An Arbitrary Walk down Wall Street

Malt Liquidity 113

In finance, good ideas are like good restaurants. They come around once in a while, and are enjoyable as long as the people you dine with keep mum, and then all of a sudden, it turns out the entire yuppie population of Manhattan saw it on some blog or video due to some writer/creator who couldn’t keep their mouth shut to not ruin a great thing for the sake of engagement, and suddenly there’s an 8 month long wait to get in. Who could argue that, whatever your opinions on PFOF and Citadel now, electronic market making and HFT didn’t originally add a ton of execution value to your bog standard retail trader? Who could argue that the “high frequency trading arms race” hasn’t gotten far out of hand? Does it matter to a single person opening Robinhood that stock trades execute at a speed that is far superior to the load time of the app itself with a tighter spread than a freshly-assembled charcuterie board?

Or, take my favorite example, the ETF. A simple idea — what if we provide relatively seamless exposure to an entire basket of highly variable liquidity for a small fee, and allow people to enter and exit at will, at any size, rather than at the whim of their fund manager? And what happened next?

Once it was mathematically proven that dampening the volatility of individual company performance by “spreading one’s bets” was optimal for returns, the tsunami of capital flooded so forcefully towards this concept such that the number of ETFs worldwide went from 276 in 2003 to 8754 in 2023. Meanwhile, the number of publicly traded companies has plummeted from over 8000 in 1996 to just 3700 in 2023. The implication is clear — we can still hold individual stocks, but they will be behooved to the baskets that control the distribution of ETF flows to their respective size in said funds. Bucketing isn’t directly the issue here — I will never disagree with the obvious logic that it’s better to have paid professionals at Schwab picking and choosing what stocks to package together — but the proliferation of S&P500, total market, and sector ETFs in particular create a hybrid market-moving mechanism that diverges from “company does good, stock go up.”

The usefulness and practicality of ETFs has been the dead horse being beaten at an Ohtani-esque clip post 2020 — just look at this filing from this week:

Clearly, the average investor who wants exposure to “electric cars” truly needs access to a fund (dependent on inflows and outflows, mind you) trading TSLA, day in, day out.

The flip side of the “finance iterates until it is impractical to continue doing so, and then does so some more because there is simply so much money out there sloshing around until any semblance of edge has been wrung out” is “regulators arbitrarily get in the way of this process sometimes.” This brings us to the longstanding argument between Grayscale and the SEC.

The hallmark of a finance journalist over the past couple years has revolved around a particularly odd, esoteric battlecry: “still no spot bitcoin ETF!” Which, in all honesty, at the rate that useless financial products are churned out, is quite the sign of regulatory arbitrariness. Currently, there are essentially these “approved” channels of easily gaining exposure to Bitcoin in the US if one desires so:

1. You can buy Bitcoin directly through an approved exchange, such as Coinbase

2. You can buy shares in a company who has tied their stakes to Bitcoin, either by holding a lot (a la MSTR) or by tying their business’ future to it (COIN)

3. You can buy a futures Bitcoin ETP, which tethers to CME Bitcoin futures (or buy those futures directly, of course)

4. You can buy a “pot” of Bitcoins held in a trust for you, which cannot be liquidated directly themselves,which leads to a divergence of the value of the “pot” relative to the actual Bitcoin value held, as I’ve written about before:

So what’s the deal? GBTC sits on a stash of bitcoin worth far more than what its shares are priced at. Shouldn’t this be free money by buying GBTC and shorting BTC? Well, not exactly. While GBTC offers exposure to BTC in the form of shares traded on an exchange, it does not provide liquid direct exposure to BTC, as GBTC cannot sell its stash of BTC. Namely, GBTC is structured as a closed-ended trust, meaning that while it is easy to hold in a regular brokerage account, its price relative to NAV is based on the supply and demand for the exposure to the underlying. When exposure to BTC was harder to come by, the demand for GBTC exposure was high and the shares traded at a premium. Now that there are many liquid options to gain exposure to BTC, including futures ETFs, a plethora of exchanges, and, of course, the old-fashioned way of just holding the coin yourself (which became far more accessible over the course of the past 5 years), the demand for GBTC-specific exposure has slipped a lot and the discount to NAV reflects that. A proper ETF — which GBTC isn’t — can match the NAV of the underlying through the creation/redemption process (and other types of arbitrage) to keep it in line. Creation/redemption guarantees that this mismatch of outstanding units relative to demand that a closed-ended fund suffers from won’t happen, as it allows ETFs to adjust to inflows and outflows.

But, due to the fact that SEC has control over what can become an ETF and what can’t, the “battlecry” refers to the situation where, though multitudes of prospective funds have applied for a spot ETF (referring to the current, real time price of a bitcoin on the direct marketplace for it, rather than a derivative like BTC futures), the SEC has blocked every single one. Enter Grayscale: to solve the problem of their trust, GBTC, drifting away from its NAV, they have been arguing that their “pot” of Bitcoins should be converted into a full-blown ETF, tethered to the spot price of Bitcoin so that their fund could be appropriately arbed with the underlying to correct this drift. Naturally, the SEC has blocked their application, due to reasons they simply won’t elaborate on.

So here lies the weird disagreement in front of the court: on one hand, the spot ETF would do nothing to actually offer “increased” access to Bitcoin, but rather an easier path to market to big allocators to collect fees. Seriously, who hasn’t longed BTC that has been wanting exposure solely because they’re waiting for a spot ETF? It strikes me as largely unnecessary — since “bitcoin mania” initially IPO’d in 2018, it’s been fairly trivial to trade it since then. BITO, the aforementioned futures ETP, has been trading since late 2021 and easily handles millions of shares traded a day at a negligible spread (though it charges a particularly rotund .95% expense ratio.) There’s a clear argument that, due to the weird nature of tracking futures and handling rollover, a bunch of spot Bitcoin ETFs would drive this cost heavily down for investors. The SEC has rebutted this argument on the grounds that the spot marked is too heavily manipulated, which in theory is fairly valid — prices diverge constantly across exchanges, paint can easily be taped or orders can be spoofed due to the decentralized, global nature of Bitcoin, and there’s a good chance that offshore exchanges have no sort of rules around MM lookback and internalization priority. That being said, is somehow the far less liquid futures market that purportedly “tracks” this spot price supposed to be any less susceptible to these price manipulation forces?

Reading between the lines (and all my other blog posts) and other caselaw, we get a clear picture that the SEC just doesn’t like crypto anymore. Totally due to chance. Totally not due to any events that might have happened.

The SEC could also be motivated by the fact that, by their reading, more access to Bitcoin is simply unnecessary, as I pointed out above — who’s on the sidelines solely because there’s no spot ETF? But when has it ever been an issue that an ETF might be “unnecessary” to give exposure to whatever it’s holding? Do we really think that there’s no redundancies or pointlessness in the 8800 ETFs that exist today? There’s no inherent logic to any of the SEC stonewalling that’s gone on, which is why one can only speculate on their intentions, and why the first sentence of the opinion highlights that even by the laissez-faire license given to agencies to make rules, the SEC’s treatment of spot ETFs cannot be squared away behind administrative power:

You really gotta enjoy the blatant hypocrisy being pointed out if you’ve followed this saga. “Arbitrary” is truly the defining word of this post.

I’ll leave the full case if you want to see this 100 page dressing-down here, but beyond speculating on when the flood of spot ETFs inevitably makes its way to the markets, here’s perhaps the thing to take away from all this.

Being an American inherently means having an excess of choices and an almost unhealthy enabling of the ability to make those choices, whether it’s purchasing 20 different kinds of mustard on a credit line that’s exponentially the size of one’s net worth or the ability to purchase any bullshit SPAC on the market.

I mean, WeWork, a company that was somehow too stupid to even IPO during ZIRP, managed to make it public and lose 99% of its value.

The SEC’s idea of “protecting investors from themselves”, as one would interpret all this hullabaloo about spot prices, is the kind of pithy intention that one could immediately invalidate with any number of practical examples, like the whole targeting and subsequent disappearance of Juul while any number of off-brand flavored vapes continue to exist. While I’m heavily skeptical of the ETF complex and how it buoys every basket and trades organic price discovery and volatility for a kind of correlated vol-complex, that’s no reason to just start capriciously preventing these products over those products or suddenly start taking them away. All this superfluous competition does have the net benefit of reducing costs to an absurd degree — it only took one brokerage to push everyone to “commissionless” trading. The flood of applications for every type of ETF is a sign that, overall, the total funds available are ginormous and continue to grow, not a sign that everything has suffered from the destruction of creativity in favor of some zero-sum race to the bottom. Markets, at the end of the day, work, and at least the courts retain the ability to remind the SEC of that fact.