The bitcoin exchange-traded fund saga entered a new, more contentious, phase Wednesday after Grayscale sued the Securities and Exchange Commission over its decision to block the company’s potential bitcoin ETF.
Hours after the ruling to halt the conversion of the Grayscale Bitcoin Trust (GBTC), the company filed a lawsuit through Donald Verrilli, a former U.S. solicitor general, whom the company hired earlier this month.
The lawsuit alleges the regulator failed to apply consistent treatment to investment vehicles, and arbitrarily blocked the company’s conversion, according to documents filed in the United States Court of Appeals for the D.C. Circuit.
That Grayscale had hired a high-powered lawyer weeks ago suggests the firm likely anticipated the SEC’s rejection. For more than eight years, the SEC has been blocking bitcoin ETFs from listing in the U.S.—not just from Grayscale, but from several other firms as well.
The first attempt to bring a bitcoin ETF to the U.S. was made in 2013; it was rejected. Dozens of other would-be bitcoin ETF issuers have tried to do the same thing and met with the same result.
The SEC finally allowed bitcoin futures ETFs to list late last year, followed by an inverse bitcoin futures ETF earlier this month.
Following the decision, the SEC is still not ready to approve a spot bitcoin ETF—one that holds actual bitcoin rather than futures contracts, which are agreements to buy and sell bitcoin on some future date.
Fraud & Manipulation
The SEC claims the spot bitcoin market is susceptible to fraudulent and manipulative acts, including wash trading, manipulations from large owners of bitcoin; hacking of bitcoin trading platforms; and trading based on material nonpublic information.
Grayscale took issue with this.
“The SEC is failing to apply consistent treatment to Bitcoin investment vehicles as evidenced by its denial of GBTC’s application for conversion to a spot ETF, but approval of several Bitcoin futures ETFs. If regulators are comfortable with ETFs that hold derivatives of a given asset, they should logically be comfortable with ETFs that hold that same asset.”
In its decision, the SEC said the bitcoin futures market and the spot bitcoin market were, in fact, different markets, one prone to manipulation and the other operated by the highly regulated Chicago Mercantile Exchange.
The SEC also said the spot bitcoin market and the bitcoin futures market weren’t as closely linked as Grayscale argues they are:
“The [bitcoin reference rate] is a once-a-day reference rate of the U.S. dollar price of one bitcoin as of 4 p.m., London time. The BRR aggregates the trade flow of its constituent spot bitcoin platforms—Coinbase, Gemini, LMAX Digital, itBit, Kraken, and Bitstamp215—during a specific one-hour calculation window.”
“While the BRR is used to value the final cash settlement of CME bitcoin futures contracts, it is not generally used for daily cash settlement of such contracts, nor is it claimed to be used for any intra-day trading of such contracts. In addition, CME bitcoin futures ETFs/ETPs do not hold their CME bitcoin futures contracts to final cash settlement; rather, the contracts are rolled prior to their settlement dates. Moreover, the shares of CME bitcoin futures ETFs/ETPs trade in secondary markets, and there is no evidence in the record for this filing that such intra-day, secondary market trading prices are determined by the BRR.”
“The Commission approved the listing and trading of such CME bitcoin futures ETPs, not because of the BRR, but because the Commission found that the listing exchanges satisfy the requirement pertaining to a surveillance-sharing agreement with a regulated market of significant size related to the underlying bitcoin assets—which for such ETPs are CME bitcoin futures contracts, not spot bitcoin.”
Unlocking Shareholder Value
The SEC was also unmoved by Grayscale’s argument that a spot bitcoin ETF was simply a better product than those already on the market, and that converting GBTC into an ETF would help investors realize billions of dollars of value.
Grayscale wrote: “Converting GBTC to a spot Bitcoin ETF would have brought the world’s largest Bitcoin fund further into the U.S. regulatory perimeter and provided U.S. investors access to Bitcoin through the familiar protections of an ETF wrapper. As of June 29, 2022, GBTC shares traded at an approximately 30% discount to NAV, representing ~$8 billion of unrealized shareholder value. We hold firm in our belief that converting GBTC to a spot Bitcoin ETF remains the best option for investors: it would effectively eliminate the discount and cause the shares to track the price of Bitcoin.”
The SEC countered that even if a spot bitcoin ETF would be a much better product than a bitcoin futures ETF or GBTC in its current over-the-counter, closed-end form, its rule prevented it from approving a spot bitcoin ETF because of the fraud and manipulation concerns:
“Even if it were true that, compared to trading in unregulated spot bitcoin markets or OTC bitcoin funds, trading a spot bitcoin-based ETP on a national securities exchange could provide some additional protection to investors, or that the Shares would provide more efficient exposure to bitcoin than other products on the market such as bitcoin futures ETPs, or that approval of a spot bitcoin ETP could enhance competition or strengthen the underlying spot bitcoin and derivatives markets, the Commission must consider this potential benefit in the broader context of whether the proposal meets each of the applicable requirements of the Exchange Act.”
“Under Section 6(b)(5) that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices—and it must disapprove the filing if it does not make such a finding. Thus, even if a proposed rule change purports to protect investors from a particular type of investment risk—such as experiencing a potentially high premium/discount by investing in an OTC bitcoin fund or roll costs by investing in bitcoin futures ETPs—or purports to provide benefits to investors and the public interest—such as enhancing competition and bolstering resiliency in the underlying commodity or futures markets—the proposed rule change may still fail to meet the requirements under the Exchange Act.”
The Way Forward
According to the SEC, the only way it would finally greenlight a spot bitcoin ETF would be for the listing exchange—in this case NYSE Arca—to enter a surveillance sharing agreement with a “significant market,” such as a large, regulated crypto exchange.
“The Commission’s focus has been consistently on whether the listing exchange has a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying bitcoin assets of the ETP under consideration, so that it would have the necessary ability to detect and deter manipulative activity.”
“…NYSE Arca has not established that it has a comprehensive surveillance-sharing agreement with a regulated market of significant size related to spot bitcoin, the underlying bitcoin assets that would be held by the Trust.”
The SEC said the hallmarks of a good surveillance agreement include the sharing of information about market trading activity, clearing activity and customer identity.
Given the ethos of crypto—which values privacy and anonymity—that may be a tough hill to climb.
Grayscale Strikes Back
For its part, Grayscale thinks the SEC is acting in an inconsistent manner and is hurting investors by not allowing it to convert its flawed product into a much better product, where premiums and discounts can be instantly arbitraged away.
Currently, GBTC trades at a massive 30% discount to the value of its underlying bitcoin holdings.
“At Grayscale, we have not and will not waver in our commitment to converting GBTC to a spot Bitcoin ETF. The decision to pursue litigation is not one we take lightly, but we are confident in our legal team, as well as our compelling, common-sense legal arguments,” the company said.
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