Wall Street’s top watchdog has poured cold water on the prospect of bitcoin exchange-traded funds, questioning whether such volatile products could comply with rules designed to protect the average investor. 

The Securities and Exchange Commission penned a letter to two Wall Street trade groups whose members believe there is money to be made from selling exposure to bitcoin and other crypto-currencies through tracker and mutual funds. The regulator questioned how bitcoin’s volatility - showcased this week when it suffered a more than 50 per cent pullback from its all-time high of over $20,000 last month - and illiquidity would gel with funds that must calculate a fair market price for their portfolio at the end of the trading day and allow investors to cash out their shares.

“Until the questions identified above can be addressed satisfactorily, we do not believe that it is appropriate for fund sponsors to initiate registration of funds that intend to invest substantially in crypto-currency and related products,” Dalia Blass, the SEC’s director of investment management wrote in the letter made public Thursday.

The letter contained a list of questions that ETF and mutual fund providers would need to answer in order to get the green light from the regulator. 

But it warned them not to seek out loopholes that could enable them to offer new products that track bitcoin or its future contracts. 

Under US law, mutual fund companies with existing regulatory approvals are allowed to introduce new funds with minimal oversight. However, the SEC said it would not be happy if that avenue was explored in an attempt to roll out bitcoin ETFs.

Last year, the SEC rejected two bitcoin ETFs - including one from Cameron and Tyler Winklevoss, the twins who sued Facebook founder Mark Zuckerber and are now said to be bitcoin billionaires - which sought to directly own the crypto-currency, and argued that  the market was too opaque to support sufficient oversight. 

The regulator’s latest notion follows a fierce bout of turbulence in the global crypto-currency market, which earlier this week dropped by more than $300 billion in value as fears of an escalated regulatory crackdown in China sparked a mass sell-off. 

Many had hoped that the SEC would be more open to the idea of bitcoin ETFs given that late last year two Chicago exchanges, CME Group and CBOE, launched bitcoin futures contracts. These, however, are regulated by the Commodity Futures Trading Commission, a smaller agency whose rules allow for new products to be marketed more easily. 

But in this instance, it looks like it is back to the drawing board.

Regulate, don't rule out
Meanwhile, Sheila Bair, former chair of the Federal Deposit Insurance Corporation , has said that crypto-currencies should be more tightly monitored but stopped short of suggesting they should be banned.

"It's something regulators need to deal with but not ban," Bair told CNBC on Thursday. Bair, who said she does not own any bitcoin, now serves as a board member for Paxos, a financial firm developing blockchain technology for crypto-currency.

"I think some additional regulation would be good, and I argue for that," she said. "Especially on anti-money laundering laws, where I think there are a lot of concerns over use of bitcoin or other digital currencies."

Her comments contrast those made by Pan Gongsheng, vice governor of the People’s Bank of China, the nation’s central bank, who earlier this week said authorities should block Chinese access to all exchanges facilitating the trade of fiat money for crypto-currencies. China has already shut down its domestic crypto-currency exchanges and imposed restrictions on “mining”, the process of generating new digital coins.

"Pseudo-financial innovations that have no relationship with the real economy should not be supported," Pan said in an internal memo.