Can crypto ETPs survive another winter?

After two crises in the space of a year saw entire ecosystems of crypto brokers, lenders, funds and exchanges collapse, a third ‘Lehman moment’ would surely prompt exchange-traded product (ETP) issuers to call time as costs rise and more counterparties falls.

Crypto’s market capitalization fell $2.1 billion to $786 billion in the 12 months to November 11, 2022, as investors weighed the impact of both the terra and FTX events, according to CoinMarketCap data.

Three months later, digital currencies and tokens have partially recovered, but headlines about insider trading and spats with regulators do not inspire confidence in a reformed asset class focused on structural soundness.

Unfortunately, none other than the largest crypto exchange, Binance, has led the latest controversy. After being linked to alleged money laundering center Bitzalto and having its new listings fabricated by insider traders, the crypto exchange’s partner firm, Paxos, was issued a Wells notice by the Securities and Exchange Commission (SEC) on February 12.

The notice targets the Binance USD (BUSD) stablecoin issued by Paxos for use on the Binance exchange and says the coin must be registered as a value. Shortly after, New York’s financial regulator ordered Paxos to stop minting BUSD, and by the end of the week, Binance’s stablecoin had posted outflows of $2.5 billion.

If US investors lose access to BUSD entirely, this could raise the question of whether other stablecoins will face similar legal challenges, with a potentially meaningful impact on the asset class.

The problems remain significant even if they are only Binance-specific, however, as CEO Changpeng Zhao announced that he will limit all of the company’s planned investments in the US, including bids to revive bankrupt companies.

ETP issuers are sensitive to bad news

Even if drama in the current third largest stablecoin – note that this used to be terra – does not result in crisis, it bears thinking about how crypto ETPs will fare during the next stress event.

According to Laurent Kssis, crypto specialist at CEC Capital, “the ETP structure itself is tried and tested” and may actually be the most robust part of its own value chain. “Even when the products have had to be removed from the list [during terra and FTX]that is because there was no purchase of the underlying asset, but the actual structure and the product itself did what it said on the tin.”

Instead, the issuers of ETPs themselves deserve closer inspection, especially after Binance-backed Eqonex went into liquidation after failing to pay creditors last year and Bitpanda closed its ETP series due to low demand and high costs.

“Some issuers don’t realize the financial burden associated with building and keeping an ETP on the market,” Kssis added. “You have to scale it, cover service providers and pay off current liabilities. I wouldn’t be surprised if we saw many more ETPs pull the plug this year.”

Ahead of future Black Swan events, he said more attention needs to be paid to issuers’ debt, including how long they have been in debt and whether they have a “going concern”, a term used to describe a company that is stable enough to continue the business for the foreseeable future.

Investors should also be aware that issuers are consolidating their product ranges. Kssis noted that there are “too many” bitcoin ETPs, while some products targeting smaller altcoins have struggled to accumulate assets — meaning shutdowns could happen across the market cap spectrum.

No party without counterpart

However, crypto ETPs are only as robust as their constituents. Another crisis event may reveal structural weaknesses that were narrowly weathered during previous unrest.

From a trading perspective, Roxane Sanguinetti, head of strategy at GHCO, said the FTX collapse caused market makers to lose a “very active” pool of liquidity.

Before FTX, Sanguinetti said ETF Stream Liquidity was already a challenge in crypto ETPs as prime brokers required each position to be capitalized between 100% and 160%, making large orders expensive for market makers to execute.

The collapse of Sam Bankman-Fried’s stock exchange then added additional risk and illiquidity, increasing bid-ask spreads for retail investors.

“Pre-FTX, we could easily quote bitcoin ETPs at 10-15 basis points, sometimes even lower than that,” Sanguinetti said. “This is no longer the case – it’s probably double that.”

She added that during the FTX crisis, bitcoin ETP spreads increased to more than 1%. Part of this was due to the costs borne by market makers when they artificially create liquidity where none existed.

While traditional ETFs settle almost immediately, Sanguinetti noted that there is “a constant liquidity gap” of two days in crypto-ETPs between when investors redeem their certificates and when issuers pass the underlying coins to market makers.

To maintain liquidity, GHCO borrows coins during the interim period, but when these borrowing costs increase during sales, they become “fixed”.

“It happened during the FTX era when the lender BlockFi went down and borrowing costs doubled,” Sanguinetti said. “Even now, the cost of borrowing and executing coins is very high.

“Spreads remain wider in the ETPs and we are looking at our counterparty risk with even more scrutiny. Therefore, when we gained access to Binance or others with potentially higher risks, we had to drop certain counterparties, which means there are fewer pools of liquidity you can access.”

Asked when costs would become prohibitive for GHCOs operating in crypto-ETPs, Sanguinetti said her firm is yet to reduce activity, but “it depends on whether an issuer is willing to pay more, because now our costs are higher”.

Another crash could tip the balance on costs, but more worrying are previously unseen structural risks. Under FTX, GHCO paid a premium for their loans to be unsecured, meaning they did not lose their collateral in cases where counterparties defaulted or called off loans early.

“This is now something that is almost impossible to do,” Sanguinetti said. “Remaining players are asking for loans with collateral, which means we have to be even more selective.”

Market makers still in the crypto “wild west” can benefit from being part of a select few in issuers’ order books, but if another crisis occurs, the tradability of crypto ETPs could be stretched to breaking point.

This article first appeared in ETF Insider, ETF Stream’s monthly ETF magazine for professional investors in Europe. To access the full issue, click here.