The SEC has approved the creation and redemption mechanism for entities, leading to a massive supply contraction of $710 billion for Bitcoin ETFs.

On July 29, the U.S. Securities and Exchange Commission (SEC) approved the creation and redemption mechanism for Spot Bitcoin and Ether exchange-traded products (ETP), marking a significant shift in the structure framework of crypto assets investment vehicles. This decision replaces the pure cash model adopted by the first batch of cryptocurrency ETPs and aligns the regulatory framework for digital asset funds with existing standards for commodity ETPs such as gold. U.S. Securities and Exchange Commission (SEC) Chairman Paul S. Atkins, who took office this April, described this move as part of a broader effort to establish a "suitable" cryptocurrency framework.

Creation and Redemption of Physical Assets: Changing the Operating Model of Crypto ETPs

The SEC's order also advanced a series of ancillary approvals, including the hybrid BTC+ETH ETP applications, options for certain spot Bitcoin ETPs, and an increase in the position limits for these derivatives, up to a threshold of 250,000 contracts, which is common in traditional commodity markets. These changes aim to align the crypto assets derivatives ecosystem with the long-established physical asset ETP ecosystem. Previously, several exchanges submitted a series of applications in July, indicating that regulators are prepared to adopt the workflows for physical asset ETPs.

Unlike cash structures, in cash structures, authorized participants (APs) submit fiat currency and rely on fund agents to execute cryptocurrency purchases in the public market, while the physical mechanism allows APs to directly deliver or receive the underlying assets Bitcoin or Ethereum. This eliminates the need for fund-driven market transactions and enables participants to use existing procurement channels, such as over-the-counter (OTC) desks, internal inventories, or lending arrangements. The result is usually a reduction in transaction costs, a narrowing of bid-ask spreads, and enhanced asset net asset value (NAV) tracking, as established by commodity ETFs like SPDR Gold Shares.

How Physical Creation and Redemption Change the Model

This operational shift will reallocate primary market flow for APs focused on arbitrage. In the physical model, they can short the ETF when a premium occurs and directly acquire Crypto Assets for creation, or redeem ETF shares for Crypto Assets when a discount arises. This eliminates execution delays and basis risk associated with cash settlement, creating cleaner hedging opportunities using CME futures. Given that open contracts for CME Bitcoin derivative products are approaching historical highs in mid-2025, liquidity appears sufficient to support these changes.

The revised mechanism has also changed the way ETF fund flows interact with the Crypto Assets spot market. In the previous model, the buying or redeeming by the fund side would directly create buying/selling pressure on the exchange, which usually affected short-term price trends. Now, APs can fulfill their asset obligations through over-the-counter (OTC) channels, thereby reducing their market footprint and potentially lowering volatility on days with high trading volumes. This is similar to the gold market's practice of settling gold ETP trading flows through over-the-counter (OTC) networks, thereby alleviating pressure on public order books.

Open the door to massive capital inflows

As infrastructure matures, several indicators will reflect the SEC's decisions on the market. These indicators include the premium and discount behavior of ETFs relative to net asset value, the price spread between CME futures and spot prices, and the on-exchange depth indicators of major dollar trading venues. Analysts will focus on whether over-the-counter market activity increases on high creation days, as well as whether the liquidity of public exchanges becomes more resilient.

From a mechanical perspective, this transition may slightly reduce the direct impact of ETF capital flow on exchanges, thereby suppressing the short-term price effects of primary market activities. However, the broader implication is that this transition will enhance scalability. Lower costs, clearer arbitrage methods, and more refined hedging tools increase the attractiveness of this investment vehicle to institutional allocators. If these advantages translate into sustained net inflows, then the upward pressure on Bitcoin and Ethereum spot demand could be substantial.

The ETF flow data from early 2025 has already shown a strong correlation between net inflows and the price increase of Bitcoin. By simplifying fund operations, physical investment models have lowered the threshold for larger allocations and achieved more predictable pricing behavior. The increase in options and higher derivative product limits further supports institutional positioning, echoing how past access innovations have helped expand commodity positions.

Regulatory reforms have effectively modernized the infrastructure surrounding crypto ETPs. By allowing for the creation and redemption of physical assets, the SEC has created a pathway for demand to flow more efficiently into digital assets, thereby reducing friction without altering the fundamental principles: liquidity drives the market, while structure determines how much liquidity can enter the chain.

710 billion dollars of massive supply contraction potential

(Source: VettaFi)

Ultimately, Bitcoin ETFs must compete in scale with the largest asset management funds in the world, and physical creation and redemption are indispensable. The operational opportunities are immense, and the efficiency brought about by this transformation is crucial for attracting more capital.

In terms of asset management scale, the largest ETF is the Vanguard Group's S&P 500 Index ETF (VOO), which holds $714 billion. In contrast, the largest spot crypto assets ETF is BlackRock's (IBIT), currently holding $86 billion.

Can the creation and redemption of physical assets allow Bitcoin ETFs to develop to a level comparable to the $700 billion scale of VOO? This requires the scale of Bitcoin ETFs to achieve a tenfold explosive growth on the current basis, but if Bitcoin continues to rise against the dollar, who knows what will happen next? With a Bitcoin price of $200,000, even without the next dollar inflow, IBIT has already entered the top ten ETFs by asset size. If the capital inflow continues in the coming years while BTC prices keep rising, then supply tightening is almost inevitable.

Conclusion:

The SEC's approval of the physical creation and redemption mechanism for Crypto Assets ETPs is a milestone in the cryptocurrency market. This reform will not only enhance the efficiency of Bitcoin and Ethereum ETFs and reduce costs, but it will also open the door for large-scale institutional capital inflows, potentially triggering a massive supply contraction of up to $710 billion, thereby reshaping the landscape of the cryptocurrency market.