The Inevitability of Cryptocurrency ETFs

Over the last twenty years one of the most notable trends in the asset management industry has been the rise of electronically traded funds (ETFs). An ETF is a fund that passively tracks a basket of securities, typically stocks or bonds. Since the first ETF tracking the S&P 500 was created in 1993, ETFs have steadily become the preferred investment instrument for millions of people and institutions seeking exposure to broad market indices. According to the research firm ETFGI, US-based ETFs have over $4 trillion in assets under management, with $326.3 billion flowing into US-listed ETFs in 2019. Within the last decade, the number of ETFs that track stock market indices has more than doubled, from 901 funds in 2010 to over 2,100 today.

Simultaneously, another less mainstream and risky trend has shaken up retail investing: the rise of digital currencies. Bitcoin, a blockchain-based peer-to-peer cryptocurrency pseudonymously invented in 2008, remains the most popular and widely held digital currency. Often referred to as “digital gold” due to its limited supply and ability to function as a hedge against inflation (like gold ETFs), Bitcoin now has a market capitalization of nearly $200 billion. According to a survey by Blockchain Capital, 30 % of those in the 18-to-34 age range would rather own $1,000 worth of Bitcoin than $1,000 of stocks or bonds. As interest has grown, established financial institutions have taken notice. Just last week, PayPal announced that it would allow US users to buy, hold, and sell cryptocurrencies. In the company’s press release PayPal CEO Dan Schulman said that the shift to digital currencies “is inevitable.”

These two trends – ETFs and cryptocurrencies – are now set to collide. At a conference held by the Chamber of Digital Commerce on October 2nd, Securities and Exchange Commission (SEC) Chairman Jay Clayton stated that the SEC is actively developing a regulatory framework that will permit ETFs that track crypto assets. The SEC is collaborating with the Office of the Comptroller of the Currency (OCC) and the Commodity Futures Trading Commission (CFTC) on an approach to oversee cryptocurrencies, which continue to exist in a regulatory grey area. Clayton’s comments came as a response to specific interest in the prospect of cryptocurrency ETFs. A recent study by Bitwise Asset Management found that 76% of surveyed financial advisors reported that they had received a question from a client about crypto in the past twelve months. In addition, a top concern of financial advisors in the survey was that cryptocurrencies lack “easily accessible investment vehicles like ETFs or mutual funds.”

While Clayton’s statement indicates that a cryptocurrency ETF could be on the horizon, proponents shouldn’t get their hopes up just yet. Historically, the SEC has been skeptical of cryptocurrencies and reluctant to grant regulatory approval to experimental ETFs. In 2018 the SEC rejected the Winklevoss Bitcoin Trust, a bitcoin ETF launched by Cameron and Tyler Winklevoss (the twins made famous for their early involvement with Facebook and subsequent depiction in The Social Network film). The SEC cited issues related to fraud and investor protection. Last March, the SEC similarly rejected Wilshire Phoenix’s proposal for a bitcoin-based ETF.

The appeal of a digital currency ETF – for both ETF issuers and retail investors – is that it would allow new investors to gain exposure to a diversified basket of cryptocurrencies. Further, crypto ETFs could offer outsized returns that are uncorrelated with the stock market. According to a recent paper by Sandip Mukherji of Howard University, over the last 60 months Bitcoin has provided higher returns (with higher volatility) than ETFs containing bonds, stocks, commodities, and other alternative assets.

Though still years away, an SEC-approved ETF tracking digital assets would accelerate capital flowing into ETFs as well as the adoption of digital currencies. As regulators better understand the cryptocurrency ecosystem and interest from investors continues to climb, a crypto ETF could happen sooner rather than later.