In what is becoming a seasonal tradition, the U.S. Securities and Exchange Commission (SEC) is using any legal and technical recourse to punt yet again on approving U.S.-based crypto exchange-traded funds (ETFs). Even with these challenges, several firms haven’t been deterred from attempting to become the first U.S operator in a global ETF market representing $6 trillion in assets under management (AUM).
We should not be that surprised by the SEC’s foot-dragging, considering the long and tortured financial history that got us to ETFs in the first place. It took around 450 years from the establishment of the first stock exchange in 16th century Antwerp until the first U.S. ETF was launched in 1993. It wasn’t until 1987′s Black Monday crash that the financial community faced a problem (see below) for which ETFs presented a sort of solution. Ever since, the instrument has often acted as a safe harbor in stormy financial climes, from the Great Recession of the late 2000s to pandemic-weary markets in the 2020s.
Like the race to bring the first crypto ETF to the U.S., the first ETF itself was not created overnight. It took several attempts to craft those early ETFs, mainly due to prevailing securities, tax and corporate law regarding structured products, managed investment schemes, mutual funds and derivatives. Crypto ETFs don’t have nearly the same universal buy-in across the financial community, so it is no surprise this has been marked with even more false starts and stumbles. It is enough to make one wonder whether crypto ETFs will ever be universally accepted: They may be too risky for the old guard and too centralized for the new one.
Crypto ETFs: An old dog forced into new tricks
ETFs were created because investors wanted to achieve the same sort of return as a market index without having to hold the constituent assets of that index directly, essentially reproducing portfolio diversification, but at lower cost and with less effort. For its time, the ETF was a radical financial innovation that, at its heart, solved a most elementary problem for investors.
Now, in the nearly 30 years since the launch of that first ETF, there are over 150 ETF providers, a list that reads like a roll call of major institutional finance: Vanguard, BlackRock, State Street, Invesco and VanEck.
For all of the benefits that traditional ETFs offer, like portfolio diversification and market performance, they do have some drawbacks, including the need for brokerage access that creates a whole litany of fees, illiquidity, trading delays tied to “market hours” and extra costs from the need for providers to maintain custody of the ETF’s underlying assets.
Now, 30 years after that first ETF, blockchain technology has literally rewritten the whole scene. Blockchain, cryptography and tokenization have made programmable finance accessible to all at the speed of the internet, creating whole currencies, derivatives and new financial industries out of decentralized consensus.
Now, what if you could take what was so attractive about ETFs 30 years ago and reconstruct that type of appeal for an entirely new world of financial options that we couldn’t even conceive of as little as 15 years ago?
It turns out we can.
Why ETF when you can ETP?
The powerful combination of decentralized finance (DeFi) protocols, on-chain asset management and smart contract technology is heralding the arrival of the decentralized version of ETFs, tokenized and fully collateralized baskets of digital assets called ETPs (exchange-traded portfolios).
These “baskets” are fully collateralized by the pooled assets that are held within the relevant smart contract. These “smart pools” can then be tokenized so investors can deposit funds into the smart contract, receiving a corresponding number of tokens that represent a given share in the underlying assets.
In addition, ETPs are non-custodial, meaning the investor remains in control of their deposited assets, and can withdraw them at any time by redeeming the corresponding tokens. Goodbye, brokerage fees and market hours.
As layer 2 blockchain protocols help reduce what have been the traditional gas fees associated with the deposit and withdrawal of smart contract funds, ETPs begin to look like very attractive products from a cost perspective. Even better, ETPs offer larger financial incentives: macro-hedges against inflation, participation in top crypto assets, pooled DeFi assets, baskets of traditional tech stocks, index-based portfolios and yield-bearing stablecoins.
ETFs have come a long way in the last 30 years, but trying to use that framework for crypto is a bit of a non-starter, even as tantalizing as it might be to some in the industry. With the advent of products that concentrate both investment and investment tools in crypto innovation – products like ETPs – investors will be able to participate in more opportunities offering better liquidity and less friction than ever.
For the old guard, it will require even more trust in a new paradigm that discards old inefficiencies. For the new guard, it will require even more imagination to not dress up tomorrow’s solutions in those same inefficiencies.
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