United States: With Regulation In Flux, The SEC Disapproves Proposed Grayscale Investments' Spot Bitcoin ETF

On June 29, 2022, the Securities and Exchange Commission (SEC) rejected Grayscale Investments' proposal to convert Grayscale® Bitcoin Trust (OTCQX: GBTC) to a spot Bitcoin ETF. See SEC 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), Exchange Act Release No. 34-95180 (June 29, 2022). This sparked market panic and resulted in a 5% drop in Bitcoin price.

Investors had been hoping for a positive response from the SEC. (Note: Grayscale Investments, which manages the world's largest Bitcoin fund, Grayscale Bitcoin Trust (GBTC), sought to convert its Bitcoin Trust Fund into a Bitcoin Spot ETF.)

The SEC concluded that NYSE Arca had not met its burden under the Securities and Exchange Act of 1934 (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), which requires, in relevant part, 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." Securities and Exchange Act, 15 U.S.C. § 78f(b)(5). The 86-page SEC order rejecting Grayscale's application for a Bitcoin Spot ETF articulates the Agency's position that Bitcoin's price is subject to manipulation on unregulated platforms, and approval of a Bitcoin Spot ETF would only invite further manipulation.

That same day, Grayscale Investments petitioned the Court of Appeals for the D.C. Circuit to review the SEC's rejection. See DC Circuit Petition for Review (June 29, 2022).

The Grayscale legal challenge underscores the need for regulatory clarity. Investors and the business community are looking for cryptocurrency regulations that are broad enough that they can't be easily evaded, but specific enough that businesses can operate with certainty.

Classifying Cryptocurrencies: Why This Is Important from a Regulatory Perspective

The issue of how to classify cryptocurrencies will likely determine how the market is regulated and, ultimately, how it matures and grows.

On August 3, 2022, a bi-partisan group of Senators introduced the Digital Commodities Consumer Protection Act of 2022 ("DCCPA"). The DCCPA gives the Commodity Futures Trading Commission ("CFTC") exclusive jurisdiction to regulate the trading of "digital commodities." Significantly, Bitcoin and Ether were specifically defined as digital commodities.

Similarly, on June 7, 2022, Senators Cynthia M. Lummis (R-WY) and Kirsten Gillibrand (D-NY) introduced a bill to regulate digital assets and promote financial innovation. The proposed legislation is the first significant, bipartisan effort to apply comprehensive regulation to digital assets. See Lummis-Gillibrand Responsible Financial Innovation Act, S. 4356, 117th Cong. (2022). The proposed legislation begins with the premise that digital assets are commodities and their regulation appropriately rests with the CFTC. Under the bill, as contemplated, the SEC's authority would be relegated to the regulation of securities offerings of digital assets, but the SEC would not have jurisdiction to regulate the products of those offerings, where they meet the criteria set forth in the bill.

The bill divides authority between the SEC and the CFTC with respect to "ancillary assets," which are generally defined as intangible, fungible assets offered, sold or provided in connection with the purchase and sale of securities through an arrangement constituting an investment contract. The CFTC generally has jurisdiction over ancillary assets that fall within the definition of digital asset. However, disclosure requirements that the bill imposes on issuers of such ancillary assets will remain subject to the SEC's jurisdiction.

Both the DCCPA and the Lummis-Gillibrand Responsible Financial Innovation Act leave the door open to some digital assets being regulated as securities. It will be interesting to see how the SEC and CFTC reconcile this obvious conflict.

CFTC Chairman Rostin Behnam, whose agency stands to gain significant new powers under the proposed bill, has opined that the bill "does a very good job" distinguishing between what are securities and what are not securities.

While digital assets are becoming mainstream in many ways, there remain substantial regulatory uncertainties and risks posed to consumers, financial stability, national security, climate, and other important international interests.

The Grayscale Case Turns on the Differences between a Spot ETF Versus a Futures ETF

To date, no Spot Bitcoin ETFs have been approved by the SEC.

In October 2021, the SEC approved a Bitcoin ETF, Teucrium, but it was only for a fund based on futures contracts. Those ETFs were governed by the Investment Company Act of 1940 (the '40 Act) and Chairman Gensler explained that he was more comfortable with that route because of the investor protection in the '40 Act.

In April 2022, the SEC approved the Teucrium ETF. See Teucrium Bitcoin Futures Fund, Registration Statement (Form S-1) (May 20, 2021). This was a futures ETF, but, unlike the earlier approved funds that had been filed under the '40 Act, Teucrium had filed under the Securities Act of 1933 ('33 Act) and the Exchange Act. Since those were the statutes under which the spot ETFs had been filed, and under the general principle of treating like situations alike absent reasoned justification, there was once again hope that, perhaps, the SEC would actually approve a spot Bitcoin ETF.

Why Convert a Bitcoin Trust to a Spot Bitcoin ETF

A spot Bitcoin ETF would trade based on the price of Bitcoin, as opposed to futures ETFs, which trade based on the price of Bitcoin futures. Bitcoin futures are a smaller market than spot Bitcoin and aren't directly correlated to the price of Bitcoin (since again, they are futures or derivatives). As such, the price of Bitcoin futures may differ from the current price of Bitcoin, therefore Bitcoin futures ETFs may occasionally follow the price of Bitcoin incorrectly.

Of note, the trust has no redemption mechanism, meaning that GBTC shares can't be created and destroyed as demand shifts. As a result, the fund's price is now approximately 30% below the value of its underlying Bitcoin.

The Bitcoin futures derivatives markets have identical exposure to fraud and manipulation that the spot markets might have, and Grayscale's attorneys wrote in a letter to the regulator last year, "It is of course foundational that the Commission – like any other federal regulatory agency – must treat like situations alike absent reasoned justification," the letter said.

We believe it is important to point out that the futures contracts underlying the bitcoin futures ETF are indeed regulated and overseen by registered futures exchanges possessing sophisticated surveillance capabilities. Meanwhile, the underlying Bitcoin of any Bitcoin Spot ETF would not be overseen by any registered entity.

Hester Peirce, a commissioner at the SEC, recently published remarks on the regulatory agency's failure to allow spot Bitcoin exchange-traded funds (ETFs) in the United States. "The continuing refusal of the SEC to approve a spot Bitcoin ETP is puzzling to many agency observers," said Peirce. "The bitcoin market has grown, matured, become more liquid, and attracted more, and more sophisticated (in the traditional financial market sense of the word), participants." Hester M. Peirce, Commissioner, Sec. and Exch. Comm'n, Remarks at the Regulatory Transparency Project Conference on Regulating the New Crypto Ecosystem: Necessary Regulation or Crippling Future Innovation? (June 14, 2022).

Grayscale's Argument

According to Grayscale's press release, "the SEC is failing to apply consistent treatment to similar investment vehicles, and is therefore acting arbitrarily and capriciously in violation of the Administrative Procedure Act and Securities Exchange Act of 1934." Press Release, Grayscale, The SEC's Decision on GBTC (June 29, 2022).

The Administrative Procedure Act (APA) is the statute that dictates how regulators govern and requires in part, that the SEC treat like situations alike. In the context of Bitcoin ETFs, that means both futures and spot-based ETFs. The Exchange Act, or '34 Act, is what governs the ability of Bitcoin ETFs to be listed on national securities exchanges like NYSE Arca.

The Grayscale team has been steadfast in its belief that this inconsistency in treatment creates an unlevel playing field for Bitcoin ETFs — and Grayscale strongly believes that the SEC should approve a spot-based Bitcoin ETF, allowing investors choice over which product best meets their investment needs. See A New Argument for a Bitcoin ETF, Grayscale (Dec. 1, 2021), https://grayscale.com/unpacking-the-news-a-new-argument-for-a-bitcoin-etf/.

While the consensus is that this is an uphill battle because there is much discretion granted to regulatory agencies, this time Grayscale has decided to test the Bitcoin ETF issue in court.

Conclusion

Since there is investor demand for such products as Grayscale's Spot Bitcoin ETF, the SEC's rejection could put the United States at a competitive disadvantage. While the SEC continues to stonewall approval of this product, many other highly regulated jurisdictions, such as Canada and Australia, have approved spot Bitcoin ETF products for retail investors, leaving U.S. investors at a disadvantage.

But, we are mindful of the fact that there are clearly inherent issues in the structure of cryptocurrencies like Bitcoin that make it appealing to use for illicit purposes, and the current status of the regulatory system does little to discourage those illicit uses because it is so loosely monitored and confusingly structured.

Bitcoin regulation in the United States can be overseen by a number of federal and state agencies, including the SEC, CFTC, OCC, Treasury, the IRS and the Federal Reserve, among others, we believe that these multiple regulatory agencies must collaborate in order to put in place a proper structure that will protect investors while maintaining a U.S. competitive advantage in the marketplace.

Summer associate Julian Finer assisted in the preparation of this advisory.

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