Crypto 'Exchange Traded Notes' (ETNs) represent an innovative new asset class that aims to provide mainstream investors exposure to cryptocurrencies like Bitcoin and Ethereum. By tracking the price of these digital assets, ETNs allow trading of crypto-linked products on traditional stock exchanges during regular market hours. This could significantly increase the accessibility and legitimacy of the crypto sector.
The London Stock Exchange (LSE) has published guidelines outlining the process for potential issuers to submit new crypto ETNs for trading on its platforms. This proposed framework aims to balance promoting financial innovation with appropriately managing the risks involved. Lets go through the highlights and see what we might learn.
Only physically backed ETNs tracking the top two cryptocurrencies by market cap, Bitcoin and Ethereum, will initially be considered. Strict requirements are also laid out around secure storage of the underlying crypto assets and regulated custodians. Additionally, approved ETNs can only be traded by professional investors.
While seeking to curb risks, these restrictions may unduly stifle competition and participation. Questions also remain around the Exchange's broad discretion, extended timelines, and potential barriers or delays for large issuances.
What are ETNs?
Crypto ETNs represent a new type of debt security that aims to provide mainstream investors exposure to cryptocurrency markets without directly purchasing volatile digital assets. They do this by tracking the price of an underlying crypto asset like Bitcoin or Ethereum which is held on the issuer's behalf. If structured properly, ETNs offer a simpler and potentially more familiar way for traditional investors to gain crypto exposure through their regular brokerage accounts.
However, ETNs are also complex financial products that rely on a third party issuer and custodian to physically hold the underlying assets. Investors are essentially trusting the issuer will maintain adequate reserves of crypto to back the notes. If something were to happen to the issuer or custodian, like insolvency or hacking, there are risks the assets may not be recoverable. There is also a lack of price discovery as ETNs must rely on reference rates set by the issuer which could potentially be manipulated.
While crypto ETNs aim to increase accessibility and legitimacy of cryptocurrencies within existing financial systems, their indirect nature and reliance on third parties also introduces additional layers of complexity and counterparty risks.
If you're anything like me then you will probably recognise that this is not exactly in alignment with the 'crypto' values of trustless and permissionless transactions.
Limiting initial ETNs to Bitcoin and Ethereum
By only considering physically backed ETNs initially tracking the top two cryptocurrencies, Bitcoin and Ethereum, regulators are understandably aiming to start with more established digital assets that they deem to be lower risk and more familiar to investors. Bitcoin as the largest cryptocurrency by market cap has the greatest brand recognition and network effects supporting its price. Meanwhile, Ethereum is the leading platform for decentralized applications and 'smart contracts'. Ethereum also houses the largest DeFi eco-system.
Limiting the scope provides more data on trading volumes and behaviours for these specific underlying crypto assets. It also allows regulators to pilot the framework before potentially expanding to incorporate other digital currencies in future.
Storage and Security Requirements
Given the risks of hacking and loss of funds in the cryptocurrency sector, regulators are rightly concerned about ensuring proper security measures are in place for any underlying digital assets. The guidelines therefore stipulate crypto ETN issuers must store 100% of assets in "cold storage", meaning offline wallets not connected to the internet. This "cold storage" approach provides the maximum protection against cyber threats, similar to how central banks securely store physical gold reserves.
However, maintaining such cold storage infrastructure also introduces significant operational complexity and costs for issuers. They must implement robust security protocols and disaster recovery plans to manage the risks of accidental loss of private keys. There is also a trade-off of less liquidity as assets cannot be accessed instantly for trading.
By also mandating regulated custodians be subject to anti-money laundering (AML) rules, regulators seek to further mitigate risks. But this also increases compliance burdens and associated expenses.
Restricting Crypto ETNs to Professional Investors Only
By limiting trading of admitted Crypto ETNs to designated segments for professional investors, regulators aim to better protect less sophisticated retail consumers who may not fully understand the risks involved. Cryptocurrencies remain a highly speculative and volatile asset class with potential for large losses. Retail investors require greater safeguards.
However, restricting access could also hamper broader participation and scaling of the asset class. Over time, as the sector matures and becomes more familiar and regulated, there may be arguments for gradually expanding access. But for now, the professional investor restriction allows regulators to pilot the framework with a subset of sophisticated market participants who are in theory better equipped to conduct due diligence and absorb potential downside.
In Conclusion,
the London Stock Exchanges framework aims to curb risks through measures like limiting initial ETNs to Bitcoin and Ethereum, strict asset custody rules, and restricting retail access.
As the cryptocurrency sector rapidly evolves, guidelines will likely require ongoing refinement. While starting cautiously is prudent given the nascent nature of these products, there are arguments more prescriptive standards could provide greater transparency and certainty for issuers.
Looking ahead, as the crypto market matures and becomes more familiar and regulated, future debate will centre around gradually expanding the scope of eligible assets and types of investors. But for now, prioritizing security through measures like cold storage and regulated custodians seems a reasonable approach at this pilot stage.
I hope this essay provided useful insights into the complex issues at play. To continue the discussion, please share this analysis with others in the crypto community. Please also consider subscribing to receive future examinations of trends in blockchain technology and digital currencies.
