Regulators get tough on crypto funds after FTX collapse

Providers of crypto exchange traded funds are struggling to establish their products as viable investments, according to regulatory experts, as a crackdown on digital assets continues.

Crypto markets endured a year of acute turbulence in 2022 when the price of popular digital assets, such as bitcoin and ethereum, plummeted from record highs. These sudden falls plunged several once-prominent firms — including lending platform Celsius Network and crypto hedge fund Three Arrows Capital — into bankruptcy.

An industry-wide crisis of confidence culminated in November, when crypto exchange FTX — which, at its height, represented a pillar of the industry — collapsed in a matter of days after a surge in customer withdrawals. The exchange’s failure sparked a renewed sense of urgency among financial regulators to crack down on crypto markets — a trend that, in turn, poses a challenge to the world of crypto ETFs.

Crypto ETFs aim to give retail investors exposure to changes in digital asset values, without the need to buy or hold them directly. Nevertheless, regulators increasingly worry that these investors need protection from volatile prices and security scares.

“We’re in the midst of a regulatory onslaught against crypto,” says John Reed Stark, former chief of the Securities and Exchange Commission’s Office of Internet Enforcement. “Every day, it seems like there’s a new lawsuit targeting the industry. The SEC is not going to stand idly by, especially when investors are at risk. Investors may not like the rules but, just like seatbelt laws, sometimes investors need protection from themselves.”

As the chief financial markets watchdog in the US, the SEC has issued a blitz of enforcement actions against prominent crypto companies, including lender Genesis and exchanges Gemini and Kraken. The commission is also at loggerheads with asset manager Grayscale, which is seeking approval from the regulator to turn its bitcoin trust into a spot ETF holding the cryptocurrency directly.

The SEC has been willing to approve crypto futures ETFs — funds that track futures contracts, which are based on crypto prices but traded on regulated futures exchanges. However, it has repeatedly stopped short of granting approval to ETFs proposing to hold cryptocurrencies themselves, arguing that they trade on largely unregulated platforms where market manipulation presents a persistent risk.

The challenge is on the industry to prove that crypto is a safe investment for Americans’ retirement accounts — and that’s a very high bar

“I doubt the commission is going to change its thinking, given that they’re suing a new crypto company every week,” argues Stephen Diehl, software engineer and critic of the crypto industry. “The challenge is on the industry to prove that crypto is a safe investment for Americans’ retirement accounts — and that’s a very high bar.”

But Grayscale has long argued there should be no distinction between spot and futures crypto ETFs, because futures ETFs in effect expose investors to the same crypto market that a spot crypto ETF would. The asset management firm sued the SEC after having its request to convert its bitcoin trust into an ETF rejected. Grayscale claimed that the regulator’s decision was “arbitrary, capricious, and discriminatory”.

“Where this lawsuit lands will likely define the landscape of cryptocurrency ETFs for years to come,” suggests Bryan Armour, director of passive strategies research at investment insights company Morningstar.

Despite the tumultuous year for crypto assets, ETFs giving exposure to them thrived for most of 2022. Investors poured more than $240mn into six US bitcoin futures ETFs during the first 11 months of 2022, with more than 80 per cent of those inflows from June onwards — precisely when crypto was thrust into an unprecedented crisis of confidence.

That trend has continued into this year. By the end of January, several crypto ETFs posted eye-popping performances, including the Valkyrie Bitcoin Miners ETF, which registered a 101 per cent return for the month.

Later, in March, several crypto ETFs posted one-week returns of roughly 30 per cent, including the ProShares Bitcoin Strategy ETF, which delivered 36 per cent, according to data firm VettaFi.

Asset manager ProShares launched the Bitcoin Strategy ETF to great fanfare in late 2021 — when it amassed more than $1bn in its first week of trading. Its performance has, however, nosedived amid crypto’s market crunch.

In 2023, though, crypto ETFs have been buoyed by a recovery in prices. Bitcoin — the world’s flagship cryptocurrency — has risen above $28,000, a roughly 70 per cent increase from its $16,500 mark at the start of the year.

But, in spite of this rebound, direct crypto trading has been affected by fears surrounding the security of customer funds — lending credence to the notion that new crypto investors put off by the risks are pivoting to ETFs as a safer entry point to digital assets.

These fears were heightened by the collapse of FTX and have been perpetuated by several security issues in the decentralised finance space, including last month’s $197mn hack of decentralised finance protocol Euler Finance.

According to Ilan Solot, co-head of digital assets at Marex, a London-based financial services firm, ETFs retain their allure for those investors interested in cryptocurrencies but new to the asset class. “If you’re new to crypto, managing your own private key [to hold currencies directly] may be riskier than having an ETF in your trading account.” 

“If someone wants exposure to bitcoin, using an ETF gives them a less efficient product but they’re paying for the convenience of not having to hold their own crypto,” notes Solot.