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Beware of Bitcoin ETF: Winklevoss Plan Raises Big Questions


Cameron and Tyler Winklevoss are going deeper into the Bitcoin business. Still best known for their alleged role in the creation of Facebook (FB), late yesterday the twins filed a proposal with the Securities and Exchange Commission that would allow them to create and market an exchange-traded fund -or ETF- that would enable individuals to invest in and trade Bitcoins as if they were stocks.

Conventional ETFs are investment vehicles that own "baskets" of different assets, usually stocks, that trade in one proportional share. For example the SPDR S&P 500 (SPY) ETF allows an investor to own the entire S&P 500 without having to buy shares of 500 different companies.

It's nearly impossible to project how much money the Winklevoss twins could make from this venture. They stand to profit in two ways. First they will take an unspecified percent of every transaction as a fee for their proprietary system of storing Bitcoins. The other way they could profit is through the increase in value of the Bitcoins they already hold. Recently the Winklevoss brothers were said to own roughly 1% or $10 million worth of the virtual currency.

If the SEC approves the Winklevoss' request each share of their ETF would be worth one-fifth of a bitcoin. It would operate like a conventional ETF. For example, the SPDR Gold Shares ETF (GLD) tracks the price of gold bullion and holds physical gold based on the amount of deposits. The Winklevoss twins would back each share sold by acquiring the underlying asset. In other words, for every five shares of a Bitcoin ETF sold, the Winklevoss Bitcoin Trust would be forced to purchase one bitcoin.

If you haven't heard of Bitcoins you're not alone. They are a digital form of currency used for largely anonymous online purchases. The value of each Bitcoin is determined entirely by the marketplace. If one of the few vendors willing to accept Bitcoins as payment is willing to take a Bitcoin transfer as payment for good worth $100 in the open market, that's what the coin is worth.

The key difference between the GLD ETF and the Winklevoss' product is that bitcoins only exist in digital form. The Winklevosses claim to have a proprietary method for storing their bitcoin holdings. The Winklevoss Bitcoin Trust would change an unspecified management fee for the maintenance of this virtual storage.

Count investor Zachary Karabell, president of River Twice Research, as a skeptic. "Launching a Bitcoin ETF raises so many questions it's hard to know where to go into this discussion," he says. "This has speculative instrument for frenetic day traders written all over it."Among the laundry list of other risk factors is the staggering volatility and shady nature of the bitcoin market. The largest exchange for bitcoin trading is a Tokyo-based company called Mt.Gox.

On its website Mt.Gox describes itself as "as one of the oldest and most established bitcoin businesses in operation today, Mt.Gox K.K. has developed a reputation based on reliability and stability, allowing users to trade with confidence." The claim says more about the Wild West nature of digital currency than it does about the stability of Mt.Gox. Though Mt.Gox recently filed with the Treasury Department to register itself as a money services business, questions remain about the reliability of the exchange and the identity of the traders using it.

So far bitcoins are most famous for wild volatility. In the last year the value of each coin has fluctuated between $13 and $266 and were recently quoted at roughly $90 each.

Of course as with all things having to do with Bitcoins, the value is strictly theoretical. As the Winklevoss filing notes "currently, there is relatively small use of Bitcoins in the retail and commercial marketplace in comparison to relatively large use by speculators." What that means in English is that it's extremely difficult to actually spend a Bitcoin until it's converted into a conventional currency. They don't act as a substitute for physical money. They are just a barrier between you and your cash.

Imagine every dollar in your wallet being worth anywhere from $13 to $266 depending on what an anonymous trader decides at any given moment. While the premise of Bitcoin and all digital currencies is that they are free from the manipulation of Central Banks that's only partially true. All digital currencies do is swap out groups like the Federal Reserve or Bank of Japan and replace them with whomever it is that's in charge of the manufacturing Bitcoins themselves.

Who is that central banker in control of the Bitcoin supply? No one knows. Here's how it's explained in the regulatory S-1 filing:

"Satoshi Nakamoto is considered to be the creator of Bitcoins and the Bitcoin Network; however, no individual with that actual name has been publicly identified as the Bitcoin Network’s creator, and the general consensus is that the name is a pseudonym for the actual inventor or inventors."

The bottom line is that the Winklevoss twins are trying to create an ETF that makes money by charging investors for the right to have fractional ownership of an imaginary currency controlled by one or more people no one has ever met.

Investors are encouraged to do their own homework on Bitcoin ETFs just as they would any other investment. But not going anywhere near Bitcoins or a Bitcoin ETF derivative is as easy as investment decisions get.

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