5. What are the key risks for the products?
The potential risks in the Bitcoin ETF can be categorized under two heads: those inherent in Bitcoin, and those that are specific to the proposed ETF.
Risks Inherent in Bitcoin
- Bitcoin network vulnerability: Virtual currencies do not have any physical existence, which makes them susceptible to online attacks. The recovery of lost Bitcoins could be difficult. The shutdown of Mt Gox, a Bitcoin exchange, exposed the Bitcoin network’s potential vulnerability.
- Reputational damage: In the past Bitcoin has allegedly been used to buy illegal goods and services. Such activity could potentially tarnish its reputation and credibility.
- Volatility in Bitcoin prices: As of October 29, 2014, Bitcoin was trading 70% lower than its all time high price. On 11% of days in the index’s history, the Bitcoin Price Index experienced changes of more than 10%. Such volatility can be potentially detrimental to ETF investors.
- Changes in the Bitcoin protocol: Disagreements within the core Bitcoin developer group or the creation of unauthorized variations in the protocol could cause confusion.
- Regulatory changes: Regulatory bodies may propose guidelines and laws impacting usage and tax implications.
- Unexpected changes in Bitcoin supply: The Bitcoin protocols have been developed so as to ensure there is no over-supply of Bitcoins, with the total maximum Bitcoin issuance expected to be capped at 21MM. However, there could be unexpected factors (such as future protocol changes) that impact the supply of Bitcoins, affecting their value.
Risk of trading Bitcoin ETF
- Ambiguity in cost: Important factors like expense ratio are still not fully determined and announced.
- Loss of private key required to access Bitcoin: The Bitcoin Trust will be responsible for the safekeeping of Bitcoin private keys for investors.
- Liquidity in underlying asset: Since ETFs utilize a create / redeem mechanism, ETF liquidity must be gauged by looking at the underlying asset’s liquidity rather than the ETF itself. Since Bitcoin is a new concept, it is hard to know how two-way flow will be impacted if there is an event that causes market stress in this asset. Poor liquidity in Bitcoin trading could potentially hamper the create/redeem activity by Authorized Participants in the ETF.
It is clear that Bitcoin and the proposed Bitcoin ETF product do carry significant risks, but also potential benefits. As we stated at the outset, it is difficult to assess upfront the potential success of any early stage innovation. If this product does get approved, ultimately the marketplace will decide if this product serves a useful need.
This article was co-authored by Aniket Ullal and Jania Kesarwani.