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05 Jul 2013

The Winklevoss twins are looking for some greater fools. Like you, perhaps. Money

You've probably heard about the Winklevoss twins, who got a great deal of money from Facebook in a 2008 lawsuit. Now they have bought up a vast number of bitcoins—reportedly about 1% of all of them—and presumably want to make bug bucks in the bitcoin market, but to succeed they need some suckers to help them out.

They recently filed a preliminary prospectus with the SEC for the Winklevoss Bitcoin Trust, which is intended to be an exchange traded fund (ETF), Felix Salmon blogged about the reasons that it would be a terrible investment if the SEC allowed it which they probably won't, but I haven't seen comments on the key fact that this ETF appears primarily a way for the Winklevii to unload their bitcoins on a large pool of greater fools.

To understand this, let's review the way that an ETF, which is sort of a hybrid between a mutual fund and a stock, works. An ETF owns a pool of assets, and each share is a claim on part of that pool. For an S&P 500 ETF, the pool is a bunch of stock, for the WBT it is a bunch of bitcoins. A regular mutual fund allows people to buy or sell every day, so they have to buy or sell corresponding amounts of the underlying asset. ETFs let people trade at any time the stock market is open, so they use a different approach to manage the asset. The ETF only deals directly with a handful of Authorized Participants (APs), typically large investment banks, and only in large blocks of shares called Creation Units or Baskets. A basket is quite large, usually worth a million dollars or more. In a typical S&P 500 fund, the Vanguard S&P 500, the basket is 50,000 shares, currently worth about $3.7 million. When an AP buys or sells a basket, it doesn't do it for cash, it does it by exchanging the shares for the underlying asset, e.g., in that Vanguard fund, 50,000 shares of the ETF for $3.7 million of stock in the proportion they are in the S&P 500. The basket exchanges clear once a day.

Since the ETF has no direct relationship with the individual shareholders, the ETF's fees are taken out of the interest or dividends for ETFs that pay them. For ETFs that don't, like gold ETFs, the ETF periodically takes its fee as a tiny slice out of each share, so the amount of asset in each share very slowly decreases. The bitcoin ETF uses this latter approach.

Each share of the WBT will be 1/5 of a bitcoin, and a basket is 50,000 shares, so a basket is 10,000 bitcoins, less the accumulated fees. At current bitcoin prices, that's worth in the ballpark of a million dollars.

When there is a liquid market in the underlying asset, this both makes the ETF quite liquid and keeps the ETF price close to the asset price due to arbitrage by the APs. If the ETF price drops below the price of the asset, an AP will buy up a block of ETFs and swap them for the asset which is worth slightly more. If the ETF rises above the price of the asset, the AP will buy the asset and swap it for a block of the ETF which it can then sell.

With this in mind, we can dismiss some of the concerns about things that might go wrong. In particular, short of a stupendous cockup, I am not worried at all that an evil hacker might steal all the bitcoins. The ETF does not deal with the public, only with a few APs that it knows, so there is no need for the wallets ever to be online. When they buy or sell a basket, they can physically meet with the AP, plug two USB keys containing the wallets into an offline PC, create the transaction, unplug the USB keys, then plug the PC into the net and publish the transaction to the bitcoin block chain. It will take a while for the transaction to percolate out into the block chain, but that doesn't matter, both because the transaction will probably happen many hours before the market reopens in the morning, and if the block chain were to reject the transaction, they know exactly who to call to fix it and/or sue.

Similarly for the ETF fees, which are deducted from each basket monthly, the ETF controls all of the baskets and the wallet into which the fees are moved, so again they can do all of the transactions off line, then publish them to the block chain.

While I agree with all of the political concerns about bitcoin, e.g., what happens if governments tax them or require a money transmitter's license (probably not really a big deal since they'll only be transmitting bitcoins to the APs), or outlaw them, a key point I haven't seen anyone ask is:

Where do you get 10,000 bitcoins?

The total transaction volume on MtGox, which everyone still agrees is the largest public bitcoin market, is about 10,000 per day, and reports say that they're capacity limited and aren't likely to get much bigger any time soon. So if someone tried to buy or sell 10,000 at once, the market would not be able to handle them, at least not at anything like the current price.

The WBT prospectus has a complex process for publishing a daily weighted average of public quotations as a NAV (net asset value) but that's just window dressing, since ETF shares trade in the market at whatever they trade for, just like any other shares. If the ETF is at all successful, its daily volume is going to be way more than 50,000 shares or 10,000 bitcoins per day. (By comparison, the Vanguard S&P fund trades 1.8 million shares per day, and the much larger SPDR S&P fund trades 144 million per day. The SPDR gold fund, which is the closest thing I can find to a bitcoin fund, trades 15 million per day, and the competing iShares gold fund trades 8 million.)

So in all likelihood, the ETF tail is going to be wagging a much smaller bitcoin market dog, and creating a two-tier market. If you are the sort of large investor who happens to have USB keys with 10,000 bitcoins in your safe deposit box, you can play with the big boys and trade baskets at the ETF price. (Such as, perhaps, two tall buff Harvard grads.) Otherwise, you can trade real bitcoins with some difficulty at MtGox, or if you have a brokerage account, you can trade by proxy by buying or selling the ETF.

Except if you trade by proxy, you are buying when the big investors are selling, and vice versa. So if the SEC were to allow this ETF to exist, it would primarily be a way for the Winklevii to dispose of large blocks of bitcoins that they can't sell now, when the price seems attractively high, and perhaps to load up when the price drops. Do you want to be on the other side of those bets?


posted at: 15:14 :: permanent link to this entry :: 0 comments
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