GUEST BLOG: Bitwise and Fund-Foolish by Aegis Frumento Esq

March 28, 2019

Most of the time, a pitch to the SEC is more cause for a nap than a newsbreak.  But last week, the Wall Street Journal reported, based on one such pitch, that 95% of reported bitcoin trading may be fake. CNBC and Fox Business followed up the story, and so it went quasi-viral. See: and
. Figuring out what's fake here -- the trading, the analysis, the news, or something else -- will take some unpacking.

The pitch in question was made by the sponsors of the Bitwise Bitcoin ETF Trust. Bitwise is the latest attempt to have the SEC approve an ETF based on a cryptocurrency. There have been several such attempts, and they have all failed. Bitwise stated its goal as "to provide direct exposure to bitcoin, priced off the equivalent of a crypto consolidated tape, while custody assets at a regulated, insured, third-party custodian." The pitch itself is a PowerPoint deck with 226 slides. Now I use PowerPoint myself in moderation, but the mere thought of 226 slides takes me back to my parents' friends' endless vacation pictures, loaded in stacks of Kodak Carousels, that I was made to endure when I was a kid. I start getting hives.

There's also something unserious about PowerPoint decks. They present too much of a temptation to glitz, with fancy graphics and charts substituting for the hard thinking needed to successfully parse a logical argument or to reduce complex subjects to plain English.  And so the Bitwise presentation is chock-full of graphs and screen shots of assorted bitcoin trading scat. There are price and volume charts, "trade size histograms," "volume spike alignments," "spread patterning analyses," and various combinations thereof. It's all very pretty, in full color and all. But I don't know how the SEC staff sat through it, with their short attention span. Maybe because if the text on those slides had been reduced to a written report, it would only have been about 15 pages long.

But anyway, here's the gist of the analysis. Bitwise claims that "Bitcoin is a globally fungible commodity with low transaction costs, near-zero transportation costs and low-to-zero storage costs." For those reasons, according to Bitwise, "you would expect a bitcoin market to be uniquely orderly and efficient, with tight spreads and nearly perfect arbitrage." Yet, after analyzing the trading in bitcoin on 81 exchanges, Bitwise concluded that only 10 of them exhibited trading patterns that met those expectations. The rest of the coin exchanges, 87% of them, did not. Therefore, according to Bitwise, only the 10 exchanges are "real," and the rest are "suspicious." That was the news that the Journal scooped.

Bitwise's pitch to the SEC, at least as far as this part of its presentation is concerned, was simply to promise that it would only do business with the 10 "real" exchanges, and only use those as the basis for valuing its ETF.

If this all strikes you as a classic example of confirmation bias, then you and I are on the same page. Bitwise doesn't explain why the majority of coin exchanges exhibit erratic trading patterns that the minority don't. It simply presents its statistical analysis as "proof" that there's a whole lot of faking going on. But without knowing why the trading in the 10 is so different from the trading in the most, it is impossible to say for sure that the 10 are real and the most are fake. It could just as easily be the reverse, with the 10 being manipulated so as to show all of the telltale signs of a real market conforming to Bitwise's expectations, while the rest simply let bitcoin trade au naturel, wild and woolly as that may be.

Bitwise had to go through this exercise because the SEC early on identified the immature, not to mention unregulated, nature of coin exchanges as an impediment to approving a cryptocurrency ETF. The issue was first raised in a January 2018 staff letter to the ICI and SIFMA, in which Dalia Blass, the Director of the Division of Investment Management, pointed out that to be approved, a cryptocurrency ETF must be able to accurately value its assets to establish a net asset value (NAV), must be able to liquidate its assets quickly to meet redemption demands, and must trade during the day at close to their NAV to avoid manipulative arbitrage. and
.  The first attempt at a cryptocurrency ETF was made by the Winklevoss twins in 2016, with their proposed Winklevoss Bitcoin Trust. In a 92-page analysis, the SEC rejected that application in July 2018. The SEC gave many examples of how bitcoin markets could be and had been manipulated before concluding that the twins had not demonstrated their assertion that bitcoin trading "generally is less susceptible to manipulation than the equity, fixed income, and commodity futures markets."

SEC Chairman Jay Clayton and especially Commissioner Hester Peirce have consistently made public statements to the effect that while the SEC expects to approve a cryptocurrency ETF eventually, none have met its requirements yet. Commissioner Peirce noted "There is a discomfort with the underlying markets in which crypto currencies trade, [and] a skepticism of the ability of markets to develop organically outside of a traditionally regulated context . . . ." All of which is to say that the SEC considers coin exchanges to be a bit funky. Bitwise, by attempting to show that at least 10 exchanges were, by its own statistical definition, "orderly and efficient," is looking to prove the SEC wrong. I don't think it will work, but a decision could come as early as April Fool's Day, so who knows?

But there's a more fundamental question: Why? An ETF is, in a sense, a derivative security. Its economic value is derived from another asset that it holds in trust for its shareholders. Why buy a derivatively held asset instead of buying the asset directly? If you are looking to hold a portfolio of a defined basket of stocks, then it is both convenient and cheaper (in the sense of saving transaction costs) to buy an ETF that holds that basket. If you are looking to hold gold, then it is more efficient (in terms of trading or liquidating) to buy an ETF that holds gold. But if you want to own shares in Apple, there is little point for you to buy an ETF that only owns Apple instead of just buying Apple directly.

And yet, both the Winklevoss twins and Bitwise proposed ETFs that holds only one asset, bitcoins. If the markets in bitcoins are as "orderly and efficient" as Bitwise demonstrated with its analysis, then why wouldn't one simply buy bitcoins on one of those 10 "real" markets? And if the answer is, because you don't really believe those markets are as orderly and efficient as Bitwise claims they are, and you want an intermediary that you can hold liable in case your bitcoins are struck with Goldfinger's Touch (see:, well that's not why ETF's were made. I may be dense for not getting it, but all these attempts at a single cryptocurrency ETF seem internally conflicted right from the start.

Of course, there are other reasons for creating a bitcoin ETF. Many people posted comments to the SEC on the various bitcoin ETF proposals, and supposedly 84% were negative. But this one in support is among my favorites:

Please approve Bitcoin ETF as soon as possible.  . . .  Crypto currency will save mankind from inflation.  . . .  Crypto investors will become wealthy. USA will be able to pay off its massive national debt if mass adoption happens. . . . .

Please let me know if you have any question.

Nope, no questions. That's as good a reason as any I've heard for approving a bitcoin ETF, better than all the rest actually. At least I don't have to suffer through a couple hundred slides to understand it.


Aegis J. Frumento
Stern Tannenbaum & Bell
Co-Head, Financial Markets Practice

380 Lexington Avenue
New York, NY 10168

Aegis Frumento is a partner of Stern Tannenbaum & Bell, and co-heads the firm's Financial Markets Practice. Mr. Frumento represents persons and businesses in all aspects of commercial, corporate and securities matters and dispute resolution (including trials and arbitrations); SEC and FINRA regulated firms and persons on regulatory compliance issues and in SEC and FINRA enforcement investigations and proceedings; and senior executives of public corporations personal securities law and corporate governance matters.  Mr. Frumento also represents clients in forming and registering broker-dealers and registered investment advisers, in developing compliance policies, procedures and controls, and in adopting proper disclosure documents. Those now include industry professionals looking to adapt blockchain technologies to finance and financial market enterprises.

Prior to joining the firm, Mr. Frumento was a managing director of Citigroup and Morgan Stanley, a partner and the head of the financial markets group of Duane Morris LLP, and the managing partner of Singer Frumento LLP.

He graduated from Harvard College in 1976 and New York University School of Law in 1979. Mr. Frumento is a frequent author and speaker on securities law issues, and is often quoted in the media on current securities law developments.

NOTE: The views expressed in this Guest Blog are those of the author and do not necessarily reflect those of Blog.