Why The SEC’s Stance On Bitcoin ETFs May Need To Change

On November 12, 2021 the SEC rejected a bitcoin exchange-traded fund (ETF) proposed by Van Eck Associates Corporation (“VanEck”) that would have directly tracked bitcoin’s spot price movements.

On March 1, 2021, Cboe BZX Exchange, Inc. filed with the SEC pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 and Rule 19b-4 thereunder, a proposed rule change to list and trade shares of the VanEck Bitcoin Trust under BZX Rule 14.11(e)(4), Commodity-Based Trust Shares. The proposed rule change was published for comment in the Federal Register on March 19, 2021. If approved, it would have become the first spot bitcoin ETF approved in the U.S.

However, the proposed rule change was rejected by the SEC earlier this month, an unsurprising outcome even in light of the regulator greenlighting three futures-based ETFs, including one from Van Eck. 

In the rejection, the SEC said Cboe had not met its burden under the Exchange Act and the Commission’s Rules of Practice to demonstrate that its proposal is consistent with the requirements of Exchange Act Section 6(b)(5), in particular, the requirement that the rules of a national securities exchange be “designed to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” 

This justification has been repeatedly used by the regulator in past rejections, but in light of futures ETFs being allowed to trade, it now seemed contradictory to many.

Key Actors

• Elizabeth Warren, United States Senator

• Gary Gensler, Chairman of the SEC
• Hester Peirce, Commissioner SEC
• Chris Giancarlo, Former Chairman of the CFTC
• Craig Salm, Head of Legal at Grayscale
• Gabor Gurbacs, Director, Digital Asset Strategy at VanEck
• Dave Abner, Global Head of Business Development at Gemini

Broader Context

An ETF is an investment vehicle that tracks the performance of a particular asset or group of assets. ETFs allow investors to efficiently diversify their portfolios without directly owning the assets. This feature is especially relevant to cryptocurrency, where many more conservative investors worry about the risks and challenges that come with buying and holding assets such as bitcoin themselves. 

The first rule filing proposing to list an exchange-traded product tracking bitcoin in the U.S. was submitted by the cryptocurrency exchange Gemini, operated by brothers Tyler and Cameron Winklevoss, on June 30, 2016. This proposal was rejected by the Commission. 

The SEC’s reason for rejecting the Winklevoss ETF and more subsequent applications has been rooted in the Commission’s concerns over fraud and manipulation in the bitcoin market. The SEC states on their website that the Commision “strives to promote a market environment that is worthy of the public’s trust and characterized by transparency and integrity” and its mission “is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation.” 

But should the SEC be restrictive of a free market and is their way of regulating really protecting consumers? In an interview at a CryptoConnect Event in Miami two weeks ago, SEC Commissioner Hester Peirce described a different role of the SEC, saying  “[f]rom my perspective, the SEC’s role is a disclosure role. To help people get the information they need to make decisions for themselves.”

There are many other spot ETF applications still in front of the SEC, and they risk receiving the same fate unless the SEC’s concerns are mollified or some other legal argument can prevail.

Approving a physical Bitcoin ETF would arguably offer better protections than what’s available on the markets today.”

– Gabor Gurbacs, Director, Digital Asset Strategy at VanEck

How Bitcoin Futures Products Made It Through 

There are some key differences between how futures and spot-based ETFs operate that are worth keeping in mind. 

First, while the bitcoin futures products needed final approval from the SEC, a lot of the leg work was done by one of its sister agencies, the Commodity Futures Trading Commission (CFTC), which has a different remit than the SEC. Former CFTC Chairman Chris Giancarlo told me, “The SEC oversees people’s retirements, and pensions, investments that go into retail investors’ savings. This is different from the CFTC’s focus on orderly and well-functioning markets, as the marketplaces overseen by the CFTC are primarily institutional, with not a lot of retail participation.” As a result, when it came to the launch of bitcoin futures, it was a matter of the exchanges certifying to the CFTC that in their judgment, bitcoin futures, as opposed to the underlying market, were not readily susceptible to manipulation. There was no requirement that there be a certification that the underlying spot markets were free of fraud and manipulation.”

This doesn’t mean the CFTC has not scrutinized the cryptocurrency space, or stepped in when necessary. For instance, in September 2021, the CFTC announced 14 complaints against various crypto trading platforms. But the exchanges themselves have much more authority to approve new products than SEC-regulated counterparts. 

Still, when the SEC finally approved the first futures-based bitcoin ETFs in early October 2021, including ProShares Bitcoin Strategy ETF and the Valkyrie Bitcoin Strategy ETF, it likely did so relying on the CFTC’s satisfaction that the methodologies used by the CME were satisfactory to minimize the ability to readily manipulate the futures markets. It is also worth noting that Gary Gensler was formerly Chairman of the CFTC.

Spot applicants are now stepping up the pressure on the SEC. On October 19, 2021, before the VanEck rejection, Grayscale Investments, the world’s largest digital currency asset manager, filed with the SEC to convert its Grayscale Bitcoin Trust (GBTC) into a bitcoin spot ETF. Yesterday attorneys at Davis Polk also sent a letter to the SEC arguing that approval of Bitcoin futures-based ETFs, but not Bitcoin spot-based ETFs like GBTC is “arbitrary and capricious” and therefore in violation of the Administrative Procedure Act (APA). The APA requires the SEC to treat like situations alike absent a reasonable basis for different treatment. This means the SEC must treat similarly situated investment products similarly. This is a new argument in the context of Bitcoin ETFs that wasn’t possible until the SEC approved the latest futures-based ETF but then rejected yet another spot-based ETF (VanEck).

“Grayscale is strongly of the belief that if the SEC is ok with futures based Bitcoin ETFs, then logically, they have to also be okay with a Bitcoin ETF. “The reason being, the issue with an ETF, whether futures or spot, has always been what the SEC believes is the potential for fraud and manipulation in the underlying spot market. The futures market uses the same Bitcoin marketplaces for pricing the underlying assets. And so, to the extent you think there is any fraud and manipulation happening on the spot Bitcoin market, that would impact the SEC’s approval for both futures and spot Bitcoin ETFs.”

– Craig Salm, Head of Legal at Grayscale

Are Concerns of Fraud and Manipulation Justified?

But here is where things get confusing. The CME relies on reference rates provided by regulated spot exchanges such as Coinbase and Kraken to price the futures contracts on which the futures ETFs are based. It is a very sophisticated process that adds to the reliability and resiliency of the data. 

During my discussion with Giancarlo, he explained, “These futures exchanges don’t just take the closing price from spot trading platforms. In fact, they don’t take the closing price at all. They take price data at different six minute intervals during the trading day, somewhere around 10 different times per day and then they create an aggregate reference price which really minimizes the possibility that Bitcoin futures are readily susceptible to manipulation. As a result, the CFTC felt comfortable with the exchanges’ self-certifications.”

That said, the spot market on the other hand is more decentralized and includes the same regulated exchanges but also may include less regulated exchanges in the pricing methodology. It has seen major liquidation events. This may be where the SEC sees the distinction between the two products. 

Other Potential Reasons for Delays

Additionally, some of the SEC’s concerns on price manipulation may stem from reports that Bitfinex used the “stablecoin” Tether to allegedly drive up the price of cryptocurrency in 2017 and 2018. A study conducted by John M. Griffin from the University of Texas at Austin – Department of Finance and Amin Shams from Ohio State University, Fisher College of Business reviewed the period between March 2017 and March 2018, when the price of bitcoin soared and its total market value rose to $326 billion. They claim about half of that increase was due to the influence of a manipulation scheme. 

Gary Gensler has said that some stablecoins, which may invest in corporate bonds and other assets, look similar to money-market mutual funds and should fall under SEC purview. The Treasury Department and other agencies recently specified that the SEC has significant authority over stablecoins like Tether.

In February, Tether settled with the New York Attorney General over allegations that it lied about the reserves backing the coin. The CFTC earlier this month ordered Tether to pay $41 million over similar claims. The SEC is reportedly also investigating various other stablecoin projects.

There may also be political reasons at play. In July of this year, Senator Elizabeth Warren, a long time skeptic of cryptocurrency, asked the SEC to take a closer look at cryptocurrency exchanges. In a July 7, 2021 letter, Warren asked SEC Chairman Gary Gensler to explain if cryptocurrency exchanges operate in a safe and efficient manner, and what regulatory action might be necessary to protect investors.

“While demand for cryptocurrencies and the use of cryptocurrency exchanges have skyrocketed, the lack of common-sense regulations has left ordinary investors at the mercy of manipulators and fraudsters…These regulatory gaps endanger consumers and investors and undermine the safety of our financial markets. The SEC must use its full authority to address these risks, and Congress must also step up to close these regulatory gaps and ensure that every investor has access to a safe cryptocurrency marketplace.”

Foreign Spot ETFs Have Run Smoothly

Another reason for frustration is the fact that many international spot cryptocurrency ETFs, including many digital assets beyond bitcoin, have been operating without incident for months or years. Earlier this year, Canadian regulators approved ETFs that hold bitcoin directly. The first one launched in February from Purpose Investments on the Toronto Stock Exchange, trading under the ticker symbol BTCC.B, which currently has 1.714B assets under management.

Gurbacs noted to me, “The vast majority of established jurisdictions in Europe, Canada, Brazil and other nations approved physical Bitcoin ETFs and tens of millions of Americans own cryptocurrencies on trading platforms.” 

Dave Abner, Global Head of Business Development at Gemini expressed similar frustration, “ As evidenced by similar funds in other jurisdictions, the model provides investors with a wrapped solution for bitcoin that works like other traditional investment products and provides returns that are completely in sync with the underlying assets. Physical ETFs have already proven to do a great job at removing performance issues with other types of products like CEFs and Futures based funds.”

However, there are differences between the US and other countries that may explain the US’s delay. For instance the Ontario Securities Commission (OSC), in approving or disapproving an ETF, the burden is on the OSC to explain why it would not be in the public interest to approve a product like a bitcoin ETF, not on the applicant. Whereas in the US, the burden is on the issuer to prove why the regulator should approve or disapprove the application.

“The approval of a spot bitcoin ETF in the US is no longer about market maturity. Approving the futures strategy funds is an endorsement of Crypto as an investable asset class.”

– Dave Abner, Global Head of Business Development at Gemini

Outlook

Despite these ongoing challenges many are still optimistic that a spot bitcoin ETF approval will come mid to late 2022. Projects are continuing to have discussions with the SEC about best practices to prevent any market manipulation or fraud. 

Craig Salm, Head of Legal at Grayscale, shared similar sentiment and explained, “During our engagements, the SEC has asked questions pertaining to Grayscale becoming a spot bitcoin ETF. The Commission is asking things like how does the index methodology work? What types of exchanges are included in there? What discretion does the index provider have? How has Grayscale’s pricing worked over the last couple of years? And these are all questions that they can only ask us because we have an actual operating investment vehicle. From those conversations, I have seen them in real time becoming more familiarized and comfortable with the spot-based products.”

A Bitcoin ETF approval will open the door for more conservative investors, and this will have a positive impact on the industry as a whole and the price of bitcoin.