Three unexpected risks from Wall Street’s foray into Bitcoin

adminJanuary 15, 2024

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It has officially become mainstream in America. 11 spot Bitcoin ETFs approved. Products from issuers including BlackRock, Fidelity and Bitwise launched on Thursday, with cumulative trading volume exceeding $7 billion in the first two days of trading.

For years, the cryptocurrency industry has been waiting for this approval to bring massive amounts of new funds into the market. The market is now open to both the largest legacy financial companies that are not ready for cryptocurrency technology and retail investors interested in cryptocurrencies.

But Bitcoin meeting Wall Street also comes with risks. Some long-time Bitcoin miners point to a potentially increased concentration of Bitcoin ownership in a small group of institutions, potential repurchases and changes in the way the Bitcoin community governs itself.

single point of failure

The most obvious concern, noted by many prominent cryptocurrency individuals, is that all the Bitcoin backing ETF shares is held by only a few designated custodians. Most issuers designated Coinbase as their custodian, with the exception of VanEck, which chose Gemini, and Fidelity, which has its own custody product.

Jameson Lopp, co-founder and CTO of Bitcoin custodian Casa, said in these situations, the custodian becomes a single point of failure and “there are relatively few ‘doors’ for government agencies to knock on.” If you want, he told The Block.

Jeffrey Ross, founder and managing director of asset management firm Vailshire Capital, believes these concerns are “overblown.” In theory, there’s a risk that a custodian could make a mistake and lose a large chunk of customers’ bitcoin, but large financial firms like ETF issuers are now taking steps to prevent such incidents from happening, he told The Block.

When it comes to potential government seizures, people liken it to the Roosevelt-era ban on gold ownership. But at the time, the U.S. dollar was backed by gold, making it an essential component of monetary policy, and Bitcoin was not in the same position, Ross said. He added, “There is no reason for the government to confiscate Bitcoin from Americans.”

A new type of double-spending attack

Another potential concern is the so-called financialization of Bitcoin, or the transfer of traditional financial practices to the Bitcoin economy. The Bitcoin economy has so far operated more or less according to its own standards.

“ETFs are a double-edged sword for the Bitcoin ecosystem,” says Caitlin Long, founder and CEO of Custodia. “The biggest drawback is that Bitcoin’s leverage-based financialization will take place in a new form. The SEC did the right thing by prohibiting custodians from lending the Bitcoin backing ETF units. But the layers above that will have blending, collateral substitution and leverage,” Long told The Block.

Bitcoin-backed securities would essentially create a Bitcoin IOU (“something that is owed to you”), says Casa’s Lopp. This means that by using ETFs instead of actual Bitcoin stored in hardware and software wallets, people own something that represents the value of Bitcoin, but without any of the essential properties such as decentralization, permissionlessness, and visibility on a public ledger. It’s possible.

“Because we don’t have access to the company’s balance sheet, we can’t be certain that your IOUs can be repaid on those assets,” Lopp said in a blog post last year.

As Long points out in his post on Now they can try the same trick with Bitcoin.

Vailshire Capital’s Ross says the current design of the SEC-approved ETF does not allow issuers to lend the bitcoin backing the ETF. However, over time, more complex derivatives may be created based on these ETFs, which could open the door to more reckless behavior. Already one of the Bitcoin ETF issuers, Grayscale, has filed an application with the SEC for a covered call ETF designed to generate returns on GBTC ETF positions.

“You have to trust that the SEC is monitoring this, but the SEC has a history of not monitoring things well,” Ross said. He is both pessimistic and optimistic about this issue. The transparency of public blockchains means that companies can choose to make their holdings public. However, companies will not provide this information unless the public asks for it. And they would only call for it if someone made a mistake, Ross argued.

“There will be big things happening on Wall Street related to Bitcoin in 2025-2026,” Ross predicts.

governance war

Another concern being discussed is that ETF issuing and trading entities that will accumulate a lot of Bitcoin and gain some authority in the Bitcoin community will begin to influence how the Bitcoin protocol is maintained in the future.

For example, if the Bitcoin blockchain splits into two significant camps, this could be problematic for ETF issuers who would have to ignore the proceeds of the current fork (or airdrop), potentially making the ETF’s underlying assets less valuable. It will remain. They may be incentivized to undermine the momentum of such forks.

Casa’s Lopp believes this idea is absurd. In the Bitcoin “block size wars” of 2016-2018, mining and crypto services companies spoke out in favor of forking Bitcoin and increasing the maximum block size. However, they did not win and the Bitcoin community decided to leave the block size the same.

The difference between now and then is that, unlike companies that have been active in the Bitcoin scaling debate in the past, ETF issuers will not be doing as many on-chain transactions and will not be interacting with the Bitcoin protocol. “So hopefully that will reduce the incentive for them to be activists in the protocol development space,” Lopp said.

But Ross expects a new governance war to break out after 2025. “(ETF issuers) will definitely try to make changes, but that doesn’t matter,” Ross said. “They will probably try to switch to proof-of-stake or change the fixed supply (of Bitcoin), but it is highly unlikely that true Bitcoin miners will allow this,” he added.

The silver lining is that Bitcoin ETFs are only a temporary solution to the transition phase that most people are moving from traditional financial instruments to Bitcoin, Ross believes. Although baby boomers currently own the most wealth, their children will not need an intermediary between them and Bitcoin.

“The longer people own Bitcoin, the more incentive they will have to learn what Bitcoin actually is. The younger generation will inherit their parents’ wealth, sell ETFs and buy Bitcoin,” Ross said.

Disclaimer: The Block is an independent media outlet delivering news, research and data. As of November 2023, Foresight Ventures is a majority investor in The Block. Foresight Ventures invests in other companies in the cryptocurrency space. Cryptocurrency exchange Bitget is an anchor LP of Foresight Ventures. The Block continues to operate independently to provide objective, impactful and timely information about the cryptocurrency industry. Below are our current financial disclosures.

adminJanuary 15, 2024