Wall Street Watchdog Keeps Bitcoin ETFs on Ice

ETFs promise low fees, tax advantages and relative ease of trading. Their adoption has upended the way stocks, bonds and commodities are traded. At stake are potentially billions of dollars in fees for managers.

But so far the industry hasn’t been able to persuade the SEC that bitcoin ETFs wouldn’t be susceptible to manipulation, fraud and illicit activities such as money laundering. Officials are unlikely to change their minds until the SEC can monitor trading activity on crypto exchanges the way it does in stocks, bonds and other assets, said

David Grim,

a Stradley Ronon attorney who previously worked in the SEC’s Division of Investment Management.

“They’re right to be concerned,” said

Kathleen Moriarty,

a prominent ETF lawyer. “The question is at what point can they be made comfortable or is it a situation they won’t ever be comfortable.”

SEC Chairman Gary Gensler, once viewed as a potential ally by asset managers, told Congress this spring that the crypto trading industry will have to submit to regulation before an ETF wins approval.

“None of the exchanges trading crypto tokens has registered yet as an exchange with the SEC,” Mr. Gensler told Congress then. “Altogether this has led to substantially less investor protection than in our traditional securities market and to correspondingly greater opportunities for fraud and manipulation.”

An SEC spokeswoman declined to comment.

Greenlighting bitcoin ETFs would open the world of crypto investing to anyone with a brokerage account. A 2019 study by Bitwise Asset Management showed that nearly 95% of all reported trading over a four-day period was artificially created by unregulated exchanges.

Bitwise used the study to support its bitcoin ETF proposal, saying the fund’s pricing would be based upon the 5% of trading it considered legitimate. The SEC rejected Bitwise’s proposal later that year, leading the firm to withdraw the effort.

The SEC has moved slowly on other new ETF concepts before ultimately approving them. The SPDR Gold Shares ETF launched in 2004 following two years of debate.

The agency took about seven years before granting issuers permission to offer leveraged ETFs, citing their complexity and the potential for misuse, Ms. Moriarty said. Those concerns turned out to be prescient: Volatility-linked leveraged funds cost investors millions in 2018 when volatility spiked, and several leveraged exchange-traded products blew up last year after oil prices fell into negative territory. Class-action lawsuits from investors followed. The SEC has since imposed some limitations on leveraged funds.

“I’ve always wondered if [the SEC] are worried about a similar situation” with bitcoin ETFs, Ms. Moriarty said. “It looks really bad because they didn’t hold fast to their concerns.”

Canada approved its first bitcoin ETFs earlier this year. The

Purpose Bitcoin ETF

launched in February, quickly amassing more than $1 billion in less than two months before bitcoin’s price decline cut that figure to a recent $712 million.

Wealthy investors can access bitcoin-holding trusts, such as the $20.8 billion

Grayscale Bitcoin Trust.

However, the trust has struggled to keep up with bitcoin’s price swings. Grayscale executives have said they intend to eventually convert the trust into an ETF.

VanEck last month applied to launch a mutual fund that trades bitcoin futures contracts rather than the cryptocurrency itself. Experts said such a proposal has the potential to pass the SEC, given the regulator’s stated desire to be able to watch underlying markets. But it is not clear that alone will be enough.

“The SEC has been in a holding pattern,” said

Ben Johnson,

director of global ETF research at Morningstar. “There are still very fundamental foundational hangups…it’s difficult to say if or when they’ll get past those.”

Write to Michael Wursthorn at Michael.Wursthorn@wsj.com