“We took over this station because the SEC wants to hear from investors like you.” [1] For nearly two months, commuters at Washington D.C.’s Union Station — just steps from the SEC’s offices — were treated to an unusual barrage of Grayscale advertisements. The ads constituted the capstone of Grayscale’s aggressive PR campaign to garner support for its application to convert the $13.5 billion Grayscale Bitcoin Trust (GBTC) into a spot-based bitcoin exchange-traded fund (ETF). The attempt was doomed to the fate of every other proposed spot bitcoin exchange-traded product (ETP): rejection. On June 29th, the SEC denied the application[2] as well as a similar application to allow for the listing and trading of another spot bitcoin product, the Bitwise Bitcoin ETP Trust (hereinafter, the “Orders”).[3]

According to the Orders, the applications were not consistent with Exchange Act § 6(b)(5), which requires the rules of a national security exchange to be “designed to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.”[4] The SEC maintained that to meet this requirement, it must be demonstrated that the exchange has “a comprehensive surveillance-sharing agreement with a regulated market of significant size” or that other sufficient means exist to prevent fraud and manipulative acts and practices in the absence of such an agreement. The latter could be demonstrated by showing that bitcoin offers novel protections beyond those that exist in traditional commodity markets or equity markets.[5] The SEC rejected Grayscale’s argument that it met both criteria.[6]

Grayscale and NYSE Arca, Inc.[7] had argued that the nature of bitcoin is fundamentally different from ordinary commodities and thus that it presents novel protections beyond those that exist in traditional commodity markets.[8] According to Grayscale and NYSE Arca, “[t]he fundamental features of bitcoin’s fungibility, transportability and exchange tradability offer novel protections beyond those that exist in traditional commodity markets or equity markets when combined with other means.”[9] The application had also contended that NYSE Arca does in fact have a surveillance-sharing agreement with a regulated market of significant size, namely, the Chicago Mercantile Exchange (CME), on which bitcoin futures products trade.[10]

Nevertheless, the SEC was not moved. First, it stated that NYSE Arca did not explain how bitcoin is fungible, transportable, or tradeable and even if it had done so, the SEC stated that these characteristics are not a novel protection beyond those that exist in traditional commodity or equity markets.[11] The SEC also dismissed NYSE Arca’s claims that the bitcoin market’s size, liquidity, market participation, or arbitrage, either individually or together, sufficiently address concerns regarding fraud and manipulation. The SEC stated that NYSE Arca offered no evidence or analysis of how the metrics and observations it cited served to detect and deter potential fraud and manipulation. The SEC added that “even if the record demonstrates that the bitcoin market’s size, liquidity, market participation, or arbitrage makes manipulation more difficult or costly … these attributes speak to providing some resistance to manipulation, rather than establishing a unique resistance to manipulation that would justify dispensing” with a comprehensive surveillance-sharing agreement.[12]

Next, the SEC dismissed NYSE Arca’s claim that the index used by the Grayscale Trust to determine the value of its bitcoin assets represents an effective alternative means to prevent fraud and manipulation. Among other reasons, it noted that the index’s exclusive use of prices of bitcoin from particular spot bitcoin trading platforms, which are subject to FinCEN’s anti-money laundering and know-your-customer regulations (and, for some, also to NYSDFS’s BitLicense program), does not provide significant protection against fraud and manipulation. The SEC stated that “any oversight afforded by FinCEN and NYFDS … is not a substitute for a surveillance sharing agreement between the Exchange and a regulated market of significant size related to the underlying bitcoin assets.”[13]

Having found that NYSE Arca failed to demonstrate that other means besides surveillance-sharing agreements will be sufficient to prevent fraudulent and manipulative acts and practices, the SEC went on to find that NYSE Arca failed to establish that it had entered into a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying bitcoin assets.[14] The SEC applied a two-pronged test to determine whether the CME was a “market of significant size.”[15] The first prong asks whether there is a reasonable likelihood that a person attempting to manipulate the ETP would also have to trade on that market to successfully manipulate the ETP.[16] The second prong asks whether it would be unlikely that trading in the ETP would be the predominant influence on prices in that market.

In analyzing the first prong, the SEC noted that the interpretation of the term “market of significant size” or “significant market” depends on the “interrelationship” between the market with which the listing exchange has a surveillance-sharing agreement and the proposed ETP.[17] The SEC found, among other things, that “the econometric evidence in the record for the proposal does not support the conclusion that an interrelationship exists between the CME bitcoin futures market and the spot bitcoin market such that it is reasonably likely that a person attempting to manipulate the proposed ETP would also have to trade on the CME bitcoin futures market.”[18] The SEC noted that NYSE Arca conceded that there were “mixed” findings regarding the lead/lag relationship between the CME futures and spot bitcoin markets. Accordingly, there was not sufficient support to determine that it is reasonably likely that a would-be manipulator of the Grayscale ETP would have to trade on the CME bitcoin futures market to successfully manipulate the Grayscale ETP.[19]

As to the second prong, the SEC found that NYSE Arca had not met its burden to show that it would be unlikely that the Grayscale ETP would be the predominant influence on prices in the CME bitcoin futures market. While NYSE Arca provided an analysis of the Grayscale ETP’s historical inflows vis-a-vis the capitalization of the spot bitcoin market, that information was not relevant.[20]

It is not surprising that the SEC denied NYSE Arca’s proposed amendments to list and trade the Grayscale and Bitwise spot bitcoin ETPs. The SEC’s denial is merely the latest in a series of similar decisions. Indeed, going forward, it is unlikely to approve the listing and trading of any spot bitcoin ETPs any time soon, as Commissioner Peirce observed in her June 14th speech to the Regulatory Transparency Project. There, she remarked that “[t]he Commission’s resistance to a spot bitcoin ETP is becoming almost legendary,” noting that she has “no idea” when the SEC will finally approve a bitcoin ETP.[21]

However, there had been hope that the SEC would finally approve a spot bitcoin ETP with the Grayscale application. Shortly prior to the SEC’s disapproval of the Grayscale ETP, the SEC had approved the listing and trading of two futures-based bitcoin ETPs that, unlike previously approved futures-based bitcoin ETPs, were Securities Act-only products. All of the previously approved futures-based bitcoin ETPs had been exchange-traded funds under the Investment Company Act of 1940 (“1940 Act”). This development led some to speculate that the SEC would allow spot bitcoin ETPs, which are also Securities Act products and not 1940 Act products.[22]

A close reading of the SEC’s futures-based bitcoin ETP approvals, however, would have dispelled the speculation. In approving the two futures-based bitcoin Securities Act ETPs, the SEC stated that its approval was “based on a finding that the CME is a ‘significant market’ related to CME bitcoin futures contracts, which would be the exclusive non-cash holdings of the proposed ETP.”[23] The SEC stressed in a footnote in each order that “[t]he SEC is not suggesting that either the development of the CME bitcoin futures market or the approval of this proposal would require the SEC to approve a proposed rule change seeking to list and trade shares of an ETP holding spot bitcoin as an asset.”[24]

In fact, the SEC did not stop there but specifically stated that its reasoning for allowing Securities Act futures-based ETPs did not extend to spot bitcoin ETPs. The SEC found the CME to be a “significant market” and noted that the CME, as a CFTC-regulated futures exchange, has “the requisite oversight, controls, and regulatory scrutiny necessary to maintain, promote, and effectuate fair and transparent trading of its listed products.”[25] The SEC concluded that, therefore, “the CME’s surveillance can reasonably be relied upon to capture the effects on the CME bitcoin futures market” whether the manipulation of the price occurred through direct trading on the CME bitcoin futures market or indirectly by trading outside of the CME bitcoin futures market.[26] This reasoning, the SEC noted, does not extend to spot bitcoin ETPs and that spot bitcoin markets are not currently regulated.[27]

Commissioner Peirce in her remarks noted that “[t]he futures-based approvals turn on the regulated nature of the future market, the CME, which is where the assets held by the ETP themselves trade.” She went on to add that the SEC went out of its way in the approvals of the Securities Act futures-based ETPs to state that the evidence does not demonstrate that there is a reasonable likelihood that a person attempting to manipulate the spot bitcoin ETP would have to trade on the CME, “an observation that was not necessary to the SEC’s approval of the future-based ETPs.”[28] This observation prompted her to remark that “[p]erhaps the SEC could be persuaded that the similarity of pricing mechanisms for the futures-based product and the spot-based product undermines its rationale for treating them differently. The SEC’s willingness to be persuaded, though, turns on whether the SEC’s primary concern is legal and logical coherence with our approvals of bitcoin futures products and other commodity-based products and not, say, using the prospect of a spot bitcoin ETP approval as an inducement to get exchanges to come in and register.”[29]

Accordingly, it is likely, based on the SEC’s reasoning in its orders approving the two Securities Act futures-based ETPs, that unless and until a spot bitcoin exchange registers with the SEC, neither NYSE Arca nor any other exchange will be able to demonstrate to the SEC’s satisfaction that it has a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying bitcoin assets of the ETP.

[1] Vicky Ge Huang and Patrick Coffee, Grayscale’s CEO breaks down why the firm is taking over the entire advertising space between 2 mass transit hubs and their Amtrak Trains for 3 Months as its Push for Bitcoin ETF Intensifies, Business Insider (April 5^th, 2022), https://www.businessinsider.com/grayscale-ads-penn-station-union-sec-bitcoin-etf-approval-campaign-2022-4.

[2] Order Disapproving a Proposed Rule Change, as Modified by Amendment No. 1, to List and Trade Shares of Grayscale Bitcoin Trust under NYSE Arca Rule 8.201-E (Commodity-Based Trust Shares), Securities and Exchange Commission (June 29, 2022), https://www.sec.gov/rules/sro/nysearca/2022/34-95180.pdf.

[3] Order Disapproving a Proposed Rule Change to List and Trade Shares of the Bitwise Bitcoin ETP Trust under NYSE Arca Rule 8.201-E, Securities Exchange Commission (June 29, 2022), https://www.sec.gov/rules/sro/nysearca/2022/34-95179.pdf.

[4] Id at 2 (citing 15 U.S.C. § 78f(b)((5)).

[5] Id at 9.

[6] NYSE Arca’s application regarding the listing of the Bitiwise Bitcoin ETP Trust only asserted that it had a comprehensive surveillance-sharing agreement with a regulated market of significant size. Because the arguments in the Bitwise application regarding the surveillance-sharing agreement are similar to those in the Grayscale application and the Grayscale application also argues that it meets an additional basis, the remainder of this article focuses on the Grayscale application.

[7] NYSE Arca, Inc. is the exchange on which Greyscale’s bitcoin ETF would have traded. NYSE Arca sought SEC approval of amendments to its listing and trading rules so that the Grayscale ETF could list and trade on its exchange.

[8] See Order Disapproving a Proposed Rule Change, as Modified by Amendment No. 1, to List and Trade Shares of Grayscale Bitcoin Trust under NYSE Arca Rule 8.201-E (Commodity-Based Trust Shares), Securities and Exchange Commission (June 29, 2022), https://www.sec.gov/rules/sro/nysearca/2022/34-95180.pdf.

[9] Id at 24.

[10] Id. at 9.

[11] Id.

[12] Id. at 26.

[13] Id. at 35.

[14] Id.

[15] Id. at 45.

[16] A surveillance-sharing agreement would help detect such conduct.

[17] Id. at 50.

[18] Id. at 51.

[19] Id.

[20] Id. at 55.

[21] Commissioner Hester M. Peirce, On the Spot: Remarks at “Regulatory Transparency Project Conference on Regulating the New Crypto Ecosystem: Necessary Regulation or Crippling Future Innovation?” (June 14, 2022), https://www.sec.gov/news/speech/peirce-remarks-regulatory-transparency-project-conference.

[22] See, e.g., Wahid Pessarlay, Valkyrie Gets Green Light for BTC Futures ETF Filed under ’33 Act, CoinGeek (May 11, 2022), https://coingeek.com/valkyrie-gets-green-light-for-btc-futures-etf-filed-under-33-act/.

[23] See Order Granting Approval of a Proposed Rule Change, as Modified by Amendment Nos. 1 and 2, to List and Trade Shares of the Valkyrie XBTO Bitcoin Futures Fund under Nasdaq Rule 5711(g), Securities Exchange Commission at 8 (May 5th, 2022), https://www.sec.gov/rules/sro/nasdaq/2022/34-94853.pdf.

[24] See Order Granting Approval of a Proposed Rule Change, as Modified by Amendment No. 2, to List and Trade Shares of the Teucrium Bitcoin Futures Fund under NYSE Arca Rule 8.200-E at 31, Securities Exchange Commission (April 6^th, 2022), https://www.sec.gov/rules/sro/nysearca/2022/34-94620.pdf.

[25] Id. at 8.

[26] Id. at 12.

[27] Id. at 14.

[28] Commissioner Hester M. Peirce, On the Spot: Remarks at “Regulatory Transparency Project Conference on Regulating the New Crypto Ecosystem: Necessary Regulation or Crippling Future Innovation?”, (June 14th, 2022), https://www.sec.gov/news/speech/peirce-remarks-regulatory-transparency-project-conference.

[29] Id.