Odd Lots - Inside the Multi-Year Quest to Create a Bitcoin ETF

Episode Date: May 14, 2018

When Bitcoin first began generating headlines, there were some who thought the cryptocurrency was a fraud and others who thought it was the next big thing. Greg King, CEO of Rex Shares LLC, was one of the latter. Like the Winklevoss twins, he set out to create an exchange-traded fund (ETF) that would allow people to invest in Bitcoin in a new way. But many years later, the U.S. securities watchdog hasn't approved such plans. On this edition of the Odd Lots podcast, we use the Bitcoin example and King's experience to explain the inner workings of ETFs. See omnystudio.com/listener for privacy information.

You can get the news whenever you want it with Bloomberg News Now. I'm Amy Morris. And I'm Karen Moscow here to tell you about our new on-demand news report delivered right to your podcast feed. Bloomberg News Now is a short five-minute audio report on the day's top stories. Episodes are published throughout the day with the latest information and data to keep you informed. Yes, there are other products like this from a variety of news organizations. But they usually rerun their radio newscasts throughout the day. That's not what we do. We create customized episodes that can only be heard on Bloomberg NewsNow.

And we don't wait an hour to publish breaking news. When news breaks, we'll have an episode up in your podcast feed within minutes. So you're always getting the latest stories and developments. Get the reporting and the context from Bloomberg's 3,000 journalists and analysts we're all over the world. Listen to the latest from Bloomberg News Now on Apple, Spotify or anywhere you listen. And welcome to another edition of the Odd Lots podcast.

I'm Tracy Allaway. And I'm Joe Wisenthall. So Joe, they say the best way to learn about something is to actually do it, right? Or the best way to understand something is to try to do it yourself. I have heard people say that and I think that's definitely true. In my experience, you only get so much from reading about something or talking about something and then you try to do it and you learn a ton. But why?

Why do you bring this up? Well, sometimes I think in finance and markets, we talk about complicated or sort of abstract topics. And the best way for people to learn about them would be if we went out and tried our hands at them ourselves. But given its finance and markets, that's difficult and or in some cases illegal. So you're saying we're not going to do an episode where we go out and launch a trading operation or anything like that. No, we're not, but we're going to do the next best thing, which is we're going to have a guest come on and talk about his specific experience trying to set up a Bitcoin exchange traded fund.

I am very excited about this. Of course, this was a huge topic late last year. So many different companies rushing to try to be the first with a ETF that gave people direct exposure to Bitcoin. It was fascinating to watch. It still hasn't happened. yet. But that exact process, I agree, I think is still a shrouded in mystery for most people, how you go about it and what it actually takes to get there. So the great thing about this conversation,

in my opinion, it's not necessarily the emphasis on Bitcoin. It's the emphasis on the ETF structure and how you would apply that to a new type of asset. And I should also say, as a bonus, we have an extra guest on Odd Lots today. That is Rachel Evans. She is our ETS. guru for Bloomberg News. She covers all sorts of ETS. She's going to be in on the conversation. And to begin with, before we bring on our main guest, she's going to help us lay out, well, the lay of the land, really, when it comes to ETFs. So Rachel, let's start with you. Thank you so much for coming on. Thank you guys for having me. So I guess the first question to you is we talk about building a Bitcoin ETF. It's been a multi-year attempt. Why has it been so

difficult. So with Bitcoin ETFs, I mean, it basically takes us back to what it takes to create a successful exchange trade of fund. First up, of course, you need to have a great idea. Now, with Bitcoin, people feel like they have a great idea. But the next step in that process is trying to get approval from the Securities and Exchange Commission, the regulator for ETFs, to actually be able to launch that fund. Now, the SEC has really been dragging its feet a little bit on this for market participants anyway, because they have some serious concerns about how Bitcoin would operate within an exchange trade of fund. Now, what this kind of comes down to, in essence, is really kind of the back office operations

of an exchange trade of fund. To make an ETF actually work, there are three key aspects that you need to have in place. The first is kind of the fairly sort of vanilla back office type arrangements. This is kind of the custodian, the board that kind of monitors how the manager is actually doing and make sure that the ETF is on target. And that's something that I think on the. custody side they've kind of had concerns about. But the second and the third kind of pillars are really kind of where the SEC has actually had issues. That's kind of on the authorized participant

side of things, which sounds a lot like jargon, right? And it is. But basically the authorized participant is the gatekeeper for ETS. They are pretty much the most important person when it comes to making an exchange trade of fund work. What they do is that when you decide to buy an ETF, you give your cash to your broker via any of the many online platforms that you have. That cash then wends its way through to the hands of an authorised participant who is the one that actually goes out and buys the stock or the bonds or the commodity that then gets put into the fund and the fund manager will then manage. The same process happens on the way out that the fund is going to give you your money back. The securities goes to their authorized participant

who then sells those securities in the market and gives you your money back. So basically they are the middleman. And the SEC is a little bit concerned about how that might work with Bitcoin. There's another the third pillar. And this is really related to the fact that ETFs are something that you can invest in for the long term or you can trade. So the third pillar for the ETFs is the market makers who are really dealing with ETFs on the secondary market. So the thing that's really important for these guys is that they do something called arbitrage. Now arbitrage is very important to ETFs because it makes sure that the price of the ETF doesn't diverge too significantly from the actual value of the ETF.

Now, the way that the market makers go about doing this is that if they see that the shares of the ETF are trading more than the underlying securities, what they might do is they will go into the market, buy up all the underlying securities, take them to that authorized participant, get some shares for the ETF, and then sell them at that higher price. They've basically been able to buy something cheap and sell it high and lock in that profit. Now, that is not only great for them because they take that margin. It's also really good for investors because it makes sure that the price of the ETF doesn't diverge too far from the actual value of the securities.

Tracy, I just learned a lot from that answer about ETFs. I tried to speak that. All kinds of stuff I didn't already know about how they were. Well, I mean, I think we have the essential building blocks for the next leg of our conversation, which is our main guest, Greg King, the CEO of Rex. shares and someone who has actually attempted to begin a Bitcoin-based ETF. So Greg, thank you for coming on all thoughts. Hey, Tracy. Hey, Joe. Rachel, good to be here. So, Greg, before we get into the specifics of the Bitcoin ETF endeavor and your journey to get there, why don't you tell us a

little bit who you are? What's your background? What is Rex shares? I mean, I think there are a lot of some well-known brands in the ETF space. But what is your firm, and how did you get there? There are, there are so many new entrants in the space, right? I started back when there were, I don't know, just a handful of ETF companies, but my journey into ETF started when I was at Barclays. So early 2000s, and Barclays was already with Aishares, the sort of 800-pound gorilla in the space,

and was developing all kinds of new asset classes, mainly commodities. And so I was on a project with them to develop some of the first commodity exchange traded products. That's how I got in. And like a lot of things in life, sort of just happened unintentional. And then I got to know a little bit about the ETF space and was fascinated and start to dig and do a little more and work on more projects with Barclays.

And kind of one thing led to another. It's been 14 years or so. And during that time, I worked for a bank, Swiss Bank, Credit Suisse, and developing some products, previously founded and sold a company called Velocity Shares, which we sold to Janus Capital. And so Rex Shares is my next company. We wanted to focus on democratizing access, right? I sort of believe that investors, the ETF is a great tool for democratizing access to new asset classes or new investment strategies. You know, as we're going to talk about, there's lumps along the way. But that's what Rex is all about. You mentioned democratizing access

to assets. I wonder how that applies to Bitcoin specifically, because of course, one of the selling points of Bitcoin is, you know, it's this decentralized currency and anyone can buy it. So walk us through how exactly you came up with the idea to apply the ETF structure to Bitcoin. So I remember I was on a business trip in Washington, D.C., actually, and I came across, I don't know if I was at a conference and the session was not very entertaining or something, and I was flipping through the news and I read an article on Bitcoin. It was sort of late 2013. Bitcoin was having a big run-up and I remember, I think I had heard of it before, but hadn't really paid that much attention. You know, price action tends to focus the mind. As we saw last year. As we saw

last year in Spades. So within the span of a couple hours, I decided to open an account with Coinbase and buy some Bitcoin. And so I personally got involved in Bitcoin then. And it wasn't on my radar for purposes of product development. It just was, it just seemed like, you know, those worlds were too far apart. But shortly thereafter or sometime around then, of course, the Winklevas filed for an ETF. And, you know, if you were in the ETF world, you saw that and it was like, wow, okay, here we go. But knowing something about how these things get done, I thought, well, that's, you know, that's going to have a lot of hurdles to overcome. And, you know, just watched from a distance. But for me, the turning point was in 2015 when the CFTC in a ruling, I think that it was a,

it was some sort of enforcement action against one of the early exchanges that in the course of making that ruling, the CFTC basically said, hey, Bitcoin is a commodity, and therefore, you know, where it's regulator. And that's when the light bulb went off for me that I saw a route to an ETF that perhaps didn't necessarily involve Bitcoin itself. futures contracts, something that was regulated by the CFTC. And of course, in 2015, there were no Bitcoin futures, but now we actually have them. And last year, we did see the launch of two Bitcoin futures that are currently trading.

Yeah, yeah, it took a while for that to develop. But for us, that was the kind of the first glimmer of, okay, I see a path here because physical bitcoins are just so intangible. It seemed like it would take a while for everyone to get comfortable. I want to ask, before we talk too much about the specific process of getting the Bitcoin ETF off the ground, I want to ask about the business of running a niche ETF company in this world where we have these huge 800-pound guerrillas like iShares. And so there are obviously some strategies that are well-known and well-trodden, whether it's

just sort of indexing strategies against the S&P 500 or emerging market strategies or country-specific strategies or factor strategies buying low volatility stocks in a basket. In the world of sort of very small sort of startup ETF companies, what is the goal? Is it to find something that becomes the next mega-ETF? Like, how do you think about these sort of upsides and downsides of the business and the general opportunities? I could answer that question for a while. But, you know, I think actually the bigger companies are the ones these days that really need to look for the mega hits to move the needle. The smaller companies can actually survive with much smaller niche products. But it is more difficult. There are so many players out there. The way we look at it is we have to believe in

something and believe that it's going to add value to the market just generally. Something that investors want, something that hasn't been done before or hasn't been done in a way that we think we can do it. and where there's a demand, right? But if you don't have that drive to kind of discover these opportunities and really work towards them, then it's a difficult place. So when did you decide that your idea for investing in Bitcoin individually could actually be transferred into something that would work as an exchange trade of funds for a variety of investors?

So in 2015, when the CFTC came on the scene, we started to say, all right, well, you know, how far are we away from a futures contract? We visited a number of the futures exchanges and really started to understand, you know, who's out there, who's working on this. Index providers are also important. The exchanges in, for example, the CME was developing an index, which at the time, you know, was not publicly announced. So we just tried to learn the ecosystem. We also decided to approach the SEC and speak to them about this off the record. And even though futures didn't exist, we generally got favorable kind of remarks from them. They thought, okay, well, this would sort of help address some of the concerns that we have regarding physical

Bitcoin. So when you embarked on that process, you know, Rachel mentioned earlier these three necessary ingredients for the ETF structure, the custodian, the authorized participants, and the market makers. When you were in the early stages of your idea, did you go out and talk to potential custodians or APs or market makers? We did. We talked to a few of the market makers, and they were active in physical trading of Bitcoin already. So there's a few firms that have been that sort of do ETF market making that were early in cryptocurrency trading. So we knew that there would be support from at least a few market makers, which is critical, as Rachel pointed out. Without that, you know, you don't really get too far. The custody piece, though, skipping back

to her first sort of back office category, that is the part that kind of really gets cleaned up with a futures contract. Right. Right. Everyone can custody a CME or CBO listed future, but custody these ones and zeros, you know, a little bit trickier. Yeah, I was just going to ask exactly that because without the futures, you could theoretically have an ETF that held the private keys.

of Bitcoins, right? But this just sort of makes it much easier, so you don't have to worry about getting hacked or all those other things. Yeah, yeah, that's right. And this is, you know, a couple years ago. So really, I think even the custody of the physical Bitcoin, and when I say physical Bitcoin, you know, it's how physical is it really? But the private keys, even the technology there was not where it is today. I think that's come a long ways as well. But thinking through the ecosystem that Rachel explained, we just thought that a derivatives contract would be the way to do this. If you look at other ETFs, say for example, we already said Bitcoin's a commodity. And if you look at gold, the way that the ETFs have been done is to hold the physical gold.

That's great. And everybody's comfortable with that process. That works well. If you look at oil, however, the ETFs don't hold physical oil. They just roll oil futures contracts. Same for natural gas, et cetera. So with commodities, you really have to look at the characteristics of the undervales. lying. And in some cases, it's just more pragmatic to hold the futures contract as a proxy for the

underlying. So we thought that this cleaned up several of those issues really pretty nicely. Grasso, inviting you to join me for the Bloomberg Law podcast. Every weekday, we help you make sense of the legal stories that shape the nation and the world. Listen for complete analysis of the biggest court cases, the latest actions from Congress and regulators, and the legal moves driving the markets. from corporate law to constitutional law and from state courts to the Supreme Court. At Bloomberg Law, we go beyond the day's headlines. We speak with top attorneys, judges, scholars, and policy experts to break down what the rulings really mean. We do this every weekday, then bring you the best conversations in our daily podcast.

Search for Bloomberg Law on YouTube, Apple, Spotify, or anywhere else you listen. On the East Coast, listen as you start. your day and on the West Coast, catch up in the evening. That's the Bloomberg Law podcast with me, June Grasso. Subscribe today wherever you get your podcast. So Greg, I got to ask, you said you went to the SEC. You got an initially what seemed to be a favorable response. What happened after that? After that, we sort of had to hurry up and wait because the futures didn't exist. So we focused on a few other things and kept trying to encourage the futures ecosystem, for lack of a better term, to populate with contracts. So being helpful, we did speak to a number of exchanges and helped

however we could, but it took a while. You know, this was the bulk of last year. And then as we know in December, we had a couple contracts that finally launched. Of course, by that time, there were a lot of people interested because I think the buzz preceded the, you know, the actual launch. Yeah, tell us a little bit about last year because obviously the second half or really the fourth quarter of 2017. It was just an absolute frenzy for Bitcoin and other cryptocurrencies. And there were numerous applications for Bitcoin ETFs. Everybody wants one. I think everybody knows how big the SPDR gold fund is, become truly democratized the way people could invest in gold. Now it's one of the biggest ETFs in the world. Talk to us to us about that. sort of frenzy and competition and what really happened over the last few months of 2017. Yeah, it was a really interesting time. And obviously, speaking from a product development perspective, it was interesting. But also at the same time, the price was just really cranking. And it was on TV all day. You know, we just, it was surreal in the sense that, you know,

in learning more, if you go back a year, trying to find articles or trying to find clips or different research on Bitcoin, it was sparse. And then by the end of the year, it was just everywhere and everybody had an opinion on it. But I think what happened is there was a press release, I think, that one of the exchanges was going to launch. And, you know, we had not filed anything publicly because, as I mentioned, there's sort of no point to do that quite yet if the futures don't exist. And so we had just sort of been waiting.

We'd had our discussions of the SEC. But people started a file, so, you know, we thought, well, we, we, we, we, we, we just, we just, the environment might be changing quickly, so let's go ahead and file as well. And, you know, we weren't the first and we weren't the last. And there were a lot of filings that came through. But ultimately, the SEC decided on a couple different occasions to really ask people to take a step back. And I think they, you know, they were clearly getting bombarded and just wanted to basically slow things down, I think. To put that all in context, when we actually had the most kind of an ETF.

filings out there. It was more than, I think it was 17 or even more than that. So the SEC was really kind of being bombarded by all these filings that all wanted Bitcoin ETFs, either the physical, as physical as you can get, or the futures. Is the expectation that were the SEC to give a green light at some point, that all of them would get approved or that some of them would be approved, or do people think maybe one or two would be approved? And those would be the big winners. Like how do, how does the SEC think about these situations where lots of entities are competing for the exact same, roughly the same thing? Yeah, that's a great question. So, and there's a lot of nuance here because there are different divisions of the SEC.

There is the CFTC, which is a totally separate regulator. And there's some, I guess, diversion of opinion in terms of where those boundaries end. But specifically, with respect to ETFs, you basically have two kinds, right? Your typical ETF is what we call a 40-act fund, right? It's an investment company. It's basically a mutual fund that has applied for certain exemptions that allow it to trade like a stock. That's essentially how ETFs really started. But then you have, and keeping in mind that Bitcoin's a commodity, you have a lot of ETFs that are actually not 40-act funds at all, they're filed under the 33 Act, and they don't have an investment manager. So what happens is that, and strictly speaking, there's probably four or five permutations of this. So if you're filing a product, it's going to go to the regulator that governs that particular type of product. And in all cases, it might lead to a different department. And that sounds a little, I guess, you know, silly. But the reality is that there are bodies of law that govern different types of investments.

differently. And that's just kind of the way the ecosystem has evolved here since, you know, since 1930s and 1940s, and it hasn't changed a whole lot. So the letter that got sent out was sent by the Division of Investment Management at the SEC, and that division is specifically concerned with 40 Act funds. There are a number of filings that are still in, and they basically don't have a nexus to the Division of Investment Management. So a letter was sent back in January by Dahlia Blas and the Investment Management Division of the SEC regarding the Bitcoin funds that had come to them seeking approval. Can you tell us a little bit about what that letter said regarding their concerns? Sure, yeah. That was sort of an industry-wide letter that came out.

And they articulated, I think it was like 38 different questions in that letter, really as a letter to the ICI. and really all mutual fund or 40 Act fund providers that ask them questions regarding valuation policies around Bitcoin, custody issues around Bitcoin, arbitrage mechanics with the market making community. Essentially, I thought it was helpful to understand where they're coming from. It's a little bit of an extraordinary move. You don't typically see something like that. But they essentially put down on paper all of their issues. And I think, a number of them had, at least in our communication with them, already been addressed. But I think this was their way of saying to the industry formally and very, you know, sort of

loudly, here is what we're concerned about. And they said it very clearly until these issues are addressed, we don't think it's appropriate to file for these products. So each provider got their own version of that letter. We got one privately as well that was tailored to our products. and each provider, I assume we are, is responding to the SEC. It's just happening outside of the registration process. That was going to be my question. So these letters get sent out in January. I realize it's only four or five months since then.

But it seems like virtually every day that passes, there's another financial institution that's tiptoeing into the crypto space or at least says they are. So are we any closer to alleviating some of the SECs? concerns, are we any closer to getting, you know, a real group of potential authorized participants, market makers, and especially custodians who might be able to do this? I think we are, actually. So the market makers have been there for a while. I think the futures volume, for example, is one of their concerns. I think that's developing nicely. The staff has

been responsive in terms of our private dialogues. So it's not like they're not focused on this. I think they just needed to slow down the timeline. I don't want to predict, obviously, the timeline. But I do think that progress is being made. And to your point, just industry-wide, there continue to be resources poured into this just from all over the place. Yeah, one thing that's striking in your recounting of the early history is things that we may not think about. as having been important bits of infrastructure. So you talk about an early attempt to create a Bitcoin price index, which, of course, is probably important for some sort of referent for a future, which then becomes important for obviously the custodial aspect of an ETF. So right now,

when you look at the landscape and we see, oh, there's a new trading desk at X firm or there's new something, these all are sort of, even if we don't really think of it, that directly bits of infrastructure that are coming in place that could theoretically support an eventual ETF. Yeah, there are a lot of building blocks that need to happen. And as you were talking, I was thinking about a house, right? You go in a house and switch on the lights and, you know, wash your hands or whatever, and everything works, right? but without those systems, electrical or plumbing or whatever it is, it's not really a fully functioning house.

So there was a lot of, I think there was a lot of interest, obviously, because Bitcoin is such a phenomenal thing, and it's so new and it's so interesting to a lot of people. But the capital markets infrastructure just wasn't there. And it's getting built out, and I think it's only a matter of time. So obviously we'll see what happens on the development of the Bitcoin ETF and all the different companies trying to get that out. Your firm, REC shares, is not just doing a Bitcoin ETF. You also have a filing out for a blockchain ETF. What could you say about the other irons in the fire, so to speak? Yeah, sure.

So the Bitcoin ETF, technically we withdrew, but we're talking to them on the side. That's actually why I can talk about it now is because we're not in the filing process. But we do have a blockchain ETF that we're hoping to launch in the upcoming weeks. We're excited about that because we think investors want exposure to this technology. And we've partnered with a portfolio manager who runs a crypto hedge fund. So he's going to be an active manager for this ETF, which is a little unusual in ETF land. Usually you're following a passive index. But this is taking the active approach and trying to get exposure to companies who've got some form of blockchain exposure or cryptocurrency-related activity that's material.

Got it. All right. So both the potential Bitcoin ETF and a blockchain ETF maybe on the way. Okay. So special thanks to our bonus guest for this episode, Rachel Evans. She's a reporter at Bloomberg News. She covers all things ETF. and also thank you to Greg King, CEO of Wreck Shares, for sharing your story. Thanks so much.

Thank you both. Thank you. So, Joe, I really enjoyed that conversation because I like talking about the nuts and bolts of ETFs, whereas I don't really like talking about the nuts and bolts of Bitcoin and blockchain so much, to be honest. No, I agree. I feel the same way because there's been a million Bitcoin conversations. We've had them on this podcast specifically. But using Bitcoin, as a lens through which you can understand this process and this massive industry and the unique challenges that Bitcoin poses with regards to custody and the arbitrage and all that stuff. I learned a ton just about the mechanics of ETFs and the regulatory aspect that I definitely didn't know about before. Yeah. And I guess it's worth pointing out that learning about the mechanics of ETFs actually helps you learn about potential strengths and weaknesses.

in the structure. You hear all the time about this idea that maybe ETFs aren't going to work one day. And what people are worried about there is that maybe the market makers or the APs won't do their jobs, essentially. You know, one day they won't do the arbitrage, maybe because the market is so volatile that they don't want to come in and take that sort of risk. But on the other hand, a lot of people in the ETF industry would say, well, if you understand how that works, it's very, very unlikely that we're ever going to encounter a day, when a big AP, which is essentially a large bank, doesn't want to make money. So it helps to understand both sides. Yeah, absolutely. And of course, something that you've done a lot of reporting

on is you hear about this, particularly with bond ETFs, which people fear that the underlying are illiquid or don't trade or don't price enough. Some of the people get anxiety every couple years about junk bond ETFs. And so understanding that exact mechanics really illuminates what it is that people get concerned about. Yes, how I learned about bond ETFs through the mechanism of a Bitcoin exchange traded fund. Okay, well, this has been another edition of the Oddlots podcast.

I'm Tracy Allaway. You can follow me on Twitter at Tracy Allaway. And I'm Joe Wysetal. You can follow me on Twitter at the stalwart. And you should follow our producer, Tofor Forges, at Forhes T, as well as the Bloomberg head of podcast, Francesca Levy. She's at at Francesca today. As well as our guests, follow Rachel Evans at Rachel Evans underscore NY.

And our guest, Greg, isn't on Twitter, but his company, Rexhares, is on Twitter at Rexhares. Thanks for listening. The news doesn't stop on the weekends. Context changes constantly. And now Bloomberg is the place to stay on top of it all. Hi, I'm David Gurra. Join us every Saturday and Sunday for the new Bloomberg this weekend. I'm Christina Ruffini.

will bring you the latest headlines, in-depth analysis, and big interviews. All the stories that hit home on your days off. And I'm Lisa Mateo. Watch and listen to Bloomberg this weekend for thoughtful, enlightening conversations about business, lifestyle, people, and culture. On Saturday mornings, we put the past week's events into context, examining what happened in the markets and the world. That on Sundays, we speak with journalists, columnists, and key political figures to prepare you for the week ahead. Join us as soon as you wake up and bring us with you wherever you're worried. weekend plans take you. Watch us on Bloomberg

Television. Listen on Bloomberg radio, stream the show live on the Bloomberg business app, or listen to the podcast. That's Bloomberg this weekend. Saturdays and Sundays starting at 7 a.m. Eastern. Make us part of your weekend routine on Bloomberg Television, radio, and wherever you

get your podcasts.