We have been receiving a lot of questions from clients regarding the growing popularity of bitcoin and cryptocurrencies in general. One of the most popular topics of discussion is centered on if or when the SEC will approve a bitcoin exchange-traded fund (ETF).1 Below are some insights.

What is a cryptocurrency?
In October 2008, the pseudonym Satoshi Nakamoto published a whitepaper that described a peer-to-peer electronic cash system called “bitcoin.” Known as a type of cryptocurrency, it is completely decentralized and cannot be influenced by any government or central bank. The bitcoin system was then implemented as open source code in January 2009.

Today, bitcoins can be purchased with US dollars and transferred person-to-person without going through a third party financial institution. This payment exchange is achieved on a technology platform called blockchain. Blockchain is an open source ledger of transactions that are approved and verified by a network of computers. Each transaction becomes a new link added to the existing chain, making the blockchain extremely secure and nearly impossible to manipulate. In order to alter the blockchain, one would have to change every link and trick every individual computer on the network. While there were skeptics at first, bitcoin has become a widely accepted payment method due to its anonymity, ease of use, and lack of credit card fees. Albeit quite volatile, bitcoin was trading over $10,000 as of December 1, 2017 and there are over 1,000 different decentralized cryptocurrencies like it.

Classification in the US
The question is – how does one classify a cryptocurrency? Is it strictly a currency made for transactions like a credit card payment system, or is it more of a store of wealth like gold? In the eyes of the US Internal Revenue Service, it is a form of property (store of wealth). However, many state regulators view it as a vehicle for money transmission. While the general public seems to be split on bitcoin’s utility, these two sources of demand are nonetheless driving extraordinary interest in cryptocurrency.

Investing in bitcoin?
There has been an ongoing effort to track the price of bitcoin with an ETF. The US Securities and Exchange Commission (SEC) initially rejected a recent bitcoin ETF proposal mainly due to a lack of regulation in the bitcoin market. However, the SEC has since decided to review its original decision. There are other investment opportunities available now besides buying bitcoins directly. In the UK, one firm offers a bitcoin exchange -traded note, and in the US, another firm offers a private trust with bitcoin exposure whose shares trade over the counter (OTC).2

Coming soon: Regulated bitcoin futures3 market
Recently, a critical ruling for the bitcoin market was reached when a firm was approved to clear bitcoin derivatives4. The development of a regulated futures market may help pave the way for bitcoin ETFs and clears a giant hurdle for the SEC regarding the lack of bitcoin regulation and oversight. Soon after this decision, the Chicago Board Options Exchange announced plans to offer its own bitcoin futures market. Moving forward, the approval of a bitcoin ETF seems probable and could open the cryptocurrency market up to many new investors.

Potential impact on financial services
Even if ETFs tracking bitcoins don’t ever take off, the blockchain that supports bitcoin and other cryptocurrencies will likely change the way many businesses, including ETFs, operate. For example, many firms have begun experimenting with blockchain to streamline the process of purchasing funds. In fact, Natixis Asset Management was one of the first asset managers to settle a transaction via blockchain. Blockchain technology has the potential to alleviate a lot of the back office issues that exist today; it could cut the time needed to process information from days to minutes and significantly reduce costs.

Cryptocurrencies and blockchain technology are likely to face evolving challenges and risks related to cybersecurity. Potential threats include bitcoin theft and misuse of the technology by bad actors. Nonetheless, if the use of blockchain technology continues to grow, it could drastically change the way banks and other financial institutions function, regardless of the success or failure of cryptocurrencies.

 


1 An exchange-traded fund, or ETF, is a marketable security that tracks an index, commodity, bonds, or a basket of assets like an index fund.

2 Over-the-counter (OTC) is a security traded in some context other than on a formal exchange such as the New York Stock Exchange (NYSE). It can be used to refer to securities that trade via a dealer network.

3 An agreement to buy or sell a particular commodity or security at a predetermined price in the future.

4 A derivative is a security with a price that is dependent upon or derived from one or more underlying assets. 

Risks:
Exchange-Traded Funds (ETFs) trade like stocks, are subject to investment risk, and will fluctuate in market value. Unlike mutual funds, ETF shares are bought and sold at market price, which may be higher or lower than the ETF's net asset value. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns. Futures contracts involve a high degree of risk and may result in potentially unlimited losses. Derivatives involve risk of loss and may entail additional risks. Because derivatives depend on the performance of an underlying asset, they can be highly volatile and are subject to market and credit risks.

Investing involves risk, including the risk of loss. Investment risk exists with equity, fixed income, and alternative investments. There is no assurance that any investment will meet its performance objectives or that losses will be avoided.

Unlike typical exchange-traded funds, there are no indexes that an active ETF attempts to track or replicate. Thus, the ability of an active ETF to achieve its objectives will depend on the effectiveness of the portfolio manager. Transactions in shares of ETFs will result in brokerage commissions, which will reduce returns.

This material is provided for informational purposes only and should not be construed as investment advice. The views and opinions expressed above may change based on market and other conditions. There can be no assurance that developments will transpire as forecasted.

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