Earlier this year, Purpose Investments released one of the first-ever Bitcoin exchange-traded funds (ETFs) approved for trading in Canada.
As the U.S. continued to catch up, an announcement was made last week that ProShares was launching a long-awaited ETF that is linked to Bitcoin futures and will trade on the New York Stock Exchange (NYSE).
Did you know? A futures market is an auction market in which participants buy and sell commodities and futures contracts for delivery on a specified future date. Futures are exchange-traded derivatives contracts that lock in future delivery of a commodity or security at a price set today.
This marks a milestone for the development and integration of the crypto industry into modern markets. Although, navigating through the U.S. Securities and Exchange Commissions (SEC) regulations is no easy feat, the ETF was just approved for listing and hit the markets on October 19.
“2021 will be remembered for this milestone,” said Michael Sapir, the CEO of ProShares. Investors who are curious about crypto, but hesitant to engage with unregulated crypto exchanges want “convenient access to Bitcoin in a wrapper that has market integrity,” he said.
For nearly a decade, crypto entrepreneurs and traditional finance firms have sought permission to launch a Bitcoin ETF in the U.S., but their applications have been delayed or denied by the S.E.C. Many remain pending.
Bitcoin Peaks After the Premiere Of $BITO
Bitcoin has been on a heater the last month, as the price of the most well-known crypto has jumped 50% the past 30-days. As crypto enthusiasts and investors anxiously awaited the historical U.S. ETF, Bitcoin peaked at an all-time high of USD$66,930 a day following the ETF’s debut.
Bitcoin’s 15% jump this past week is thought to be influenced from the rumours surrounding the launch of the ETF.
The ProShares Bitcoin Strategy ETF trades on the NYSE under the ticker $BITO. The firm’s final prospectus met no opposition or resistance the day ahead of its proposed listing.
During the first day of trading on October 19, $BITO saw 24.3 million shares exchanging hands, which equates to about US$1 billion in volume.
This broke a record for the most natural volume ever seen on the first day of trading for an ETF. The US$1 billion turnover was second (in dollars) only to a BlackRock carbon fund, in which the opening volume was not as natural as $BITO’s debut.
Did you know? “Natural volume” refers to an organic, “grassroots” volume of trading that isn’t propelled by one or more gigantic institutional investors .
The opening price of $BITO was $40.88 per share, closing the day on Tuesday at $41.94. The next day Bitcoin hit a new all-time high, surpassing the previous peak of US$64,863 back in April of this year. Many crypto, particularly the Bitcoin bulls, consider the launch of $BITO to be a “validating moment” for cryptocurrency as a whole.
$BITO closed today at $43.28 and has traded over 29 million shares, defying the expectations of many bankers and analysts.
The opportunity of a fund such as this is the introduction into the world of digital currencies to a whole new class of investors, further promoting a global adoption of cryptocurrency.
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Questioning the Accuracy of ETFs Tracking Bitcoin
Now, for all the crypto bulls that are out there touting about this ETF, there are a fair number of bears that are not quite satisfied.
Some purists within the realm of crypto are hungry for a fund that directly holds crypto, rather than being based on futures. This brand-new ETF takes bets on Bitcoin’s price fluctuations rather than the true price of the underlying crypto. The futures that this ETF is based on are the Bitcoin futures that trade within the Chicago Mercantile Exchange (CME).
As with nearly any asset on this earth, there are bears.
The common denominator that skeptics want retail investors to know is that you are not actually buying Bitcoin. Rather than tacking the “spot price” of Bitcoin, the $BITO ETF speculates on the future price of the digital asset.
Although many believe tracking Bitcoin futures is currently the most accurate way to track the price, the nuances involved in the futures market may be difficult to grasp for a majority of retail investors, who may be tricked into thinking the ETF tracks the digital asset directly.
“This is not something for retail investors to buy, in my opinion. There’s plenty of outlets to buy bitcoin directly,” Tyrone Ross, CEO of Onramp Invest, which provides crypto asset management technology for financial advisors, tells CNBC. “Buying a futures ETF, where the average retail investor does not understand ETFs or futures, which are complicated, is not the best product for retail investors.”
Fund managers who trade futures often must roll out of expiring contracts into new ones, as futures are a leveraged financial instrument much like options. This style of investing may lead to prices of $BITO being more volatile than Bitcoin itself.
While several companies are applying to launch similar ETFs, such as Invesco and Valkyrie, the question that comes to investors’ minds the most is how accurate the ETF prices are in tracking the movement of Bitcoin.
Grayscale, a fund that actively buys and holds Bitcoin through its Grayscale Bitcoin Trust ($GBTC) has been a popular choice among crypto-loving investors. However, the fund is only available on the over-the-counter (OTC) markets unless you are a wealthy, accredited investor.
The OTC market version of the $GBTC is often criticized for having faulty accuracy between the quoted price and Bitcoin’s movement.
Even cryptocurrency exchanges can vary up ~5% when it comes to quoting the price of Bitcoin, as there is no single reliable market reference, making the true price of Bitcoin difficult to track.
On the bright side, many analysts are pleased with $BITO, as tracking Bitcoin via futures is widely regarded as the most accurate method within the stock market today that can capture Bitcoins’ price at any given moment in time.
Along with Coinbase ($COIN) going public this year, $BITO debut on the market presents an exciting step in the long journey of the implementation of crypto into the mainstream. Although crypto critics and even skeptic regulators are still rampant, the world of digital assets in 2021 is showing no signs of slowing down.
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3. Different Types of Dark Pools
There are over 50 dark pools registered with the SEC as of February 2020. This variety of dark pools falls into three different categories.
3.1 Broker-Dealer-Owned Dark Pool
A broker is someone who acts as an agent, and simply buys and sells securities on behalf of someone else, without actually owning the securities. Think of a real estate agent. They facilitate the sale and take a commission for the transaction.
A dealer is an entity who buys and sells securities on behalf of itself. Also referred to as a principal, dealers buy and trade securities with their own inventory as well.
A broker-dealer performs both duties.
Broker-dealers set up dark pools for their clients and in some cases, their own proprietary traders. The pools retrieve their prices from the order flow they already facilitate, which adds to the element of price discovery.
Did you know? Price discovery is the means through which an asset’s price is set by matching buyers and sellers according to a price that both sides find acceptable. It is largely driven by supply and demand.
Examples of some broker-dealer-owned dark pools include
- CrossFinder – Credit Suisse
- Sigma X – Goldman Sachs
- Citi-Match – Citibank
- MS Pool – Morgan Stanley
3.2 Agent Broker or Exchange-Owned Dark Pool
As their name suggests, these dark pools act as agents (or brokers), and not principals (dealers). They never own the securities, but simply facilitate the exchange within the dark pool.
Prices are always derived directly from the exchanges, and calculated by the national best bid and offer (NBBO).
Did you know? The NBBO is calculated and disseminated by Security Information Processors (SIP) as part of the National Market System Plan (NMSP), which is used to process security prices. There are two SIPs responsible for this task. The Consolidated Quotation System (CQS) gives the NBBO for securities listed on the New York Stock Exchange (NYSE), NY-ARCA, and NY-MKT, whereas the Unlisted Trading Privileges (UTP) Quote Data Feed gives the NBBO for securities listed on the Nasdaq.
Examples of agency broker dark pools include:
- Instinet
- Liquidnet
- ITG Posit
Examples of exchange-owned dark pools include:
- BATS Trading
- NYSE Euronext
3.3 Electronic Market Makers Dark Pools
This category of dark pools are offered by independent operators. These dark pools act as principals for their own accounts. The quotes for electronic market maker dark pools are void of NBBO calculation, bringing price discovery into the scenario.
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4. Winners and Losers of Dark Pools – Is thePlaying Field Fair?
Both retail and institutional investors have had their share of winning and losing during the existence of dark pools.
Despite retail investors historically benefit from large institutions using dark pools to prevent them from adversely affecting the market price of stocks, there have been some developments within the realm of the market that bring a dose of controversy into the mix.
Institutions first rejoiced in the idea of dark pools to avoid adverse price changes in the midst of them buying or selling a giant block of shares. They were especially pleased with their decision once HFT came into play within the traditional exchanges. Many institutions looked at HFT as a predatory algorithm that aimed to detect large orders within the displayed markets and trade against them; a banned method known as front-running.
A problem arose within the dark pools. Liquidity became scarce as the number of institutions using dark pools increased. Anytime a dark pool had heavy institutional interest on either the buy side or sell side of a stock, finding an entity to buy or sell the other side of these extra-large trades became increasingly difficult.
As a result, HFT became accepted within many dark pools, which ended up resulting in the same front-running-like activity the institutions wanted to avoid.
Front-running unfortunately became an issue within dark pools, to the point where many operators were handed fines, and in some cases lawsuits. Crooked traders could detect when another trader is going to buy a stock. They would then swiftly buy the stock before you are able to, and sell it to you at a higher price.
Amid the GameStop, Inc. ($GME) and Robinhood fiasco earlier in the year, you may have heard the term payment for order flow (PFOF).
This involves large market making firms paying brokers such as Robinhood for the privilege of executing trades for them.
The market makers aim to get the customer the best price, but will often collect a difference between the price that the buyer is willing to pay and the seller is willing to accept. This creates an income stream for firms such as Robinhood.
Putting this method into context, a market maker could take on the duty of filling a buy order of a stock at $5.05/share. By inspecting both the dark pool and the traditional exchange, the market maker may find that there are sellers for $5.02. They would then purchase this block of shares, and likely sell it right to you (the Robinhood customer) for $5.04; not only claiming to get you the best price possible, but also pocketing the $0.02/share difference.
While this may seem trivial, the $0.02 spread equates to $20,000 on a block of 1 million shares. Robinhood facilitates millions of trades per day; it manages 18 million accounts and over US$80 billion. No wonder these firms pay the app to execute trades. The arbitrage is bountiful.
Such practices are causing controversy around the company’s methods of generating revenue. Brokerages earnings from PFOF are incentivized more by maximizing profits rather than providing customers the best prices possible, leading to a conflict of interest.
Retail investing can also suffer further with the use of dark pools by mutual funds and pension funds. The pricing and cost advantages that these types of funds receive within dark pools can ultimately benefit them; at the cost of the retail investor of course. Scooping up the difference between a cheaper block of shares than the one your fund purchases is a classic example of front-running.
5. The Future of Dark Pools
Regulators, who have naturally viewed dark pools as suspicious, have been paying more attention as HFT continues to cause controversy in the form of retail investors being taken advantage of.
Perhaps the most significant effort to curb this problem is the “trade-at” rule, which requires all brokers to send their clients’ trade orders to exchanges, and not to dark pools. The only exception to this would be if the dark pool could be executed at a better price than the exchange.
The long-term sustainability of dark pools could be compromised due to this loss of volume; however, many argue it is for the greater good of the stock market.
Gary Gensler, chairman of the SEC has seriously considered banning the practice of PFOF. Companies like Virtu Financial ($VIRT) and Robinhood ($HOOD) would be dramatically affected as their revenue depends on PFOF.
According to Gensler, half the trading volume within the U.S. market is happening from exchanges, by dark pool “wholesalers.”
Retail heavy stocks are especially seeing increasing volume happening within dark pools, which can be as high as 70%. While this is good for firms because of increased dark pool liquidity, it can lead to disadvantages to the average retail investor.
Ideally, Gensler stresses that internalized wholesale exchanges should be saved for institutions, and the alarming number of smaller retail orders being facilitated within these dark pools can be problematic.
Additionally, further transparency on dark pools needs to be addressed due to risky and potentially predatory trading strategies such as short positions, derivatives, and naked shorting.
Retail trades started to be executed on dark pools to help liquidity for institutions, while not holding any real benefit for retail. Now the overload of retail trades on dark pools is tipping the scale in the institutions favour.
As regulators continue to inspect this shadowy side of the market, we can expect better transparency, stronger price improvement for small orders, less PFOF-based business models, and re-routing of retail orders back to traditional exchanges.
The SEC aims to have the U.S. catch up to Canada as far as regulation and transparency, not to mention the executing costs for traditional markets in the U.S. have been jacked up in comparison to up north due to the lower supply of exchange-facilitated trades.
What direction do you think the market should go as far as regulating dark pools?[/fusion_text][/fusion_builder_column][/fusion_builder_row][/fusion_builder_container]