Experts Warn of Financial System Risks as Bitcoin ETFs Bridge Gap between Crypto and TradFi

Ruholamin Haqshanas
Last updated: | 3 min read
Source: AdobeStock / Gajus

The recent launch of exchange-traded funds (ETFs) tracking Bitcoin (BTC) has sparked concerns among experts about the potential risks that could emerge as cryptocurrencies become further intertwined with the traditional financial system.

The Securities and Exchange Commission (SEC) approved 11 spot Bitcoin ETFs earlier this month, marking a significant moment for the crypto industry, which has faced challenges such as bankruptcies and criminal activities.

Previously, the SEC had rejected these products, citing concerns about investor protection.

However, a court challenge brought by Grayscale Investments prompted the SEC to reconsider its position.

Spot Bitcoin ETFs Could Attract $100 Billion in Investments

The combined assets of these ETFs amount to around $21 billion, and analysts predict that they could attract as much as $100 billion in investments this year from both retail and institutional investors.

Some experts have expressed concern that if these products gain widespread adoption, they could introduce risks to other parts of the financial system, particularly during times of market stress, as per a Reuters report

They argue that the ETFs could exacerbate Bitcoin price volatility or create disconnections between the ETF price and the actual value of the cryptocurrency.

These concerns are based on evidence from previous volatility events involving ETFs.

Furthermore, experts point to the interplay between financial and crypto markets, highlighting the risks they can transmit to one another.

They cite examples such as the liquidation of crypto lender Silvergate Bank due to the collapse of the FTX crypto exchange, which subsequently contributed to the failure of Signature Bank.

The collapse of Silicon Valley Bank also triggered a run on the stablecoin USD Coin.

“As investors pour money into these products, you substantially increase the risk of much greater interconnection between the core of the financial system and the crypto ecosystem,” said Dennis Kelleher, CEO of Better Markets, an advocacy group that had urged the SEC to reject bitcoin ETFs, citing risks to investors and the financial system.

Spot ETFs Could Amplify Volatility

Bitcoin’s daily average volatility is approximately three and a half times that of equities.

However, some experts have warned that spot Bitcoin ETFs could amplify this volatility, especially during market turmoil.

They also highlighted other potential risks associated with complex ETFs, such as the decoupling of ETF prices from the underlying assets, which can stress institutions heavily exposed to these products or reliant on them for liquidity management.

There have been instances of stress in complex, less liquid, and highly leveraged exchange-traded products in the past.

For instance, in 2018, a volatility-tracking exchange-traded note collapsed amid a surge in volatility, resulting in investor losses of $2 billion.

In 2020, the COVID-19 pandemic caused sell-offs in some corporate bond ETFs, which would have spread to the broader fixed-income market if not for emergency support from the Federal Reserve.

While the ETF industry generally disputes claims that its products pose systemic risks, issuers of Bitcoin ETFs acknowledge various market, policy, and operational risks in their disclosures.

However, they also claimed that the immaturity of Bitcoin may lead to unforeseeable hazards.

The extent of these risks largely depends on the level of adoption of Bitcoin ETFs.

“Systemic risk is all about size… We do not yet know enough about who is actually purchasing these and in what proportions,” Olivier Fines, head of advocacy and policy research, EMEA, at the CFA Institute, said.

On the other hand, crypto industry executives argue that crypto crises have primarily been contained within the crypto sector, and connectivity between cryptocurrencies and the financial system remains limited.

“I don’t see cataclysmic… dynamics in any of these products,” said Steve Kurz, global head of asset management at Galaxy Digital, which partnered with Invesco on its ETF.