Vomiting frogs and other ‘dust’ prove vexing for US bitcoin ETFs

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US exchange traded funds that invest directly in bitcoin are building up stores of digital assets they did not buy and cannot sell after inadvertently receiving them as “gifts” attached to their cryptocurrency purchases.

Digital artworks of frogs vomiting rainbows and other cartoonish imagery have shown up in bitcoin wallets run by ETF providers, including Cathie Wood’s Ark Investment Management and Bitwise Asset Management, according to analysis from blockchain analytics group Arkham Intelligence and a review of their holdings by the Financial Times. Arkham says it has also tracked more than $20,000 worth of non-bitcoin tokens that have made their way to wallets associated with BlackRock’s bitcoin ETF.

The unexpected virtual arrivals have been embedded in previous cryptocurrency transactions — akin to stapling a cheque to a banknote — and sold by past owners. Cryptocurrency trades handled via blockchain, by design, cannot be reversed, potentially handing the funds a small windfall.

However, the funds are unable to cash in on their fortune because the bitcoin ETF managers would need regulatory approval to sell the bonus virtual assets, known colloquially as “dust”, to avoid falling foul of tax regulations. The Securities and Exchange Commission, which greenlit the first spot bitcoin ETFs in January, has not granted that approval.

“These are just weird crypto artefacts that legacy SEC structures and legacy tax structures were not designed to accommodate,” said Joe Hall, an attorney with the Davis Polk law firm.

US spot bitcoin ETFs have hoovered up more than 500,000 bitcoin since their long-awaited launch in January, which means the issue of “dust” has been growing.

Many of the gifts have been made possible by the creation of types of tokens that allow text and images to be embedded into bitcoin, creating bitcoin NFTs (non-fungible tokens).

A review by the FT of Bitwise’s bitcoin ETF wallets found that some of them appear to hold assets other than bitcoin, such as a images of a frog vomiting a rainbow and a figure in a cartoon spaceship as well as a rare sliver of cryptocurrency that once belonged to American computer scientist Hal Finney, the first recipient of bitcoin after its pseudonymous creator, Satoshi Nakamoto.

“Dust” swept up into ETF digital vaults includes a “Bitcoin Puppet” NFT, which found its way into an Ark ETF wallet in March, according to Arkham.

This artwork — which features a “puppet” sporting a bucket hat, smoking a pink pipe and holding a sign with the words “Runnin’ Bitcoin” — was worth about $20,000 as of Friday, according to cryptocurrency data site CoinGecko. Bitwise noted that a similar NFT that found its way into one of its wallets appeared to be a fraudulent replica.

The bitcoin NFT’s original owner appears to have spent it by mistake in February, and several transactions later, the piece of bitcoin was acquired by Ark’s ETF through normal fund operations, according to a person familiar with Arkham’s analysis. 

Ark did not respond to multiple requests for comment about the Bitcoin Puppet.

Bitwise in late January took the unusual step of deciding to provide the blockchain addresses of the digital wallets that hold the fund’s bitcoin. Although it cannot prevent the accumulation of unwanted digital assets, it “can keep an eye on [the assets] for any future potential value there that we may or may not be able to realise for shareholders down the line”, said Katherine Dowling, general counsel for Bitwise.

Coinbase, which serves as custodian for many of the bitcoin ETFs, including Bitwise’s, noted that it “will always encourage clients to keep their wallet addresses private”.

Bitcoin ETF issuers have put in place policies to keep “dust” at arm’s length, regulatory filings show. Selling these sorts of assets could imperil the ETFs’ legal status, forcing investors to file more complicated tax paperwork.

That would make the ETF “significantly less attractive to investors”, said Jay Laurila, an accountant at Cohen and Co who specialises in tax work for ETFs. Such an outcome could “kill the product”, Hall said.

To avoid that, BlackRock’s bitcoin ETF — which last month became the fastest ETF to amass $10bn in assets — has a policy of forfeiting unexpected virtual assets, placing them in a separate wallet where they could stay in perpetuity or be donated to charity, according to a person familiar with the ETF’s handling of the unsolicited crypto gifts.

The SEC did not respond to a request for comment about best practices for bitcoin ETFs.