Insiders reveal that the SEC has required all applications for Bitcoin spot ETFs to use the cash creation/redemption model and to remove all implications of physical redemption in their documents. What are the key differences between these two models? The following article provides a detailed explanation.
BlackRock, ARK Invest, and WisdomTree recently submitted modified proposals for Bitcoin spot ETFs, adopting the cash creation method, which is preferred by the U.S. Securities and Exchange Commission (SEC) for redemption. This change marks a significant shift in the industry and may indicate a delay in the discussion of the option for physical redemption. It is also a strategic move to simplify the operational process before the Christmas holiday.
Both the physical redemption model and the cash redemption model hold Bitcoin as their underlying asset in Bitcoin spot ETFs, with the main difference lying in the redemption process. The SEC tends to favor the cash redemption model because it allows only the issuer to handle Bitcoin, avoiding the situation where unregistered broker-dealer subsidiaries deal with Bitcoin.
However, the cash redemption model involves real cash flow in Bitcoin ETFs, which may incur tax obligations such as capital gains tax, as it is considered an actual buying and selling activity. On the other hand, the physical redemption model directly exchanges ETF shares for Bitcoin without involving the inflow and outflow of cash, making it simpler in terms of tax treatment and potentially avoiding tax burdens arising from cash transactions. Let’s discuss these two redemption models:
Physical Redemption Model:
– Market Maker (MM): Liquidity providers in the market. They are either registered U.S. securities broker-dealers regulated by the securities regulatory authority or unregistered entities without regulatory oversight.
– Authorized Participant (AP): Financial institutions authorized to create and redeem ETF shares, usually in large “creation units.”
– Listing Exchange: Platform for trading ETF shares.
– ETF Sponsor: Company managing the ETF.
– Transfer Agent: Third party handling the transfer of ETF shares.
– Bitcoin Custodian (e.g., Coinbase): Entity responsible for safeguarding the ETF’s Bitcoin assets.
– Spot Cryptocurrency Exchange: Place for immediate delivery of Bitcoin trades.
– Trading Day (T day) Process:
– Market makers request redemption of ETF shares from authorized participants, especially when the ETF’s price deviates from its net asset value (NAV). After approval from the ETF sponsor, market makers receive shares for redemption.
– On the next business day (T+1), they deliver these shares, and the Bitcoin custodian releases Bitcoin to them, which can be sold on the spot market. This model helps maintain consistency between the ETF price and the Bitcoin market value.
Cash Redemption Model:
– Redemption Order Submission: Market makers, whether registered or not, submit orders to authorized participants to redeem ETF shares at a price below the net asset value for arbitrage purposes.
– Order Approval: ETF issuer approves the redemption request.
– Purchase of ETF Shares: Market makers purchase shares through the listing exchange.
– Cash Movement Instruction: ETF issuer instructs the Bitcoin custodian to prepare cash from cold reserves for sale.
– Transaction with ETF Issuer: The issuer directly exchanges Bitcoin for dollars with market makers.
– Cash Delivery to Transfer Agent: Market makers deliver cash to the transfer agent.
– Bitcoin Delivery: The custodian provides Bitcoin to market makers, who may sell it for arbitrage profits.
– Share Delivery and Cash Release (next day): Market makers deliver the shares to the transfer agent, and the issuer releases cash to them, completing the entire process.
The reason why the U.S. Securities and Exchange Commission (SEC) is more inclined towards the cash redemption model may include the following points: Firstly, the cash redemption model is more operationally convenient, making the regulatory process more direct and transparent, facilitating effective monitoring and auditing by regulatory authorities. Secondly, this model can reduce the risk of directly impacting the Bitcoin market price due to large-scale redemptions or purchases, thereby minimizing the possibility of market manipulation. Additionally, the cash redemption model helps better manage liquidity risk, especially in times of high market volatility, providing greater flexibility and stability.
Finally, the SEC considers investor protection and believes that the cash redemption model can more effectively shield investors from the direct impact of underlying asset price fluctuations, particularly in the highly volatile cryptocurrency market.