With Regulation in Flux, SEC Rejects Proposed Grayscale Investments’ Spot Bitcoin ETF | Kelley Drye & Warren LLP

On June 29, 2022, the Securities and Exchange Commission (SEC) rejected Grayscale Investments’ proposal to convert Grayscale® Bitcoin Trust (OTCQX: GBTC) into a spot Bitcoin ETF. SeeSEC Order Disapproving a Proposed Rule Change, as Amended by Amendment No. 1, for the Listing and Trading of Shares of Grayscale Bitcoin Trust Pursuant to NYSE Arca Rule 8.201-E (Commodity-Based Trust Shares), Exchange Act Release No. 34-95180 ( June 29, 2022). This triggered market panic and resulted in a 5% drop in Bitcoin price.

Investors had hoped for a positive response from the SEC. (Note: Grayscale Investments, which manages the world’s largest Bitcoin fund, Grayscale Bitcoin Trust (GBTC), attempted 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 the proposal complies 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 USC § 78f(b)(5). The 86-page SEC order denying 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 approving a Bitcoin Spot ETF would only invite further manipulation.

On the same day, Grayscale Investments petitioned the Court of Appeals for the DC Circuit to review the SEC’s denial. 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 cannot be easily avoided, but specific enough that businesses can operate with security.

Classification of cryptocurrencies: why this matters from a regulatory perspective

The question 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 bipartisan 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 trading in “digital commodities”. Significantly, Bitcoin and Ether were specifically defined as digital goods.

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 that their regulation appropriately rests with the CFTC. Under the bill, as envisioned, 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 “linked assets,” which are generally defined as intangible, exchangeable assets that are offered, sold, or delivered in connection with the purchase and sale of securities through an arrangement that constitutes an investment contract. The CFTC generally has jurisdiction over ancillary assets that fall within the definition of digital asset. However, disclosure requirements imposed by the bill on issuers of such ancillary assets would remain subject to the SEC’s jurisdiction.

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

CFTC Chairman Rostin Behnam, whose agency would gain significant new powers under the proposed bill, has said the bill “does a very good job” of distinguishing between what are securities and what are not.

While digital assets are becoming mainstream in many ways, there remains significant regulatory uncertainty and risk to consumers, financial stability, national security, climate and other important international interests.

The Greyscale 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. These ETFs were governed by the Investment Company Act of 1940 (’40 Act) and Chairman Gensler explained that he was more comfortable with that route because of the investor protections of 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 previously approved funds that had filed under the ’40 Act, Teucrium had filed under the Securities Act of 1933 (’33 Act) and the Exchange Act. Since this was the statute under which the spot ETFs were filed, and under the general principle of treating similar situations without 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 will trade based on the price of Bitcoin, unlike futures ETFs, which trade based on the price of Bitcoin futures. Bitcoin futures are a smaller market than spot Bitcoin and are not directly correlated to the price of Bitcoin (since again they are futures or derivatives). As such, the price of Bitcoin futures may deviate from the current price of Bitcoin, therefore Bitcoin futures ETFs may occasionally track the price of Bitcoin incorrectly.

Note that the trust has no redemption mechanism, meaning that GBTC shares cannot be created and destroyed as demand changes. As a result, the fund’s price is now roughly 30% below the value of its underlying Bitcoin.

Bitcoin futures derivatives markets have the same exposure to fraud and manipulation as spot markets, and Grayscale’s lawyers wrote in a letter to the regulator last year, “It is, of course, fundamental that the Commission — like any other federal regulatory agency — must treat similar situations without reasoned justification, says the letter.

We believe it is important to point out that the futures contracts underlying the bitcoin futures ETF are actually regulated and monitored by registered futures exchanges that have sophisticated monitoring capabilities. Meanwhile, the underlying Bitcoin of any Bitcoin Spot ETF will not be monitored by any registered entity.

Hester Peirce, a commissioner at the SEC, recently published comments on the regulatory agency’s failure to allow spot Bitcoin exchange-traded funds (ETFs) in the United States. “The continued refusal of the SEC to approve a spot Bitcoin ETP is puzzling to many agency observers,” Peirce said. “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 fails to apply consistent treatment to similar investment vehicles, and therefore acts arbitrarily and capriciously in violation of the Administrative Procedure Act and the Securities Exchange Act of 1934.” Press Release, Grayscale, SEC Decision on GBTC (June 29, 2022).

The Administrative Procedure Act (APA) is the statute that dictates how regulators govern and, in part, requires the SEC to treat similar situations. 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 stock exchanges such as the NYSE Arca.

The Grayscale team has been steadfast in its belief that this inconsistency in treatment creates uneven competition for Bitcoin ETFs – and Grayscale strongly believes that the SEC should approve a spot-based Bitcoin ETF, allowing investors to choose which product best meets their investment needs. . See A new argument for a Bitcoin ETFGrayscale (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 a lot of discretion given 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 block approval of this product, many other highly regulated jurisdictions, such as Canada and Australia, have approved spot Bitcoin ETF products for retail investors, leaving US investors at a disadvantage.

But we are mindful of the fact that there are clearly inherent problems in the structure of cryptocurrencies like Bitcoin that make it attractive to use for illegal purposes, and the current state of the regulatory system does little to discourage these illegal uses because it is so loosely monitored and confusingly structured.

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

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

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