How S&P Dow Jones’s crypto indices could transform the bitcoin industry

S&P Dow Jones Indices announced plans to launch “global crypto-asset indices” as early as next year. This development could be a major catalyst for the cryptocurrency market.

S&P Dow Jones Indices is a joint venture of S&P Global, Dow Jones & Company and CME Group. It manages tens of thousands of stock indices.

“As cryptocurrencies rapidly develop as a distinct asset class, the time has come for independent, reliable and user-friendly market benchmarks,” — заявил Peter Roffman, head of Innovation and Strategy at S&P Dow Jones Indices.

For crypto products, the company uses data from analytics platform Lukka, which tracks prices for 550 cryptocurrencies in real time. Recently Lukka closed a $15 million Series C funding round, which was led by S&P Global and asset manager State Street.

Lukka collects data according to equity market standards, and its products meet institutional-grade requirements. It is claimed that the company developed the “first in the world” methodology for pricing crypto assets based on fair market value.

Why indices matter

Indices measure the overall state of the market or a sector and track price movements of various asset classes, as well as baskets formed by common characteristics.

For active investors, indices allow them to compare the performance of their decisions with the broader market and gauge the success of their strategy.

There is also a large cohort of passive investors who do not seek to beat the market on returns but to profit from its real dynamics. This includes individual investors as well as investment organizations that follow conservative, low-risk strategies — for example, pension funds or asset managers. For passive investors, indices replace trading strategies.

In the last decade, the importance of indices has grown significantly, as after the 2008 crisis many financial firms shifted to passive investment strategies.

Indices also form the basis for selecting underlying assets in a variety of index funds, the shares of which trade on exchanges. Such funds simplify investors’ access to an asset or basket of assets and are becoming increasingly popular.

The launch of cryptocurrency indices by S&P Dow Jones Indices will provide a real foundation for creating Bitcoin-based exchange-traded funds (ETFs), which the biggest players in finance have grown accustomed to investing in.

How Grayscale trusts work

There are already crypto-based funds on the market — the trusts from American Grayscale Investments. Shares of these trusts, which are backed by one or more cryptocurrencies, are sold exclusively to accredited investors in private placements. Purchases typically require a lock-up period, after which they can be sold to retail investors on the secondary market — in Grayscale’s case only on over-the-counter (OTC) venues. Grayscale tracks the price of the underlying asset itself.

As of December 9, Grayscale managed assets of $12.1 billion, though earlier in the year this figure hovered around $2.5 billion.

12/09/20 UPDATE: Net Assets Under Management, Holdings per Share, and Market Price per Share for our Investment Products.

Total AUM: $12.1 billion$BTC $BCH $ETH $ETC $ZEN $LTC $XLM $XRP $ZEC pic.twitter.com/Rt4hQEeMb7

— Grayscale (@Grayscale) December 9, 2020

Not all companies are willing to take the risk of direct cryptocurrency investments; for some it is easier to invest indirectly, without leaving the familiar and safe environment. Grayscale funds serve this purpose. In late November, plans to invest $500 million in GBTC (a Bitcoin trust) were announced by American investment firm Guggenheim Partners.

The most common type of index funds in the financial market are ETFs — funds whose shares trade on stock exchanges alongside the shares of publicly listed companies.

Crypto ETFs and the problem of fake trading

The first attempt to register a Bitcoin ETF was by the Winklevoss twins in 2016. They submitted the corresponding application to the U.S. Securities and Exchange Commission (SEC). However, officials rejected it several times, and after the latest denial the Winklevosses terminated the attempts.

Bitcoin ETF attempts were also pursued by SolidX and VanEck (the latter is one of the main players on the American ETF market). After extended consultations with the SEC in September 2019 they also withdrew their application.

Subsequently VanEck redirected its efforts in this direction to Europe and, at the end of November this year, launched trading of a Bitcoin-backed exchange-traded note (ETN) on Germany’s Xetra.

Wilshire Phoenix also filed an application for a Bitcoin ETF, but likewise did not succeed. In the end, they decided to register a Bitcoin trust intended to be a competitor to GBTC from Grayscale.

Bitwise filed an application in January 2019, and then at every stage of proceedings with regulators openly and understandably explained the rationale.

One of the main complaints by the SEC in reviewing all applications was the high level of manipulation in the crypto markets. In the officials’ view, this made it impossible to track the true price of the underlying asset (Bitcoin).

To address this, Bitwise tried to find “white” exchanges that broadcast real trading volumes. After examining trading data on 85 platforms with daily trading volumes above $1 million, Bitwise confirmed that on most of them there was suspicious activity: for example, repeated trades, lack of trading at certain hours, too even a distribution of orders in the book, and so on.

Only ten Bitwise-examined exchanges did not raise questions about trading activity. These exchanges were Binance, Bitfinex, Coinbase, Kraken, Bitstamp, BitFlyer, Gemini, itBit, Bittrex and Poloniex. Bitwise proposed that these be used by the SEC to determine Bitcoin’s price in its ETF.

From there emerged Bitwise’s bold claim that 95% of all Bitcoin trading on crypto exchanges is fake. In reality, the company noted that for most exchanges it is impossible to determine what share of trades is executed by real traders and what portion is a product of manipulation.

During 2019 the SEC rejected Bitwise’s application several times. The latest round of review took place in early October and also ended in failure. In January this year Bitwise finally withdrew the application, although then the head of the company’s research department, Matt Hougan (responsible for persuading the SEC) said they would return to the issue when “the time comes.”

Despite Bitwise not achieving its goal, it initiated an important discussion about the reliability of publicly reported cryptocurrency trading data.

In its materials Bitwise criticized CoinMarketCap’s approach: the service published data supplied by exchanges (Reported Volume) without impediments. Little-known exchanges benefited from inflating volumes to make the top of the rankings, as CoinMarketCap sorts exchanges by volume by default. Wash trading (fraudulent trades) was usually used for this.

As a result, amid a backlash, the aggregator introduced the “Adjusted Volume” metric, began seeking other approaches to ranking exchanges and even founded an “alliance” of exchanges to combat fake trading. The initiative, however, did not progress. But many other major aggregators followed CoinMarketCap: Coingecko, CryptoCompare and others published their own ratings of “white” exchanges.

Another SEC complaint was the lack of custodial services for storing bitcoins. By 2020 this problem was also solved: there is a market for cryptocurrency custody services, and it works.

The importance of ETFs for the crypto market

ETFs are the most popular type of index funds among both individual and institutional investors. The ETF market in the U.S. is already comparable to the stock market: in November assets under management of exchange-traded funds surpassed $5 trillion.

More professional investors have adhered to passive strategies over the last decade, directing a substantial portion of capital into ETFs. The three largest U.S. asset managers by assets under management — BlackRock, Vanguard and State Street (the so-called “Big Three”) — own 80% of the country’s total ETF market.

Because ETFs are treated as regular stocks, non-accredited investors also have access to them— ordinary people with small sums. Many of them also prefer passive investing strategies.

This trend is evident in Russia as well: although there are currently only 50 ETFs there (compared with more than 2000 ETFs in the U.S.), the volume of retail investments in ETFs this year has tripled versus 2019.

A Bitcoin ETF also mirrors the trend toward viewing the first cryptocurrency as “digital gold” in investment circles. The structure of the Bitcoin market resembles that of a traded commodity with the possibility of physical or indirect ownership, for example via derivatives. An ETF is a suitable way to convert Bitcoins into a regular stock and to build a bridge for cryptocurrencies to the most active market—the equity market.

If you consider Citibank forecasts that the price of Bitcoin will rise as it replaces traditional gold in investment portfolios, a Bitcoin ETF could also become an additional means of competition. After all, gold ETFs are popular among investors: global holdings of such funds at the start of November reached a record of nearly 3,900 tonnes of gold, or $235 billion.

As Bloomberg analysts expect, the continuation of quantitative easing in the United States (apparently the only option) will lead to higher demand for defensive assets, namely gold and Bitcoin as defensive assets. The trend toward increasing demand for defensive assets is driven by market uncertainty and the grim state of the global economy. When the uncertainty ends is unknown, that is the nature of uncertainty, so this trend can be considered long-term.

In the battle between Bitcoin and gold for leadership among defensive assets, ETFs could play a key role.

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