Canadian investors may soon get easy access to the burgeoning market for cryptocurrencies through TSX-listed exchange-traded funds that track the price performance of bitcoin.
Such ETFs in Canada could arrive even before similar products that have been awaiting approval in the United States. But in doing so, they will also expose investors in this country to risks that are both elevated and not widely understood, given the complexities of how bitcoin works and the regulators' unfamiliarity with the bitcoin market.
This week, ETF provider Evolve Funds Group Inc. filed a preliminary prospectus with the Ontario Securities Commission for the launch of an actively managed bitcoin ETF that would trade under the symbol BITS.
It is not alone in planning to enter the space: Horizons ETFs Management (Canada) Inc. is also looking to build an ETF that will track the bitcoin currency. The firm is still in the preparation stage and has not yet filed a preliminary prospectus, Steve Hawkins, president and co-CEO of Horizons ETFs, told The Globe and Mail.
"There will be demand from investors who want exposure to the bitcoin space, and firms like ours want to take a leadership position in creating product for those investors," Mr. Hawkins said.
" … I see the bitcoin market as one that is continuously evolving, and we see it becoming a necessary trading tool down the road, just like currencies and commodities,' Mr. Hawkins said.
Raj Lala, president and chief executive of Evolve Funds Group Inc., said he has seen huge investor appetite to participate in the growth of the bitcoin market. "For some people, buying bitcoin directly is a daunting task. Providing them easier access, directly through their brokerage account with an ETF would allow them to participate in the growth of bitcoin, as well as in its performance," he said in an interview.
Bitcoin and other cryptocurrencies have surged in value in recent months, creating a ripple effect of investor interest. The price hit a record high of more than $5,000 for one bitcoin at the beginning of September, a monstrous gain after starting the year near $700. But the price of bitcoin has also been highly volatile, with swings of more than 10 per cent in one day not uncommon.
Bitcoin is a digital currency that is not backed by any country's central bank. It enables individuals to transfer value to each other and pay for goods and services without the need for a middle man – typically the banks and the mainstream financial system. One typical use would be to wire transfer money to another person. The technology behind the function of bitcoin currency is known as blockchain – an online digital ledger that keeps a record of recent transactions. Once a transaction is completed, it goes into a blockchain database and is kept as a permanent secure record.
But there can be risks associated with bitcoin's underlying markets, which sometimes include drug dealers and online hackers. Many of the exchanges trading bitcoin reside in jurisdictions outside the home country, which makes regulatory oversight difficult.
Controversy has been swirling around the digital currency; China earlier this month announced plans to shut down its bitcoin exchanges in an attempt to limit risks in a highly speculative market, according to numerous media reports. In the United States, JPMorgan Chase and Co.'s CEO Jamie Dimon memorably said he would fire any employee trading bitcoin for being "stupid." He told investors at a conference in New York that the cryptocurrency "won't end well" for investors and that it was "worse than tulip bulbs" and says it's an investment that will likely collapse.
Both developments caused bitcoin's value to slightly dip in price, but they did not appear to dim investors' appetite to gain access to the cryptocurrency.
Still, the bitcoin market in Canada remains largely unknown among mainstream investors. The country's first bitcoin investment fund manager received regulatory approval this month in Ontario and British Columbia. First Block Capital Inc. was given the green light by the British Columbia Securities Commission (BCSC) to operate as an investment fund manager and exempt market dealer and launch a bitcoin investment fund known as the Canadian Bitcoin Trust.
"Cryptocurrency investments are a new and novel form of investing in Canada," said Zach Masum, manager, legal services, capital markets regulation for the BCSC, and leader of its tech team. "We have seen from the market and from investors that there is a strong appetite for access to these kinds of investments."
While the industry applauded the approval, the fund is for accredited investors only and requires a minimum $25,000 investment – hence opening the door to the bitcoin market only for larger institutions and ultra-high net worth Canadians. The firm hopes to provide access to a broader retail group but knows it will require continued work with the regulators to make it happen, said Sean Clark, co-founder of First Block Capital. One of the obstacles the investment firms must overcome is a perception that bitcoin is not a legitimate currency free from black-market influence.
Many individuals who use cryptocurrencies are libertarians and deep technologists, Mr. Clark said. "They don't actually like finance or structure so they operate in the shadows. This is why you commonly hear bitcoin being associated with drug dealers and hackers. But we want to show that this is a product that can be on Bay Street, and by being open with the regulators, we can be a very successful asset manager in this space."
In Canada, the regulators took six months of due diligence before making a decision on First Block. During the process, the BCSC flagged regulatory concerns not typical of a traditional application for registration, including fair pricing of bitcoin and the custodian of the investment – an institution that is in charge of keeping the assets safe for investors. The BCSC met with First Block's custodian numerous times to review its policies and procedures and ensure the bitcoin assets were being held safely for investors.
"First Block was required to implement robust policies and procedures to address all these issues," says Jason Brooks, the partner at Borden Ladner Gervais LLP who led the legal team that represented First Block in its registration application. "They had to satisfy the regulators that they had done a significant degree of due diligence on the parties they are partnering with in connection with their business."
The terms and conditions of First Block's registration allow the firm to work under the current regulatory framework while providing the BCSC with unique mechanisms to monitor the operations closely. "For now, First Block's registration will only allow them to manage funds that invest in bitcoin and they will need to obtain regulatory approval before they expand into other cryptocurrencies or make other significant changes, including a change to the entity used to hold custody of the bitcoin investments of their fund," Mr. Brooks said.
Providing retail investors with direct access to bitcoin has been a regulatory nightmare for many jurisdictions.
In the United States, at least three investment firms have attempted to launch bitcoin ETFS with no success – and several more ETFs are sitting in the pipelines. The most famous of the batch is the Winklevoss Bitcoin ETF (COIN).
Created in 2013 by Cameron and Tyler Winklevoss – the twins famous for their legal battle with Facebook founder Mark Zuckerberg – COIN has been sitting on the regulator's shelf for more than three years. The duo have repeatedly gone back to the Securities and Exchange Commission (SEC) asking for approval only to be dismissed due to lack of regulation in the bitcoin market.
After its most recent rejection in March, the SEC stated in its ruling the ETF required more regulatory oversight due to the "fraudulent and manipulative acts and practices in the underlying market."
Major concerns include liquidity of the ETF as well as security issues such as the lack of surveillance sharing agreements – which identify and limit market manipulation – between the major exchanges on which bitcoin is traded.
Canadian ETF providers are taking a different approach than First Block Capital, by tapping into the futures market of bitcoin rather than gaining access to the physical bitcoin market. Futures are a type of derivative that allow investors to speculate on what a price will be at a later date. Many of the ETF filings in the United States have switched strategies to include the futures market of bitcoin – a market regulators understand better.
"A product that has underlying futures contracts is something the regulators can get their heads around and it's an area that we are very familiar with," said Mr. Hawkins, who has launched several ETFs based on futures market contracts. "The regulators know we have experience in this area and we would hope to be able to come to market with a similar product very quickly."
The launch of the ETF filings in both Canada and the United States all hinge on the Chicago Board Options Exchange's launch of CBOE bitcoin futures expected later this year.
CBOE Holdings, which runs a number of exchanges including the Chicago Board Options Exchange and the CBOE Futures Exchange, is creating the bitcoin futures using data supplied by a bitcoin exchange called Gemini, run by the Winklevoss brothers.
With ETF providers jumping on the bitcoin bandwagon, Canada could be the first in North America to win the race to market, says Eric Balchunas, U.S. ETF analyst with Bloomberg Intelligence.
"I wouldn't be shocked if we saw a bitcoin ETF in Canada get out before the U.S market," Mr. Balchunas said in an interview. "Canada has historically been faster and more liberal with approving products. Canada approved its first ETF within a year, whereas the U.S. took four years to market. Canada approved a marijuana ETF last year and the U.S. still hasn't approved one here. So it's happened before where Canada is first to market with a product."