Ark raises concern over Coinbase concentration in Bitcoin ETF filings days before potential approval

As the anticipation of the approval of a spot Bitcoin ETF finally comes to a head, the Ark 21Shares Bitcoin Trust has made 16 significant clarifications and additions to its S1 filing across several areas, ranging from operational processes to financial responsibilities and regulatory aspects, providing a more explicit, more detailed framework for the ETF’s functioning.

The revised filing specifies the CME CF Bitcoin Reference Rate – New York Variant for the Bitcoin – U.S. Dollar trading pair, setting a clear historical reference point with a rate of $43,731.74 as of December 22, 2023. This provides a precise valuation marker for the Bitcoin market at that time.

Further, the role of third parties, named “Bitcoin Counterparties,” is distinctly clarified. They are identified as affiliates but not Authorized Participants, delineating their role in the purchase process of Bitcoin for the Trust. This distinction underscores the separation of responsibilities in the ETF’s operational structure.

In a critical amendment regarding the roles of Authorized Participants, it’s emphasized that their involvement will be strictly in cash transactions for creating and redeeming shares. The Trust retains the sole responsibility for selecting Bitcoin Counterparties for Bitcoin transactions, underscoring an independent operational procedure.

The filing also introduces new information about potential marketing support arrangements, specifying that such arrangements will not involve the Trust directly and the Sponsor will bear any associated costs and/or the Sub-Adviser. This arrangement aims to protect the Trust’s assets from being used for marketing activities.

Notably, the filing addresses potential challenges in the creation and redemption process of the ETF’s Baskets. It outlines scenarios where market disruptions could impact the ETF’s ability to maintain its share price close to Bitcoin’s actual value. Provisions for suspending the creation and redemption of Baskets during significant disruptions are included, indicating a cautious approach to market volatility and operational risks.

The filing also delves into the overlap in roles of the Bitcoin Custodian and Prime Broker, addressing industry concentration risks. The limitation on the amount of Bitcoin held in the Trust’s Trading Balance for transactional and expense management purposes is highlighted, reflecting a strategic approach to risk management.

Further, a more defined process for borrowing bitcoin or cash from Coinbase Credit, Inc. is laid out, emphasizing efficient cash management for trade and expenses. The amendment also discusses the dynamic determination of the “Authorized Amount” of Trade Credits, adding an element of flexibility and responsiveness to market conditions.

The amendment introduces a new aspect concerning the interest rates on Trade Credits, emphasizing a dynamic approach to setting these rates based on various market and credit factors.

Moreover, the Trust’s decision to cover on-chain transaction fees for Bitcoin transactions is a significant operational change, simplifying the cost structure for Authorized Participants. The potential for in-kind creation and redemption of shares was shortened as it remains subject to regulatory approval and is currently uncertain.

Regarding taxation, the Trust’s use of bitcoin for expenses is now interpreted as a sale, impacting tax implications. The amendment provides a more detailed view of the tax treatment for various shareholder transactions, reflecting a nuanced understanding of cryptocurrency taxation.

Lastly, the “Item 13. Other Expenses of Issuance and Distribution” section in the filing offers a comprehensive overview of the estimated costs associated with issuing and distributing Shares, providing transparency on financial obligations related to the ETF offering.

These amendments enhance the clarity and detail of the Ark 21Shares Bitcoin Trust’s operational, financial, and regulatory framework, addressing various complexities and risks inherent in managing a Bitcoin ETF amid an intricate and competitive scene among several other major institutional filings.

Breakdown of all 16 amendments.

Below is a detailed run-through of all the major amendments and their potential implications for the Bitcoin ETF filing from Ark.

Index Price Update

The filing was amended to specify the CME CF Bitcoin Reference Rate – New York Variant for the Bitcoin – U.S. Dollar trading pair. Initially, the document left the date and the reference rate value as placeholders. These placeholders have been updated with the amendment to reflect a specific date and value. As of December 22, 2023, the rate, which CF Benchmarks Ltd. calculates, was set at $43,731.74. This change adds a precise historical reference point to the filing, giving a clearer picture of the Bitcoin market value at that particular time.

Bitcoin Counterparty Definition

The filing was also amended to clarify the role and identity of the third parties involved in the process of purchasing shares for the Ark 21Shares Bitcoin ETF. Initially, the document described these third parties as potentially being affiliates of Authorized Participants, but with no clear distinction regarding their direct involvement as Authorized Participants. The amendment specifies that these third parties, referred to as “Bitcoin Counterparties,” are not Authorized Participants themselves but maybe Authorized Participants’ affiliates.

This distinction is important as it clarifies the separation between the entities authorized to purchase and redeem shares directly from the Trust (Authorized Participants) and those designated to handle the actual purchase of Bitcoin equivalent to the cash deposited by the Authorized Participants (Bitcoin Counterparties). The rest of the process, as outlined in the document, remains unchanged: the Sponsor, on behalf of the Trust, instructs these Bitcoin Counterparties to purchase Bitcoin with the deposited cash and then deposit this Bitcoin into the Trust’s account with the Bitcoin Custodian, resulting in the issuance of the corresponding amount of Shares to the Authorized Participant.

Share Redemption Process

The roles and responsibilities of the Authorized Participants in creating and redeeming shares in the Ark 21Shares Bitcoin Trust was also clarified. The revised text emphasizes that Authorized Participants will exclusively deal in cash transactions when creating shares (investing in the Trust) and redeeming them (withdrawing from the Trust). This change highlights that Authorized Participants will neither handle Bitcoin directly nor instruct the Trust or a Bitcoin Counterparty on managing Bitcoin transactions during the share creation or redemption processes.

The amendment further details that the Trust is solely responsible for choosing the Bitcoin Counterparty to facilitate Bitcoin transactions, whether receiving Bitcoin for share creation or delivering it for share redemption. This distinction is crucial as it underlines that the Bitcoin Counterparty acts independently and is not an agent of the Authorized Participant in these transactions.

Additionally, the amendment names the Prime Broker and the Lender as the Bitcoin Counterparties as of the prospectus date, providing a specific reference to the entities involved in the transaction process.

Overall, this amendment brings more clarity to the operational structure of the Trust, explicitly defining the roles of Authorized Participants and the Trust concerning Bitcoin transactions and identifying key entities involved in these processes.

Marketing Support Arrangements

Information about potential marketing support arrangements for the Trust was added. This new section specifies that the Sponsor and/or the Sub-Adviser of the Ark 21Shares Bitcoin Trust might engage in additional agreements to support the marketing of the Trust. Significantly, it is clarified that the Trust itself will not be a party to these marketing support arrangements.

The amendment also addresses the financial implications of such agreements. It states that any fees or costs arising from these marketing support arrangements will be borne by the Sponsor and/or the Sub-Adviser, not the Trust itself. This clarification ensures that the financial responsibilities for marketing-related activities are explicitly assigned to the Sponsor and/or Sub-Adviser, safeguarding the Trust’s assets from being utilized for these purposes.

Creation / Redemption Risks and Trading Balance Limitations

If the creation and redemption process of the ETF’s Baskets (which are essentially bundles of shares) encounters unexpected difficulties, and amendment states that this could significantly impact the ETF’s ability to maintain its share price close to the actual value of Bitcoin (NAV, or Net Asset Value). These difficulties could arise from various issues, including volatility in Bitcoin’s price, problems with the Bitcoin Custodian (such as insolvency, business failure, security breaches, or operational failures), disruptions in Bitcoin trading platforms, or issues within the Bitcoin network itself, such as network outages, congestion, or high transaction fees demanded by miners.

In response to these potential challenges, the ETF has provisions for suspending the creation and redemption of Baskets. This suspension could happen if, for instance, the Bitcoin network faces outages or other significant problems that disrupt transaction processing. During such suspensions, the spread in trading – the difference between the buying and selling price – may widen, leading to the ETF’s shares trading at a premium or discount compared to the actual price of Bitcoin. Moreover, if the Bitcoin market becomes less liquid, meaning it’s harder to buy and sell large amounts of Bitcoin quickly without affecting its price, this could also cause the ETF’s share price to diverge from the underlying value of Bitcoin.

In a related amendment, the filing clarified limits on the amount of Bitcoin that may be held in the ETF’s Trading Balance. This balance will only contain enough Bitcoin to manage a specific creation or redemption transaction or to cover Trust Expenses that the Sponsor Fee does not already cover. This limitation is likely aimed at reducing the risk associated with holding large amounts of Bitcoin, which can be volatile and subject to various external factors that could impact its value.

Service Provider Concentration Risk

A detailed explanation regarding the potential overlap in the roles of the Bitcoin Custodian and Prime Broker for Ark’s 21Share Bitcoin Trust and other competing products was added. This amendment highlights the current market situation where only a limited number of digital asset intermediaries have the reputation and operational capability to serve as Bitcoin Custodian and/or Prime Broker. The concern addressed is that these service providers may also serve similar functions for competing exchange-traded products (ETPs) that offer exposure to the spot bitcoin market or other digital assets.

This situation creates a risk for the Trust due to the industry concentration of these service providers. The amendment explains that sharing these custodial and brokerage services among various products might lead to fewer options for intermediaries available to the Trust. This could pose challenges in finding and appointing replacement service providers if needed. Furthermore, the amendment addresses the risk of magnified impact due to this concentration. If the Bitcoin Custodian or Prime Broker faces operational disruptions or adverse developments, it could affect the Trust and other products using the same services, leading to a broader loss of confidence in ETPs related to the spot Bitcoin market or other digital assets.

Additionally, the amendment introduced a clause about the management of the Trust’s bitcoin holdings. It specifies that the amount of bitcoin held in the Trading Balance will be limited. This limitation is set to ensure that the bitcoin held is only what is necessary for processing creation or redemption transactions or for paying Trust Expenses not covered by the Sponsor. This addition aims to clarify the operational limits regarding the Trust’s bitcoin holdings, ensuring they are explicitly managed on transactional necessity and expense management.

Post-Trade Financing Agreement Update

Ark’s 21Shares Bitcoin Trust, in its agreement with Coinbase Credit, Inc., now has a more defined process and purpose for borrowing bitcoin or cash as trade credit. This revision elaborates on how the Trust can use borrowed funds to efficiently manage cash creations, redemptions, and payment of various expenses, including the Sponsor’s Fee. The key change is the detailed explanation of how this borrowing mechanism allows the Trust to lock in bitcoin prices at the time of trade or payment rather than waiting for the transfer of funds or bitcoin between accounts, which could be subject to delays.

Additionally, the amendment clarifies the process for both purchasing and selling Bitcoin in connection with creation and redemption orders. It highlights the Trust’s strategy of borrowing either cash or bitcoin to expedite these transactions, emphasizing the aim to secure bitcoin prices swiftly rather than being delayed by fund transfers.

The Trust’s acknowledgment of an unspecified maximum amount of trade credit that could be established in the future is another significant addition. This indicates a potential limit on the amount of funds the Trust can borrow, though it’s not currently defined.

Furthermore, the amendment details determining the “Authorized Amount” of Trade Credits. It specifies that this amount will be decided daily at the Lender’s discretion, based on various factors, including the availability of financing and credit assessment of the Trust. This introduces a dynamic element to the amount the Trust can borrow, dependent on the Lender’s conditions and the market environment. The Lender’s discretion in extending Trade Credits, especially during material market disruptions or shortages of bitcoin for lending, is also emphasized, highlighting the conditional nature of this financial arrangement.

Interest Rate on Trade Credits

Ark amended the interest rates on Trade Credits, also known as the “financing fee.” This fee will now be determined daily at the discretion of the Lender. Several factors, including the availability of financing, market prices, and a credit assessment of the Trust, will influence the Lender’s decision. This change implies a more dynamic and flexible approach to setting the financing fee, potentially reflecting the volatile nature of the cryptocurrency market.

Additionally, the amendment specifies the process of creating and redeeming shares within the Trust. Authorized Participants (APs) will only use cash for these transactions to create and redeem shares. Notably, APs will not engage in direct or indirect purchase, holding, delivery, or receipt of Bitcoin in the creation or redemption process. This responsibility is solely on the Trust, which will select a Bitcoin Counterparty different from the Authorized Participant for these transactions.

When creating shares, the Trust will receive Bitcoin from a Bitcoin Counterparty, which it selects independently and not as an agent or under the direction of an Authorized Participant. Similarly, the Trust will send Bitcoin to a chosen Bitcoin Counterparty, again independent of the Authorized Participant, for redemption. This structure ensures that the Authorized Participants’ involvement is limited to cash transactions. At the same time, the Trust manages the Bitcoin transactions with its chosen counterparties, maintaining a clear separation of roles and responsibilities in the share creation and redemption process.

Authorized Participant Transaction and Creation / Redemption Procedure Update

The Ark 21Shares Bitcoin Trust will now cover the costs associated with Bitcoin-related on-chain transaction fees for both creation and redemption transactions and transactions with the Prime Broker. The Sponsor will assume these expenses as part of the Sponsor Fee. It clarifies that Authorized Participants are only responsible for cash liabilities related to creation and redemption costs, such as trading fees and slippage. This amendment simplifies the cost structure for Authorized Participants, clarifying that their financial responsibilities are limited to specific cash-related costs.

Additionally, the amendment introduces a significant change regarding the potential for in-kind creation and redemption of shares, with the section reduced significantly. While the Trust may allow Authorized Participants or third parties acting on their behalf to engage in in-kind transactions for creating and redeeming shares in the future, this is subject to regulatory approval. The amendment highlights that the timing for such regulatory approval is uncertain, and no guarantee will be granted. This update implies that while the option for in-kind transactions may be considered, there is no assurance that it will be available to Authorized Participants or their third-party counterparts in the future. This change adds a layer of uncertainty regarding the operational mechanics of the Trust, particularly in terms of how shares might be created or redeemed in the future.

Use of Bitcoin for Expenses and Taxation Changes on Share Sales

The Trust will now explicitly use Bitcoin to cover certain expenses, a move interpreted under current IRS guidance as constituting a sale of Bitcoin. This new aspect implies that when the Trust utilizes Bitcoin for expenses, it is effectively selling that portion of it, potentially impacting its tax implications.

Regarding the taxation of shareholders, the amendment clarifies and expands on the tax treatment of various transactions involving the Trust’s shares. Previously, it was outlined that when shareholders sell their shares, they are treated as selling their proportional share of the bitcoin in the Trust. The gain or loss on this sale is calculated based on the difference between the sale price of the shares and the shareholders’ tax basis in bitcoin.

The recent amendment refines this by stating that the above treatment applies specifically to sales other than redemptions. Additionally, it introduces the concept of cash redemptions. In such cases, when the Trust sells bitcoin to fund a shareholder’s redemption, the gains or losses from this sale are expected to be treated as if they were incurred directly by the shareholder being redeemed. This could mean that the tax implications for the shareholder in a cash redemption scenario are directly linked to the gains or losses realized by the Trust from the sale of bitcoin used to fund that redemption.

Furthermore, the amendment maintains the previous stance that a redemption of shares in exchange for the underlying bitcoin is generally not a taxable event. The shareholder’s tax basis and holding period for the bitcoin received in such redemption are aligned with their basis and holding period in the Trust’s bitcoin immediately before the redemption.

Overall, these changes emphasize a more detailed and nuanced approach to the taxation of different types of transactions shareholders might engage in with the Trust, reflecting a response to the evolving understanding of cryptocurrency taxation.

Additional Expenses Disclosure

A new section detailing the estimated costs associated with issuing and distributing the Shares, as outlined in the Prospectus, was filled in. This section, titled “Item 13. Other Expenses of Issuance and Distribution,” provides an overview of various fees and expenses, excluding underwriting commissions and discounts, that the registrant (Ark 21Shares Bitcoin Trust) expects to incur.

Significantly, the SEC registration fee is marked as “N/A,” with a note explaining that the exact amount is indeterminate at this stage. This is because the securities being registered have an unspecified quantity, and the fee will be determined under specific SEC rules.

The listing fee for the Shares is specified as an actual amount of $12,000. The estimated costs include $87,000 for auditor’s fees and expenses and a substantial $670,000 for legal fees and expenses. Printing expenses are estimated at around $168,000, and miscellaneous expenses amount to $13,000.

In total, the estimated expenses for issuing and distributing the Shares are projected to be $950,000. This inclusion gives potential investors and stakeholders a clearer picture of the financial obligations and costs that Ark 21Shares Bitcoin Trust anticipates concerning their ETF offering.

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