By: Paul Coste
The Securities and Exchange Commission (SEC) has been denying applications for spot bitcoin exchange-traded funds (ETFs) since the Winklevoss twins’ first application in 2017, consistently reasoning that the products are not “designed to prevent fraudulent and manipulative acts and practices,” which is required by the Exchange Act. However, the agency does not offer much beyond that as an explanation for why the products do not meet the standard of approval. On Tuesday, August 29, a three-judge panel in the United States Court of Appeals for the District of Columbia Circuit held that the SEC had wrongly denied Grayscale’s proposal for a spot bitcoin ETF in June 2022, because the agency had failed to adequately explain why it had approved bitcoin futures ETFs, a product that was “materially similar” across relevant regulatory factors.
Exchange-traded funds are regulated financial products that can represent a wide range of assets that investors can purchase and sell shares of, similar to stocks. A bitcoin futures ETF is underpinned by bitcoin futures contracts, a type of derivative trading instrument where two parties enter into a contract agreeing to buy or sell bitcoin at a specific price on a specific date in the future. The price of bitcoin futures and the market price of bitcoin can diverge based on the sentiment of futures traders. For example, if traders feel that the price of bitcoin will rise, futures contract prices will tend to be higher than the market price of bitcoin. The first bitcoin futures ETF approved by the SEC began trading on October 19, 2021. Both spot bitcoin ETFs and bitcoin futures ETFs track the price of bitcoin, but because spot bitcoin ETFs are backed by real bitcoin, while bitcoin futures ETFs are backed by derivatives of bitcoin, spot bitcoin ETFs follow the price of real bitcoin more closely. Despite this slight difference, the two products are 99.9% correlated in price.
To get a new product listed for trading, securities exchanges generally must file a rule change with the SEC. The agency reviews new rules on a case-by-case basis and will approve a new rule if it is consistent with Exchange Act and SEC regulation requirements. Under the Exchange Act, rules of an exchange must be “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination …, to remove impediments to… a free and open market…, and, in general, to protect investors and the public interest”.
The SEC has consistently cited failure to meet the “designed to prevent fraudulent and manipulative acts and practices” requirement of the Exchange Act as their reason for denying applications to list bitcoin related products on exchanges, specifically finding that protections built into bitcoin, such as the blockchain and size and liquidity of the bitcoin market, alone were insufficient to prevent fraud. The agency would require a surveillance sharing agreement with a related and regulated market of significant size. In early 2022, the SEC found two bitcoin futures ETFs to satisfy their significant market test because both products’ listing exchange had a surveillance sharing agreement with the Chicago Mercantile Exchange (CME). Both products were approved.
Grayscale, an asset management firm owning 3.4 percent of outstanding bitcoins worth around $16 billion, later proposed that their spot bitcoin ETF be set up with a similar surveillance agreement. When the SEC denied Grayscale’s proposal for a spot Bitcoin ETF product in June 2022, Grayscale petitioned the D.C. Court of Appeals, arguing that the SEC’s decision was “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law” and in violation of The Administrative Procedure Act. The court ultimately determined that Grayscale had put forth sufficient evidence to show that their proposed spot bitcoin ETF and the already approved bitcoin futures ETFs were materially similar. The court of appeals’ holding that the SEC’s denial of Grayscale’s proposal was wrong did not mean that Grayscale’s ETF was automatically approved. The decision requires the SEC to review the proposal and leaves them with a few options.
Option 1: The SEC could choose to appeal, which would trigger a review by the entire appeals court or by the Supreme Court.
Option 2: The SEC could again reject Grayscale’s proposal but for different or more specific reasons.
Option 3: The SEC could try to roll back its approval of bitcoin futures ETFs to combat the argument that they are treating similar products differently.
Option 4: The SEC could approve Grayscale’s proposal for a spot bitcoin ETF.
The SEC has until Mid-October to make a decision. Policy analysts believe that it is unlikely that the SEC will appeal to the Supreme Court, “given how conservatives on the court have repeatedly limited agency discretion”. It is also unlikely that the SEC would try to roll back the approval of bitcoin futures ETFs, as there are already hundreds of millions of dollars invested in the products. The path of least resistance for the SEC would be to approve Grayscale’s spot bitcoin ETF.
The fact of the matter is that the court of appeals in this decision has essentially expressed support for Grayscale’s argument that their proposed bitcoin ETF is “materially similar” to the approved bitcoin futures ETFs because the underlying assets are 99.9% correlated and because the surveillance sharing agreements with the CME are “identical and should have the same likelihood of detecting fraudulent or manipulative conduct in the market for bitcoin.” They do not have a reason to move off this endorsement unless the SEC is able to explain how the difference in the underlying asset being real bitcoin rather than bitcoin futures makes it more difficult for the CME surveillance agreement to detect fraud.
After a yearlong onslaught of enforcement actions and lawsuits following the high-profile collapses of cryptocurrency entities such as FTX and Terra/LUNA, it seems the SEC has suffered a major setback in regulating the cryptocurrency industry. Upon the approval of Grayscale’s spot bitcoin ETF, a roadmap would essentially be provided for the several already pending proposals for similar products from some notable large asset management firms, including BlackRock, Fidelity, WisdomTree, VanEck, Bitwise and Invesco. Further down the road, it is not unreasonable to expect similar spot ETF products in other cryptocurrencies, such as Ethereum. An approval of Grayscale’s spot bitcoin ETF would allow investors to get exposure to the world’s largest cryptocurrency without having to own it, ultimately opening the door for wider mainstream acceptance of digital assets. The battle the cryptocurrency industry has been fighting with the SEC seems to be taking a massive turn in the industry’s favor.
Student Bio: Paul Coste is a second-year law student at Suffolk University Law School and staff writer on the Journal of High Technology Law. Paul received a Bachelor of Science in Economics from Northeastern University.
Disclaimer: The views expressed in this blog are the views of the author alone and do not represent the views of JHTL or Suffolk University Law School.
