Introduction
For years, the Securities and Exchange Commission (SEC) has squashed the efforts of cryptocurrency proponents in launching Bitcoin exchange-traded funds (ETFs). Since 2021 alone, the SEC has rejected more than 30 Bitcoin ETF proposals, a move justified by the agency as necessary to protect investors. Their main concern? The potential for fraud, market manipulation, and unpredictable volatility normally associated with cryptocurrencies. Yet, the recent unanimous ruling in Grayscale Investments, LLC v. SEC appears to signal a pivotal turning point. There is a renewed sense of hope and optimism that this case might signal a regulatory breakthrough potentially reshaping the crypto investment landscape.
Grayscale Fights Back
Grayscale, controlling over 3% of all Bitcoin, made headlines in 2021 when it filed to convert its vast treasure of Bitcoin assets into an ETF. However, like many before it, the firm encountered resistance from the SEC. A rejection soon followed, pushing Grayscale to challenge the decision in court. Grayscale’s argument was simple: the SEC had previously approved Bitcoin futures so why should ETFs be treated any differently? Given the close ties between futures and ETFs, Grayscale believed the denial of their ETF proposal was baseless.
Understanding ETFs and Futures: Before diving deeper, it may be helpful to understand the nuances of ETFs and futures. These two financial instruments, while popular, serve different purposes and have distinct characteristics.
An ETF, much like a mutual fund, is essentially a basket of assets, which can include stocks, bonds, commodities or any combination of these that tracks an index. Similar to individual stocks, ETF shares can be freely traded on stock exchanges making them desirable for their diversification, liquidity, cost-effectiveness.
Futures, on the other hand, are standardized contracts that bind two parties to buy or sell an asset at a predetermined price on a specified future date. These contracts are traded on futures exchanges and can be based on a variety of underlying assets, from commodities like oil and gold to financial instruments such as interest rates or currencies. Notably, futures enable investors to use leverage to control a portion of the underlying asset with a relatively small amount of capital catering to both speculative and hedging strategies.
Despite their unique features, ETFs and futures have some important parallels. For one, both instruments allow investors to gain exposure to an asset or group of assets without owning them directly. Second, because both instruments are designed to mirror the performance of their respective underlying assets they inherently share an intrinsic economic connection.
The “Significant Market Test” Conundrum
In articulating their rejection, the SEC argued that Grayscale’s ETF proposal failed to meet the dual prongs of the “significant market test.” This test gauges whether the listing exchange has a “surveillance sharing agreement” with a related regulated market of significant size giving it the capacity to detect and deter manipulation. A surveillance sharing agreement essentially facilitates cooperative monitoring efforts to combat market malpractices, fraud, and other wrongdoings. Emphasizing the distinctions between futures markets and ETFs, the SEC maintained that Grayscale's proposal fell short of adequately addressing the prevention of fraud and manipulation. The court, however, was not swayed by the SECs rationale, questioning the agency's inconsistent application of the test for ETFs compared to futures, especially in light of the 99.9% market correlation between them. The court ultimately held that the SEC’s denial of Grayscale’s ETF was “arbitrary and capricious” when compared with recently approved Bitcoin futures traded products. Applying the administrative law principle that “agencies must treat like cases alike,” the court vacated the order.
In their brief, Grayscale took further issue with the application of the SEC's significant market test, deeming it legally unsound. They highlighted that the surveillance-sharing agreement requirement overstepped the statutory requirements of the Exchange Act. The U.S. Chamber of Commerce, in its amicus brief, reinforced this stance, echoing the assertion that the SEC's test isn't expressly within the Exchange Act and isn’t articulated in any regulatory guidelines. As per 15 U.S.C. § 78f(b)(5), exchanges are simply tasked with formulating rules aimed at preventing “fraudulent and manipulative” activities.
Further adding to the uncertainty regarding the test, the SEC – in its Winkelvoss Order that denied a similar Bitcoin ETF application – indicated that the two prongs used in the analysis were merely “illustrative and not exclusive.” Despite the test’s contentious nature, the court, having already rejected the SEC's decision on different grounds, was able to sidestep the issue leaving it to be addressed at another time.
Aftermath
The ripple effects following the ruling were felt immediately with Coinbase’s stock surging upwards of 15% and the Bitcoin market as a whole seeing appreciation. Such a reaction hints at some transformative shifts on the horizon:
Regulatory Transparency: The ruling may catalyze the SEC into offering clearer and more transparent guidelines for cryptocurrency regulations. More transparency could lead to more predictability and instill greater confidence in the crypto market.
Institutional adoption: Many institutional players have remained on the sidelines waiting for more secure and regulated investment vehicles. The pathway to Bitcoin ETFs opening up may signal an opening for these entities to channel substantial investments in the crypto realm further increasing adoption.
Increased Crypto Legitimacy: With the crypto arena long seen as the Wild West, many retail investors have been skeptical. A landmark legal triumph such as this could bolster the perceived legitimacy of the entire crypto market, potentially attracting a wave of retail investors who had previously been on the fence.
Conclusion
While the Grayscale verdict is a major victory for crypto enthusiasts, the journey from here is far from smooth. The SEC’s next moves are uncertain as the window for appeal remains open until mid-October. Although the SEC could offer a more specific reason in a renewed rejection of Grayscale's application, a more drastic option at the SECs disposal would be to roll back approval for Bitcoin futures to address the inconsistencies in their decisions. For now, many large firms like BlackRock Inc. and Fidelity with pending applications find themselves eagerly waiting in the balance.
*The views expressed in this article do not represent the views of Santa Clara University.
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