Two models for creating redemptions for spot Bitcoin ETFs

Physical model or cash model?

A few days ago, BlackRock and other Bitcoin spot ETF applicants negotiated with the US Securities and Exchange Commission (SEC) on some technical details of the ETF. One of the key negotiating elements, and what is considered to be the final and most critical disagreement at the moment, is whether to use the in-kind or cash model to handle the creation and redemption of ETF shares.

A lot of articles and posts are written in a foggy way, and the more you look at them, the more confused they become. If you want to really understand these two models, you have to look directly at the PPT that BlackRock wrote to the SEC, focusing on the following two figures:

The first picture is a mock-up.

The second diagram is the cash model.

First of all, for a better intuitive understanding, we can replace the financial term with its underlying real meaning. The physical model is actually the BTC (Bitcoin) model. The cash model, on the other hand, is the USD model. Doesn’t it suddenly seem much easier to understand by replacing the obscure financial “slang” with the approachable BTC and USD?

After the name change, as the name suggests, the so-called in-kind, that is, the creation of BTC, means that the ETF shares are directly linked to the amount of BTC, and the additional ETF shares are issued to buy the equivalent amount of BTC. Conversely, when you redeem your ETF shares, you sell an equal amount of BTC. It’s a very intuitive and simple model.

On the other hand, the so-called cash creations, that is, USD creation, are to convert ETF shares into the corresponding amount of BTC through US dollars, and issue additional ETF shares, which must first be converted into USD, and then converted USD into BTC. The same is true for redeeming ETF shares.

Looking at the above two pictures, let’s take a closer look at the specific operation process.

Let’s take a look at the process of physical creation (BTC creation).

The blocks in the diagram are different entities. The dotted line is the flow of information, while the solid line is the flow of assets. We can see that the ETF Issuer (white square) does not have access to the Market Maker (MM) itself, so they need to be separated by a series of intermediaries or agents, such as AP (authorized participant, green square), TA (Transfer Agent, black square), and BTC Custodians (Bitcoin Custodian, Blue Square), etc.

APs are generally large banks, such as Bank of America (BAC), JPMorgan Chase (JPM), Goldman Sachs (GS), Morgan Stanley (MS), etc. They are the operators of the ETF business and directly control the additional issuance and redemption of ETF shares.

This diagram drawn by BlackRock is the redemption process. If we read it backwards, it’s time to create a process.

The starting point of the process is that the market maker needs more ETF shares, then it needs to apply to the AP. After the AP negotiates and approves with the ETF issuer, the additional ETF shares are handed over to the TA (equivalent to the ETF issuer), and then the ETF issuer directs the TA to the market maker.

This is often the case when U.S. stock exchanges such as the NASDAQ have a lot of dollars pouring in to buy the ETF. At this time, market makers continue to sell the additional ETF shares and recycle the US dollars.

At the same time, market makers need to hand over an equivalent amount of spot BTC purchased from a spot crypto exchange to a BTC custodian, which is equivalent to handing over to an ETF issuer.

Market makers use USD to buy spot BTC on their own. Therefore, the dollar is digested in the market maker’s own body and does not move between entities, so it does not appear in this chart. The only assets that appear in the chart are ETF shares (reel icon) and BTC (Bitcoin icon).

Note: The entire process takes 1 day. In other words, after the share application and creation are completed, the delivery of ETF shares and BTC spot will not be carried out until the next day, which is T+1.

The redemption process is reversed. When a market maker buys back ETF shares in the market to a certain extent, it must apply to the ETF issuer for redemption of BTC spot through AP.

After approval by the ETF issuer, delivery takes place at T+1: the market maker returns the ETF shares to the TA, and the ETF issuer directs the BTC custodian to transfer the BTC spot to the market maker.

It can be seen that under the physical/BTC model, ETF issuers only need to deal with the mapping and bookkeeping of ETF shares and BTC, and do not need to worry about their current fluctuating USD prices in the market.

Essentially, this is the equivalent of using the BTC standard to denominate ETF shares. For example, my ETF splits BTC into 10,000 shares, then 1 ETF is always equal to 0.0001 BTC, which is 1000 satoshis shares.

BlackRock prefers this option. But the SEC disagrees. The SEC prefers the second option, the cash/USD model.

At a glance, you can feel that the cash/USD model is much more complex than the physical /BTC model above. Let’s take a look at the process, then appreciate how the two compare and why they take different positions.

In the Cash/USD model, the ETF issuer needs to add a proxy role, the cash custodian (Cash Custodian, which is drawn in the same black square as TA, meaning that the two roles can be the same entity).

Let’s start with creation. The starting point of the process is still to start with a market maker applying for a new ETF share. The difference is that on the day of approval, the market maker has to complete a series of operations: sell the ETF in the U.S. stock market, buy BTC in the crypto market, and then hand over the BTC spot to the BTC custodian (i.e., the ETF issuer).

Note that at this point, the TA will give the USD needed to buy BTC to the market maker. It is equivalent to the market maker buying BTC, using the ETF issuer’s money, not his own money, that is, the BTC spot bought for the ETF issuer.

On the next day (T+1), the TA and cash custodian directed by the market maker and ETF issuer will deliver the ETF shares and USD cash. The market maker hands over the USD from the sale of the ETF to the cash custodian (i.e., the ETF issuer), and the TA (i.e., the ETF issuer) gives the additional ETF shares to the market maker.

It can be seen that under the cash/USD creation model, the two markets are separated by using USD. A market maker is more like a “tool man” who only needs to trade ETF shares/USD and BTC/USD in the two markets without thinking.

If arbitrage or loss between markets is caused by factors such as the time difference between the two market operations, or the price difference between the markets, then under the second model, the market maker does not need to bear such an inter-market risk.

The redemption process is similar, but in the opposite direction. The market maker buys back the ETF from the U.S. stock market and sells BTC in the crypto market (the recovered USD is immediately handed over to the cash custodian). The next day (T+1), the market maker and TA deliver: the market maker hands over the repurchased ETF shares to the TA, and the TA returns the USD to the market maker.

If we put aside the various entities set up for compliance and abstract them from the perspective of assets, then the former physical/BTC model is essentially a direct exchange of ETF <-> BTC, while the latter cash/USD model is essentially an indirect exchange of ETF <-> USD <-> BTC.

As an issuer and trader, BlackRock naturally wanted to use a physical/BTC model that was simpler for itself and the issuer did not have to bear inter-market risk. However, the SEC, as the regulator, will prefer to adopt the cash/USD model, which isolates the risks of the two markets and makes it easier to regulate them separately, to ensure that the US dollar is the pricing currency of the main body, and to make it easier to tax the participating entities because the tax is pegged to the US dollar.

Therefore, some analysts say that the cash/USD model has more advantages in terms of spread and taxation, which is obviously from the position of market makers and regulators.

In addition, there are still some erroneous statements and understandings in some self-media.

For example, the cash/USD model has a stronger pull effect, which is wrong. Under both scenarios, the inflow of US dollars into the ETF leads to the BTC pull, and the outflow leads to the smashing. It’s the liquidity decision, not the model and the way it works.

Another example is investor responsibility (inter-market)

, which is also wrong. Intermarket risk is only allocated between the market maker and the ETF issuer, which is one of the differences between the two options, as detailed above. Whether they will pass the risk on to investors in some way is not a question of what the model is all about.

There is also a common misconception that under the physical/BTC model, investors will get physical BTC by selling ETFs, while under the cash/BTC model, investors will get USD, which is also wrong. ETF investors in the U.S. stock market buy ETFs with US dollars, and sell ETFs to recover US dollars. BTC investors in the crypto market sell BTC to recycle US dollars, and buy BTC with US dollars.

In other words, there is not much difference between the two options in terms of experience for investors in the end market.

Source: Golden Finance