Exchange traded funds (ETFs) are investment vehicles that allow would-be investors to dip their toe into a given market without the attendant risk of buying the asset itself.

These so-called ETFs are classified by the U.S. Securities and Exchange Commission as securities, and they track the movements of a given investment — a commodity like gold or a certain kind of company stock — with no need for the investor to buy the gold or stock directly.

ETFs are extremely useful for mitigating risk while still providing appropriate exposure in hot markets, and they’ve long been recognized as an essential tool for wary investors.

ETFs, then, seem tailor-made for new cryptocurrency investors. Cryptocurrency is famously volatile and unstable, and the barriers to entry for new investors can be quite high. There’s a need, at the bare minimum, to set up an account on an exchange, and crypto exchanges are pretty much unregulated. If an investor doesn’t want to risk putting his or her money into an unregulated and possibly unscrupulous exchange, then he or she has to go through the trouble of setting up a wallet and keeping it secure.

A Bitcoin-based ETF could potentially eliminate all of these issues, giving investors good exposure to Bitcoin in a familiar and regulated environment. Bitcoin ETFs have run into several regulatory hurdles, however. We’re going to take a look at how a Bitcoin ETF could function, why there’s demand for them, and what regulatory challenges they need to overcome.

Bitcoin ETF Basics

The first thing to understand about ETFs in general is that they are passive investment instruments. There are no fees to manage or keep track of them, even though they are actively traded on public markets.

Every ETF is tied to an index, and the ETF’s performance tracks the performance of the underlying index. In the case of a cryptocurrency or Bitcoin ETF, the index could consist of a portfolio of mixed cryptocurrencies or just an index tied to the price of Bitcoin.

The main difference between holding a Bitcoin ETF and just holding Bitcoin alone is that there is no need to worry about the security or storage of that Bitcoin — the ETF adds a layer of insulation and protection since the investor’s money is tied to the price and not to the digital asset itself.

There’s no exchange to be hacked, no wallet to be phished — just money in the market following the price of Bitcoin.

Read: Bitcoin for Dummies

Another thing that makes ETFs attractive to common investors is that there is no minimum investment. While Bitcoin is (nearly) infinitely divisible, most exchanges require certain minimum buys to cover their fees when buying or selling Bitcoin. Since an ETF does not signify ownership of the asset — just a bet on its price — these can largely be done away with.

ETFs can also be set up in such a way that they pay dividends to their investors. If you were to try to set up a similar scheme with actual Bitcoins, this would involve paying someone to watch the wallet and sell off a portion of the coins at regular intervals to pay “shareholders.” Since no actual Bitcoins are bought and sold when investing in an ETF, the process is greatly simplified.

Perhaps most importantly, the mechanism for paying these dividends falls under “like-kind” U.S. tax rules, so tax liabilities barely enter the picture. By contrast, cryptocurrency is generally subject in the U.S. to both short- and long-term capital gains tax, whether trades are made crypto-to-crypto or crypto-to-fiat. These taxes can be quite hefty — up to 40 percent in some short-term cases.

So, the core argument for Bitcoin ETFs is that they provide a safer, more stable way for investors to take advantage of the Bitcoin market without entering the Wild West, unregulated world of actual Bitcoin buying. ETFs are a long-standing financial tool for managing risk and simplifying the investment process, and their automatic exposure to U.S. regulatory laws would seem to make them a desirable alternative to letting investors run amok in the “physical” Bitcoin market.

Unfortunately, Bitcoin ETFs have been dogged with controversy since their inception.

ETF Challenges

The key player in the Bitcoin ETF drama is the SEC. As ETFs fall under the definition of a security, as per the so-called Howey Test, the SEC has regulatory authority over them.

Briefly, the Howey Test is a measure for determining whether a given financial instrument is a security. It stems from a 1946 Supreme Court case involving shares in a citrus grove. The court determined that a given financial instrument is a security — and thus under the purview of the SEC — if it meets three criteria: an investment of money, in a common enterprise, with the expectation of profits tied to the actions of others.

Read: What is the Howey Test?

Bitcoin ETF Approval?

Over the course of 2018, the SEC has repeatedly barred various ETF applications from coming to market.

In an Aug. 22 ruling, the commission expressly denied two Bitcoin ETFs from operating on the New York Stock Exchange’s Arca exchange. The exchange itself, in collaboration with the proposed ETF provider ProShares, had originally filed its application in December 2017. The ProShares case was not the only ruling made by the commission on the subject of Bitcoin financial tools in 2018, but it’s probably the most recent and relevant — and certainly the most representative.

The commission started off by saying that it was not considering the validity of Bitcoin, alone. Its ruling was strictly tied to the creation of Bitcoin-based ETFs. This was seen by some as a bit of a sidestep, as the commission did not have to directly declare Bitcoin a security or a non-security, which is a side issue that the market upon which the market has been seeking clarification.

Instead, the commission focused almost entirely on the threat of fraud and market manipulation within the larger Bitcoin market.

There’s a small silver lining to this representative Bitcoin financial instrument case. The commission shortly after issued a stay of its August decision for further review. Furthermore, the rejection itself was based upon the need for more assurances, notably a large Bitcoin futures market. Should that market develop, the thinking goes, Bitcoin ETFs might yet be on the table in the future.

Bitcoin Progress

Bitcoin has come a long way since Satoshi Nakamoto’s landmark 2008 white paper, growing from a niche cypherpunk toy to a mainstream financial instrument. Yet, the market has not fully matured, and the SEC’s repeated rulings seem to be stifling that. In a circular way, the commission has declared that the market is not yet fully insulated from fraud and manipulation, and thus it cannot use financial tools that would help protect investors from fraud and manipulation.

Still, Bitcoin’s Mainstream and Wall Street acceptance is growing, and some market observers predict it’s only a matter of time before Bitcoin ETFs become just another tool in the crypto investment toolkit.

Bitcoin ETF News

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