Summary:

On 10 January 2024, the Securities and Exchange Commission (SEC) approved the listing and trading of spot Bitcoin Exchange-Traded Products (ETPs), marking an exciting moment for the crypto industry. The SEC approved eleven applications from companies including BlackRock, Ark Investments, Fidelity, Invesco, and VanEck. This authorization was a significant win for the industry, as the SEC had been rejecting spot Bitcoin applications for over a decade due to concerns about fraud and manipulation.

On 23 May 2024, the cryptocurrency industry hit another major milestone when the SEC approved rule filings allowing the listing of the first U.S. ETPs investing in the Ether token. This recent authorization was driven by proposals from Nasdaq, the NYSE, and CBOE Global Markets Inc. Importantly, before trading on these products begins, the SEC also needs to approve the securities public offering documents, or S-1, filed by the product sponsors, which at the time of this writing has not yet occurred. Then, on 18 June, the SEC sent ConsenSys a closing letter confirming that it will not pursue an enforcement action related to its investigation into Ethereum 2.0.

Background:

What is Ether?

Ethereum is a decentralized global software platform powered by blockchain technology. It serves as the foundation for the cryptocurrency Ether (ETH). Launched in 2015 by the founders of ConsenSys, it functions as a distributed, permissionless, virtual network on which applications can be developed. There is no limit on the amount of Ether in circulation at any given moment. As of May 2024, there are 120 million Ether coins in existence.

Controversy Surrounding ETP Approval 

The question of whether to approve Bitcoin and Ethereum ETPs was controversial for many years. Proponents have argued that ETPs would provide a familiar and convenient way for investors to gain exposure to digital assets, potentially broadening the market by attracting institutional investors such as pension funds and registered investment advisors. They also contended that the approval of spot Bitcoin and Ethereum ETPs would help mature the market, providing a safer, regulated avenue for investment in cryptocurrencies.

On the other hand, opponents raised concerns about the risks associated with these funds, particularly regarding market manipulation and fraud. They argued that the spot markets for digital assets are rife with abuses, thus exposing investors to heightened risks. They also maintained that SEC approval could lend undue legitimacy to cryptocurrencies, which some believed were primarily speculative assets with limited real-world utility.

Grayscale Investments, LLC v. SEC

For more than a decade, the SEC rejected spot Bitcoin ETPs. On 29 June 2022, the SEC denied digital asset manager Grayscale’s application to list a spot Bitcoin ETP on the NYSE Arca exchange. The SEC argued that the proposal failed to meet standards designed to prevent fraudulent and manipulative practices and to protect investors and the public interest. In response, Grayscale fileda lawsuit in the U.S. Court of Appeals for the D.C. circuit challenging the denial in June 2022.

On 29 August 2023, Judge Neomi Rao ruled that the SEC’s denial of Grayscale’s proposal was arbitrary and capricious, noting that the SEC had previously approved two Bitcoin futures ETPs and had not properly explained its different treatment of Grayscale’s proposal. On 13 September 2023,the SEC allowed the deadline to appeal this ruling to pass without filing an appeal, paving the way for its January approval of the listing and trading of spot Bitcoin ETPs.

Latest Approval

Overview

On 23 May 2024, the SEC issued an order approving the applications from Nasdaq, the Chicago Board Options Exchange (CBOE), and the New York Stock Exchange (NYSE) to list ETPs tied to the price of Ether. The SEC found that the proposals were consistent with Section 19(b)(1) of the Securities Exchange Act of 1934 and Rule 19b-4.

Commission Findings Under Exchange Act Section 6(b)(5)

The SEC order explained that the proposals met Exchange Act Section 6(b)(5), which requires that exchange rules be designed to prevent fraudulent and manipulative acts and practices, protect investors, and maintain the public interest. A critical factor in the SEC’s approval was the exchanges’ surveillance-sharing agreements with the Chicago Mercantile Exchange (CME). The SEC reviewed data from the CME Ether futures market and spot Ether trading pairs on platforms like Coinbase and Kraken.

This analysis, using data taken at hourly, five-minute, and one-minute intervals from October 2021, through March 2024, confirmed a consistently high correlation between these markets. The high correlation between spot Ether prices and CME Ether futures prices would effectively enable regulators to potentially identify trading anomalies in the Ether ETP markets. Consequently, the SEC concluded that the listing exchanges’ surveillance-sharing agreements would help detect and prevent fraud and manipulation in the Ether ETPs market. While the CME does not directly surveil the spot Ether market, the high correlation between spot Ether prices and CME Ether futures prices may help regulators spot trading anomalies before they escalate. To meet the requirements of Exchange Act Section 6(b)(5), applicants should take the following steps:

• Demonstrate Preventive Measures Against Fraud and Manipulation:Applicants must show that their proposals include robust mechanisms to detect and prevent fraudulent and manipulative practices. This can be achieved through surveillance-sharing agreements with regulated markets of significant size, like the CME.
• Provide Comprehensive Data Analysis: Applicants should conduct and present thorough correlation analyses. These analyses should include data at various intervals (hourly, five-minute, and one-minute) over a significant period of time, demonstrating a high correlation between the spot market and a regulated futures market such as the CME.

Commission Findings Under Exchange Act Section 11A(a)(1)(C)(iii)

Additionally, the proposals met Section 11A(a)(1)(C)(iii), which aims to ensure that brokers, dealers, and investors have access to accurate information about securities transactions. To meet this requirement, applicants should take the following steps:

• Exhibit Price Information Transparency:Applicants should develop policies and procedures to provide quotation and last-sale information via securities information processors and update intra-day indicative values and net asset values on the Trusts’ websites every fifteen seconds.
• Commit to Regular Portfolio Disclosures:They must ensure transparency through regular portfolio disclosures and robust surveillance procedures, including data exchange agreements and conditions for trading halts.
• Emphasize Equity Securities Classification and Compliance Monitoring:Applicants should classify Trust shares as equity securities to ensure they are subject to existing trading rules. Additionally, they must commit to monitoring compliance with these rules and be prepared to initiate delisting procedures if necessary.

Approval Timeline

Despite this approval, trading will not start immediately. Fund managers will still require separate SEC approval before launching Ether ETPs, and the timeline for these approvals remains unclear.

Implications

The approval of Ether ETP listings demonstrates the impact of the Grayscale decisions on digital-asset-related ETPs, a decision that confirmed what is required of exchanges seeking to list these products.

Prominent issuers such as Ark/21 Shares, Bitwise, BlackRock’s iShares, Fidelity, Franklin Templeton, Grayscale, Invesco/Galaxy, Hashdex, and VanEck are now preparing to offer Ether funds.

The approval of Ether ETPs has led to a surge in the price of Ether, reflecting investor optimism about the potential for increased institutional investment and market liquidity, with analysts predicting a significant boost to Ethereum’s market value similar to the impact of Bitcoin ETPs.

Finally, an important reminder – the Ether ETP sponsors still need their related S-1 filings approved before trading of the product can commence. It remains possible, therefore, that some or even all of these products might not be available to investors for some time.

Put Patomak’s Expertise to Work

Patomak has deep experience in helping financial institutions navigate the emerging risks and opportunities related to crypto-assets, market trends and public policy developments. We are prepared to help banks, digital-asset managers, and numerous other market participants identify and assess market opportunities in the digital assets space, as well as develop tailored risk and compliance programs or guide overall regulatory strategy. This includes reviewing and assessing Bitcoin and Ethereum ETP applications. If you have any questions regarding the matters in this publication or would like to learn more about how Patomak can assist with your tailored needs, please reach out to Laura Magyar, Managing Director, at lmagyar@patomak.com, or Mark Wetjen, Senior Advisor, at mwetjen@patomak.com.