Bitcoin 'ETFs': Unseen Risks to Financial Stability
Exploring how Bitcoin Exchange-Traded Products amplify systemic risks through indirect exposures, leverage, and regulatory loopholes.
I have been reading about the growth in options on BlackRock’s Bitcoin Trust (IBIT), which calls itself an ETF when it’s not. Unlike traditional ETFs regulated under the Investment Company Act of 1940, IBIT operates under the 1933 Exchange Act, lacking the same investor protections and oversight. So my question is: how did we get here, and what are the implications?
The SEC’s approval of Bitcoin Exchange-Traded Products was a forced decision, primarily driven by judicial pressure and the need to align its rulings with a court’s findings (source) in the case Grayscale Investments, LLC v. SEC, No. 22-1142 (D.C. Cir. 2023).
Background for the Need for SEC Approval
Most exchange-traded products (ETPs) can rely on pre-approved generic listing rules established by the SEC. However, these standards are tailored for securities-based ETPs. Bitcoin ETFs, which hold a non-security asset, fall outside the scope of these rules.
To list a Bitcoin ETF, exchanges must propose a specific rule change under Rule 19b-4 of the Securities Exchange Act of 1934. The SEC evaluates these rule changes individually to ensure compliance with Section 6(b)(5) of the Securities Exchange Act of 1934. This section requires that the rules prevent fraud, manipulation, and promote investor protection.
Historically, the SEC rejected Bitcoin ETFs due to concerns about market manipulation and inadequate surveillance mechanisms. The Grayscale court ruling in 2023 forced the SEC to reconsider and approve spot Bitcoin ETFs after courts determined the rejections were inadequately justified.
Court of Appeals Misunderstanding the Crypto Market
The Court of Appeals ruling is full of factual errors and misunderstandings about the crypto market:
“As with commodities, there are spot and futures markets for bitcoin. [..] One such derivative is a future [..] which trade on commodity futures exchanges, like the Chicago Mercantile Exchange (“CME”).”
Futures contracts, as regulated by the Commodity Futures Trading Commission (CFTC), are standardized contracts traded on registered exchanges like the CME. These contracts include strict regulatory oversight for market integrity, risk management, and clearing processes.
A significant portion of derivatives activity in Bitcoin markets occurs in the form of perpetual futures (perps) on offshore, unregulated platforms like Binance, Bybit, and OKX.
Perpetual futures are not true futures contracts:
They have no expiration date.
They rely on funding rates to align prices with the spot market.
They are not traded on CFTC-registered exchanges and do not conform to U.S. legal definitions of "futures."
The court’s assumption that these contracts fit the CFTC’s framework for regulated futures markets is inaccurate.
“An exchange-traded product may offer continuous share redemption and creation, allowing arbitrage to prevent the product’s price from deviating too far from the value of its underlying assets [..] Listing on an exchange is desirable because it helps eliminate this discount.”
Passive Single-Asset Fund Seems Mischaracterized as an ETF
Bitcoin ETFs structured as 1933 Act trusts differ fundamentally from traditional ETFs that comply with the 1940 Act. These Bitcoin ETPs (exchange-traded products):
Do not provide the diversification typical of 1940 Act ETFs.
Are single-asset, passively managed funds, meaning they are not subject to the investment protections (fiduciary standards, active portfolio management) expected from traditional ETFs.
The court's reliance on assumptions about listings that one would expect for ETF structures (e.g., continuous creation/redemption and diversified underlying assets) does not align with the unique nature of Bitcoin ETPs. These vehicles are essentially 1933 Act trusts, which behave differently.
Arbitrage Misunderstood
Authorized Participants (APs) in traditional ETFs typically play a critical role in arbitrage by:
Creating ETF shares by purchasing the underlying assets.
Redeeming ETF shares to obtain the underlying assets when price discrepancies exist.
However, in the case of Bitcoin ETFs:
Some APs may not have direct access to trade the underlying Bitcoin on spot markets due to operational, legal, or risk constraints.
Even when APs can trade Bitcoin, the fragmented and volatile nature of spot Bitcoin markets makes arbitrage far less efficient than in securities markets.
The court assumes arbitrage will function seamlessly, ignoring these operational realities. This misjudgment impacts claims such as:
“As Grayscale explains, it cannot offer the continuous share redemptions and creations that are permissible for ETPs and add enormous value. Accordingly, Grayscale’s shares trade at a discount as much as 30 percent. Grayscale estimates this leaves over $4 billion on the table for its investors.”
For a very long time, Grayscale traded at a premium, which would mean a listing with redemptions could have been considered beneficial for holders. The fact that many ETPs cannot trade Bitcoin directly and that so-called Bitcoin ETFs are unregulated means that the redemption mechanism for other securities-related ETPs is not available for Bitcoin ETFs, regardless of listing.
Inefficiencies in Bitcoin Spot and Futures Markets
The assumption that
“Bitcoin futures are derivatives of bitcoin and, as long as the market is efficient, arbitrage will drive the prices together”
is problematic.
This assumption is valid in mature markets like equities or commodities, where robust regulation, liquidity, and arbitrage opportunities align futures and spot prices. However:
The majority of Bitcoin derivatives trading occurs on offshore platforms like Binance and Bybit, where perpetual futures dominate.
Perpetual futures are not true futures contracts (no expiration, reliance on funding rates) and behave differently from traditional CFTC-regulated futures.
Price anomalies in spot and futures markets further suggest inefficiency.
The SEC has consistently cited concerns about manipulation in Bitcoin markets, driven by low transparency, wash trading, and limited oversight.
“Because evidence of the lead/lag relationship between [Bitcoin spot and CME futures] was inconclusive, the Commission doubted the connection between the two markets.”
The absence of evidence for the lead/lag relationship means that crypto spot and futures markets are inefficient, with independent price formation. Therefore, Bitcoin spot and futures markets are not like cases.
Grayscale and Its Market Impact
The statement,
“Because Grayscale owns no futures contracts, trading in Grayscale can affect the futures market only through the spot market,”
is false.
Grayscale Bitcoin Trust (GBTC) allowed accredited investors to subscribe to shares directly by depositing Bitcoin. These shares were subject to a lock-up period (6 or 12 months depending on the timeframe). Historically:
GBTC traded at a premium due to the absence of redeemability and limited supply of GBTC shares in the open market.
Hedge funds and institutional investors exploited this premium through arbitrage by minting GBTC shares and selling them after the lock-up period.
The premium turned into a discount in early 2021 as competition (e.g., Bitcoin ETFs in other jurisdictions) reduced demand for GBTC shares. This exacerbated losses for firms like Celsius and BlockFi, who used GBTC arbitrage strategies with leveraged Bitcoin deposits.
GBTC’s central role in leveraged trading amplified systemic risk and impacted unregulated derivatives and lending markets. Its influence extended far beyond the spot market.
Since the Court of Appeals ruled in favor of Grayscale, triggering the SEC’s decision to approve several Bitcoin ETFs, the court's assumptions—based on inaccurate market realities—have led to regulatory decisions that are similarly flawed.
Who Is to Blame?
Not the Court of Appeals, but NYSE Arca, whose submissions were misleading and demonstrated a lack of understanding of Bitcoin’s market dynamics:
“NYSE Arca compared the historical inflows of bitcoins into Grayscale to bitcoin’s market capitalization. The comparison showed that while Grayscale experienced nearly $7 billion of inflows over a two-year period, the market capitalization of bitcoin grew by $721 billion.”
The assets Grayscale held over the period participated equally in the appreciation of Bitcoin. Since they had inflows, it would mean they grew more than the overall Bitcoin market. I didn’t check the numbers; I am taking what NYSE Arca submitted verbatim.
Comparing Bitcoin to other asset classes is irrelevant and misleading when assessing whether Grayscale was or was not able to dominate prices. This is ludicrous for NYSE Arca to make such statements. This reasoning also ignores that inflows into Grayscale (GBTC) were significant relative to Bitcoin's liquidity and actual daily trading volume, not its market capitalization. Market capitalisation is not an indicator of liquidity or price influence—liquidity in spot markets is far smaller than market cap.
What Does This Mean for Bitcoin ETPs That Call Themselves ETFs, Like the iShares Bitcoin Trust (IBIT) by BlackRock?
The biggest investors in these products are hedge funds like Millennium. But why?
The Q1 Shareholder Letter of Coinbase states (source):
“In Q1, we grew the number of institutional customers compared to Q4 and were proud to welcome or expand relationships with Alameda, Brevan Howard Digital, Invesco, GSA Capital, Lakestar, Market Securities, Millennium Global, Silvergate, Shapeshift, and World of Women.”
Bitcoin ETFs typically charge between 0.25% to 1% annually as a management fee. For a large institutional investor, this is significant, especially considering that Bitcoin itself does not yield any income.
Institutional rates at Coinbase Custody are usually tiered based on volume and are much lower than ETF fees (potentially less than 0.05% annually for large clients). Institutions like Millennium, trading significant volumes, likely benefit from highly favorable terms, including low custody costs and rebates on trading fees.
Why, then, would Millennium pay a premium for ETF exposure when direct custody is cheaper and more flexible and already available to them?
It seems obvious that the intention is not simply to gain exposure to Bitcoin, as that would not be an efficient way for them to achieve this. Furthermore, the usual arguments in favor of ETFs do not apply here:
There is no enhanced regulatory protection.
The assets are unlikely to be acceptable to banks as collateral.
Since they have a direct relationship with Coinbase, they do not gain any advantage from avoiding the effort to build such a capability.
Trading Strategies and Behavior
Institutions may use a strategy of buying Bitcoin ETFs and shorting CME Bitcoin futures. This arbitrage could aim to profit from discrepancies between ETF pricing and the underlying market. In other words, these Bitcoin ETPs have now assumed the function that the Grayscale fund once held.
The IBIT Bitcoin ETF now boasts the highest option activity among similar products according to Bloomberg, a development that should not be celebrated as sign of growing market sophistication but rather seen as evidence that this product has become the mechanism of choice for creating leveraged crypto investments. This surge in derivatives trading around the ETF underscores its role as a critical tool for institutions employing complex arbitrage strategies, such as buying Bitcoin ETFs while shorting CME Bitcoin futures. In essence, Bitcoin ETPs like IBIT have effectively taken on the systemic role that the Grayscale fund once held, facilitating speculative and leveraged positions in the broader crypto market.
Interestingly, Ethereum investors often stake ETH rather than trading it, as staking provides additional yield. This difference suggests that the issues associated with a Bitcoin ETP would be less pronounced in the case of Ethereum-based ETPs. Bitcoin's appeal lies in market exposure, while Ethereum investors may seek value-added opportunities.
Unique Characteristics and Systemic Risks
The iShares Bitcoin Trust prospectus specifies that authorized participants (APs) generally cannot trade Bitcoin directly. Instead, these transactions are executed through designated firms.
These firms, however, are not under any obligation to make markets in Bitcoin, adding a layer of operational constraint.
Key characteristics and risks include:
Single-Asset Fund: The fund invests solely in Bitcoin.
Relatively Small Market: Bitcoin's market size is limited compared to other asset classes.
Overlap of Participants: These trading firms can also be investors in the iShares Bitcoin Trust (IBIT).
Such a structure presents unique risks, as its liquidity and redemption mechanisms depend heavily on market participants with direct Bitcoin trading capabilities. During periods of high volatility or stress, the reliance on third parties to access liquidity could amplify market pressure on the fund and lead to cascading liquidations given the futures and options investments. Additionally, this structure creates conflicts of interest that diversified funds would not experience.
For instance, a decision to sell IBIT shares could require the same firm to make a price—a unique constellation that creates systemic fragility and conflicts of interest. The IBIT ETP has become a vehicle for hedge funds to facilitate leveraged investments in crypto, bringing this activity dangerously close to prudentially regulated banks.
The Basel prudential standards make trading crypto for banks unappealing due to the prohibitive cost of capital. Bitcoin ETPs create an illusion of regulated exposure by being marketed as exchange-traded products. Despite this, the Basel prudential standards impose a "look-through" requirement for crypto-linked instruments, meaning that exposure to Bitcoin via ETPs must be treated as if it were direct exposure to Bitcoin itself. However, the ETP structure still creates a loophole through which the Basel rules become less effective because of the way it increased leveraged crypto investments by hedge funds to which banks have direct exposure.
Regulatory Loophole: Bitcoin ETF/ETP amplify indirect exposures which are notoriously difficult to monitor
The Basle monitoring from 2023 indicates that a significant portion of banks' prudential cryptoasset exposures arises from indirect holdings and activities instead direct ownership of cryptoassets like Bitcoin or Ether. This can include clearing but also things like investment in Singtel. I am not sure of this refers to the Singapore Telecoms firm or their more VC subsidiary, but the point is, a client’s risk stemming from crypto impacts how a bank has to assess the risk this client presents. The 2023 report showed that a single bank accounted for 62% of overall crypto prudential exposures, with four others covering 35% of the remaining.
With Bitcoin ETPs, this exposure could become more pervasive, as firms indirectly invest in these products through funds, portfolios, or other vehicles, often without clear disclosure. This significantly increases the likelihood of indirect crypto exposure touching entities far removed from the core crypto ecosystem.
Investors and corporations often allocate capital through fund managers or ETFs without granular transparency regarding the underlying holdings. A mutual fund, pension fund, or hedge fund could hold Bitcoin ETPs, and its investors (banks, corporates, or individuals) would inherit indirect crypto exposure unknowingly. Without a comprehensive look-through mechanism, identifying who ultimately bears crypto exposure becomes challenging and impractical. The question really is whether the risk management systems of banks are equipped to look through the investment portfolio of clients to know if there is such indirect exposure e.g. in. case of fund of fund investments this becomes very challenging.
Other factors indicating a regulatory loophole
According to then 2024 Allocator's Guide to Digital Asset Hedge Funds from Coinbase, we also have the fact that dedicated crypto Hedge Funds are small in size.
“More than 80% of crypto funds have less than $50 million in AUM, and only 5% have AUM north of $500M.”
This has two implications. They tend to be exempted from Investment Advisors Act reducing regulatory oversight but also is a further sign that the investments come from investors with mixed portfolios blurring the lines who presents crypto and non-crypto exposures further.
Taken together, this situation could undermine the Basel framework and create a scenario where crypto exposure proliferates under the guise of regulated financial instruments. By using the ETF label, these ETPs obscure their nature as single-asset funds with distinct and often amplified risk profiles. This structural ambiguity, coupled with strategies that embed crypto exposure into traditional financial portfolios, poses systemic risks that regulators and investors alike may struggle to identify or mitigate effectively.
The risks ETFs pose to financial stability are not new observations (Reports of the Advisory Scientific Committee of ESRB). Neither is the discussion about leverage originating from crypto exchanges (BIS) or questioning the rationale for investing in funds that offer no diversification benefits (ECB). The unusual subscription and redemption process of Bitcoin ETPs has also been noted as concerning by some (e.g., Fidres), particularly given the high market concentration among a few providers:
Coinbase held 85% of all Bitcoins owned by Bitcoin ETPs as of Q2 2024.
There is a “significant concentration among a few LPs, which raises concerns about failure or reduced efficiency in the fund creation/redemption process.”
But what is missing is a recognition that these factors, in combination, present novel and significant risks to financial stability. By creating a structure that:
Mislabels ETPs as ETFs,
Involves banks with only theoretical knowledge of the risks associated with trading crypto,
Allows crypto risks to proliferate through indirect exposures,
Operates under high-risk and opaque models, and
Is increasingly used to facilitate leverage, thereby taking a role in the financial system that is not typically expected for such products,
Bitcoin ETPs effectively undermine Basel's goal of limiting systemic risks tied to cryptocurrencies.
Somebody needs to stop providers like BlackRock from mislabeling their products, plain and simple. The SEC should step up and enforce stricter rules prohibiting the use of "ETF" for products that fail to meet the regulatory standards of the Investment Company Act of 1940. Let’s call them what they are—"Unregulated Exchange-Traded Crypto Trusts"—to avoid misleading investors. If the SEC has the power to clean this up, they should use it.
“The iShares Bitcoin Trust ETF is not an investment company registered under the Investment Company Act of 1940, and therefore is not subject to the same regulatory requirements as mutual funds or ETFs registered under the Investment Company Act of 1940.”
So why are you calling them an ETF then, Blackrock?
And what’s the deal with allowing a high-risk product like crypto to operate with only cash subscriptions and redemptions? This structure needs a serious rethink. It’s a setup waiting to fail in volatile markets.
As for banks trading crypto—that’s another ballgame entirely and beyond the SEC’s competence. But you’re either in or you’re out.