It has been widely accepted that Bitcoin ETF applications have been the main driver for Bitcoin’s return to the April 2022 level at above $40k. The thesis is simple: with a new layer of institutional legitimacy, the capital pool for Bitcoin inflow would deepen.

From hedge funds and commodity trading advisors (CTAs) to mutual and retirement funds, institutional investors have easy access to diversify their portfolios. And they would do so because Bitcoin is an anti-depreciating asset.

Not only against forever-depreciating fiat currencies but against not-so-capped gold. In contrast, Bitcoin is not only limited to 21 million but its digital nature is secured by the world’s most powerful computing network. So far, 13 applicants have maneuvered to serve as institutional Bitcoin gateways.

According to Matthew Sigel, VanEck’s Head of Digital Asset Research, SEC approvals will likely bring “more than $2.4 billion” in H1 2024 to boost Bitcoin price. Following the SEC’s court battle loss against Grayscale Investment for its Bitcoin trust-ETF conversion, the Bitcoin ETF approvals are now perceived as near-certainty.

Most recently, SEC Chair Gary Gensler met with Grayscale representatives alongside seven other Bitcoin ETF applicants. Later, in a CNBC interview, Gensler confirmed that the path to Bitcoin ETFs is a matter of sorting out technicalities.

“We had in the past denied a number of these applications, but the courts here in the District of Columbia weighed in on that. And so we’re taking a new look at this based upon those court rulings.”

The most telling indicator in that direction is that BlackRock, the world’s largest asset manager, has integrated Wall Street-friendly rules. In that framework, banks could participate as authorized participants (APs) in Bitcoin ETF exposure. This is also notable given that Gary Gensler himself is a former Goldman Sachs banker.

Considering this likely horizon, what would the Bitcoin ETF landscape look like?

The Role and Concerns of Custodians in Bitcoin ETFs

Of 13 Bitcoin ETF applicants, Coinbase is the BTC custodian for 10. This dominance is not surprising. BlackRock partnered with Coinbase in August 2022 to link BlackRock’s Aladdin system with Coinbase Prime for institutional investors.

Furthermore, Coinbase has established a cozy relationship with government agencies, from ICE and DHS to Secret Service, to provide blockchain analytics software. At the same time, the largest US crypto exchange keeps track of law enforcement and agency information requests in annual transparency reports.

As the favored pick, Coinbase would serve the dual role of crypto exchange and ETF custodian. This drove Coinbase (COIN) shares to new highs this year, preparing to close 2023 at +357% gains. On the other hand, the very same SEC that regulates Coinbase as a publicly traded company, sued Coinbase in June 2023 for operating as an unregistered exchange, broker, and clearing agency.

According to Mike Belshe, BitGo CEO, this could cause friction on the path to Bitcoin ETF approvals. In particular, Belshe views Coinbase’s fusion of merchant and custodial services as problematic:

“There are many risks in setting up the Coinbase business that we do not understand. There is a high probability that the SEC will refuse to approve applications until these services are completely separated,”

Previously, the SEC’s often-stated reasoning behind Bitcoin ETF refusal revolved around market manipulation. For instance, as the recipient of BTC flows, Coinbase could front-run ETF orders just before ETF order execution to profit from the price differential.

The SEC has insisted on strict trading controls and market surveillance to prevent potential market manipulation. This is on top of the existing partnership between Coinbase and Cboe Global Markets for surveillance-sharing.

Suffice to say, it is in the interest of Coinbase and its COIN shareholders to not erode the integrity of BTC custody. Of greater importance is how Bitcoin redemptions will be accomplished.

In-Kind vs. In-Cash Redemptions: Analyzing the Options

The Bitcoin ETF concept revolves around BTC exposure while avoiding the potential pitfalls of BTC self-custody. After all, it has been estimated that up to 20% of Bitcoin supply is forever lost due to forgotten seed phrases, phishing and other self-custody foibles.

Once that more centralized BTC exposure is accomplished, how would investors redeem the exposure? In addition to market surveillance, this has been the SEC’s focal point, bifurcating redemptions into:

In-kind redemptions: While existing Grayscale (GTBC) shares are not directly redeemable for Bitcoin, relying on the secondary market instead, Bitcoin ETFs would change that. The aforementioned authorized participants (APs) would be able to exchange BTC ETF shares for a corresponding BTC amount.

This is the preferred approach of most Bitcoin ETF applicants, given its common use in traditional stock/bond ETFs. This approach would also benefit the market, as it minimizes the risk of price manipulation by avoiding the need for large-scale BTC sales. Instead, APs can gradually sell their bitcoins without flooding the market to artificially suppress the price.

In-cash redemptions: By default, this approach is reductionist, offering a more direct BTC-to-fiat pipeline when APs exchange ETF shares for cash.

Given that the SEC is a part of the USG fiat system, the watchdog agency prefers it. In-cash redemptions would close the redemption lifecycle loop by keeping the capital in TradFi instead of exploring BTC custody.

As of the November 28th memorandum between the SEC and BlackRock, it is clear that the approach is not yet settled. BlackRock revised its in-kind redemption model, following the SEC’s concern on market maker (MM) risk. In the new model, there would be an additional step between the MM and the market maker’s registered broker/dealer (MM-BD).

Against the in-cash model, the revised in-kind model would remove the need to pre-fund sell trades. This means that ETF issuers don’t have to sell assets/raise cash to meet AP redemption requests. Despite the complexity, this wouldn’t impact unlevered free cash flow.

Moreover, market makers would burden the risk of redemption execution instead of that risk falling onto APs. With lower transaction costs and better bulwark against market manipulation, BlackRock’s preferred in-kind redemptions appear to gain ground.

Another large asset manager, Fidelity Investments, also prefers an in-kind model as noted in the December 7th memorandum.

It will then be up to the SEC to set the post-Bitcoin ETF landscape.

Market Implications and Investor Perspectives

In the short-run, following the Bitcoin ETF approvals, the VanEck analyst estimates $2.4 billion inflow. VanEck forecasts a $40.4 billion deeper capital pool within the first two years.

In the first year, Galaxy researcher Alex Thorn sees over $14 billion in capital accumulation, which could push the BTC price to $47,000.

Some analysts are more optimistic, however. The Bitwise research team forecasts that Bitcoin ETFs will not only be “the most successful ETF launch of all time” but that Bitcoin will trade above the new all-time-high of $80k in 2024.

If the SEC follows through on its anti-crypto tradition, it could pick some details that would have a deterrent effect. For instance, a high redemption threshold would disincentivize APs to create BTC ETF shares in the first place because the upfront cost of buying a large amount of bitcoins would be perceived as too burdensome and risky.

Case in point, existing gold ETF redemptions, treated as ordinary income, incur 20% long-term capital gains tax. On the other hand, in-cash redemptions would not trigger a taxable event until Bitcoin is sold.

If the SEC approves in-cash models for some applicants, investors would be more incentivized to redeem ETF shares in cash instead. In turn, this could lead to greater price manipulation potential.

Altogether, the SEC has ample wiggle room to place a large downward pressure on the price of Bitcoin, notwithstanding its stated goal of investor protection.

Conclusion

2024 is poised to be the trifecta year for Bitcoin. With Bitcoin ETF inflows, the market also expects the 4th Bitcoin halving and the Fed’s ingress into rate cuts. In the meantime, the dollar will continue to erode, even in the best-case scenario of 2% annual inflation rate.

The latter two drivers may even overshadow Bitcoin ETFs, regardless if the SEC opts for in-kind or more downward-loaded in-cash redemptions. In either case, Bitcoin is poised to cross a new legitimacy milestone. This itself is bound to please Bitcoin holders over the following years.