Those Winklevoss twins are at it again. After helping to launch Facebook and featuring heavily in the Academy Award-nominated film The Social Network, the brothers are now making headlines and tapping into a trend at the same time. They recently filed a proposal with the U.S. Securities and Exchange Commission (SEC) to create an exchange-traded fund (ETF) based on the new and often poorly understood world of bitcoins. They’re not the first to try to make an investment product out of the trend—stock exchange SecondMarket is also trying to launch a bitcoin investment trust with initial seed money of US$2 million.
The question is, Are bitcoin ETFs a good idea?
Let’s start with answering the main question. What are bitcoins? A bitcoin is a peer-to-peer digital currency—you can’t hold it in your hand, you can’t put it in your wallet (you store it in a digital wallet), and it doesn’t have royalty stamped on one side. People use them to make anonymous purchases online from any source that accepts them. You can use bitcoins to buy above board items such as gift cards, music downloads and video games. You can even use them to donate to WikiLeaks without anyone knowing what you’re up to. And because they’re anonymous, they’re playing a growing role in the black market.
Where do they come from? Bitcoins are a virtual product of the Internet—like gold, you mine for them using computer programs that solve complex mathematical equations.
The bitcoin market is pretty small, for now at least. Right now, there are 11,760,800 bitcoins with a total outstanding value of US$1.44 billion, according to Bitcoinwatch.com. At the moment, a single bitcoin sells for about US$135 (after peaking at more than US$250 in April).
But while the market is small, the creation of a bitcoin ETF could be a game changer. According to the guys from SecondMarket, it could draw more institutional investors into the space. And as Tyler Winklevoss told the New York Times about the new ETF, “it eliminates the friction of buying and reduces the risks associated with storing bitcoins while offering similar investment attributes to direct ownership.”
While the notion of bitcoins is intriguing (after all, it’s a whole new currency mined from a place that didn’t exist 20 years ago), critics say an ETF could cause some bigger problems. Paul Kedrosky, our keynote speaker at the upcoming Investment Innovation Conference, warns that the ETF could drive bitcoin prices because they trade so thinly day to day. “The trouble starts when the derivatives [the ETF] are more liquid than the underlying asset.” True enough. According to Bitcoinwatch.com, the number of bitcoin transactions during the last 24 hours was a lowly 50,391. They’re still not widely used (and, of course, some of the users are buying illegal things with them).
But to me, another bigger question involves security—bitcoins are stored in online wallets. You need a private key code to use your bitcoins. But those codes can be hacked (as happened to Instawallet in April). And right now, it’s virtually impossible to reclaim losses due to online theft. The ETF isn’t immune from this kind of theft, and there are a few important references in the SEC filing made by the Winklevoss twins (i.e., “The loss or destruction of a private key required to access a bitcoin may be irreversible. The trust’s loss of access to its private keys or its experience of a data loss relating to the trust’s bitcoins could adversely affect an investment in the share.”)
If bitcoins do turn out to be a new kind of bubble—a tulip bulb for the 21st century—then an ETF could add a lot of soap to the water. But if bitcoins do end up being the currency of the future—and that’s a big if—an ETF might help to add credibility to the space.