Seemingly overlooked in the hoopla about the Winkelvoss twins filing to create a Bitcoin ETF is a simple fact: if approved, the trust may rapidly supplant Mt. Gox and other exchanges as the principal price discovery mechanism for the cryptocurrency.
Commentary in the popular press about the Winkelvoss S-1 filing to create an investment vehicle for Bitcoins has been largely negative, alarmist, and ill-informed. Meanwhile, over at the Bitcoin forums, reactions include cautious optimism, outright cynicism, and worries about whether the Winkelvoss twins are somehow looking to dump their large holdings of Bitcoins via the proposed ETF.
But lost in the buzz of reactions, I think, is an important point about what investors should expect to happen to existing Bitcoin exchanges if and when the Winkelvoss Trust is approved and begins trading. We can take a cue from the influence of precious metals ETFs, and gold in particular.
According to the latest quarterly update from the World Gold Council, total ETF gold holdings represent a mere 6.5% of total gold demand. And according to the London Bullion Market Association, the average daily volume of gold transferred between LBMA market makers represents nearly 35% of total gold ETF holdings — meaning it takes just 3 days of turnover to match the entire amount of gold held by all ETFs across the globe. Yet, despite their relatively small total size, gold ETFs have a direct impact on price discovery in the gold market. In other words, the price paid by investors for a given amount of gold in the ETFs, as well as for options on the ETFs, does not merely track the spot gold price, it helps set that price.
Now compare the case of a commodity like gold, which starts off relatively liquid anyway but becomes vastly more so via the mechanism of an ETF, with that of Bitcoins, where the average investor on the street can find it exceptionally difficult to navigate the maze required to buy the cryptocurrency or to convert it back to dollars or other fiat currency. Over the last 30 days, the largest Bitcoin exchange by volume, Mt. Gox, has moved just 1.1 million Bitcoins in USD trade. If the barriers to Bitcoin investment were suddenly torn down by the approval of the Winkelvoss ETF, opening Bitcoin to the entire US investment market, just how much total volume might trade in the ETF relative to existing exchanges — one sixteenth as much (not far from 6.5%), maybe half as much, twice as much, or ten times as much?
Of course, there’s more to the Bitcoin economy than what passes through exchanges — as of this writing around the start of July 2013, nearly 35,000 transactions totalling almost 1 million Bitcoins had occurred in the last 24 hours. Likewise, there is more to gold demand than what passes through LBMA. Moreover, investing in the ETF clearly is a different activity than directly exchanging between dollars and Bitcoins. But all of that is beside the point.
The point is simply that if investors and speculators have direct and highly liquid access to a vehicle enabling them to take a position in Bitcoin relative to dollars, then clearly trade in that investment vehicle will itself represent an aggregate market view on the value of Bitcoin in dollars. And to the extent that ETF volume may wind up not just competing with traditional exchange volume but may actually come to swamp it by a large margin, the Winkelvoss Bitcoin Trust may become the price discovery mechanism for Bitcoin. If investment in gold ETFs plays a significant role in setting price with a mere 6.5% of total demand, expect the same to be true for a Bitcoin ETF representing a potentially much higher share of total demand. Should this happen, investors would expect arbitrage to keep the ETF rates and the traditional exchange rates very close, but the primary price discovery mechanism would no longer be the exchanges — it would be the ETF. Of course the trust itself would actually have to buy and sell Bitcoins, but not nearly as many as would change ownership due to changes in ownership of the trust’s shares. In this environment, it would not be surprising to see investors entirely abandon exchanges that were especially inefficient or otherwise unable to maintain a low level of friction in the BTC/USD trade. (Mt. Gox, we’re looking at you.) And should options become available on the ETF, as they are with the SPDR Gold Trust (GLD) and iShares Gold Trust (IAU) for example, investors could expect the influence of the Bitcoin Trust on exchange rates to become even stronger.
In my view, this would be unalloyed great news for the Bitcoin economy in general and for Bitcoin investors in particular.
As I touched on in an earlier article, the Bitcoin economy could benefit hugely from the availability of standardized derivatives on the cryptocurrency. (See “Bitcoin Derivatives, Liquidity and Counterparty Risk”.) For quite awhile now, I have hoped and expected that this would eventually emerge from within the Bitcoin community itself, but so far everyone and their brother seems intent on setting up yet another new person-to-person trading network of one ilk or another — entirely avoiding counterparty risk and making it nearly impossible to create the kind of standardized derivative products that serious investors would actually use in significant volume. If the Winkelvoss Bitcoin Trust is approved, I would expect demand for such trading networks to diminish significantly. Adjusting for volume potentially created by the ETF itself, as baskets of shares are created and redeemed (and remember the Winkelvii themselves already own a large chunk of Bitcoins which could be used for this purpose, should they choose to do so), I would expect trade on Bitcoin exchanges themselves to take a hit, as some of their existing volume of speculation and investment moves to the ETF and options on the ETF, leaving exchange for actual commerce purposes between individuals and businesses.
Demand for the old-fashioned exchanges will likely remain from market participants who prefer to keep their activities ‘under the radar,’ so to speak, and if Bitcoin takes off as a real currency for conducting real business, converting directly between the cryptocurrency and fiat may become more popular. But if I were an early stage investor pondering the creation of yet another person-to-person, trading network-style Bitcoin currency exchange, I might now be looking much less favorably on such short-term easy ways forward. A potentially much larger opportunity would come from grabbing the counterparty risk bull by the horns and creating something new. In my view, if the Winkelvii get their way with the trust, the market will soon see a ‘real’ exchange that takes on the role of counterparty for all trades, provides market making, and all but annihilates the existing and in-progress network-style exchanges.
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