How Will SEC's Approval of In-Kind Redemptions for Bitcoin and Ether ETFs Reshape The Crypto Market?

The U.S. Securities and Exchange Commission (SEC) approval on Tuesday of in-kind creations and redemptions for spot bitcoin and ether ETFs aligns them more closely with traditional exchange-traded funds and is set to unlock new market efficiencies and smoother trading.

The decision replaces the existing system, which requires ETF issuers to switch between cash and the underlying asset when shares are distributed or redeemed, with one that allows them to deal in the bitcoin or ether directly.

Eliminating cash from the equation brings the U.S. into line with Europe, reduces market volatility and could embolden institutions to take larger bets in the ETF market.

"For institutional investors managing large allocations, this represents a fundamental improvement in how these products interact with the underlying crypto markets," Laurent Kssis, an ETF expert and crypto trading adviser at CEC Capital, said in an interview. "Having implemented this mechanism in our European ETP programs, we can attest that in-kind processes fundamentally transform market dynamics."

Since their inception last year, the crypto ETFs have been restricted to in-cash creation and redemptions. That means the authorized participants (APs) — the entities that issue and redeem ETF shares — provide cash to the issuer in exchange for shares to meet the rising demand.

The issuer then buys the underlying bitcoin or ether on the open market to ensure the ETF is properly backed. During redemptions, the ETF issuer sells the underlying asset and gives the cash to the AP in exchange for the shares.

This buying and selling of the underlying asset is typically done at a specific, predetermined price called the daily fix or the time the fund's net asset value is calculated, leading to concentrated activity and increased volatility around that time.

In contrast, for the in-kind model generally used in traditional ETFs the authorized participants deliver the underlying asset directly to the issuer in exchange for shares. During redemptions, the issuer returns the underlying assets and the AP gives back the ETF shares.

Smoother trading

Since the switch to an in-kind mechanism eliminates the intermediate step of converting between cash and assets, the result is a more organic, less disruptive flow between the ETF and its underlying holdings.

Kssis called the SEC's approval a watershed moment for the digital assets industry.

"When large volumes are created or redeemed through cash mechanisms, authorized participants must execute massive buy or sell orders in the underlying crypto markets, which amplifies volatility precisely when markets are already under stress," he said.

In-kind creation and redemption breaks the volatility cycle, he said.

"Instead of forcing market transactions, we simply transfer the underlying assets directly, removing what was essentially a volatility multiplier. This isn't theoretical —we've observed this dampening effect first hand in European markets where in-kind mechanisms have operated seamlessly," Kssis said.

AI's take

"The acquisition or disposal of the underlying assets by the APs can happen more flexibly over time, minimizing their market impact and thus helping to dampen price volatility in the underlying asset."

"ETFs that create and redeem shares through in-kind transfers of underlying securities tend to minimize capital gains distributions and allow ETFs to trade closer to their net asset value."

According to the New York Digital Asset Investment Group (NYDIG), the switch not only simplifies ETF operations it also has implications for secondary markets and the financial aspects of ETFs, as well as second-order effects on market participants.

"For secondary market trading, because creation and redemption orders can be satisfied by the underlying crypto and not just shares, it may reduce the trading of the ETF shares, especially during the critical NAV index calculation windows. In addition, the change should also lead to tighter spreads to NAV, lower tracking error, lower create/redeem costs, and potential tax benefits," NYDIG said in an explainer.

Cash model is inefficient

The setup leaves the door open for high volatility around the daily fix, particularly on days of large redemptions and creations, which require significant buying and selling of securities. A 2024 study said that cash redemptions can exacerbate market volatility during times of market stress or downturn.

Additionally, analysts told CoinDesk that arbitrageurs tend to congregate in the market around the daily fix window, resulting in increased volatility.

AI's take

"Since in-cash ETFs lack the precise arbitrage mechanism of in-kind ETFs to keep prices aligned with the NAV, there can be wider bid-ask spreads and more noticeable deviations from NAV during volatile periods. This can lead to increased price swings."

"During times of extreme market stress, the process of cash redemptions can exacerbate volatility. To meet redemption requests, ETF managers need to sell securities quickly, which can depress prices in the underlying market and create a feedback loop, amplifying volatility."