Experts Highlight Risks of Spot Bitcoin ETFs

The approval of spot Bitcoin ETFs by the SEC in January was a long-awaited event. However, the entry of major financial players into the industry brings several risks for the cryptocurrency, writes The Block.

One of the most apparent issues highlighted by industry experts is the concentration of Bitcoin holdings by the funds.

Single Point of Failure

Almost all issuers of the 11 exchange-traded products have designated the largest American crypto company, Coinbase, as the custodian of the cryptocurrency. Exceptions include VanEck, which opted for Gemini, and Fidelity with its own storage service.

Jameson Lopp, co-founder and CTO of Casa, believes that in such a scenario, the custodian becomes a single point of failure. According to him, authorities “won’t have to knock on many doors” if they decide to confiscate the Bitcoins locked in ETFs.

Jeffrey Ross, founder and managing director of Vailshire Capital, considers such concerns exaggerated. Theoretically, there is a risk of custodian error and loss of a significant volume of assets. However, large financial companies like the current Bitcoin fund issuers take measures to prevent such incidents, the expert noted.

Speculations about possible confiscation by authorities refer to the ban on gold ownership imposed by the Roosevelt administration during the Great Depression. At that time, the dollar was backed by the precious metal, making it an important component of monetary policy, whereas cryptocurrency is in a different position, Ross believes.

“The government has no reason to take Bitcoins from Americans,” he added.

A New Type of Double-Spending Attack

Another potential issue could be the so-called financialization of Bitcoin or the transfer of TradFi practices into the crypto economy, which has so far operated more or less by its own standards.

For this reason, Caitlin Long, founder and CEO of Custodia, called ETFs a “double-edged sword for the ecosystem.” 

“The main drawback is that new forms of Bitcoin financialization based on leverage will emerge. The SEC did the right thing by prohibiting custodians from lending assets that support ETF structures, but at a higher level, there will be mixing [of client and broker assets], collateral substitution, and leverage,” she noted.

Lopp also believes that Bitcoin-based securities will essentially create debt receipts. This means that through ETFs, people will own not the real cryptocurrency, but something representing its value, lacking essential qualities like decentralization, censorship resistance, and transparency of the public ledger.

“Since you can’t verify the company’s balance, there’s no certainty that your debt receipt can be redeemed for the asset it represents,” Lopp stated.

Long, in a thread on X, pointed out examples where Wall Street companies artificially inflated stock volumes through fictitious trading. Now they have the opportunity to try these tricks with Bitcoin, she believes.

Yes @Dr_Gingerballs‘ post abt CNS is very informative. It’s the kind of “skimming mechanism” in some #WallSt operational processes to which I’ve been referring over the yrs, which pick Mom&Pop’s pockets in hard-to-detect ways. It doesn’t create more #BTC tho—just more of the ETF

— Caitlin Long ?⚡️? (@CaitlinLong_) January 12, 2024

Ross confirmed that the SEC-approved structure for Bitcoin ETFs does not allow issuers to lend cryptocurrency to support shares. However, over time, products may become the basis for complex derivatives that “open the doors” to more risky behavior, the expert believes.

Grayscale, one of the issuers of a spot Bitcoin fund, has already applied to launch an ETF with a covered call option.

“We have to trust that the SEC is monitoring this, but the agency also lacks sufficient monitoring experience,” noted the founder of Vailshire Capital.

He assessed the near-term prospects of the products with little optimism, suggesting that in 2025-2026 we will witness several of their collapses.

Governance Conflict

Another issue discussed in the community is the potential attempts by institutional players to influence decisions regarding the future development of Bitcoin. Companies accumulating significant volumes of cryptocurrency in ETFs will gain a certain authority, which they might use for their own purposes.

Lopp considers this idea far-fetched. He recalled that during the “war” over block size in 2016-2018, miners and crypto service firms expressed support for a network fork and an increase in maximum volume. But their opinion did not prevail.

The expert also noted that ETF issuers do not actually interact much with the blockchain itself.  

“Therefore, we hope they will have less incentive to become activists in protocol development,” he concluded.

Ross believes that “governance wars” are quite possible sometime after 2025. ETF issuers will certainly try to make changes, but unsuccessfully, he added.

“They will likely attempt to switch to Proof-of-Stake or change the fixed amount [of Bitcoins], but there is practically no chance that true Bitcoiners will allow this to happen,” he stated.

Earlier, the SEC’s decision to approve spot Bitcoin ETFs was criticized from various positions by the agency’s commissioner Caroline Crenshaw and the international environmental organization Greenpeace.