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Research the dynamics of market manipulation before you jump in Bitcoin ETFs – Cointelegraph

Investors are hopeful that a Spot Bitcoin exchange-traded fund (ETF) could be approved by the U.S. Securities and Exchange Commission (SEC). The excitement began in early June when investment giant BlackRock filed a product application and a court ordered the SEC to reconsider its rejection of Grayscale’s proposal to convert Bitcoin Trust (GBTC) into a spot ETF. The momentum gained momentum after the ruling.

The SEC’s opposition to ETFs is related to the fact that Bitcoin (BTC) is traded in unregulated venues around the world, posing challenges to preventing fraud and price manipulation.

One attempt to address this issue includes Supervisory Sharing Arrangements (SSAs) with some crypto exchanges. In theory, this could help identify bad actors trying to manipulate the market. Critics question the effectiveness of these SSAs, given their inability to cover the entire market. The ETF builds on precedent decisions that allowed spot commodity ETFs based on the relevance of the underlying commodity futures market.

Related: With Bitcoin halving just around the corner, it may be time to take risks.

The SEC stipulates that in order to be considered a “substantial regulated market,” futures must take the lead in price formation. In other words, information from the futures market takes precedence over the spot market in the price discovery process. However, even if price discovery is driven by the futures market, there are still some instances where manipulation in the spot market can spill over to the ETF. The devil is in the details, more specifically in the price source for the net asset value (NAV) calculation and the method of creation and redemption (cash or in-kind).

Consider a scenario in which a manipulator succeeds in reducing the price of an underlying commodity by 5% in an unregulated spot market.

2019 Bitwise report on using volume-weighted median prices to protect against NAV manipulation.Source: Bitwise

When creation and redemption are done in-kind, there is a direct arbitrage that acts like a communication vessel between the ETF and the unregulated spot market. In this example, the arbitrageur simply buys an undervalued spot product, sells the corresponding amount of ETF, and then uses the purchased product to create new ETF units to cover his short position in the ETF. You can exploit it by doing The profitability of this trade lasts until there is substantial convergence between the spot commodity price and the ETF equivalent. Liquidity determines how much each price moves towards convergence, but some of the correction will come from the ETF price, meaning that manipulation in the spot market will at least partially trickle down to the ETF.

Very similar arbitrage is possible when creation and redemption are done in cash and NAV is calculated using commodity prices derived from unregulated spot markets. Arbitrageurs buy undervalued spot products and sell ETFs, using cash to create ETF units to cover short positions and pricing used in NAV calculations (determining the price paid for a product). Try to reproduce the method and sell the product. Other than lower capital efficiency (due to cash outlays for creation) and less execution risk in replicating the NAV price, the transaction is essentially the same as for in-kind creation, and the results are similar.

Related: Even after Bitcoin Spot ETF, futures will be the best crypto game in town

Are there settings that effectively protect ETFs from manipulation? Using spot prices derived from futures curves for NAV calculations, combined with cash creation and redemptions, has emerged as the most promising alternative. If an arbitrageur tries to apply the same method as in the previous case, there is no guarantee that he will be able to sell the product at a price similar to the price used to calculate the NAV, especially if there are manipulators in the spot market . This trade is no longer arbitrage. The pipe connecting spot prices and ETF prices is blocked.

Conversely, this setup facilitates an easy arbitrage path between ETFs and futures. Whenever the price of the ETF deviates from the spot price implied by the futures curve, the arbitrageur executes a trade in the opposite position, perfectly hedging the futures, establishing a solid link between the ETF and the futures market. can. It is reasonable to assume that an ETF with these characteristics would be resistant to unregulated spot market manipulation, similar to futures contracts and futures ETFs.

Both academics and practitioners have already found solid evidence supporting the idea that CME Bitcoin futures are dominant in Bitcoin price discovery. There is no doubt that a spot Bitcoin ETF in the US will be a positive development for traditional markets and the crypto industry. American pastor Chuck Swindoll once said, “The difference between good and great is the attention to detail.” Keeping the devil away makes Bitcoin ETFs truly great for investors It has potential.

Joao Marco Braga da Cunha I am a portfolio manager at Hashdex. He earned a master’s degree in economics from Fundação Getulio Vargas and then a doctorate in electrical and electronic engineering from the Pontifical Catholic University of Rio de Janeiro.

This article is for general informational purposes only and is not intended to be, and should not be taken as, legal or investment advice. The views, ideas, and opinions expressed herein are those of the author alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

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