Gauging Spot Bitcoin ETF's Impact on Price Volatility

The U.S. Securities and Exchange Commission (SEC) is widely expected to greenlight one or more exchange-traded funds (ETFs) that invest directly in bitcoin (BTC) rather than in futures tied to the cryptocurrency.

Analyst consensus is that approval will have a bullish impact on prices. Analysts disagree, however, on whether approval will subdue bitcoin's notorious price volatility, which has dented its appeal as a haven asset.

While the Bitcoin blockchain is decentralized, its token, BTC, is concentrated in the hands of a relatively small number of owners, known as whales. Because of the size of their holdings, these whales hold great influence over prices, often triggering violent swings. A spot ETF, which is supposed to track the value of the underlying assets closely, could trim their influence by broadening the owner base.

"A spot ETF would provide bitcoin exposure to a much wider swath of market participants, including institutional investors and financial advisors," Nate Geraci, the president of registered investment adviser The ETF Store, said in an interview conducted over direct messaging on X. "A deeper pool of bitcoin investors via the ETF wrapper could theoretically help lower volatility since there would be a greater number and diversity of investors. That should make it more difficult for larger bitcoin whales to push prices around."

According to estimates from Galaxy Digital, the addressable market size of a U.S. bitcoin ETF could be $14 trillion in just one year after the spot ETF launch, and $39 trillion in the third year.

Such a strong uptake could boost liquidity in the underlying asset, ensuring less volatile trading conditions where prices don't fluctuate rapidly. Liquidity refers to the ability of a market to absorb large orders at stable prices.

"Volatility tends to drop as the space matures, more institutional liquidity and infrastructure develops, and the asset acclimates to normalcy," Richard Rosenblum, co-founder and president at crypto liquidity provider GSR, said over Telegram.

In the equity markets, an increase in ETF ownership tends to boost liquidity in the underlying stocks, according to a 2018 paper by Mehmet Saglam, associate professor of finance at the Carl H. Lindner College of Business at the University of Cincinnati; Tugkan Tuzun, an economist at the Federal Reserve Board and Russ Wermers, associate professor of finance at the Smith School of Business.

"Using several measures of liquidity, we find that ETFs increase the liquidity of their underlying stocks. We find that illiquidity measures, effective spreads, quoted spreads, Amihud, and implementation shortfall all increase when the ETF ownership of the stock goes down," according to the paper, which examined S&P 500 and Nasdaq stocks.

"Examining the price dynamics over large order executions, we find that one primary channel of higher liquidity is due to arbitrageurs trading against potential mispricings between the ETF and the basket of underlying stocks," the paper said.

Arbitrageurs take offsetting positions in two markets to profit from pricing differences between them. For instance, if an ETF trades at a discount to the value of the underlying stocks, an arbitrageur will buy the ETF and sell underlying stocks, effectively adding liquidity to the underlying assets.

Laurent Kssis, an ETF expert and crypto trading adviser at CEC Capital, takes the opposing position, arguing that spot ETFs could become a source of BTC price volatility.

ETFs are created and redeemed in kind or in cash. The widely used in-kind creation involves authorized participants (APs) depositing a basket of securities with the issuer in exchange for new ETF units. Under cash creation, APs provide cash and the issuer purchases the actual asset.

According to Kssis, in cash creation, the issuer is exposed to the difference between the prices at which assets have been acquired and the daily reference price at which the net asset value (NAV) is calculated.

"We need a reference price where we audit the fund to calculate the NAV," Kssis said in a Telegram interview. "With in-kind creations, APs purchase assets and deliver them to the issuer. With cash creations, if the issuer manages to buy them cheaper, then it makes a little profit, but if it buys them higher, it coughs up the excess."

"Hence, at the time of fixing, you will have more arbitrageurs trading around that time channel and creating volume to either push the market or trade discrepancies between the cash and futures price of bitcoin, effectively creating volatility inadvertently during that period," Kssis added.

Recently, there were rumors on the X that the SEC wants the ETF applicants to work through cash creation.