Winkelvoss ETP could become THE pricing mechanism for BTC

[DrGregMulhauser]

Thanks for these clarifications, Dr. Mulhauser.

You're very welcome -- just 'Greg' is fine by me, though. 

Does this mean - theoretically - I could take a bunch of Bitcoin and become an accredited intermediary in the Winklevoss ETP, deposit the coins into their "vault" and then just simply have a bunch of shares I can place sell orders for on the exchange?

The S-1 doesn't specify who the Authorized Participants might be, or what requirements might be in place for becoming one, but in theory, the answer to your question seems to be yes, given this from page 4 of the S-1:

"The creation and redemption of Baskets require the delivery to the Trust, or the distribution by the Trust, of the number of Bitcoins represented by the Baskets being created or redeemed, the amount of which will be based on the combined NAV of the number of Shares included in the Baskets being created or redeemed. The initial number of Bitcoins required for deposit with the Trust to create Shares is [10,000] per Basket."

Sort of like I deposited some bitcoins as collateral and was then given Difficulty future shares (for example CoinBr.iDiff-E on Bitfunder) by the issuer and was then a "market maker" for the futures and able to freely trade my shares.

Without peeking at the specific futures contract you mentioned, I can't say whether the analogy holds, but I can say that this creation and redemption mechanic is exactly what makes the intermediaries well positioned to provide market making services and to engage in arbitrage that ensures the price of Bitcoins via shares closely tracks Bitcoins purchased directly via the same currency as the shares. It's the job of the Authorized Participants to gauge market demand and create or redeem accordingly, and it's very much in their interests to keep everything operating smoothly and efficiently. Far from being a bad thing, as some folks might infer due to their privileged role in being able to swap shares for the underlying entity, their involvement is actually what make the whole thing possible.

As long as things are setup in a way that ensures that 1 share floating in the market always has 1 associated bitcoin in the "vault", I think I see no danger here. Let them build all the derivatives they want on the ETP as long as they are forced to cover their shorts or whatever and deal with the consequences of their actions.

Yep, I agree -- although there might be plenty of risks associated with the whole thing, I don't think the design itself is flawed in such a way that it would contribute to those risks. In other words, yes, there might be all kinds of problems and all kinds of unforeseen consequences, but those won't be the result of someone's having just set it up crazily in the first place.

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[molecular]

Thanks again, Greg, for the info. I'm seeing quite a bit clearer now how this works.

Eager to see how this plays out, but I guess there'll be a long wait now for the SEC.

[dominicus]

Adding my gratitude to Greg for investing his time here and sharing the details on the mechanics of the ETP.

The basket, market-maker, and non-connectivity of micro-trades vs. exchanges was enlightening. 

[DrGregMulhauser]

And many thanks for promoting such a friendly environment on the forum -- I appreciate it! 

[NewLiberty]

And many thanks for promoting such a friendly environment on the forum -- I appreciate it! 

Yes, we are all friends here.    So I will apologize in advance for the terribly long post to follow.
TL;DR? The ETP does not guarantee 1 bitcoin = 1 share, and the manipulation mechanisms I've described are in the design.

Without speculating about who might want to do what to which currency pair and for what sort of reason, I'd just like to clarify some of the mechanics of how ETFs operate.

From the standpoint of individual investors, shares or units in ETFs are traded -- i.e., bought and sold -- rather than created or redeemed. For present purposes, 'creation' refers to the issuance of a share and the placing of the underlying entity into the issuer's safekeeping to back that share, while 'redemption' refers to the reverse process of removing the underlying entity from the issuer's hands.

In the case of index-based ETFs and commodity ETFs, creation and redemption only occurs in relatively large baskets. The sheer size and value of those baskets means that individual investors never actually wind up redeeming them. The creations and redemptions still occur in the background, however, courtesy of 'Authorized Participants', as they're called in the case of the Winkelvoss trust.

For a real world, happening-right-now sort of example, consider the SPDR Gold Trust: it really does add gold to its custodian's vaults when investors add money to the fund, and it really does liquidate gold from the vaults when investors "cash out". But this process is intermediated typically by large financial institutions who agree to perform this role. When an individual buys one unit in the gold trust, it does not mean that one specific piece of gold is immediately added to the vaults. What actually happens is that the individual is really buying not from the trust itself, but from an intermediary, and they are buying a unit which has already been backed with gold added to the vault. (Otherwise, the intermediary wouldn't have had the unit to sell in the first place.)

If it is approved, investors will find a very similar process in the Winkelvoss trust as the size of the fund expands or contracts in response to demand. The Winkelvii will not be rushing out to buy or sell .2 Bitcoins each time an individual investor buys or sells one share in the trust, and they will not be swapping out .2 Bitcoins in response to individual investors saying they'd like their one fifth of a Bitcoin now please. However, the APs will be causing exactly that sort of process to happen on a larger scale as they handle baskets of 50,000 shares at a time and either distribute them to buyers or collect them from sellers.

Without the involvement of these intermediaries providing a buffer between the issuer and the trade in ETF shares, it would be difficult for the thousands of different ETPs out there even to exist.

The redemption, especially if intermediated, is where the 1 Bitcoin to 1 share in the vault link breaks.
Due to your sophistication with the operation of ETFs, you are likely very aware of how this breakage has affected some commodity and currency ETFs previously, so among friends, let us make at least one more friendly mention of it.

The breakage occurs through collateralization.

In the discussion before us, the Winklevoss SEC S-1, redemption works as follows
This is on page 54 for those who are reading along http://www.sec.gov/Archives/edgar/data/1579346/000119312513279830/d562329ds1.htm
Delivery of redemption distribution
The redemption distribution due from the Trust will be delivered to the Authorized Participant on the third business day following the redemption order date if, by 9:00 a.m. New York time on such third business day, the Trustee’s DTC account has been credited with the Baskets to be redeemed. The Trustee will transfer the redemption Bitcoins from the Trust Custody Account to the redeeming Authorized Participant’s Authorized Participant Custody Account. If the Trustee’s DTC account has not been credited with all of the Baskets to be redeemed by such time, the redemption distribution will be delivered to the extent of whole Baskets received. Any remainder of the redemption distribution will be delivered on the next business day to the extent of remaining whole Baskets received if the Trustee receives the fee applicable to the extension of the redemption distribution date, which the Trustee may, from time to time, determine and the remaining Baskets to be redeemed are credited to the Trustee’s DTC account by 9:00 a.m. New York time on such next business day. Any further outstanding amount of the redemption order shall be cancelled. The Trustee is also authorized to deliver the redemption distribution notwithstanding that the Baskets to be redeemed are not credited to the Trustee’s DTC account by 9:00 a.m. New York time on the third business day following the redemption order date if the Authorized Participant has collateralized its obligation to deliver the Baskets through DTC’s book-entry system on such terms as the Sponsor and the Trustee may from time to time agree upon.

This opens the door for settlement of redemption in collateral rather than in Bitcoin.  The typical collateral honored is "Legal Tender" which discharges a debt.

As long as things are setup in a way that ensures that 1 share floating in the market always has 1 associated bitcoin in the "vault", I think I see no danger here. Let them build all the derivatives they want on the ETP as long as they are forced to cover their shorts or whatever and deal with the consequences of their actions.

Yep, I agree -- although there might be plenty of risks associated with the whole thing, I don't think the design itself is flawed in such a way that it would contribute to those risks.

In light of this language in the design, would you consider the design to contribute to the risk that 1 share floating in the market always has 1 associated Bitcoin in the "vault"? 

In other words, yes, there might be all kinds of problems and all kinds of unforeseen consequences, but those won't be the result of someone's having just set it up crazily in the first place.

We agree, I also would not characterize this as "crazy".  "Savvy", "cunning", or "clever" would be more my choices.

Again, I wish the Winklevoss brothers every success in this adventure, and hope for them to profit greatly.  It is brave and bold and can be a game changer.  I also would likely personally enjoy working with them on projects of this nature or others, they are smart and motivated. 
To the topic of this thread, I will suggest that for the sake of Bitcoin's success as a medium of exchange, I am not so eager for the Winkelvoss ETP to become THE pricing mechanism for BTC, as some others might be.

[molecular]

In pursuit of a friendly athmosphere I first thank NewLiberty for his insightful post.

Now some questions: "settlement of redemption in collateral" means "give USD instead of bitcoins", right?

But then the brothers could just sell coins from the vault on the physical market (no audit, right?) and the bitcoin money supply (physical + ETF holdings) would get inflated (nooooo!).

Did I get that roughly right?

If not, could someone sketch a scenario how this could go wrong (for bitcoin)?

[NewLiberty]

In pursuit of a friendly athmosphere I first thank NewLiberty for his insightful post.

Now some questions: "settlement of redemption in collateral" means "give USD instead of bitcoins", right?

yes

But then the brothers could just sell coins from the vault on the physical market (no audit, right?) and the bitcoin money supply (physical + ETF holdings) would get inflated (nooooo!).

Did I get that roughly right?

If not, could someone sketch a scenario how this could go wrong (for bitcoin)?

Sort of...there are audits (pp 39,48,64 et al), but the requirement is for bitcoin or sufficient collateral, and the auditor is not yet named.  

There are other risks identified in the S-1 as well which might be interesting on Page 18.  The bitcoins can be lost, and "The Trust will not insure its Bitcoins."  They will have some insurance for their custodial activities, but there is no guarantee that you will get Bitcoins out.  If insurance is paid out, it is almost guaranteed that it will be paid in fiat legal tender.  Your statement about the brothers selling them out from under the trust is not going to happen, that would be fraud.  But if somehow the Bitcoin mysteriously disappeared and no one could figure out how or where they went... and the insurance kicks in...  you get the same result.

Essentially, we Bitcoin folks are very likely NOT the intended customers for this ETF.  We can already buy sell trade our Bitcoins with little economic friction or risk.  This is for the investor marketplace.  Folks that DO need this are those don't have / don't want Bitcoin wallets, the speculators, and ... financial institutions up to and including central banking agents.  If they want to go short on Bitcoin, without ever owning a Bitcoin, this is a way to do it.  

Another fundamental problem arises when and if there is ever a serious economic event that causes major currency collapse.  You won't have any bitcoin, you will have ETF shares which may or may not be redeemable.

[DrGregMulhauser]

The ETP does not guarantee 1 bitcoin = 1 share, and the manipulation mechanisms I've described are in the design.

Just to clarify first: the proposed ETF provides an initial ratio of 5 shares to 1 Bitcoin, and this ratio will change very slowly over time, as the fund's fees are deducted from the Bitcoins it holds.

Any remainder of the redemption distribution will be delivered on the next business day to the extent of remaining whole Baskets received if the Trustee receives the fee applicable to the extension of the redemption distribution date, which the Trustee may, from time to time, determine and the remaining Baskets to be redeemed are credited to the Trustee’s DTC account by 9:00 a.m. New York time on such next business day. Any further outstanding amount of the redemption order shall be cancelled. The Trustee is also authorized to deliver the redemption distribution notwithstanding that the Baskets to be redeemed are not credited to the Trustee’s DTC account by 9:00 a.m. New York time on the third business day following the redemption order date if the Authorized Participant has collateralized its obligation to deliver the Baskets through DTC’s book-entry system on such terms as the Sponsor and the Trustee may from time to time agree upon.

This opens the door for settlement of redemption in collateral rather than in Bitcoin.  The typical collateral honored is "Legal Tender" which discharges a debt.

Since the S-1 -- remember, it is only an S-1 -- specifies just that the AP, Sponsor and Trustee must agree on appropriate collateralization, it seems to me premature to speculate on the nature of the collateral they might agree upon. Possibly more to the point, though, is that to my mind, this proviso sounds more like a mechanism intended to promote the orderly operation of the fund -- and to prevent it becoming bogged down by Trustee nitpicking over the precise time of day or day of the week that a Basket of shares is to be delivered -- than a mechanism intended to provide a disguised back door for market manipulation. What we're talking about here is the AP promising to deliver the shares even if they may wind up being late, and the Trustee being willing to remove Bitcoins from the trust and discharge them to the AP on the understanding that the corresponding shares will in fact be delivered to it. As far as I can tell, qualitatively speaking, this is little different from an arbitrageur shorting the shares of any ETF while buying the underlying on the spot market.

[DrGregMulhauser]

Essentially, we Bitcoin folks are very likely NOT the intended customers for this ETF.  We can already buy sell trade our Bitcoins with little economic friction or risk.  This is for the investor marketplace.  Folks that DO need this are those don't have / don't want Bitcoin wallets, the speculators, and ... financial institutions up to and including central banking agents.

Yes, I'm sure you're right on this: this is not aimed primarily at the folks who are already buying and selling Bitcoins anyway (and who would not want to hand over a fee to someone else for the privilege!).

[NewLiberty]

The ETP does not guarantee 1 bitcoin = 1 share, and the manipulation mechanisms I've described are in the design.

Just to clarify first: the proposed ETF provides an initial ratio of 5 shares to 1 Bitcoin, and this ratio will change very slowly over time, as the fund's fees are deducted from the Bitcoins it holds.

Any remainder of the redemption distribution will be delivered on the next business day to the extent of remaining whole Baskets received if the Trustee receives the fee applicable to the extension of the redemption distribution date, which the Trustee may, from time to time, determine and the remaining Baskets to be redeemed are credited to the Trustee’s DTC account by 9:00 a.m. New York time on such next business day. Any further outstanding amount of the redemption order shall be cancelled. The Trustee is also authorized to deliver the redemption distribution notwithstanding that the Baskets to be redeemed are not credited to the Trustee’s DTC account by 9:00 a.m. New York time on the third business day following the redemption order date if the Authorized Participant has collateralized its obligation to deliver the Baskets through DTC’s book-entry system on such terms as the Sponsor and the Trustee may from time to time agree upon.

This opens the door for settlement of redemption in collateral rather than in Bitcoin.  The typical collateral honored is "Legal Tender" which discharges a debt.

Since the S-1 -- remember, it is only an S-1 -- specifies just that the AP, Sponsor and Trustee must agree on appropriate collateralization, it seems to me premature to speculate on the nature of the collateral they might agree upon. Possibly more to the point, though, is that to my mind, this proviso sounds more like a mechanism intended to promote the orderly operation of the fund -- and to prevent it becoming bogged down by Trustee nitpicking over the precise time of day or day of the week that a Basket of shares is to be delivered -- than a mechanism intended to provide a disguised back door for market manipulation. What we're talking about here is the AP promising to deliver the shares even if they may wind up being late, and the Trustee being willing to remove Bitcoins from the trust and discharge them to the AP on the understanding that the corresponding shares will in fact be delivered to it. As far as I can tell, qualitatively speaking, this is little different from an arbitrageur shorting the shares of any ETF while buying the underlying on the spot market.

We agree that we are prematurely speculating.  This is a conversation about the future, in all its nebulosity.  We are prematurely speculating on what the ETF could become, pricing mechanism and all the rest of what might or might not someday be.  Speculation and hedging are normal for ETFs.

We also agree that the proviso is carefully worded to sound like a mechanism intended to promote the orderly operation of the fund, as it should be.
We also agree that the back door for market manipulation is not disguised.  Indeed, it would be difficult to disguise it.  ETFs are famous for being the vehicle of choice for such mechanisms.  It does not need to be intentional on the part of the Fund creators, it comes along on the ride as an unintended (but predictable) consequence.  I am alleging no mal-intention at all.  The kind, deeply litigious, gracious and wise founders of this ETP clearly only have the best of intentions.  

We also agree that an arbitrager might short the ETF and buy on the spot market.  They also might not be arbitraging and be simply selling short and not buying Bitcoin anywhere.  They can do this by posting sufficient collateral in fiat.  There are some entities with a whole heck of a lot of fiat legal tender and the ability to print more at will.
Again all of this is purely premature speculation on the future.  The document is less than a month old, everything can change before any of this becomes real.  Further, that the risks are out in the open is good for the Fund creators, as it shows that the fund investors are accepting of them in order to receive the benefit of fund ownership, and it is in that spirit that this is offered.

[NewLiberty]

Essentially, we Bitcoin folks are very likely NOT the intended customers for this ETF.  We can already buy sell trade our Bitcoins with little economic friction or risk.  This is for the investor marketplace.  Folks that DO need this are those don't have / don't want Bitcoin wallets, the speculators, and ... financial institutions up to and including central banking agents.

Yes, I'm sure you're right on this: this is not aimed primarily at the folks who are already buying and selling Bitcoins anyway (and who would not want to hand over a fee to someone else for the privilege!).

There is another customer that could deeply benefit from ETF use: large merchants.

If, to pick a name out of a hat: Amazon wanted to accept Bitcoin, they may need to use the swift liquidity of the ETF to manage volatility risk.  In this way, it could be a tool to GREATLY expand the Bitcoin merchant economy.

[molecular]

There are other risks identified in the S-1 as well which might be interesting on Page 18.  The bitcoins can be lost, and "The Trust will not insure its Bitcoins."  They will have some insurance for their custodial activities, but there is no guarantee that you will get Bitcoins out.  If insurance is paid out, it is almost guaranteed that it will be paid in fiat legal tender.  Your statement about the brothers selling them out from under the trust is not going to happen, that would be fraud.  But if somehow the Bitcoin mysteriously disappeared and no one could figure out how or where they went... and the insurance kicks in...  you get the same result.

If the brothers took the coins from under the trust, they would certainly make it look like they "mysteriously disappeared" and it'd be hard to catch them.

Essentially, we Bitcoin folks are very likely NOT the intended customers for this ETF.  We can already buy sell trade our Bitcoins with little economic friction or risk.  This is for the investor marketplace.  Folks that DO need this are those don't have / don't want Bitcoin wallets, the speculators, and ... financial institutions up to and including central banking agents.  If they want to go short on Bitcoin, without ever owning a Bitcoin, this is a way to do it.  

Another fundamental problem arises when and if there is ever a serious economic event that causes major currency collapse.  You won't have any bitcoin, you will have ETF shares which may or may not be redeemable.

I don't quite understand how this is any different from the "paper games" being played with gold and silver in order to suppress them. So could this ETF be the instrument the enemies of bitcoin could use to suppress its price or not? I still can't answer this question even with this detailed info you guys here are distilling from the document.

[halfawake]

Essentially, we Bitcoin folks are very likely NOT the intended customers for this ETF.  We can already buy sell trade our Bitcoins with little economic friction or risk.  This is for the investor marketplace.  Folks that DO need this are those don't have / don't want Bitcoin wallets, the speculators, and ... financial institutions up to and including central banking agents.

Yes, I'm sure you're right on this: this is not aimed primarily at the folks who are already buying and selling Bitcoins anyway (and who would not want to hand over a fee to someone else for the privilege!).

There is another customer that could deeply benefit from ETF use: large merchants.

If, to pick a name out of a hat: Amazon wanted to accept Bitcoin, they may need to use the swift liquidity of the ETF to manage volatility risk.  In this way, it could be a tool to GREATLY expand the Bitcoin merchant economy.

Why would they bother with this when there are already tools that let merchants manage (or even eliminate) volatility?  Coinbase and bitpay already have functionality that can do this for merchants.

[DrGregMulhauser]

Why would they bother with this when there are already tools that let merchants manage (or even eliminate) volatility?  Coinbase and bitpay already have functionality that can do this for merchants.

As far as I'm aware, the existing ways of managing volatility are pretty weak -- and lack the liquidity necessary for hedging any kind of larger position. I took a look at this awhile back in an article called Bitcoin Derivatives, Liquidity and Counterparty Risk and concluded that the situation at the time was severely limited. But I'd be very happy -- eager, in fact -- to learn of some new addition to the fray.

(The last I knew, when the likes of Coinbase or BitPay referred to "managing volatility", what they meant was "avoid volatility by not holding Bitcoins any longer than necessary".)

The eventual availability of options on something like the proposed Bitcoin ETF would be an absolute godsend in this respect.

[DrGregMulhauser]

We agree that...

We also agree that the proviso is...

We also agree that the back door...

We also agree that an arbitrager...

Hmm, I'm pretty sure I wouldn't agree with all those agrees...but we can at least agree to disagree on that. 

[NewLiberty]

Why would they bother with this when there are already tools that let merchants manage (or even eliminate) volatility?  Coinbase and bitpay already have functionality that can do this for merchants.

(The last I knew, when the likes of Coinbase or BitPay referred to "managing volatility", what they meant was "avoid volatility by not holding Bitcoins any longer than necessary".)

yes. Coinbase and Bitpay service function in an automatic way rather than managed, in short they aren't ETFs.  When you are looking at large merchants, there are even better options than what Coinbase and Bitpay type services do.  This is one of the things that ETFs and commodity futures products were designed for, to manage volatility in your supply chain.  If you want to manage risk (as it take some measurable and flexible risk and get the reward of that) but not lose flexibility, you can hedge against your risk with an ETF to as much extent as you please rather than being in a fixed percentage with automatic conversion to fiat.  Coinbase and Bitpay have the Small-Medium Enterprise (SME) as their sweet spot for marketability.

[NewLiberty]

We agree that...

We also agree that the proviso is...

We also agree that the back door...

We also agree that an arbitrager...

Hmm, I'm pretty sure I wouldn't agree with all those agrees...but we can at least agree to disagree on that. 

Anything in particular?

[DrGregMulhauser]

I don't quite understand how this is any different from the "paper games" being played with gold and silver in order to suppress them. So could this ETF be the instrument the enemies of bitcoin could use to suppress its price or not? I still can't answer this question even with this detailed info you guys here are distilling from the document.

For my part, I would have imagined that folks concerned about market manipulators would be more concerned about the relatively low volume exchanges we have at the moment, where just a few million dollars here or there can exert quite an influence on exchange rates. Generally speaking, I think boosting volume and increasing market breadth makes it harder, not easier, to fiddle with free markets.

[Scott J]

Why would they bother with this when there are already tools that let merchants manage (or even eliminate) volatility?  Coinbase and bitpay already have functionality that can do this for merchants.

(The last I knew, when the likes of Coinbase or BitPay referred to "managing volatility", what they meant was "avoid volatility by not holding Bitcoins any longer than necessary".)

yes. Coinbase and Bitpay service function in an automatic way rather than managed, in short they aren't ETFs.  When you are looking at large merchants, there are even better options than what Coinbase and Bitpay type services do.  This is one of the things that ETFs and commodity futures products were designed for, to manage volatility in your supply chain.  If you want to manage risk (as it take some measurable and flexible risk and get the reward of that) but not lose flexibility, you can hedge against your risk with an ETF to as much extent as you please rather than being in a fixed percentage with automatic conversion to fiat.  Coinbase and Bitpay have the Small-Medium Enterprise (SME) as their sweet spot for marketability.

It seems that if we want big business to start accepting bitcoin, we need an ETF for them to manage risk - at least while the currency is so volatile.

[NewLiberty]

I don't quite understand how this is any different from the "paper games" being played with gold and silver in order to suppress them. So could this ETF be the instrument the enemies of bitcoin could use to suppress its price or not? I still can't answer this question even with this detailed info you guys here are distilling from the document.

TL;DR?   Yes


It isn't much different to the gold and silver paper games except in respect to time-frame.  Gold and silver ETFs in large part did become the primary mechanism for price discovery.  In part that is an artifact of how gold pricing was previously set (using a very old and non-transparent method of five bankers in London deciding what it was).  That was easily replaced by the real-time pricing of ETFs.  Bitcoin already has that real-time pricing though, so it may likely not follow the same path...

But to put out an answer...

If Bitcoin has enemies, and if they wanted to suppress the price, (or introduce volatility) and if these enemies have enough fiat, and if such an ETF becomes the primary mechanism for price discovery then... yes.