The U.S. Securities and Exchange Commission approved spot bitcoin exchange-traded funds (ETFs) applications.
Many believe this approval provides investors with a more direct and straightforward way to gain exposure to the cryptocurrency market through traditional investment channels.
Cryptocurrencies such as bitcoin have been around for well over a decade. But with major legal fiascos involving some of its biggest names, including the collapse of the FTX exchange, digital assets have carried too much risk for most financial advisors to consider for their clients.
With these ETFs now granted SEC approval, many of those concerns should fade as they allow financial advisors to utilize them as another potential class of liquid alts, says Sandy Kaul, Franklin Templeton's Head of Digital Asset & Industry Advisory Services.
In a conversation with Action!, Kaul explains what she sees as the importance of these ETFs and how they will impact the digital asset space. Of course, this is not investment advice and each advisor should consider the risk tolerance and needs before recommending investments in digital assets. We hope you enjoy this discussion with a leader in the space who will share her vision for the year ahead.
For those who aren't conversant in digital assets, what are cryptocurrencies? Why should financial advisors pay attention to them?
SANDY KAUL: Cryptocurrencies are a new type of asset, most importantly, used to transact on decentralized platforms. Keeping in mind FTX and Binance were centralized exchanges for digital assets, they can be seen as the drivers of a “new network economy” built on blockchain technology that differs significantly from today’s network economy.
In today’s network economy, leading technology platforms and payment processing are centralized. Tech companies like Amazon, Uber and Apple run them. For example, when a consumer transacts on any of these platforms, they use government-issued fiat currency – like U.S. dollars in the United States to process payments for goods and services. In many scenarios, the centralized tech company utilizes the consumer data collected by its platform to drive its business model. They also take a significant portion of the business economics and value that creators, providers or developers provide in exchange for letting those participants utilize their platform.
Decentralized blockchain networks operate differently. Rather than being controlled and owned by a specific company, these networks operate, many using open-source software, like a utility open to all participants. Anyone can build an application on a decentralized platform or use their marketplaces without sharing the revenues with the platform provider. Transactions are recorded on the decentralized blockchain ledger at the heart of the platform. Rather than paying in a government-backed fiat currency like U.S. dollars to transact with an application built on this new decentralized platform or to record the transaction on the blockchain ledger, users can pay in a specific cryptocurrency issued by the platform itself as well as other utility tokens in the decentralized finance ecosystem.
This decentralized finance network makes the crypto ecosystem an exciting new domain for financial advisors to watch. There are, and will continue to be, many innovations and new use cases to improve or reform traditional commerce and finance. In a sense, these platforms are like a new set of tech-savvy, digital emerging innovators. Many have their own currency, they build their own transaction rails, they have their own set of entrepreneurs building applications on top of those transaction rails, and they have their own set of consumers using those applications to buy, sell, game, post, shop, and more. Unlike today’s company-linked centralized platforms, these decentralized crypto platforms publicly share all their transaction data, their intellectual property and are based on the legal decentralization concept where a community of stakeholders govern the products and services and make the technology available to anyone in the network. Moreover, they offer better economics to creators and users. Not only do some of the decentralized networks choose not to take a cut of the revenues generated by applications that run on their platform, many applications reward their most active contributors and users by giving them tokens that recognize the value of their participation.
Thus, over time, these new decentralized networks powered by cryptocurrencies represent a new growth opportunity that may begin to take market share from today’s platform companies. They also represent a valid use case for digital assets that differs from the centralized crypto exchanges that dominated the headlines in 2023.
What is important about this approval? What does this mean for financial advisors?
KAUL: The launch of a spot bitcoin ETF is important for three reasons:
First, it makes it easier to access and custody bitcoin. Today, an investor can either have exposure to bitcoin through an OTC-exchange trust structure, where it can be difficult or disadvantageous to exit the investment, or they purchase bitcoin directly through a centralized crypto exchange that may or may not be regulated as a securities exchange and hold their bitcoin in a wallet that is custodied by the exchange or they can access the decentralize finance (DeFi) ecosystem we covered above and self-custody bitcoin in their own individual wallet – both of which provide operational risk.
Secondly, it offers more regulatory certainty to US investors. ETFs are regulated securities with rules around the issuers, the authorized participants and all the service providers covering how the assets are handled. They are listed on regulated securities exchanges. This makes the investment easier to hold in a commingled way with other, more traditional investments for clients that are willing to accept the risks associated with the underlying asset, bitcoin.
Third, it will likely open investors' understanding of the broader crypto ecosystem. The bitcoin ETF is likely to bring more money into the crypto domain as issuers buy bitcoin for their ETFs. This influx of funds will likely accelerate the overall ecosystem's growth and highlight the opportunities beyond bitcoin. There are many coins and tokens that offer growth investments in the crypto ecosystem. Franklin Templeton’s Digital Asset team provides research on a broad array of coins, including bitcoin.
How would a wealth advisor use a spot bitcoin ETF for their clients?
KAUL: The spot bitcoin ETF can help investors diversify their investment portfolios. It offers a way of expanding the asset class exposure and potentially reducing the correlation of the investor’s portfolio to the traditional equity and bond markets. There has been growing interest in offering alternatives to individual investors. Many new products that provide exposure to traditional alternatives, such as private equity or private credit, are through vehicles with limited liquidity windows. The spot bitcoin ETF is designed to be marked to market daily and can be bought or sold at will. This will provide a new type of more liquid alternative exposure. This is open to advisors with clients who want access to the new blockchain technology and are comfortable accepting the underlying valuation and volatility risk of the assets in the ETF. This new ETF allows investment while mitigating some operational and regulatory uncertainty risks discussed above.
How can firms develop policies for the use of spot bitcoin ETFs?
KAUL: Firms may want to provide more education about the underlying bitcoin asset so that investors are aware of the historical volatility and unusual nature of the asset itself. Some may want to create guidelines around how much of an investor’s overall portfolio holdings should be placed into this new type of alternative exposure. Legal and compliance should approve the marketing materials - there is a lot of guidance about how to market digital assets, including a well-documented risk assessment.
Several wealth management leaders, including Jamie Dimon and Warren Buffet, have repeatedly commented negatively on cryptocurrencies. What do you make of their critiques?
KAUL: It is easy to get excited about new technology advancements. One such example was the rush to invest in generative AI firms in 2023. The crypto domain also represents a huge technological advancement. Still, it is harder for many investors to understand because, although the ETF is not decentralized, there is a large decentralized crypto ecosystem, and has been set up to operate differently than today’s economic models. No one underlying “firm” or “company” offers the decentralized network. The typical framework is a software protocol that is autonomously run, with a Foundation and operating companies that help govern the technology. Most crypto offerings – including bitcoin – only have a foundation and a community of interested developers and users. These decentralized networks also created their own utility and governance tokens to operate.
It makes it harder for many traditional investors to understand. These same investors talk freely about the novel and exciting nature of blockchain as a technology, but they are less willing to embrace the decentralized business model enabled by these blockchains. Over time, I believe this split between liking the technology and not liking its application will likely fade. I believe a broader swath of investors will better understand decentralized businesses and embrace the technology and its main application – the crypto ecosystem. Until then, it is important that advisors carefully document any recommendations that match an investor’s desire to invest in emerging technology and they understand the associated risks.
The price of bitcoin, the most well-known cryptocurrency, has experienced rapid inclines followed by rapid declines. Do you expect digital assets to remain highly volatile even if spot ETFs are approved?
KAUL: Part of the volatility in the crypto domain can be explained by its market capitalization. Any asset with a lower market cap will tend to be more volatile as there is little liquidity to absorb buy and sell orders. When there is a shift in sentiment, it is often hard to reprice the asset and the price swings can become more extreme. This is true of small-cap stocks today as an example. As more money comes into bitcoin and the crypto ecosystem, the market depth will improve and there is likely to be somewhat lower volatility. That is not to say that volatility will not pick up in a big market moving event, but this is true of any market.
What role do you see cryptocurrency playing in asset management?
KAUL: Cryptocurrencies are likely to become seen as an alternative asset class that offers good growth opportunities to investors and acts as a diversifier to today’s dominant equity and bond exposures. In my opinion, many investors will want to have a small portion of their portfolio held in crypto assets.
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