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ETF Specialist

Does the World Need a Bitcoin ETF?

The short answer: No.


Earlier this week, Math-Based Asset Services LLC submitted paperwork to the SEC seeking permission to create a bitcoin exchange-traded fund, perhaps setting the record for one of the most outlandish ETF filings to date. The proposed fund would hold bitcoins in a trust structure similar to those used by gold ETFs, and it would protect its assets using a proprietary security system. The fund is being proposed by Tyler and Cameron Winklevoss, who are best known for their multiple lawsuits against  Facebook (FB). Notably, the filing has the support of Kathleen Moriarty of Katten Muchin Rosenman LLP; she was involved in the creation of early physical commodity ETFs. Although the bitcoin is an interesting concept, the asset is riddled with risks that prevent it from having any investment merit in its current state.

Bitcoins are a digital commodity generated and governed by an open-source algorithm. In simplified language, new bitcoins are created upon the completion of complex math problems and are intended to function as an alternative to fiat currency by operating independently from governments and central banks. In a nod to a long history of gold-backed currencies, the act of generating new bitcoins is called "mining." Unsurprisingly, bitcoins initially only attracted the interest of libertarian-leaning technocrati, but are quickly becoming noticed by more mainstream market participants.

A recent survey of leading economists by the IGM Forum showed an overwhelming consensus that the primary driver of bitcoin value is speculation on the asset's future acceptance as a currency. Today, the number of businesses that accept bitcoins as a form of payment is extremely limited, a state that is likely to persist in the face of bitcoins' volatility: In 2013, the price of a single bitcoin has ranged from $13 to more than $200, with extreme fluctuations regularly occurring over the course of minutes. Bitcoins are best conceptualized as a highly speculative commodity whose volatility is driven, in part, by price manipulation and its faulty infrastructure.

Bitcoins exist in digital form only, so investors are subject to the risk of fraud and losses arising from hacking-related activities. Bitcoin prices have crashed in the past after widespread hacking saw large numbers of participants irrevocably stripped of their assets. Indeed, one of the many risks listed in the proposed trust's paperwork is the irreversible loss of the trust's assets should a security breach occur. Considering bitcoins' security track record, this risk is not insignificant.

The crypto-currency's biggest impediment to legitimacy is perhaps its faulty infrastructure. Hackers can manipulate bitcoin prices through denial of service attacks. Bitcoin prices tank when service lags or halts completely during attacks on exchanges, allowing the attacker to scoop up cheap bitcoins and sell them when prices re-stabilize post-assault. The major bitcoin exchanges already have demonstrated their susceptibility to denial of service attacks. In April of 2013, digital assaults forced primary bitcoin exchange Mt. Gox offline for days, which sent the price of bitcoins plummeting. Without reliable infrastructure in place, bitcoins are likely to continue their trend of extreme volatility. When bitcoin prices swing by double-digit percentages regularly, companies are even less inclined to consider bitcoins as a form of payment.

Legitimacy will be the least of the proposed fund's troubles if governments make bitcoins entirely illegal. The bitcoin market has remained largely unregulated, but it is already coming under heightened regulatory scrutiny this year. Many of Mt. Gox's assets were frozen, and another exchange was charged with money laundering and was shut down. Bitcoins have a notorious reputation as the payment of choice for the online purchase of contraband. The outlawing of bitcoins is listed as one of the fund's risks in the filing, and the SEC is unlikely to act until the legal gray area that bitcoins currently occupy is resolved.

The proposed bitcoin trust will have to clear tremendous regulatory hurdles before launching, if it ever does. The SEC likely will put this opaque, risky, and illiquid asset under extreme scrutiny. Should the proposed fund beat the odds and make it to launch, the vast majority of investors should avoid it just as much as retailers avoid using bitcoins as payment today.

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Abby Woodham does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.