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It's clear that many folks don't understand how the price dynamics of ETFs with underlying securities operate. A share in an ETF is a fixed basket of securitie

It's clear that many folks don't understand how the price dynamics of ETFs with underlying securities operate. A share in an ETF is a fixed basket of securities. If the price of the ETF differs from the basket, the ETF share creation/redemption mechanism drives the price back to the fair-market value of the basket. If the price of the ETF share is too high: Market participants will short the ETF and buy the underlying. They will then take the underlying to the ETF admin, who will then create shares thus closing out the short. If the price of the ETF share is too low: Market participants will buy the ETF and short the underlying. They will then take the shares to the ETF admin, who will then redeem the ETF share for the underlying, thus closing out the short. Without the ability to short the underlying, there is no mechanism to maintain equilibrium in the share price of the ETF.

zhoutong 13y ago
As you have said, the creation/redemption mechanism will enable fair price discovery. The inability of shorting the underlying doesn't matter here, because if the ETF can be redeemed freely, an investor can buy the underpriced ETF and redeem immediately and sell in the spot market. The only difference of this from actually shorting is the time. During the time of this operation, there may be adverse movement in the underlying price making the arbitrage too risky. It's true that fully efficient arbitrage may not happen. But saying that there's no mechanism to maintain equilibrium price of the ETF is entirely wrong. If the ETF price is $60/BTC and the spot is $85/BTC, there's a huge incentive for investors to buy ETF and redeem and then sell in the spot market, even if it takes days. People who already have both BTC and USD in their hands can also quickly increase their BTC holdings, for free! Therefore, the ability to short underlying simply doesn't matter, as long as ETFs can be created and redeemed fairly freely.
- jpdoctor 13y ago
  > if the ETF can be redeemed freely Not just freely, but without any substantive delay. > If the ETF price is $60/BTC and the spot is $85/BTC, there's a huge incentive for investors to buy ETF and redeem and then sell in the spot market, even if it takes days. Once you think this through, you will come to the conclusion that the mean-squared deviation of the (spot-ETF) is related to the speed at which the shares can be redeemed. Modern investors quickly lose faith in any derivative that does not track the underlying. If you want an example: Shorting of bank stocks was banned by the SEC during the Lehman meltdown. The bank index ETFs went nuts, and the levered ones never really recovered. (See SKF. Those of us who predicted the meltdown made a lot less money because of it.)
RockyMcNuts 13y ago
not sure I agree with your detective work. If the price of the ETF is too low... you can buy the ETF, take it to the ETF sponsor, they will convert it into the underlying, you can then sell the underlying. Ability to short = ability to borrow. If you can borrow Bitcoins from someone, you can sell them, and then you're short. While there may not be an active lending market, in principle no reason it couldn't be done. A lot of times the ETF sponsor or a related entity will participate in arbitrage to keep prices in line... they might have ability to lend to each other. In fact, that may be an important way the Winklevii expect to make money. (in addition to the fact their Bitcoin hoard is more valuable if it's more liquid and more accepted by traditional investors) Now, if the underlying is illiquid and doesn't have good price discovery, the ETF will probably be in the same situation. In the example above, if you're not darn sure you can sell the underlying pretty quickly at a higher price than the ETF, you're not going to attempt the arb. So if the market is illiquid, the arbs don't step in until the spread is more egregious.
- jpdoctor 13y ago
  > in principle no reason it couldn't be done. I'm not suggesting otherwise. I am pointing out that a genuine, fast mechanism for shorting needs to be available in order for the ETF price to track the underlying. That mechanism will take quite a while before there is enough confidence for market participants to have faith in the ability to short.
  - RockyMcNuts 13y ago
    I guess I would say a genuine, fast mechanism for price discovery and liquid trading Bitcoin long and short needs to be available. As long as the ETF sponsor stands by to exchange the ETF for Bitcoin and vice versa, shorting isn't really required. If it were a closed-end-fund with no exchanges for the underlying, then you would need ability to borrow/short.
sneak 13y ago
If I'm reading this right, doesn't that mean a "basket" at a time, or 10k BTC increments?
- jpdoctor 13y ago
  Yes, I didn't want to complicate the issue. In order to keep the admin costs low, the ETF demands that blocks of shares be redeemed at once. (for example: The gold ETF GLD requires 50K shares be created/redeemed at once, iirc.)

zhoutong 13y ago

As you have said, the creation/redemption mechanism will enable fair price discovery. The inability of shorting the underlying doesn't matter here, because if the ETF can be redeemed freely, an investor can buy the underpriced ETF and redeem immediately and sell in the spot market. The only difference of this from actually shorting is the time. During the time of this operation, there may be adverse movement in the underlying price making the arbitrage too risky. It's true that fully efficient arbitrage may not happen. But saying that there's no mechanism to maintain equilibrium price of the ETF is entirely wrong. If the ETF price is $60/BTC and the spot is $85/BTC, there's a huge incentive for investors to buy ETF and redeem and then sell in the spot market, even if it takes days. People who already have both BTC and USD in their hands can also quickly increase their BTC holdings, for free! Therefore, the ability to short underlying simply doesn't matter, as long as ETFs can be created and redeemed fairly freely.

jpdoctor 13y ago
> if the ETF can be redeemed freely Not just freely, but without any substantive delay. > If the ETF price is $60/BTC and the spot is $85/BTC, there's a huge incentive for investors to buy ETF and redeem and then sell in the spot market, even if it takes days. Once you think this through, you will come to the conclusion that the mean-squared deviation of the (spot-ETF) is related to the speed at which the shares can be redeemed. Modern investors quickly lose faith in any derivative that does not track the underlying. If you want an example: Shorting of bank stocks was banned by the SEC during the Lehman meltdown. The bank index ETFs went nuts, and the levered ones never really recovered. (See SKF. Those of us who predicted the meltdown made a lot less money because of it.)

RockyMcNuts 13y ago

not sure I agree with your detective work. If the price of the ETF is too low... you can buy the ETF, take it to the ETF sponsor, they will convert it into the underlying, you can then sell the underlying. Ability to short = ability to borrow. If you can borrow Bitcoins from someone, you can sell them, and then you're short. While there may not be an active lending market, in principle no reason it couldn't be done. A lot of times the ETF sponsor or a related entity will participate in arbitrage to keep prices in line... they might have ability to lend to each other. In fact, that may be an important way the Winklevii expect to make money. (in addition to the fact their Bitcoin hoard is more valuable if it's more liquid and more accepted by traditional investors) Now, if the underlying is illiquid and doesn't have good price discovery, the ETF will probably be in the same situation. In the example above, if you're not darn sure you can sell the underlying pretty quickly at a higher price than the ETF, you're not going to attempt the arb. So if the market is illiquid, the arbs don't step in until the spread is more egregious.

jpdoctor 13y ago
> in principle no reason it couldn't be done. I'm not suggesting otherwise. I am pointing out that a genuine, fast mechanism for shorting needs to be available in order for the ETF price to track the underlying. That mechanism will take quite a while before there is enough confidence for market participants to have faith in the ability to short.
- RockyMcNuts 13y ago
  I guess I would say a genuine, fast mechanism for price discovery and liquid trading Bitcoin long and short needs to be available. As long as the ETF sponsor stands by to exchange the ETF for Bitcoin and vice versa, shorting isn't really required. If it were a closed-end-fund with no exchanges for the underlying, then you would need ability to borrow/short.

sneak 13y ago

If I'm reading this right, doesn't that mean a "basket" at a time, or 10k BTC increments?

jpdoctor 13y ago
Yes, I didn't want to complicate the issue. In order to keep the admin costs low, the ETF demands that blocks of shares be redeemed at once. (for example: The gold ETF GLD requires 50K shares be created/redeemed at once, iirc.)