There has been a lot of debate and confusion around the nature of cash creation based ETFs, here is an explanation of the market dynamics involved.
The SEC has been actively engaging with potential issuers of spot Bitcoin ETFs, holding meetings throughout December. These discussions have led to a unanimous shift among issuers toward adopting a cash creation methodology instead of the typical “in-kind” transfers, marking a departure from the standard practice for other ETFs. Opinions on this change vary, but the general consensus is that it will have minimal impact on investors, significant implications for issuers, and reflects unfavorably on the SEC.
To understand the significance of this shift, it’s essential to outline the fundamental structure of Exchange Traded Funds (ETFs). ETF issuers collaborate with Authorized Participants (APs), who can exchange a predetermined amount of the fund’s assets (stocks, bonds, commodities, etc.) or a defined amount of cash, or a combination of both, for a fixed quantity of ETF shares at a predetermined fee.
Under “in-kind” creation, a standard creation unit might involve exchanging 100 Bitcoin for 100,000 ETF shares. However, with cash creation, the issuer must continuously publish the real-time cash amount required to acquire, in this example, 100 Bitcoin as the cryptocurrency’s price fluctuates. The issuer is then responsible for promptly purchasing the required Bitcoin to comply with fund covenants or selling them in the case of redemption.
This mechanism applies universally to all ETFs, debunking claims that cash creation means the fund won’t be backed 100% by Bitcoin holdings. While there might be a brief delay after creation, during which the issuer secures the necessary Bitcoin, any prolonged delay increases the issuer’s risk. A negative cash balance could lower the Net Asset Value, impacting fund performance and the issuer’s ability to attract assets.
Issuers face the challenge of balancing the goal of quoting a tight spread between creation and redemption cash amounts with the need to trade at or better than the quoted amounts. This requires sophisticated technology, as demonstrated by the example comparing the purchase price on Coinbase alone versus four regulated U.S. exchanges. The technology hurdle is evident, especially considering the complexity involved in traversing numerous market/price level combinations.
In conclusion, the shift to cash creation in spot Bitcoin ETFs introduces nuances that issuers must navigate, balancing tight spreads with efficient trading and emphasizing the need for advanced technology in this evolving landscape.
