LONDON/WASHINGTON - The launch of U.S. exchange-traded funds (ETFs) tracking bitcoin deepens ties between the volatile world of cryptocurrencies and the traditional financial system, potentially creating unforeseen new risks, some experts say.

The Securities and Exchange Commission (SEC) this month approved 11 spot bitcoin ETFs from issuers including BlackRock and Invesco/Galaxy Digital, in a watershed moment for a crypto industry dogged by bankruptcies and crime.

The SEC had long rejected the products citing investor protection concerns, but was forced to rethink its position after losing a court challenge brought by Grayscale Investments.

Crypto enthusiasts say the products will allow investors to more easily and safely gain exposure to bitcoin. But when approving the products, SEC Chair Gary Gensler warned bitcoin remains a "volatile asset" and that investors should be wary.

The ETFs combined have around $21 billion in assets, and could draw as much as $100 billion this year alone from retail and institutional investors, some analysts predict. Bitcoin is down more than 6% since the products were launched.

If widely adopted, the products could pose risks to other parts of the financial system during times of market stress by exacerbating bitcoin price volatility, or creating dislocations between the price of the ETF and bitcoin, said some ETF experts, citing evidence from previous ETF volatility events.

Others said last year's U.S. banking upheaval showed that financial and crypto markets can transmit risks to one another. Crypto lender Silvergate Bank, for example, liquidated following withdrawals sparked by the collapse of crypto exchange FTX, which in turn stoked panic that contributed to the failure of Signature Bank, regulators have said. The collapse of Silicon Valley Bank, meanwhile, sparked a run on stablecoin USD Coin.

"As investors pour money into these products, you substantially increase the risk of much greater interconnection between the core of the financial system and the crypto ecosystem," said Dennis Kelleher, CEO of Better Markets, an advocacy group which had urged the SEC to reject bitcoin ETFs, citing risks to investors and the financial system.

Conceived in 2009 as an alternative payment mechanism, bitcoin is mostly used as a speculative investment. Its daily average volatility is roughly three and a half times that of equities, according to the Wells Fargo Investment Institute.

Bitcoin ETFs could "particularly exacerbate" that volatility in times of market stress, and other channels through which ETFs can create systemic risks, said Antonio Sánchez Serrano, principal economist at the European Systemic Risk Board, the European Union's financial risk watchdog.

Those other channels include the decoupling of the ETF price from the underlying asset, which can cause stress for institutions heavily exposed to the products or which rely on them for liquidity management.

"The differences with a plain-vanilla stock ETF are simply too large in terms of embedded risks," Serrano wrote in an email to Reuters, referring to bitcoin ETFs, which he classified as complex.

Exchange-traded products that are complex, less liquid and highly leveraged have experienced stress in the past.

In February 2018, a volatility-tracking exchange-traded note went bust amid a surge in volatility, causing investors $2 billion in losses.

In 2020, COVID-19 shutdowns sparked a sell off in some corporate bond ETFs. That stress would have spread to the broader fixed income market had the Federal Reserve not provided emergency support, including buying shares of bond ETFs, the CFA Institute, an investment professional organization which has also studied ETF risks, has argued.

The ETF industry generally disputes that its products pose systemic risks.

In their risk disclosures, bitcoin ETF issuers list a slew of market, policy, and operational risks, but acknowledge the immaturity of bitcoin means some hazards may be unforeseeable.

The SEC did not respond to a request for comment.

 

"TOMORROW'S FAILURE"

To be sure, the risks will largely depend on how widely adopted the ETFs ultimately become, said Serrano and other experts.

"Systemic risk is all about size... We do not yet know enough about who is actually purchasing these and in what proportions," Olivier Fines, head of advocacy and policy research, EMEA, at the CFA Institute said in an email.

Crypto industry executives also point out that crypto crises, most notably when cryptocurrencies lost around two-thirds of their $3 trillion value in 2022, have mostly been contained to the crypto sector.

Connectivity between cryptocurrencies and the financial system still remains "very limited," said Lapo Guadagnuolo, senior analyst at S&P Global Ratings.

ETF issuers also say they have created guardrails. For example, the products will be redeemed in cash, rather than bitcoin, minimizing the number of intermediaries that physically hold the cryptocurrency.

"I don't see cataclysmic... dynamics in any of these products," said Steve Kurz, global head of asset management at Galaxy Digital, which partnered with Invesco on its ETF.

Still, at least one top SEC official has flagged concerns.

When voting against approving the ETFs in January, SEC Commissioner Caroline Crenshaw said in a statement that the agency had not considered whether the ETFs would create a nexus with traditional markets that "allows crises in largely non-compliant crypto markets to spill over."

Crenshaw, who did not respond to a request for comment, also said she was worried the ETFs could pave the way for riskier products.

"I fear that today we are setting ourselves up for tomorrow's failure," she added.

(Writing by Tommy Reggiori Wilkes; Reporting by Hannah Lang and Elizabeth Howcroft; additional reporting by Saqib Ahmed, Chris Prentice and Douglas Gillison Editing by Michelle Price and Anna Driver)