My 5 year trading career was spent as the head Asia Ex Japan Australia ETF market maker for Deutsche Bank and then Citibank. If the Winklevoss COIN ETF is approved, the price of Bitcoin will decisively punch through the last all time high. However the ways in which the ETF and the trading surrounding it will affect the Bitcoin exchange and trading ecosystem is just as important as the price spike.
A thorough understanding of how ETFs trade in both the primary and secondary market is essential to predicting the ways in which the ecosystem will change.
Below are useful definitions.
Primary Dealer (PD) or Authorised Participant (AP): These firms are allowed to create and redeem ETF units directly with the fund manager at the Net Asset Value.
Designated Market Maker (DMM): These firms have a contractual obligation to the exchange to provide continuous bid and ask quotes at a specified maximum spread through the trading day. Usually PDs and APs are also DMMs.
Net Asset Value (NAV): At the end of each trading day, the fund manager will value the assets held by the ETF and produce an NAV. The fund’s management fees will be taken from the NAV each day.
Indicative Net Asset Value (INAV): During the trading day, the INAV is calculated by valuing the underlying assets at current market prices.
Portfolio Composition File (PCF): Each morning the fund manager will publish the PCF file. This file tells traders what assets and in what quantities the ETF holds. Using the PCF file, traders compute the INAV or fair value of the ETF throughout the trading day.
Creation and Redemption Unit: This is the multiple of ETF shares that can be created or redeemed by the PD.
The most relevant aspect of the ETF is how units will come into existence.
DMMs initially will not carry inventory. One privilege they have is the ability to naked short the ETF. If a DMM is short ETF units by the end of the trading day, they must create new units by the settlement day which is trade date plus two business days (T+2).
As the DMM sells ETF units to the market, they will purchase Bitcoin in the quantities specified by the PCF file. Assume that 1 COIN share represents 0.01 Bitcoin. If the DMM sells 10,000 shares, they must buy 100 Bitcoin.
At the end of the trading day, the DMM will submit a creation request to the fund manager. The fund manager will give instructions for where the DMM must deposit Bitcoin.
If the creation unit is 1,000 shares, the DMM will submit an order for 10 creation units. The fund manager will supply instructions on what address to deposit Bitcoin. After the Bitcoin is sent, the fund manager will legally bring new ETF shares into existence and deposit them into the DMM’s Depository Trust Company (DTC) account.
The DMM will then deliver these shares to the exchange by the settlement date, and the exchange will credit customer accounts with ETF shares.
Large asset managers may not wish to purchase ETF shares in the secondary market because they intend to purchase a large amount. Instead they will contact a PD and ask them to create units on their behalf. The PD charges a fee for such trades.
Being a PD and or DMM of a popular ETF is a license to print money. PDs for the COIN ETF will make a killing.
Assuming DMMs start with no Bitcoin inventory, if they become net long ETF shares then by the end of the trading day they can redeem. As traders sell ETF shares into the DMM, the DMM will hedge this long exposure by short selling Bitcoin.
Given that many of COIN’s DMMs are traditional trading houses and or banks, I do not believe they will avail themselves of margin or futures trading on non-US based and regulated exchanges. As a result the likely outcome is that DMMs will negotiate with Gemini and other US exchanges to borrow Bitcoin from the exchange’s inventory to short sell on the market.
In exchange for tendering ETF shares to the fund manager, the DMM will receive an amount of Bitcoin as specified by the PCF file. Once this Bitcoin is received, they will pay back their Bitcoin loan.
The listed APs for COIN are Convergex, KCG, and Virtu Financial. I suspect that these firms will also act as DMMs.
None of these firms have a history of Bitcoin trading. That means that their comfort level with exchanges other than Gemini will be nil.
If COIN is as popular as we all expect, then DMMs will need to day trade a significant amount of Bitcoin. Liquidity on Gemini, Coinbase, and itBit will be challenging.
Due to regulations, US exchanges offer the least amount of Bitcoin trading products. Margin and futures trading is not offered. Even worse, the majority of supply is mined abroad. The over the top KYC requirements to open accounts in America scare many miners away from selling their coins on these exchanges. The stringent requirements also mean that exchanges can only service Americans.
Except for the Gemini auction, DMMs will not be able to cheaply trade Bitcoin on US-regulated exchanges. They will rely upon OTC brokers. The largest US-domiciled broker is Cumberland Mining, a subsidiary of DRW Trading. Cumberland can access the largest pools of liquidity through their long standing relationships with large traders and exchanges globally.
Market Structure Implications
Gemini sans Bitcoin ETF is irrelevant. If the ETF is approved, volumes on the exchange will ratchet higher. Coinbase and itBit will bite the dust. Traders arbitraging the ETF vs. Bitcoin will primarily trade on Gemini. It will be the most direct and easy hedge.
The daily Gemini auction will become the most important pricing signal. As the assets under management (AUM) of the ETF grows, the daily flows of creations and redemptions will underpin strong auction volumes.
International spot exchange volumes will benefit from OTC brokers sourcing intra-trading day liquidity. Those platforms where miners and traders feel comfortable buying and selling spot Bitcoin will benefit.
Let’s all come together and pray to our deity of choice for an approval. Also it would help if the twins deposit large brown paper bags of cash with relevant SEC decision makers. Make Bitcoin great again!