As ETFs and Virtual Currencies Increase in Popularity, Their Marriage Prompts Regulatory Questions

Since the turn of the century, exchange traded funds (ETFs) have grown from an industry of less than $100 billion to a $2 trillion behemoth. And as virtual currencies such as Bitcoin continue to permeate the mainstream — now accepts payment in Bitcoin, as do thousands of other online retailers — it was inevitable that virtual currency ETFs would emerge, leaving regulators scrambling to claim authority over these new financial products.

An ETF is an investment vehicle that, unlike a mutual fund, trades during the day on stock exchanges at a price determined by the market. With a traditional mutual fund, investors both purchase and redeem their shares through the fund itself. In contrast, an ETF generally sells its shares in large quantities — typically between 50,000 and 250,000 — to “authorized participants” (generally large institutional investors), receiving in exchange a basket of securities from the authorized participant. The authorized participant then sells the ETF shares on the secondary market to investors, typically through a major stock exchange. ETFs can track the market value of a set of stocks, an entire stock exchange, currencies, or even commodities. Primary reasons for the growing popularity of ETFs among everyday investors include the ability to invest even small amounts of money in a diversified basket of products, as well as the ability to indirectly invest in products (such as oil, gold, or foreign currency) that would be difficult or impossible for the typical investor to actually possess.

With the Winklevoss twins recently filing form S-1 with the Securities and Exchange Commission (SEC) for a Bitcoin-tracking ETF, the question of how virtual currency ETFs will be regulated looms large with prospective investors and fund managers alike. All ETFs, at the very least, must register with the SEC under the Securities Act of 1933 (the 33 Act) – which requires filing form S-1 and any necessary amendments. Additionally, most ETFs are subject to the more complex regulatory framework of the Investment Company Act of 1940 (the “40 Act”) — though with certain ETF-appropriate exemptions.

A minority of ETFs —generally those investing directly in currencies or commodities—are not regulated under the 40 Act at all. ETFs investing in commodity futures are regulated by the Commodity Futures Trading Commission (CFTC) as well as by the SEC under the 33 Act. ETFs investing only in currencies or commodities are subject to SEC regulation under the 33 Act, but are not subject to 40 Act or CFTC regulation.

The regulation of virtual currency ETFs will likely hinge on how governmental agencies classify virtual currencies. Although virtual currencies can be used to buy goods and services much like conventional currencies, the finite supply of certain virtual currencies like Bitcoin may also suggest similarities to commodities.

Regulators are already working to sort out these thorny classification issues; the SEC, for example, has established a Digital Currency Working Group to explore virtual currencies. Whatever classifications these agencies eventually choose, they should strive to remember the importance of ETFs as a vehicle allowing everyday investors access to innovative investment opportunities that might otherwise be out of reach.