US regulator makes important decision about Bitcoin derivatives

Bitcoin has been back in the news. The US Securities and Exchange Commission (SEC) handed a blow to the cryptocurrency when it denied an application by the Winklevoss twins (of Social Network fame) to create an exchange-traded fund (ETF) based on Bitcoin called the Bats BZX Exchange. An ETF is an investment fund that holds assets such as stocks, commodities, or bonds, and trades them using an index, and is managed by a recognised and authorised broker dealers.

An ETF based on Bitcoin would have been a big step for the unstable electronic currency. While the exchange price of Bitcoin has remained high, mostly due to speculation from Asian markets, Bitcoin continues to be largely ignored by investors and users, and adoption of BTC as a means of exchange remains very low. The proposed ETF would have served to legitimise Bitcoin and would have allowed new investors to join the market and trade it as a commodity.

However, in denying the application the SEC produced a scathing review of the current Bitcoin market. The document states:

“One commenter states that the market for bitcoin, by trade volume, is very shallow. This commenter notes that the majority of bitcoin is hoarded by a few owners or is out of circulation. The commenter also notes that ownership concentration is high, with 50 percent of bitcoin in the hands of fewer than 1,000 people, and that this high ownership concentration creates greater market liquidity risk, as large blocks of bitcoin are difficult to sell in a timely and market efficient manner. This commenter claims that daily trade volume is only a small fraction of total bitcoin mined. […]

With respect to spot bitcoin trading outside the United States, the information in the Exchange’s proposal and from commenters demonstrates that the bulk of bitcoin trading occurs in non-U.S. markets where there is little to no regulation governing trading,103 and thus no meaningful governmental market oversight designed to detect and deter fraudulent and manipulative activity.”

The SEC concludes that the combination of volatility and lack of regulatory oversight make the proposed creation of a derivatives market a risky endeavour that it cannot support, although it opens the door for a future examination of this decision.

Interestingly, the SEC order serves to cement the concept that Bitcoin is not a currency, but it is a commodity and therefore should be regulated as such. The SEC recognises that the Commodity Futures Trading Commission (CFTC) has declared Bitcoin as a commodity, and as such it has the role of regulating its implementation in the United States, and policing exchanges trading in BTC. This is in line with the assessment we made in our First Monday paper (with Chris Marsden), where we favoured the commodity solution.

Speaking of that paper, it is heartening to see that the SEC agrees with many of our own findings regarding the volatility and vulnerability of the cryptocurrency. We found that the hoarding nature of many of those involved in the currency gave a few operators disproportionate power over the exchange price.

However, the SEC’s decision will do nothing to dent the enthusiasts. As of writing, Bitcoin has been on yet another price rollercoaster, that seems to be the only certainty in the crazy world of Bitcoin.

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