Analysis: US bitcoin ETFs raise questions over broader financial system risks

Signature Bank

31/01/2024 06:00

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      ETFs deepen ties between bitcoin and mainstream finance
    

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      Volatility, price dislocation pose broader risks-experts
    

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      Experts say 2023 banking failures show contagion
possibilities
    

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      Risks depend on how widely adopted products become
    

  
    By Elizabeth Howcroft and Hannah Lang
       LONDON/WASHINGTON, Jan 31 (Reuters) - The launch of U.S.
exchange-traded funds (ETFs) tracking bitcoin deepens ties
between the volatile world of cryptocurrencies and the
traditional financial system, potentially creating unforeseen
new risks, some experts say. 
    The Securities and Exchange Commission (SEC) this month
approved 11 spot bitcoin ETFs from issuers including BlackRock
 BLK.N  and Invesco/Galaxy Digital, in a watershed moment for a
crypto industry dogged by bankruptcies and crime.  
    The SEC had long rejected the products citing investor
protection concerns, but was forced to rethink its position
after losing a court challenge brought by Grayscale Investments.
        Crypto enthusiasts say the products will allow investors
to more easily and safely gain exposure to bitcoin. But when
approving the products, SEC Chair Gary Gensler warned bitcoin
remains a "volatile asset" and that investors should be wary. 
    The ETFs combined have around $21 billion in assets, and
could draw as much as $100 billion this year alone from retail
and institutional investors, some analysts predict. Bitcoin is
down more than 6% since the products were launched. 
    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 creating dislocations
between the price of the ETF and bitcoin, said some ETF experts,
citing evidence from previous ETF volatility events. 
    Others said last year's U.S. banking upheaval showed that
financial and crypto markets can transmit risks to one another.
Crypto lender Silvergate Bank, for example, liquidated following
withdrawals sparked by the collapse of crypto exchange FTX,
which in turn stoked panic that contributed to the failure of
Signature Bank, regulators have said. The collapse of Silicon
Valley Bank, meanwhile, sparked a run on 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 which had urged the SEC to reject bitcoin ETFs,
citing risks to investors and the financial system.
    Conceived in 2009 as an alternative payment mechanism,
bitcoin is mostly used as a speculative investment. Its daily
average volatility is roughly three and a half times that of
equities, according to the Wells Fargo Investment Institute. 
        Bitcoin ETFs could "particularly exacerbate" that
volatility in times of market stress, and other channels through
which ETFs can create systemic risks, said Antonio Sánchez
Serrano, principal economist at the European Systemic Risk
Board, the European Union's financial risk watchdog.
        Those other channels include the decoupling of the ETF
price from the underlying asset, which can cause stress for
institutions heavily exposed to the products or which rely on
them for liquidity management. 
        "The differences with a plain-vanilla stock ETF are
simply too large in terms of embedded risks," Serrano wrote 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 experienced stress in the past. 
    In February 2018, a volatility-tracking exchange-traded note
went bust amid a surge in volatility, causing investors $2
billion in losses. 
    In 2020, COVID-19 shutdowns sparked a sell off in some
corporate bond ETFs. That stress would have spread to the
broader fixed income market had the Federal Reserve not provided
emergency support, including buying shares of bond ETFs, the CFA
Institute, an investment professional organization which has
also studied ETF risks, has argued. 
        The ETF industry generally disputes that its products
pose systemic risks.
        In their risk disclosures, bitcoin ETF issuers list a
slew of market, policy, and operational risks, but acknowledge
the immaturity of bitcoin means some hazards may be
unforeseeable. 
    The SEC did not respond to a request for comment. 
    
    "TOMORROW'S FAILURE"
    To be sure, the risks will largely depend on how widely
adopted the ETFs ultimately become, said Serrano and other
experts. 
        "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, most notably when cryptocurrencies lost around
two-thirds of their $3 trillion value in 2022, have mostly been
contained to 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 also say they have created guardrails. For
example, the products will be redeemed in cash, rather than
bitcoin, minimizing the number of intermediaries that physically
hold the cryptocurrency.
    "I don't see cataclysmic... dynamics in any of these
products," said Steve Kurz, global head of asset management at
Galaxy Digital, which partnered with Invesco on its ETF.
    Still, at least one top SEC official has flagged 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,
also said she was worried the ETFs could pave the way for
riskier products.
    "I fear that today we are setting ourselves up for
tomorrow's failure," she added. 

 (Writing by Tommy Reggiori Wilkes; Reporting by Hannah Lang and
Elizabeth Howcroft; additional reporting by Saqib Ahmed, Chris
Prentice and Douglas Gillison
Editing by Michelle Price and Anna Driver)
 ((thomas.wilkes@tr.com; +44 (0) 7769 955711;))