Are cryptocurrency ETFs a risk to the financial market?
7 min readTable of Contents
An influential think-tank in South Korea focused on finance and economics has raised concerns about the possible approval of cryptocurrency ETFs in the country.
The Korea Institute of Finance, through researcher Bo-mi Lee, argued that the potential risks associated with these financial products may far outweigh their benefits.
This has sparked a debate about the implications of crypto ETFs on global financial markets. After all, they could have a significant impact on market volatility, asset allocation, and liquidity.
Cryptocurrency ETFs in the context of the global financial market
Cryptocurrency ETFs can have significant impacts on the global financial market, especially in the long term.
These products allow investors to gain exposure to cryptocurrencies like Bitcoin and Ethereum without owning the underlying assets. As such, they are praised for potentially increasing the accessibility and liquidity of the market.
However, they also bring with them a set of risks that could jeopardize the stability of financial systems around the world. The ability of ETFs to attract substantial capital into the cryptocurrency market, especially during periods of rising prices, raises questions about their overall impact on financial stability.
Indeed, investors have shown strong interest in the launch of Bitcoin ETFs, with inflows exceeding $20 billion in the first few weeks of trading.
This represents a huge influx of capital. An average of over $500 million per day (which is equivalent to approximately 10,000 BTC). Therefore, it even surpassed the daily production of Bitcoin, which is approximately 1,800 BTC.
Additionally, these funds may not offer the same degree of investor protection as other ETFs, as they are subject to more flexible controls regarding their fees and conflicts of interest.
In fact, even the chairman of the US Securities and Exchange Commission (SEC), Gary Gensler, has expressed reservations about these products. Despite having voted in favor of Bitcoin ETFs, he stated that their approval by the agency did not represent an endorsement of Bitcoin.
Gensler described cryptocurrency as follows:
“…in short a speculative and volatile asset, which is also used for illicit activities, including ransomware, money laundering, tax evasion and terrorist financing.”
Increasing market volatility
One of the main concerns about cryptocurrency ETFs is that they could increase market volatility. Cryptocurrencies are already known for their price swings, so adding ETFs to the equation could exacerbate those fluctuations.
As ETFs attract more investors, the inflows and outflows of capital can lead to sharp price movements. During times of market euphoria, this could result in a large inflow of capital into the cryptocurrency market, potentially creating “bubbles.”
On the other hand, in bearish times, rapid outflows of funds could trigger sharp declines, increasing overall market instability.
However, according to data analytics firm Bauer, Bitcoin’s volatility has been steadily decreasing over the past few years. For example, according to Bauer, volatility has not exceeded 4.5% since the introduction of Bitcoin futures. This data takes into account the 100-day average of daily price changes in percentage points.
The company expects this volatility to decrease further with the recent introduction of Bitcoin ETFs.
Distortions in resource allocation and liquidity
Another issue that has come to light is the potential for distortions in the allocation of resources and liquidity during market fluctuations. When a large volume of capital flows into the cryptocurrency market through ETFs, there may be inefficiencies in the distribution of resources throughout the financial system.
Financial institutions may allocate more resources to crypto assets. However, this would be at the expense of other sectors, leading to potential imbalances. Furthermore, the liquidity of financial markets could be negatively affected.
This is especially important. After all, in the United States, monetary tightening and the high issuance of Treasury bonds by the Fed are already causing a significant reduction in overall liquidity.
The Fed has been reducing its balance sheet, letting $95 billion a month expire. So there is a decrease in the amount of idle money in the market.
The reduction in the balance of reverse repurchase agreements is expected to reach zero by the third quarter of 2024. Therefore, it tends to generate more pressure on bank reserves, with the potential to cause liquidity stress in the financial system.
Systematic risk
Cryptocurrency ETFs may also introduce systemic risks to the financial system in a broader analysis.
After all, these funds can more closely connect traditional financial markets and the cryptocurrency market.
This interconnectivity means that significant disruptions or failures in the crypto market could have a domino effect on the financial system, affecting other asset classes and financial institutions.
Although ETFs are designed for increased liquidity, during periods of market stress, that liquidity can dry up.
If many investors try to sell their crypto ETF holdings simultaneously, it could lead to a lack of liquidity.
The need for robust regulatory frameworks
To mitigate the risks associated with cryptocurrency assets and their underlying ETFs, robust regulatory frameworks are crucial.
These structures must protect investors and ensure the stability of financial markets.
For example, in 2022, the White House released the first comprehensive regulation for the responsible development of digital assets.
It has encouraged action by existing regulators such as the SEC and the Commodity Futures Trading Commission (CFTC).
However, the US president has limited power over these matters, and the White House guidelines are only recommendations.
The guidelines released by the Biden administration address issues such as consumer protection. They also seek to promote financial stability and advance responsible innovation.
However, the collapse of cryptocurrency exchange FTX and other high-profile industry failures, such as BlockFi, changed everything. After all, US regulators began to adopt a more hostile approach towards crypto assets.
To be clear, the CFTC and (especially) the SEC have started a crackdown on the cryptocurrency industry.
Most recently, President Joe Biden vetoed a congressional resolution that would have overturned SEC guidance on cryptocurrencies. The crypto industry claims the guidance would have hindered its ability to work with banks.
The decision to veto this resolution has caused great frustration among the crypto community. After all, many people have raised concerns that it would be a barrier to innovation and growth in the industry.
Biden vetoes the resolution to nullify SAB 121.
Process? Who cares.
Consumer protection? No thanks.
Appeasing Gensler’s crypto vendetta? Sure thing.
This is a slap in the face to innovation and financial freedom. #Crypto #Fail pic.twitter.com/4QPhKkhN4r
— Cody Carbone (@CodyCarboneDC) May 31, 2024
South Korea’s financial landscape
Concerns about the introduction of cryptocurrency ETFs are particularly high in South Korea. After all, the country’s financial regulator has already taken steps to tighten crypto rules to protect users.
For example, since July 19, registered cryptocurrency exchanges in the country are required to evaluate the tokens listed on their platforms. In addition, the new regulation requires crypto exchanges in the country to comply with basic rules for listing tokens. They are also required to reevaluate the tokens already listed every six months.
Another requirement is that exchanges carry out reliability tests on the issuing entity, in addition to verifying the security standards and regulatory compliance of cryptocurrencies.
Finally, the country warned that platforms that fail to comply with the new rules will face penalties. These could include a minimum of one year in prison or fines.
The Impact of Crypto ETFs on South Korea’s Financial Stability
The introduction of cryptocurrency ETFs in South Korea could impact the country’s financial stability, especially since the country is a major player in the cryptocurrency market.
In the first quarter of this year, the South Korean won became the top fiat currency for cryptocurrency trading, surpassing the US dollar.
The won reached a trading volume corresponding to $456 billion on centralized cryptocurrency exchanges, thus surpassing the $455 billion volume in US dollars.
Similarly, a recent survey revealed that most young South Koreans are losing faith in the national pension system, with many saying they see cryptocurrencies and stocks as better alternatives.
The study found that more than three-quarters of people aged 20 to 39 do not trust the state pension system. More than half of those surveyed who said they were making their own retirement plans said they were building their funds with stocks and cryptocurrencies.
Given the huge demand for cryptocurrencies in South Korea, crypto ETFs could generate significant capital inflows into the country, Lee said in her report. She argued that this would result in inefficiencies in resource allocation. She added that financial market liquidity and the health of financial firms would worsen when prices fall.
Therefore, the researcher said that the country should do more research on the potential losses and benefits of introducing cryptocurrency ETFs. Currently, Lee argues that the losses will outweigh the benefits to be gained.
Conclusion of the study
The Korea Institute of Finance’s report on the potential risks of cryptocurrency ETFs highlights the need for caution on the part of regulators. After all, while these financial products offer some benefits, potential risks to financial stability, market volatility, and asset allocation cannot be ignored.
The study highlighted the need for more comprehensive research and robust regulatory frameworks to ensure that the introduction of cryptocurrency ETFs does not lead to unintended consequences.
