Crypto ETFs are coming

Two of the hottest investment markets – Exchange Traded Funds (ETFs) and cryptocurrencies – have rapidly come together amid clamor for liquid, transparent and fair vehicles that allow retail investors to access digital assets. In the space of a week, three crypto-focused ETFs unveiled plans to list on public, regulated markets in Australia and the US, bringing digital currencies and the blockchain technology that enables them ever closer to the mainstream.

None of the three products, however, will directly hold Bitcoin or any other digital currencies as legislators here and in the US are yet to agree on formal regulation of the more than US$2.58 trillion market according to CoinMarketCap. Instead, the funds launched in October are focused on the industry around crypto – what BetaShares CEO Alex Vynokur calls the “picks and shovels in the gold rush” - and, in the case of the US listing, futures that track the performance of Bitcoin.

But ASIC’s release in late October 2021 announcing guidance on the use of crypto assets as underlying assets for exchange traded products (ETPs) after months of industry consultation may mean ETFs with direct exposure to the underlying currencies may be much closer than once thought.

Surge in interest from ETF providers

Despite doubts over their intrinsic value, the number of cryptocurrencies has exploded. There are nearly 10,000 listed on CoinGecko with a combined market capitalisation of $US2.66 trillion in mid-October, although more than 40 per cent of that is accounted for by Bitcoin, the original digital currency.

Seeing the rapid growth in value of cryptocurrencies and demand from investors, businesses in the ETP market have rushed to respond. ETPs are enjoying their own spectacular growth surge, with inflows up to a record $A2.9 billion in September, according to BetaShares. The same data source also shows the total value of funds in ETPs in Australia hitting a new record of $125.3 billion, up 76 per cent since the start of the year.

BetaShares’ Vynokur says the firm worked for a long time on developing a fund and has seen unprecedented registered interest in the launch of its Crypto Innovators ETF (CRYP) in November 2021. The fund will focus on companies such as trading venues, mining operators and equipment providers who derive at least 75 per cent of their revenue from directly servicing cryptocurrency markets or have the same share of net assets in direct holdings of liquid crypto-assets.

In October 2021, ETF Securities launched the ETFS Fintech & Blockchain ETF (FTEC) focusing on companies using the foundation technology that enables crypto-assets, as well as data and research companies, digital wallets and buy now, pay later providers that are disrupting the traditional financial services market.

Interestingly, the ASX itself is set to become a major test case for blockchain technology or more accurately. ‘distributed ledger technology’, with an upgrade to its ageing CHESS depositary system by the privately held Digital Asset Holdings. If successful, it would make the ASX the first exchange in the world to use blockchain for clearing and settlement by April 2023.

Meanwhile, in the US, ProShares overcame years of resistance from the SEC to win approval to list its Bitcoin Strategy ETF (BITO), which trades Bitcoin futures that give investors exposure to movements in the price of the notoriously volatile original cryptocurrency. On its first day, the fund attracted $US984 million of trades and rose 4.1 per cent.

And in late October, Cboe welcomed the Cosmos Global Digital Miners Access ETF (Cboe: DIGA) to the Cboe exchange, providing Australian investors with exposure to global leaders in digital asset mining and infrastructure tracked by the Global Digital Miners Index, custom designed by Cosmos Asset Management.

In each case, the ETF firms have avoided direct holdings of crypto-assets that would trigger resistance from the regulators and focused instead on assets such as public company shares and futures contracts traded on the Chicago Mercantile Exchange that have existing, well understood structures and operate in regulated markets.

Regulators issue guidance to address concerns

The ETF launches highlight the extraordinary demand for crypto investing which, for now is being met on lightly regulated crypto exchanges and by managers such as Apollo Capital, which is enjoying extraordinary demand for unlisted crypto-backed investments from family offices and institutions.

Henrik Andersson, Chief Investment Officer at Apollo, says the ProShares ETF launch was a “watershed’ for crypto-currencies because it is the first fund offering investors exposure to bitcoin prices. However, he says it was not the best approach for investors because of the effect on returns from the high cost of rolling over futures contracts.

Andersson thinks it could be as early as the middle of 2022 that investors will be offered crypto ETFs based on currency holdings, rather than futures or shares of crypto-related companies, as regulators become increasingly comfortable with the asset class.

Submissions to the Senate Committee on Australia as a Technology and Financial Centre - which reviewed issues around digital assets - as well as recent advice from ASIC, highlight the issues regulators want to overcome before allowing such assets on public regulated markets.

ASIC’s concerns include whether crypto-assets can be reliably priced, how crypto-assets should be classified with respect to underlying asset rules, and how product issuers can ensure these products comply with Australia’s regulatory framework, including for custody, risk management and disclosure.

In a guidance note released at the end of October, ASIC took the market by surprise when it revealed a path to the listed markets for crypto and crypto-related offerings. In keeping with an earlier statement that not-all crypto assets were suitable for the retail market, ASIC restricted its blessing to bitcoin and ether (which are digital tokens validated by the Ethereum platform). But its statement that providers of exchange traded crypto funds could advance providing they had detailed custody arrangement and certain disclosures is seen as setting a path for the first crypto-backed ETPs.

“It’s great to see increased clarity from ASIC on this matter,” says Andersson. “It opens things up for the first crypto ETP or ETF in Australia in the coming months.”

The next hurdle would be the exchanges, ASX and Cboe, who would still have to be satisfied the applicants met their own rules and that there were adequate protections in place to protect investors. ASX’s own submission to the Senate Inquiry raised concerns over asset custody, security and the presence of bad actors drawn to the crypto market by the explosion in speculative activity.

Regulation may support digital assets innovation

The final report of the Senate Committee on Australia as a Technology and Financial Centre, delivered in mid-October, recommended a series of changes to address concerns and draw Australia level with other countries that have already moved on regulating cryptocurrencies. The recommendations include a new market license for crypto businesses, new legal structures to accommodate blockchain-based organisations and a review of the way capital gains tax applied to crypto transactions.

“Australia has significant potential to keep advancing as a technology and financial centre, if we grasp the opportunity to update our regulatory frameworks, drive innovation and enhance our competitiveness,” the committee says in the report. Committee Chair, Senator Andrew Bragg, says he wants the recommendations in the report to be legislated over the next 12 months.

BetaShares’ Vynokur welcomes the move to regulate the crypto industry, noting that it would provide increased investor protection and expand the possibilities for an industry he says is the most significant technological advance since the birth of the internet.

“We definitely think that a regulatory framework is crucial to ensure investor protection. We believe it’s a better way to go than having unregulated players attracting Australian retail investors to unregulated venues to trade digital assets and cryptocurrencies,” Vynokur says.

If Australia can find the right path for regulating cryptocurrency amidst strong interest, there may be many more investors and investment products to follow building on the recent launch of these ETFs.