US SEC gives green light, encryption ETF enters commodity era

Author: Golem, Odaily Planet Daily

On July 29, the U.S. Securities and Exchange Commission (SEC) officially permitted Authorized Participants (APs) to create and redeem crypto ETFs in physical form. This means that going forward, Bitcoin and Ethereum ETFs will be on par with other commodity-based ETFs (such as those for oil and gold), allowing the creation and redemption of ETF shares using physical assets. Previously, Bitcoin and Ethereum ETFs were restricted to cash-based creation and redemption only.

Cash-Based vs. Physical-Based

So, what are the differences between creating and redeeming crypto ETFs through cash-based and physical-based methods?

Cash-Based: APs settle with ETF issuers using cash

The previous process for cash-based creation and redemption of Bitcoin and Ethereum ETF shares is briefly outlined as follows:

ETF Creation Process

The ETF issuer announces a daily cash basket amount, representing the total cash required to create one "creation unit";

Authorized Participants (APs) deliver cash to the ETF issuer;

Upon receiving the cash, the ETF issuer purchases the corresponding amount of crypto assets on the market and adds them to the ETF's custodial pool;

Finally, the ETF issuer issues the corresponding number of ETF shares to the AP.

ETF Redemption Process

When the market price of the ETF falls below the daily Net Asset Value (NAV), APs buy the corresponding number of ETF shares on the secondary market;

APs return these shares to the ETF issuer;

The ETF issuer sells the equivalent amount of Bitcoin/Ethereum based on the redeemed shares and converts them into cash on the spot market;

The issuer then returns this cash to the AP to complete the redemption.

Physical-Based: APs settle with ETF issuers using "physical assets" (i.e., cryptocurrencies)

ETF Creation Process

The ETF issuer defines a "creation unit," typically tens of thousands of ETF shares. The Net Asset Value (NAV) corresponding to this unit is the total amount of crypto assets that the AP must deliver;

Through pre-agreed secure custody and transfer protocols with the ETF issuer, the AP "packages" the specified basket of crypto assets and transfers them to a designated custodial account;

After verifying the received assets are correct, the issuer delivers the corresponding number of ETF shares to the AP.

ETF Redemption Process

When the market price of the ETF on the exchange is lower than its NAV, the AP buys at least one creation unit's worth of ETF shares on the secondary market;

The AP returns this batch of ETF shares to the issuer and submits a "physical redemption" request;

After confirming receipt of the ETF shares, the issuer transfers the equivalent crypto assets (based on the latest NAV and position weights) back to the AP from the custodial account via the original route;

The AP reclaims the corresponding crypto assets.

What is the Significance?

As can be seen, allowing physical-based creation and redemption of crypto ETFs does not mean ordinary investors can directly exchange their ETF shares for crypto assets. Instead, it means the settlement medium between Authorized Participants (APs) and ETF issuers has shifted from cash to "physical crypto assets." This not only grants existing crypto ETF assets (such as Bitcoin and Ethereum) the same regulatory status as commodities like gold and oil but also brings the following benefits:

Reducing AP Costs and Enhancing Market Efficiency

In cash-based settlements, ETF issuers must use the cash delivered by APs to purchase crypto assets. Given the fast-changing nature of the crypto market, this process can lead to increased transaction fees and slippage.

In physical-based settlements, APs directly deliver crypto assets to ETF issuers, effectively avoiding additional transaction fees and slippage, thus reducing costs. By eliminating delays and costs associated with spot trading, it streamlines interactions with ETF issuers and helps the ETF's secondary market price stay closer to its NAV, boosting market efficiency.

Additionally, in cash-based transactions, capital gains distributions at the fund level may be triggered, whereas physical transfers generally do not constitute capital gains at the fund level, further lowering APs' tax costs.

Mitigating the Impact of ETF Redemptions on Crypto Market Prices

In cash-based redemptions, ETF issuers are forced to sell crypto assets in bulk to secure cash, which can trigger "liquidity crunches."

In physical-based redemptions, however, the process merely involves ETF issuers returning crypto assets to APs without market transactions. Once APs receive Bitcoin or Ethereum, decisions on whether to sell immediately, how to sell, and to whom are entirely at their discretion. Compared to large-scale, one-time liquidations by ETF funds, APs' actions are more decentralized, market-driven, and flexible.

Providing a More Efficient Mechanism for ETF Arbitrageurs

ETF market arbitrage relies on the "primary market arbitrage" mechanism, where APs conduct creation/redemption operations based on the spread between the ETF's price and its NAV. In cash-based systems, time lags between spot trading and ETF creation/redemption can lead to arbitrage failures or increased costs due to market price fluctuations. In physical-based systems, APs can directly establish or close positions using crypto assets, enabling more efficient, larger-scale, and faster arbitrage.

A more efficient arbitrage mechanism also helps crypto ETF prices closely track their net asset value, thereby improving liquidity.

Integrating Crypto Assets into the Deep Structure of Mainstream Finance

Internationally, commodity ETFs (e.g., for gold, silver, crude oil) mostly use physical-based creation and redemption. Crypto ETFs adopting the same mechanism signifies that crypto assets are being integrated into the deep structure of the mainstream financial commodity system, encouraging global institutional allocation to crypto assets.

The introduction of the physical mechanism provides a structural buffer for larger-scale capital inflows in the future, facilitating the entry of longer-term funds from institutions, pension funds, and hedge funds.

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