The U.S. Securities and Exchange Commission pushed for bitcoin exchange-traded funds to have a key difference from major stock funds, and that decision’s effect on how the funds trade will only become clear over time.
The bitcoin funds that launched Thursday are using a share redemption process that turns the underlying crypto into cash. Most ETFs primarily use an in-kind redemption process, where the underlying asset does not have to be actually sold.
While the rules around share redemption do not directly affect the smaller trades that retail investors do in brokerage accounts, they come into play for the execution of larger trades made by institutions.
There is some concern that using the cash-only redemption model could make the plumbing of the ETFs less efficient.
“It could be that certain funds are capable of getting better execution prices than others. The other thing is that those trading costs, whether it be transaction costs or the market impact type costs that aren’t necessarily quantifiable, those costs are now borne by investors,” said Bryan Armour, director of passive strategies research for North America at Morningstar.
In-kind redemptions are typically used by major equity funds and, as crypto asset manager Grayscale pointed out in a presentation to the SEC, commodities funds. Using cash-only redemption could result in ETFs that have weaker liquidity and wider bid-ask spreads, Grayscale argued.
But Steven McClurg, chief investment officer at Valkyrie, said the situation may be more analogous to fixed income ETFs, where cash redemption is more common because the authorized market participants working with the funds may be more comfortable with that process.
“In this situation, there’s a lot of APs that don’t have the ability to transact in bitcoin. If it was an in-kind model, then it would throw a lot of advantage toward the APs that do have that ability. … We want as many market makers and authorized participants in these products as possible, because that makes for better markets,” McClurg said.
From a regulatory perspective, the decision to only allow cash redemptions simplifies the chain of custody for bitcoin and removes broker-dealers from the process, said Jeremy Senderowicz, an attorney and shareholder at Vedder Price, a firm that specializes in ETFs.
SEC Chair Gary Gensler said in a statement Wednesday that broker-dealers are still expected to follow best interest regulations with regard to crypto products, a potential sign that the SEC is wary of those firms becoming directly involved with these funds.
The good news for investors is that the cash-redemption process should not change the tax treatment of the funds, even though cash redemptions are more generally associated with mutual funds than ETFs. Many investors and financial advisors choose to use ETFs because the funds give them more control over when to create tax events.
“These things are taxed as grantor trusts. Consensus is that when an AP is redeemed for cash, the tax consequences only accrue to that AP. So it is not like cash redemptions on mutual funds and regular 40-Act ETFs where, to the extent that it’s a cash transaction, taxable income stemming from fund transactions is passed through to all the shareholders,” Senderowicz said.
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