US bitcoin ETFs raise questions over broader financial system risks

By: Admin

LONDON/WASHINGTON, Jan 31 (Reuters) - The launch of U.S. exchange-traded funds (ETFs) tracking bitcoin deepens ties between the volatile world of cryptocurrencies and the traditional financial system, potentially creating unforeseen new risks, some experts say.

The Securities and Exchange Commission (SEC) this month approved 11 spot bitcoin ETFs from issuers including BlackRock (BLK.N), opens new tab and Invesco/Galaxy Digital, in a watershed moment for a crypto industry dogged by bankruptcies and crime.

The SEC had long rejected the products citing investor protection concerns, but was forced to rethink its position after losing a court challenge brought by Grayscale Investments.

Crypto enthusiasts say the products will allow investors to more easily and safely gain exposure to bitcoin. But when approving the products, SEC Chair Gary Gensler warned bitcoin remains a "volatile asset" and that investors should be wary.

The ETFs combined have around $21 billion in assets, and could draw as much as $100 billion this year alone from retail and institutional investors, some analysts predict. Bitcoin is down more than 6% since the products were launched.

If widely adopted, the products could pose risks to other parts of the financial system during times of market stress by exacerbating bitcoin price volatility, or creating dislocations between the price of the ETF and bitcoin, said some ETF experts, citing evidence from previous ETF volatility events.

Others said last year's U.S. banking upheaval showed that financial and crypto markets can transmit risks to one another. Crypto lender Silvergate Bank, for example, liquidated following withdrawals sparked by the collapse of crypto exchange FTX, which in turn stoked panic that contributed to the failure of Signature Bank, regulators have said. The collapse of Silicon Valley Bank, meanwhile, sparked a run on stablecoin USD Coin.

"As investors pour money into these products, you substantially increase the risk of much greater interconnection between the core of the financial system and the crypto ecosystem," said Dennis Kelleher, CEO of Better Markets, an advocacy group which had urged the SEC to reject bitcoin ETFs, citing risks to investors and the financial system.

Conceived in 2009 as an alternative payment mechanism, bitcoin is mostly used as a speculative investment. Its daily average volatility is roughly three and a half times that of equities, according to the Wells Fargo Investment Institute.

Bitcoin ETFs could "particularly exacerbate" that volatility in times of market stress, and other channels through which ETFs can create systemic risks, said Antonio Sánchez Serrano, principal economist at the European Systemic Risk Board, the European Union's financial risk watchdog.

Those other channels include the decoupling of the ETF price from the underlying asset, which can cause stress for institutions heavily exposed to the products or which rely on them for liquidity management.

"The differences with a plain-vanilla stock ETF are simply too large in terms of embedded risks," Serrano wrote in an email to Reuters, referring to bitcoin ETFs, which he classified as complex.

Exchange-traded products that are complex, less liquid and highly leveraged have experienced stress in the past.

In February 2018, a volatility-tracking exchange-traded note went bust amid a surge in volatility, causing investors $2 billion in losses.

In 2020, COVID-19 shutdowns sparked a sell off in some corporate bond ETFs. That stress would have spread to the broader fixed income market had the Federal Reserve not provided emergency support, including buying shares of bond ETFs, the CFA Institute, an investment professional organization which has also studied ETF risks, has argued.

The ETF industry generally disputes that its products pose systemic risks.

In their risk disclosures, bitcoin ETF issuers list a slew of market, policy, and operational risks, but acknowledge the immaturity of bitcoin means some hazards may be unforeseeable.

The SEC did not respond to a request for comment.