physically-backed commodity ETFs based on the correlation of the underlying futures market.

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SEC has established that futures must lead the price discovery process over spot in order to be considered a “regulated market of significant size.” In other words, in the price formation process, futures markets’ information is prioritized over spot markets.However, even if price discovery is led by futures markets, there are still situations where manipulation in the spot market can spread to ETFs. The details make a difference, specifically the price sources used in the Net Asset Value (NAV) calculation and the creation/redemption process (cash or in-kind).

Consider a scenario where a manipulator successfully pushes down the price of the underlying commodity by 5% in an unregulated spot market.

A 2019 Bitwise report proposes using volume-weighted median prices as a safeguard against NAV manipulation. Source: Bitwise.

If creation and redemption are done in-kind, there is a direct arbitrage opportunity between the ETF and the unregulated spot market, like a bridging container. In this example, arbitrageurs can profit by simply buying undervalued spot commodities, selling an equivalent amount of ETF shares, then using the purchased commodities to create new ETF units and closing their short positions on the ETF. This trade profitability will continue until the spot commodity price converges substantially with the ETF’s equivalent value. The degree to which prices move towards convergence depends on their liquidity, but some adjustments will come from ETF prices, meaning manipulation in the spot market spreads to the ETF to some extent.

There’s also a very similar arbitrage opportunity when creation and redemption are done in cash, and NAV is calculated based on commodity prices from the unregulated spot market.Arbitrageurs buy undervalued spot commodities and sell ETF shares, use cash to create ETF units to close their short positions, then sell the commodities in an attempt to replicate the pricing method used for NAV calculation (which determines the price paid during creation). Apart from being less capital efficient (due to cash creation costs) and having a slight execution risk when replicating NAV prices, this trade is essentially the same as in-kind creation and has similar consequences.

Is there an effective mechanism to protect ETFs from manipulation? Using the spot price derived from the futures curve to calculate the net asset value (NAV), and combining it with cash creation and redemption, seems to be the most promising alternative. If an arbitrageur attempts to use the same method as before, there is no guarantee of selling the goods at a price similar to the one used in NAV calculation, especially when manipulators exist in the spot market. This trading is no longer arbitrage. The pipeline connecting spot prices and ETF prices is blocked.

On the other hand, this mechanism provides a direct arbitrage path between ETFs and futures. Whenever the ETF price diverges from the spot price implied by the futures curve, arbitrageurs can take opposite positions in futures and perfectly hedge in futures, establishing a strong connection between the ETF and futures markets. There is reason to believe that an ETF with such characteristics will be as resistant to manipulation in unregulated spot markets as futures contracts or futures ETFs.

Scholars and practitioners have found compelling evidence supporting the dominant role of the Chicago Mercantile Exchange (CME) Bitcoin futures in price discovery for Bitcoin. There is no doubt that the launch of a spot Bitcoin ETF in the United States would be a positive development for both traditional markets and the cryptocurrency industry. As the American pastor, Chuck Swindoll, once said, “The difference between good and great is attention to detail.” By avoiding issues, a Bitcoin ETF has the potential to bring true greatness to investors.

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