What Is Cryptocurrency?

A cryptocurrency is a digital or virtual currency that is secured by cryptography, which makes it nearly impossible to counterfeit or double-spend. Many cryptocurrencies are decentralized networks based on blockchain technology—a distributed ledger enforced by a disparate network of computers. A defining feature of cryptocurrencies is that they are generally not issued by any central authority, rendering them theoretically immune to government interference or manipulation.

Understanding Cryptocurrencies

Cryptocurrencies are digital or virtual currencies underpinned by cryptographic systems. They enable secure online payments without the use of third-party intermediaries. “Crypto” refers to the various encryption algorithms and cryptographic techniques that safeguard these entries, such as elliptical curve encryption, public-private key pairs, and hashing functions.

Cryptocurrencies can be mined or purchased from cryptocurrency exchanges. Not all e-commerce sites allow purchases using cryptocurrencies. In fact, cryptocurrencies, even popular ones like Bitcoin, are hardly used for retail transactions. However, the skyrocketing value of cryptocurrencies has made them popular as trading instruments. To a limited extent, they are also used for cross-border transfers.

What Is a Cryptocurrency ETF?

A cryptocurrency exchange traded fund (ETF) is a fund consisting of cryptocurrencies. While most ETFs track an index or a basket of assets, a cryptocurrency ETF tracks the price of one or more digital tokens. Based on investor sales or purchases, the share price of cryptocurrency ETFs fluctuates on a daily basis. Just like common stocks, they are also traded on a daily basis.

How Does a Cryptocurrency ETF Work?

Cryptocurrency ETFs provide several benefits to investors, such as significantly lower cryptocurrency ownership costs and outsourcing of the steep learning curve required to trade cryptocurrencies.

There are two kinds of cryptocurrency ETFs:

• The first type is backed by physical cryptocurrencies. The investment firm managing the fund makes purchases of cryptocurrencies, and ownership of the coins is represented as shares. When purchasing shares in the ETF, investors will indirectly own cryptocurrencies. Thus, owners can gain exposure to cryptocurrencies without the accompanying expense and risk of owning them outright.
• The second type is a synthetic variant that tracks cryptocurrency derivatives like futures contracts and cryptocurrency exchange traded products (ETPs). For example, many ETFs proposed to the U.S. Securities and Exchange Commission (SEC) track prices of bitcoin futures contracts traded at the Chicago Mercantile Exchange (CME).

The first cryptocurrency ETF, the ProShares Bitcoin Strategy ETF (BITO), started trading in October 2021. This is an ETF that tracks bitcoin futures prices.

The ETF share price mimics price movements of derivatives, instead of prices of actual cryptocurrencies. Therefore, the price of shares in a given cryptocurrency ETF rises with an increase in futures contract prices. It declines with a corresponding decrease. Just like other derivatives, synthetic cryptocurrency ETFs carry added risk because their operations may not always be transparent.

Regulatory Status of Cryptocurrency ETFs

For cryptocurrency enthusiasts, ETFs are the holy grail that will boost liquidity and the adoption of cryptocurrencies for investment purposes. As far back as 2014, approximately five years after bitcoin (BTCUSD) first began trading at an exchange, the Winklevoss twins filed an ETF proposal for the cryptocurrency with the SEC.

The agency rejected their application. Since then, there has been a flurry of applications from various investment firms—including one set up by the Winklevoss twins, who applied again this year—seeking to profit off bitcoin’s price volatility. In 2021 alone, the SEC recorded receipt of at least 12 applications.

The SEC elucidated its concerns in a January 2018 letter and explained the rationale for rejecting ETF applications. Among its concerns are the absence of transparency at cryptocurrency exchanges (which set the price of individual tokens), the potential for market manipulation, and low liquidity levels in cryptocurrency markets.

The situation in cryptocurrency markets has changed since the agency published its letter. Trading volumes at exchanges have multiplied. The overall market cap for cryptocurrencies has surpassed $2 trillion. (It had reached a peak of $800 billion when the SEC published its letter.) North America’s biggest cryptocurrency exchange, Coinbase Global Inc. (COIN), is now a publicly traded entity, and, as mentioned above, the first cryptocurrency ETF started trading in October 2021.

There has also been a changing of the guard at the agency’s helm. Former SEC Chairman Jay Clayton was an old hand who was considered hostile to cryptocurrencies. In 2021, he was replaced by former Commodity Futures Trading Commission (CFTC) chief Gary Gensler, who taught a course in blockchain and cryptocurrencies at the Massachusetts Institute of Technology. Gensler’s appointment has rekindled hopes for approval of a Bitcoin ETF, but he has said that he agrees with his predecessor’s assessment and views on crypto markets.