Bitcoin tracker funds threaten a clash by bringing together two fundamentally incompatible financial systems, says one former investment banker.
Bitcoin exchange-traded funds (ETFs) are still on the drawing board: as at end-August 2018, ten applications from potential issuers were sitting with the US securities regulator, pending approval.
The Securities and Exchange Commission (SEC) has cited the inadequacy of cryptocurrency exchanges’ surveillance-sharing agreements and the risk of market manipulation as its two key reasons for denying a green light to these financial products.
Yet many market observers expect such concerns to ease and for bitcoin tracker funds to see the light of day in the US by 2019.
ETFs, most of which track indices of shares, bonds, commodities and currencies, have proven to be one of the most successful financial innovations of the last two decades. Their promise of low-cost, liquid and diversified access to a variety of markets had helped attract over $5tn in assets by July 2018.
“It’s standard practice on Wall Street to reuse collateral”
Yet it’s the behind-the-scenes involvement of ETF managers in the lending of funds’ holdings that worries one cryptocurrency market observer.
Caitlin Long is a Harvard Law School graduate and formerly an investment banker at Credit Suisse and Morgan Stanley.
“It’s standard practice on Wall Street to reuse collateral,” Long told New Money Review.
One economist, Manmohan Singh of the International Monetary Fund (IMF) estimates that the volume of securities lent by institutional investors (pension funds, insurers, government entities and asset managers) to the global banking system has risen by 50 percent in the last four years and now totals $1.5tn.
Banks can repledge the securities they borrow from investment funds, using their own name—in other words, as if they were the owners of the borrowed assets. And each time a bank repledges a borrowed asset, it generates a loan within the global financial system, boosting the supply of money.
The volume of loans in this “shadow banking” system—so-named because it operates outside the system for regulated bank deposits—is closely monitored by the bodies responsible for monitoring the safety of the global financial system, such as the G20 Financial Stability Board, the Bank for International Settlements (BIS), the IMF and the leading central banks.
The share of shadow banking assets within the financial system has risen for the fifth year in a row, the BIS said recently, and now totals $160tn, about a half of all global lending.
Securities lending is a lucrative activity for the asset managers involved
When asset managers lend out securities from the funds they control, they receive a cut of the resulting revenues. Investment funds also engage custodian banks to look after clients’ assets. These banks often specialise as securities lending agents, an activity for which they too receive fees.
Securities lending is a lucrative activity for the firms involved. For example, BlackRock, the world’s largest asset manager and issuer of ETFs, generated nearly $600m in securities lending income last year, around 5 percent of its total revenues.
It is unclear whether any of the bitcoin ETFs awaiting regulatory approval would be looking to lend out their cryptocurrency holdings. Details of the ETFs’ proposed custodial arrangements, as detailed on their filings, are minimal.
Gold and others precious metals ETFs, perhaps the closest equivalent to yet-to-be-approved bitcoin ETFs, tend to hold their bullion in two forms: allocated and unallocated metal.
An allocated account is one to which a bullion dealer credits individually identified gold bars on behalf of ETF investors. Lists of such bars are published daily on ETF issuers’ websites, and verification that the bars are actually in place is conducted via a semi-annual audit of the bullion dealer’s vaults.
By contrast, gold held in an unallocated account is not segregated from the bullion dealer’s other assets. Unallocated gold is therefore a general claim against the dealer, and unallocated metal holdings could in theory be pledged to multiple parties.
State Street Global Advisors, manager of the SPDR Gold Trust (GLD), the world’s largest gold ETF, says that while it has a policy of lending out up to 40 percent of its ETFs’ assets, this does not apply to GLD and a small list of other ETFs, which do not engage in lending to third parties.
However, State Street says GLD’s holdings may be held temporarily in an unallocated account when fund units are being created or redeemed, or when metal is being sold to meet expenses.
More than one person can claim ownership of the same asset
Caitlin Long argues that there’s a fundamental philosophical difference between the cryptocurrency market, where a supply limit may be hardwired into the underlying software protocol, and the existing financial system, where banks and other institutions often reuse (or “rehypothecate”) assets over and over again.
This allows them, effectively and with the approval of the global monetary system’s overseers, to inflate the money supply indefinitely.
“Accounting standards allow rehypothecated assets to be accounted for by multiple owners,” says Long.
In other words, more than one person can claim ownership of the same asset held within the financial system—and it’s perfectly legal for them to do so.
Such practices can lead to confusion. In 2013, when an offer was made to take US company Dole Foods private, initially 33 percent more people claimed to own the company’s shares than there were shares outstanding. This was down to institutions having borrowed the shares from the original owners—and both categories claiming entitlement to the share offer.
The confusion was eventually resolved by a painstaking process of reconciliation, conducted by custodian banks and the Depositary Trust Company (DTC), which keeps the ultimate record of US companies’ share ownership.
Meanwhile, custodian banks have been subject to regular censure for other shortfalls in their business practices.
In 2015, for example, the UK’s Financial Conduct Authority (FCA) fined the UK arm of BNY Mellon, the world’s largest custodian bank, £126 million, for breaching its safe custody rules. This was the eighteenth penalty levied in four years on UK-based financial institutions for breaches of the country’s asset custody regime.
BNY Mellon, said the FCA, had failed to maintain adequate books and records for client assets supervised from its UK office. And it had made unauthorised use of those assets, held in so-called omnibus accounts, to settle the trades of other clients. More seriously, BNY Mellon had failed to segregate client assets held in omnibus accounts from assets belonging to the bank.
“There’s no lender of last resort in bitcoin”
Long says similar practices, if ever applied to cryptocurrencies, risk trouble.
“There’s no lender of last resort in bitcoin,” says Long.
“If Wall Street ever gets into a run on the bank, or if there’s a hard fork like the one in 2016 between ethereum (ETH) and ethereum classic (ETC), where the majority of the value goes to the new coin, it could trigger real losses. This is a different animal and it’s not fundamentally compatible with the way Wall Street does business.”
“I’m not interested in having an accident happen pertaining to bitcoin that will be blamed on bitcoin,” says Long.
“Hopefully more people will realise that they don’t own bitcoin unless they own their private keys and that a bitcoin ETF is just a paper asset.”
“I’m also very interested in seeing the fine print of the contracts if physically backed ETFs do get regulatory approval,” she says.
However, says Long, there are two things bitcoin ETF issuers could do to increase the security of client holdings, one of which involves passing the entitlement to ownership down the line to fund investors.
“Bitcoin ETFs could offer physical settlement to holders—redemption of the shares in the ETF for the actual bitcoin,” she says.
Some gold ETFs have a similar provision written into fund documents, although it’s usually prohibitively expensive to request the physical redemption of gold from the ETF.
Another safeguard, says Long, would be to make use of the public nature of the bitcoin blockchain. Bitcoin’s blockchain, which is updated every ten minutes, could provide an unforgeable audit of an ETF’s holdings, and one that’s a radical improvement on a semi-annual audit of bullion held in a vault.
“Publishing a bitcoin public key would be much better than publishing a list of gold bars,” suggests Long.
