Crypto Laws Deciphered #1 - BTC ETPs in the US
Confused w/ legal jargons? Read on as I guide you through the landmark Grayscale court decision and highlight what you should look out for after the recent approval of BTC Spot ETPs.
1. Overview
The Grayscale court decision,1 in which the U.S. Court of Appeals for the District of Columbia held that the SEC failed to adequately explain its reasoning in disapproving the listing and trading of Grayscale’s then proposed Bitcoin spot ETP, was recently acknowledged by the SEC’s chairman Gary Gensler as the key reason for the approval of the 11 Bitcoin spot ETPs (visit my earlier article2 for the approval’s financial implications).3 It is thus noteworthy to review the Decision and draw insights from it, which may be of relevance to the SEC’s looming decision concerning the Ethereum Spot ETPs filings (the final deadline for the first in line, i.e. VanEck Ethereum ETF, will be on 23 May 20244).
In gist, I aim to digest the Decision and discuss the legal implications flowing from both the Decision and the Approval. The legal position of Hong Kong will be reviewed in another article.
2. Understanding Bitcoin Spot and Futures ETPs
Bitcoin spot market: cash is exchanged for bitcoin, with delivery expected immediately
Bitcoin futures market: future is a contract to buy or sell an asset at a predetermined price on a specific later date; it is a derivative—it derives its value from the underlying spot market; futures contract traded on commodity futures exchanges, like the Chicago Mercantile Exchange (“CME”), is regulated by the Commodity Futures Trading Commission
Bitcoin spot/futures exchange-traded products (“ETPs”): investment funds that hold either Bitcoin or Bitcoin futures contract seeking to be listed and traded on a national exchange will become ETPs upon approval
3. Deciphering the Grayscale Court Decision
3.1. Timeline
October 2021: Grayscale applied to convert Grayscale Bitcoin Trust (GBTC) into a Bitcoin spot ETP
Fall of 2021: SEC ETF approval for funds investing in BTC futures contracts, such as the Proshares Bitcoin Strategy ETF (BITO) and VanEck Bitcoin Strategy Fund (XBTF) [note that the application filings are pursuant to the Investment Company Act of 1940, which has a different regulatory approach to approval compared to the Securities Act of 1933]
April 2022: SEC approved NYSE Arca’s proposal to list the Teucrium Bitcoin Futures Fund (aka Hashdex Bitcoin Futures ETF). Notably, it was filed under the Securities Act, which the spot Bitcoin ETPs were also filed thereunder, prompting suggestions of their approval
May 2022: SEC approved Nasdaq’s proposal to list the Valkyrie XBTO Bitcoin Futures Fund
29 June 2022: SEC denied Grayscale’s application for the conversion of GBTC into a Bitcoin spot ETP, on the basis that the proposal failed to demonstrate how it is “designed to prevent fraudulent and manipulative acts and practices”5; thereafter, Grayscale filed a petition for review, stating that SEC’s approval of Bitcoin futures ETFs, but not Bitcoin spot ETFs, is “arbitrary and capricious” and “unfair discrimination”, in violation of the Administrative Procedure Act and Securities Exchange Act of 19346
29 August 2023: the United States Court of Appeals for the District of Columbia Circuit ruled in favour of Grayscale and vacated SEC’s denial order, on the basis that Grayscale’s Bitcoin spot ETP is similar to Bitcoin futures ETPs. Contrary to the principle of “similar cases should be treated similarly”, the SEC failed to adequately explain why it approved the listing of two Bitcoin futures ETPs but not Grayscale’s Bitcoin spot ETP
3.2. Procedure for a securities exchange to list a new product for trading
Securities exchange must file a rule change with the SEC:7 accordingly, NYSE Arca (an affiliate of the NYSE) filed proposed rule change to list and trade Grayscale’s Bitcoin spot ETP
The SEC shall approve the rule change if it is “consistent with the requirements of the [Securities] Exchange Act and the rules and regulations thereunder applicable to the [securities exchange]”.8 “Requirements of the [Securities] Exchange Act” include, inter alia, that:
“The rules of the exchange are designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation …, to remove impediments to … a free and open market…, and, in general, to protect investors and the public interest; and are not designed to permit unfair discrimination between customers, issuers, brokers, or dealers, or to regulate … matters not related to … the administration of the exchange.”9
The burden to demonstrate that a proposed rule change is “consistent with the requirements of the [Securities] Exchange Act” is on the securities exchange proposing the new rule10
To meet the “requirements of the [Securities] Exchange Act” as quoted above, historically (as evidenced by the commodity-trust ETPs that have been approved by the SEC), one such method is by the listing exchange (i.e. NYSE Arca in Grayscale’s case) entering into a surveillance-sharing agreement with “a regulated market of significant size related to the underlying or reference bitcoin assets” (i.e. CME in Grayscale’s case). In particular:11
Surveillance-sharing agreement (“SSA”) provides for:
Sharing of information about market trading activity, clearing activity, and customer identity;
The ability of parties to the agreement to obtain access to and produce requested information (which is unencumbered by existing rules, laws, or practices)
Purpose: this ensures the availability of information necessary to detect and deter potential manipulations and other trading abuses, enabling the SEC to effectively protect investors and promote the public interest
Applying all the above:
For the two Bitcoin futures ETPs approved by the SEC under the Securities Exchange Act: the SEC acknowledged that the listing exchanges (i.e. respectively, NYSE Arca and Nasdaq) had SSAs with the Bitcoin futures markets on which pricing of the ETP would be based, i.e. the CME, thus fulfilling the requirements as quoted above;
In contrast, for Grayscale’s Bitcoin spot ETP, while the SEC acknowledges that the SSA between the listing exchange—NYSE Arca, and the CME, are identical with that in the Bitcoin futures ETP which was earlier approved;12 nonetheless, the SEC finds that the CME Bitcoin futures market, whilst regulated, does not constitute a “market of significant size” related to spot Bitcoin (i.e. being the underlying bitcoin assets to be held by the Trust)13
3.3. The Court of Appeals’ decision
The ruling in a nutshell
It is a fundamental principle of administrative law that agencies must treat like cases alike (“Scope of Review”);
The denial of Grayscale’s proposal was arbitrary and capricious because the Commission failed to explain its different treatment of similar products (“Similar Products” and “Failure to Explain”);
Grayscale’s petition to review is granted and the SEC’s denial order is vacated
Scope of Review
Administrative Procedure Act requires the reviewing court to “hold unlawful and set aside agency action” that is “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law”14
When assessing an “arbitrary and capricious” claim, the Court considers whether the agency’s decision was “reasonable and reasonably explained”
Similar Products
The Court found that Grayscale’s Bitcoin spot ETP is similar to the Bitcoin futures ETPs on the basis that the underlying assets—Bitcoin and Bitcoin futures—are closely correlated. As ultimately, they all track the Bitcoin market (aka spot) price
Although the Bitcoin futures ETPs hold CME futures contracts whereas the Grayscale’s Bitcoin spot ETP holds Bitcoin directly, the Court agreed that there is 99.9% correlation b/w Bitcoin’s spot market prices and CME futures contract prices. This is because Bitcoin futures are derivatives of spot bitcoin, as long as the market is efficient, arbitrage will drive the prices together:15
Failure to Explain
In a nutshell: as (i) the spot and futures markets for Bitcoin are highly related (as established above); and (ii) the listing exchanges for Grayscale’s Bitcoin spot ETP and the approved Bitcoin futures ETPs have identical SSAs with the CME, the SSAs should have the same likelihood of detecting fraudulent or manipulative conduct in the Bitcoin spot and futures market
Hence: The Court finds that the SEC failed to explain why a SSA with the CME was sufficient to protect Bitcoin futures ETPs from potential fraud, but not Grayscale’s Bitcoin spot ETP
Notably, applying the definition of “market of significant size”, contrary to SEC’s finding, the Court held that the CME bitcoin futures market is a “market of significant size” related to spot bitcoin market. In particular, the Court finds the SEC failed to adequately explain its reasoning. In gist:
To establish the CME Bitcoin futures market as “a market of significant size” related to Grayscale’s Bitcoin spot ETP, it must be shown that:
(i) There is a reasonable likelihood that a person attempting to manipulate the ETP would also have to trade on the CME Bitcoin futures market to successfully manipulate the ETP (“First Limb”);
(ii) It must be unlikely that trading in the ETP would be the predominant influence on prices in [the surveilled] market, i.e. the price of Bitcoin futures traded on the CME (“Second Limb”)
Re First Limb, I note that:
Broadly construed, by accepting Grayscale’s evidence that “the CME Bitcoin futures prices are 99.9% correlated with spot market prices”, “spot and futures markets for Bitcoin are 99.9% correlated”, and that “fraud in spot market would present identical problems for a bitcoin ETP and a bitcoin futures ETP”, the Court may have implicitly signalled that the reverse is true, i.e. fraud in Bitcoin futures market would present identical problems for a Bitcoin futures ETP, as well as a Bitcoin spot ETP. In any event, the Court noted that the SEC did not dispute the close correlation as argued by Grayscale.
Comment: I would argue that the (financial / mathematical) permissibility of the Court’s extrapolation is doubtful, and regardless, this does not lend support to fulfilling the requirement that there has to be “a reasonable likelihood that a would-be manipulator of the proposed ETP would also have to trade on the CME bitcoin futures market to manipulate the bitcoin spot ETP”. In essence, with respect, the Court seemed to have shy away from the crucial distinction between correlation and pre-condition. This can be reconciled with the fact that, understandably, the Court does not need to have an explicit ruling in this respect. This is because applying the test for reviewing the SEC’s decision (see “Scope of Review” above), it only needs to be shown that the SEC failed to reasonably explain why it is unnecessary for the Bitcoin futures ETPs to fulfil the First Limb but necessary for the case of Grayscale’s Bitcoin spot ETP. This brings me to the ensuing point.
In SEC’s previous approvals of the Bitcoin futures ETPs—Teucrium Bitcoin Futures Fund and Valkyrie XBTO Bitcoin Futures Fund—the SEC found that16 it was unnecessary to establish the requirement under the First Limb because: the proposed “significant” regulated market (i.e., the CME futures market) with which the listing exchange has a SSA with is the same market on which the underlying bitcoin assets (i.e., CME bitcoin futures contracts) trade. However, the SEC noted that in the context of Bitcoin spot ETPs, the spot Bitcoin owned by Grayscale were assets not traded on the CME futures market, this constituted a “significant difference”, further claiming that NYSE Arca had to fulfil the First Limb, i.e. demonstrate futures market leads to the spot market (the “Lead/lag Relationship”).17 The Court, while qualifying its Decision by stating that “[w]hatever the reality of the lead/lag relationship”,18 noted that the SEC provided no support for the foregoing claims and as such, the inconsistent treatment of similar products is arbitrary and capricious.
Comment: this qualification is remarkable as it may well be a moot point for the parties should the SEC deny the ETH spot ETFs (even if the Court’s Decision herein is to be followed, this may well be a point of differentiation/substantiation for the case of ETH)
Re Second Limb, the Court finds that:
Grayscale holds just 3.4% of outstanding Bitcoin and Bitcoin is a deep and liquid market, also, as the SEC concluded, the CME is a “large futures market”. Thus, if trading in Grayscale has a minimal impact on the price of Bitcoin, it necessarily follows that trading in Grayscale will have a minimal impact on the CME Bitcoin futures market. While the SEC argued that Grayscale, with approximately $30b assets, might dwarf the CME market for Bitcoin futures (which had approximately $1.7b of open contracts), the Court found such deduction unconnected and inadequate
4. SEC’s Statement on the Approval of Spot BTC ETPs
Albeit the Approval is largely welcomed, it is far too early to suggest that the SEC is loosening its grip (in all sense). In particular, Gary Gensler highlighted the following:19
The Approval of a spot ETP holding Bitcoin, which is a non-security commodity, by no means signal SEC’s willingness to approve listing standards for crypto asset securities
The vast majority of crypto assets are investment contracts (under the Howey test20) and thus subject to the federal securities laws
The Approval does not signal approval or endorsement of crypto trading platforms or intermediaries, which, for the most part, are non-compliant with the federal securities laws and often have conflicts of interest
Bitcoin is primarily a speculative, volatile asset that’s also used for illicit activity including ransomware, money laundering, sanction evasion, and terrorist financing (cf: underlying assets in the metals ETPs have consumer and industrial uses)
5. Sen. Elizabeth Warren’s Proposed Digital Asset Anti-Money Laundering Act of 2023
Earlier in July, the Act,21 which aims to require the Financial Crimes Enforcement Network to issue guidance on digital assets, is introduced in the Senate. It is currently read twice and referred to the Committee. While it is likely that we will not see much traction until the end of the Presidential Election, I wish to pinpoint that:
The Act has expanded the definition of “Financial Institutions” to include a wide variety of players (such as digital asset miners, validators, network participants with control over network protocols, or any other person facilitating or providing services related to the exchange, sale, custody, or lending of digital assets): they will now also be subject to the requirements of records and reports on monetary transactions under the Bank Secrecy Act, unless the digital assets are used solely for internal business applications, or not offered for sale / traded / converted to fiat currency or another digital asset, or otherwise deemed to pose little illicit finance risk
United States persons engaged in a transaction with a value greater than $10,000 in digital assets through one or more offshore accounts will be required to file a Report of Foreign Bank and Financial Accounts (FBAR) with the IRS
The Secretary of Treasury is to establish an AML/CFT examination and review process for money services businesses and other digital asset entities, is to impose more stringent KYC requirements by mandating verification of customer and counter-party identities, keeping of records, and filing of reports on transactions involving unhosted wallets or wallets hosted in non-Bank Secrecy Act compliant jurisdictions
6.Look Out for: Potential Approval - ETH spot ETFs
The following shows a list of ETFs filed, with the earliest deadline being 23 May 2024.22
Possible outcome 1: Approval (in light of the previous ETH futures ETFs approvals)
In September/October 2023, the SEC had approved ETH futures ETFs. According to Bloomberg ETF analyst James Seyffart,23 he opined that the SEC implicitly accepted ETH as a commodity when approving these ETFs because the SEC did not challenge ETH’s classification during the ETF’s registration process with the CFTC. Should the SEC challenge it now, it will be in essence engaging in a turf war with the CFTC (as if they have not already haha). In this light, ETH will share the same status as BTC, as a non-security commodity.
Possible outcome 2: Classification of ETH as a “non-security, non-commodity” instrument
While I do not endeavour to engage in a full-fledged discussion of classifying whether ETH is a security or commodity or neither (perhaps save this to another occasion), I wish to flag out that, back in June 2023, there were suggestions by JPMorgan strategists that ETH could be designated into a new category, which would attract regulations more onerous than commodities but less stringent than securities.24
The strategists drew attention to a statement made by William Hinman, former Director of the SEC’s Division of Corporation Finance, in June 2018. Hinman opined that ETH is not a security as:25
“… putting aside the fundraising that accompanied the creation of Ether, based on my understanding of the present state of ether, the Ethereum network, and its decentralized structure, current offers and sales of ether are not securities transactions”
His argument is essentially that owing to ETH’s decentralized structure, it will not fulfil the requirement of “common enterprise” and “efforts of others” under the Howey test. My take is akin to Hinman’s, in the narrow sense that “economic substance of the transaction always determines the legal analysis, not the labels”, aka there may be situations where the DApps or DAOs built on the Ethereum network may be considered as an investment contract. Anyway, that’s for another time.
In this regard, I have argued that Howey’s investment contract test is surprisingly similar to to the test defining Collective Investment Scheme in Hong Kong (which is a security under the Securities and Futures Ordinance). I also attempt to transplant the SEC’s categorisation of Binance’s staking program as securities to a landmark crypto fraud case in Hong Kong.26
7. Sneak Peek: Regulating VA ETFs in Hong kong
Virtual asset futures ETFs are now listed and traded on the the Stock Exchange of Hong Kong, namely, Samsung Bitcoin Futures Active ETF, CSOP Bitcoin Futures ETF and CSOP Ether Futures ETF, all of which invest in CME Bitcoin / Ethereum futures. In a recent circular, the Securities and Futures Commission signified their willingness to accept applications for VA spot ETFs.27 It is reported that over 10 funds in Hong Kong are intending to apply for SFC’s approval, aiming to be listed in Q1-2 of 2024.28 Remarkably, while the US only allows in-cash subscriptions and redemptions model, the SFC permits both in-cash and in-kind. In relation to the eligible underlying tokens of the ETFs, SFC-authorised VA Funds should only invest in VA tokens eligible for retail trading, which must be large-cap VA included in at least 2 acceptable indices (one of which is published by the Hong Kong Virtual Asset Consortium). On 12 January 2024, the Consortium changed the composition of large-cap VAs, notably removing BUSD and adding Optimism (OP), Injective (INJ).29
With these in mind, in my next article, I will be addressing the following topics:
The regulatory landscape of VA ETFs in Hong Kong, in particular, how our regulations purportedly address the risks surrounding VA ETFs trading
Nature of in-kind vs in-cash models, and the rationale behind US’s adoption of the in-cash model
Notable regulations in other jurisdictions (e.g. South Korea)
Stayed tuned for more and please support my endeavour!
What the Finance #1 - BTC Spot ETFs 101
Foreword !!Buckle up as the approval is looming!! Here, my goals are simple: I highlight the approval’s significance to retail investors like yourself and I help you understand the potential price movements, macroeconomics, BTC halving and the relevance of the gold ETF.
https://cointelegraph.com/news/grayscale-court-decision-key-bitcoin-etf-approval-says-gary-gensler; see also https://www.sec.gov/news/statement/gensler-statement-spot-bitcoin-011023 in which Gensler stated that, inter alia:
(i) The SEC acts within the law and how the courts interpret the law;
(ii) While the SEC are now faced with a new set of filings of spot bitcoin ETPs similar to those they have disapproved in the past, circumstances have changed, of which he referred to the Grayscale court decision;
(iii) Based on the foregoing and other reasons in the approval order, Gensler felt “the most sustainable path forward is to approve the listing and trading of these spot Bitcoin ETP shares”
s19 of the Securities Exchange Act
s19(b)(2)(C) of the Securities Exchange Act
s6(b)(5) of the Securities Exchange Act
r700(b)(3) of the Commission Rules of Practice
note 1
note 11
5 U.S.C. § 706(2)
See Teucrium Order, 87 Fed. Reg. at 21,679: https://www.federalregister.gov/documents/2022/04/12/2022-07748/self-regulatory-organizations-nyse-arca-inc-order-granting-approval-of-a-proposed-rule-change-as; see also Valkyrie Order, 87 Fed. Reg. at 28,852: https://www.federalregister.gov/documents/2022/05/11/2022-10065/self-regulatory-organizations-the-nasdaq-stock-market-llc-order-granting-approval-of-a-proposed-rule
While Grayscale argued that “given the significant size of the CME futures markets, 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, since arbitrage between the derivative and spot markets would tend to counter an attempt to manipulate the spot market alone” (see p.33 of https://www.sec.gov/comments/sr-nysearca-2021-90/srnysearca202190-20125938-286383.pdf), this was rejected by the SEC on the basis of that the argument lacked additional data or analysis support. Even accepting the presence of efficient arbitrage, the SEC found that NYSE Arca failed to explain why that would imply “a would-be manipulator would be reasonably likely to trade specifically on the CME bitcoin futures market rather than on unregulated bitcoin futures markets or other bitcoin derivatives markets”. Regarding the Lead/Lag relationship, the SEC noted that “if the spot market leads the futures market, this would indicate that it would not be necessary to trade on the futures market to manipulate the proposed ETP, even if arbitrage worked efficiently, because the futures price would move to meet the spot price” (see p.40313 of note 11)
See pg.16 of the Decision (note 1)
The Howey test provides that: an investment contract, defined as “investment of money in a common enterprise, with a reasonable expectation of profits to be derived from the efforts of others”, is a security
Great job breaking down the 50 Shades of Grayscale. Important lesson