A dozen reasons why the SEC should have approved Grayscale’s Spot Bitcoin ETF

In a recent episode of “What Bitcoin Did” with host Peter McCormack, Grayscale’s longtime CEO, Michael Sonnenshein, said the company’s decision to sue the US Securities and Exchange Commission (SEC) was not taken lightly. In the sometimes contentious interview, Sonnenshein noted that Grayscale has been in open communication with the top securities regulator, speaking often and regularly.

“To actually make the decision to sue the regulator that oversees our business was a pretty tough decision to have to make,” Sonnenshein said. He added that the effort is “almost existential” for the future of Grayscale, and could have significant implications for “bitcoin itself.” (Grayscale and CoinDesk are both owned by Digital Currency Group.)

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Grayscale decided to sue in June 2022, the same day that its application to convert the Grayscale Bitcoin Trust (GBTC) into a “spot” exchange-traded fund (ETF) was rejected. The trust today is the world’s largest bitcoin investment vehicle, holding an estimated 3% of bitcoin’s total supply and earning Grayscale millions of dollars in management fees per year. “You don’t have to be a GBTC holder past, present or future to care about this lawsuit,” Sonnenshein said.

It is difficult to say whether the efforts here are as central as claimed. There are certainly many companies looking to enter the bitcoin ETF market. The SEC has rejected about a dozen bitcoin ETF proposals so far, including from Fidelity, SkyBridge Capital and Valkyrie Investments. And the estimated 1 million investors in Grayscale’s trusts could certainly benefit from a conversion – GBTC today trades at a massive discount to its underlying bitcoin holdings, in part because the “closed-end” trust model makes it easy to deposit, but do not withdraw bitcoin, limiting the chance of arbitrage.

(In fact, to give a sense of the demand, FTX’s “adult in the room” John J. Ray III decided to sue Grayscale on behalf of the bankrupt hedge fund Alameda Research, one of the largest holders of GBTC and Grayscale’s Ethereum Trust, in an attempt to pressure Grayscale to open withdrawals and reduce fees. Grayscale has called the lawsuit “misleading.”)

So why doesn’t the SEC just approve these investment products? The SEC’s consistent explanation — such as that provided in a 70-plus-page briefing in December — has been that the spot bitcoin ETF proposals have failed to meet standards to prevent fraud and protect investors.

To say it has been an unsatisfactory response is to undersell it (more than GBTC is being undersold). In fact, many observers go so far as to say that the SEC is “arbitrary and capricious,” a phrase that comes up time and time again when it comes to the watchdog’s oversight of crypto. At least, that’s a phrase that appeared repeatedly in hundreds of letters that interested and unrelated parties wrote to the SEC asking it to approve the bitcoin ETF product.

Approving a bitcoin ETF would be a proactive step toward providing consumers with a regulated way to gain exposure to bitcoin. While crypto is in political limbo today, there is still demand for these products – as clear as day by reading some of the letters to the SEC. It’s true that the SEC has a mandate to protect investors, but preventing products from coming to market—when similar products are easy to access overseas—only limits the agency’s ability to regulate effectively.

The core argument for approving a spot bitcoin ETF, at least at this point, is that the SEC’s concerns about manipulation are literally inconsistent — and possibly in violation of the Administrative Procedure Act, as Ribbit Capital’s Sigal Mandelker and Jessi Brooks wrote. The agency has already approved exchange-traded products using bitcoin futures contracts, notably NYSE Arca’s proposal to list and trade shares in the Teucrium Bitcoin Futures Fund and Nasdaq’s proposal to list and trade shares in the Valkyrie XBTO Bitcoin Futures Fund. Both funds provide “monitoring sharing agreements” designed to prevent manipulation, which the SEC says each spot BTC application has lacked.

Setting aside the additional costs and risks associated with managing and “rolling over” bitcoin futures contracts, it’s not clear that this additional oversight actually protects investors from the kinds of risks the SEC is concerned about. As Grayscale lawyers have noted in the past, “the reference rate for the CME Bitcoin futures market and the price indices that BTC and other spot bitcoin products use to value their shares are based on the same data: trading prices reported on the same bitcoin trading platforms.” In other words, any potential fraud in bitcoin markets will affect spot and futures-based products alike.

There is an additional argument that the SEC has often regulated crypto ex post facto – going after firms after crimes have been committed, and as it says “regulating through enforcement.” A bitcoin ETF would be a more proactive way for the SEC to expand oversight while avoiding “picking winners and losers,” University of Arkansas law professor Carol Goforth wrote. So far, SEC Chairman Gary Gensler, by rejecting every spot-bit-bit ETF application on his desk, has cut off his nose to defy his face.

It’s possible the SEC will expand on its reasoning today, when it and Grayscale have a chance to present their opening arguments in the lawsuit. Analysts at Bloomberg Intelligence give Grayscale a 40% chance of winning the case, which Sonnenshein said the company would consider appealing all the way to the US Supreme Court if it loses.

In the podcast interview, Sonnenshein said he “can’t imagine” why the SEC “wouldn’t want” to benefit investors by converting the vehicle. Far from protecting consumers, the only explanation for Gary Gensler’s “arbitrary and capricious” actions is to save face.