The Surprising – and Blatantly Obvious – Risk of the Winklevoss Bitcoin ETF

By Kyle Torpey Jan 8, 2015 6:45 AM EDT

NEW YORK (InsideBitcoins) — The upcoming bitcoin exchange-traded fund (NASDAQ: COIN) from the Winklevoss Twins has been one of the top stories in the industry for the past year, but the duo’s recent SEC filing could seem problematic to potential investors. According to their application in which they propose a sale of one million COIN shares on the NASDAQ, there will be no legal recourse for shareholders in a situation where the bitcoins backing the offering are lost or stolen.

“There is a risk that part or all of the Trust’s bitcoins could be lost, stolen or destroyed.”

 

If bitcoin’s short history has taught the world anything, it’s that trusting someone else to hold one’s bitcoins when they aren’t liable for any losses will usually end in disaster.

No insurance and no one to blame

Winklevoss bitcoinIn one particular section of the SEC filing for the Winklevoss Investment Trust, it is admitted that there will be nothing a shareholder can do if something happens to the bitcoins backing the ETF. A number of different risks related to the Trust are discussed in the section, Risk Factors Related to the Trust and The Shares, including problems related to a possible breach or exploitation of the Trust’s security system.

The irreversibility of bitcoin transactions is mentioned as a risk, and it is noted that this feature of bitcoin could become problematic if a mistake were made by one of the custodians of the Trust’s bitcoins:

“Although the Trust’s transfers of bitcoins will regularly be made to or from the Authorized Participant Custody Accounts, and to the Sponsor Custody Account and the Trust Expense Account (each of which are custodied and administered by the Custodian), it is possible that, through computer or human error, or through theft or criminal action, the Trust’s bitcoins could be transferred from the Trust Custody Account in incorrect amounts or to unauthorized third parties. To the extent that the Trust is unable to seek a corrective transaction with such third party or is incapable of identifying the third party which has received the Trust’s bitcoins through error or theft, the Trust will be unable to revert or otherwise recover incorrectly transferred Trust bitcoins. To the extent that the Trust is unable to seek redress for such error or theft, such loss could adversely affect an investment in the Shares.”

In other words, shareholders could be in trouble if another Mark Karpeles makes his way into the Winklevoss Investment Trust’s secure lair. A rather long description of many different accidents that could leave the Trust without any bitcoins was also included in this section of the document:

There is a risk that part or all of the Trust’s bitcoins could be lost, stolen or destroyed. The Sponsor believes that the Trust’s bitcoins held in the Trust Custody Account will be an appealing target to hackers or malware distributors seeking to destroy, damage or steal the Trust’s bitcoins. Although the Security System’s design includes various elements, such as redundancy, segregation and cold storage, to minimize the risk of loss, damage and theft, neither the Custodian nor the Sponsor can guarantee that the Security System will prevent such loss, damage or theft, whether caused intentionally, accidentally or by act of God. Access to the Trust’s bitcoins could also be restricted by natural events (such as an earthquake or flood) or human actions (such as a terrorist attack). Any of these events may adversely affect the operations of the Trust and, consequently, an investment in the Shares.

If the note about possible thefts or accidental losses leading to an adverse affect on an investment in shares of the Winklevoss Investment Trust was not enough to give people flashbacks to MtGox, the true reality of the situation was laid out rather clearly in the next section:

The Shareholders’ limited rights of legal recourse against the Trust, Trustee, Sponsor, Administrator, Trust Agency Service Provider and Custodian and the Trust’s lack of insurance protection expose the Trust and its Shareholders to the risk of loss of the Trust’s bitcoins for which no person is liable.

The Trust will not insure its bitcoins. The Custodian will maintain insurance with regard to its custodial business on such terms and conditions as it considers appropriate in connection with its custodial obligations and will be responsible for all costs, fees and expenses arising from the insurance policy or policies. The Trust will not be a beneficiary of any such insurance and does not have the ability to dictate the existence, nature or amount of coverage. Therefore, Shareholders cannot be assured that the Custodian will maintain adequate insurance or any insurance with respect to the bitcoins held by the Custodian on behalf of the Trust. Further, Shareholders’ recourse against the Trust, Custodian and Sponsor under [New York] law governing their custody operations is limited. Similarly, the Shareholders’ recourse against the Administrator and Trust Agency Service Provider for the services they provide to the Trust, including those relating to the provision of instructions relating to the movement of bitcoins, is limited. Consequently, a loss may be suffered with respect to the Trust’s bitcoins which is not covered by insurance and for which no person is liable in damages.

Trading comes with tradeoffs

As we’ve seen with the recent Bitstamp hack, trading comes with tradeoffs. Whether you’re talking about an ETF or a traditional bitcoin exchange, there’s always the chance the trusted party behind the exchange platform isn’t someone worthy of that trust.

Whether it’s malice or incompetence, keeping bitcoins in the hands of an exchange is still an issue in this young industry. Of course, the only individuals who have to depend on exchanges to hold their bitcoins are relatively-high frequency traders. If you’re someone who wants to trade bitcoin on a regular basis rather than hold or simply use it when you need it, then it’s important to remember the counterparty risk that is always at play in these sorts of situations.

Keep your private keys to yourself

One of the key aspects of bitcoin is that it allows individuals to take control over their own funds without the need to trust another third part with their money. And yet, there are still a large amount of users who are willing to trust an exchange or bitcoin bank with their coins. If you’re tired of having your money inflated, used for bailins, stolen, or censored, then keep your private keys to yourself.

You can follow @kyletorpey on Twitter.

Photo credit: NASDAQ.com

  • This appears to be people surprised that real companies do in fact have to list every possible fucking risk they can think of, up to and including aliens coming to visit. This is something they’re required to do. This is what passes for “investment reporting” in Satoshistan.

  • Nuno Edgar Fernandes

    I would say this to be a matter of risk/return trade-off. If you’re going to provide a probable high return trading strategy, at least disclosing the real risks is honest. To say the least…

  • HLTGRP

    Troll ^^^^

  • cryptoboy

    “Of course, the only individuals who have to depend on exchanges to hold their bitcoins are relatively-high frequency traders.”

    Not true. People who want to convert cash in their restricted retirement accounts would greatly benefit from such an ETF. It’s true you may be able to use a self-directed IRA and probably invest in something like BIT, but there is a $25K min investment, so most people won’t be willing or won’t be able to put that much.

  • Bitcoins and Gravy

    I should also add that since I joined the Bitcoin Community back in 2011 I have seen many signs of things to come. Overlooked as trivial by the average observer, these things are not lost on those of us who see through. For example, notice how Cameron sometimes ties a half (single) windsor and at other times he ties a full (double) windsor.
    Tyler, on the other hand, always ties a half windsor.

    There are signs of things to come . . .

  • Bitcoins and Gravy

    In simple terms, this is a set up. Yet another way to sully the name of bitcoin for the general public. There will be plenty of suckers who buy in and much crying and gnashing of teeth when these suckers lose their shirts. Twill be a veritable field day for talking heads world wide.

    I may have to change my opinion about the Winklevoss twins. I used to think of them as cute and cuddly. Now I think of them as homely and stone like.

  • It’s not that out of the ordinary for a commodity-based ETF, but the issue is that we’re talking about bitcoin — not gold or silver. I think many had the impression that this was going to be an insured bitcoin investment vehicle where shareholders can sleep easy at night, but it appears that the protections for shareholders are comparable to MtGox.

  • “Cold storage” was in quotations for a reason. The issue is not that it’s easy to get hacked or lose bitcoins. The issue is that it’s easy to get “hacked” or “lose” bitcoins.

  • I was referring to a rumor as well. Sorry if that wasn’t clear. They talk about how rumors could negatively impact COIN shares in their filing.

  • Matt Odell

    Mt. Gox didn’t practice true cold storage practices. Management there was either severely incompetent to the point of negligence or they were complicit in fraud. It very well could have been an inside job. Also the US Govt seized $5M of Gox funds that were held in a US bank account, that complicated everything and may have pushed them to do things they wouldn’t have done otherwise.

    Using tried and true multi-sig cold storage techniques with a proper chain of custody for the different keys, you can create a system that is extremely secure. I think it is misleading to make it seem like cold storage is not safe because “Gox had Cold Storage.”

  • votingmachine

    If they are going to back the COIN symbol with bitcoins they have to buy when there is demand pressure for the COIN fund and liquidate when there is selling pressure.

    Say bitcoin is stable, but the COIN is selling. The market price of of COIN falls lower than bitcoin. The fund should buy the COIN, and sell the bitcoin (making a small profit), and balancing the prices. Say there is COIN buying demand. The market price of COIN rises higher than bitcoin. The fund should sell COIN shares, and buy bitcoin (making a small profit) and balancing prices. The market expects that arbitrage, and also acts to equalize, but the fund has to have a bitcoin per COIN share. That implies that they will have a active bitcoin wallet.

    The fund SAYS investors should consider hacking. You are correct in saying they are not ignoring it, and that there are some pretty simple isolation procedures that common sense says to implement. You have to consider it. You can dismiss the risk as insignificant, or not. Generally people that dismiss risk are not the successful investors/speculators.

  • votingmachine

    I was more getting at the power of the rumor. It is possible to buy a DDoS attack … which would not affect the bitcoin balance, but would create the appearance of a bitcoin balance based hack. If no one can access the Winklevoss’ site, and there is a rumor of a bitcoin loss, then even though the hack is minor league DDoS, the money is made in a stock market position.

  • MtGox’s bitcoins were held in “cold storage” too.

  • MattMazz

    Not as dumb as people who don’t pay attention to the NUMEROUS high profile Bitcoin hacks that have happened in the past 4 weeks. But hey if you’re cool with all that, do you want to make an appointment to see my beachfront property in Arizona?

  • JLT

    what a dumb article, there bitcoin holdings are on a harddrive in a bank vault. they’re not online, or going to be transferred from the wallet they are in. the dumbest ppl that i have ever seen are some of the ppl that write bitcoin articles.

  • bitWhisky

    Just go buy/earn the real damn thing!

  • They actually included the rumor of insecure storage or a hack as another risk 🙂

  • votingmachine

    That makes it also a bit vulnerable to a rumor. A short-and-distort scheme could be run where you buy Puts, and sell calls, then buy a hack on the fund (ironically, using bitcoins to pay the hackers). The rumor of the hack spirals down the fund, then close the trade.

  • KleptoCoinsNews

    And if they do read and then become surprised by the risks, then they knew nothing about bitcoin.

  • KleptoCoinsNews

    Winklevoss twins can use bitcoins to pay for cloning themselves for all I could care.

  • Probably the majority of investors who don’t read SEC filings and prospectuses.

  • Elwar

    So surprising that they listed it as a risk in their filing. Who is supposed to be surprised?

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