The ‘Bitcoin (Crypto) ETF’ Primer Series: PART IV

By Rodrigo Zepeda, CEO, Storm-7 Consulting

INTRODUCTION

In Part I of this Blog Series, we provided an analysis of crucial underlying financial market fundamentals and methodologies relating to what are globally referred to as ‘exchange-traded funds’ (ETFs). It was identified that the top two regional markets for ETFs were first, the United States (US) market, and second, the European market (i.e., European Union (EU)) (Deutsche Asset Management 2017, p. 5). In Part II of this Blog Series, we explored the nature of crypto futures ETFs and crypto spot ETFs in more depth, and in particular, the distinction between Bitcoin (BTC) futures ETFs and Bitcoin spot ETFs, in terms of characteristics and US regulatory frameworks.

Strictly speaking, in the US an ETF may be registered under the Investment Company Act of 1940 (1940 Act), whereas US commodity-based ‘exchange-traded products’ (ETPs) may be registered under the Securities Act of 1933 (1933 Act). Both ETFs and ETPs referencing Bitcoin futures have been listed to trade in the US, however, to date the ‘U.S. Securities and Exchange Commission’ (SEC) has steadfastly refused to approve an ETP based on a spot Bitcoin market. In the words of SEC Commissioner Hester M. Peirce, “The Commission’s resistance to a spot bitcoin ETP is becoming almost legendary.” (Peirce 2022).

We previously analysed why the different regulatory approval procedures under the 1940 Act and under the 1933 Act using Form 19b-4, played such a crucial distinguishing role with respect to achieving such regulatory approval. We identified why a new proposed Bitcoin spot product is required to submit a ‘proposed rule change’ (PRC) to the SEC further to the requirements of the Securities Exchange Act of 1934 (1934 Act), in order to obtain formal listing approval (Investment Company Institute 2017, p. 7). Such a PRC requires inter alia that the rules of an ‘exchange’ are designed to prevent fraudulent and manipulative acts and practices, and to protect investors and the public interest (1934 Act, section 6(b)(5)).

To date, the SEC has disapproved all PRCs filed with respect to potential Bitcoin spot ETPs, because it has not found such proposals to be consistent with section 6(b)(5) of the 1934 Act. In particular, the SEC has generally identified the lack of a relevant ‘Surveillance Sharing Agreement’ (SSA) as being fatal to such applications. To approve a PRC, the SEC must find that the PRC is consistent with section 6(b)(5) of the 1934 Act, i.e., the exchange has the capacity to enforce compliance with its rules and securities laws designed to prevent fraud and manipulation (SEC 1994).

The evaluation undertaken by the SEC must consider whether the US exchange sponsoring the Bitcoin spot ETF, has entered into SSAs with relevant foreign markets, and whether those SSAs can provide it with information needed to enforce its rules and US laws and regulations to protect investors from the effects of intermarket manipulation (SEC 1994). There are many SEC decisions which have set out principles to take into consideration when analysing the authorisation process for a future Bitcoin spot ETP. A select few considered here include:

(1) SEC Release No. 34-80206; File No. SR-BatsBZX-2016-30; 10 March 2017 (Bats 2017);  

(2) SEC Release No. 34-83723; File No. SR-BatsBZX-2016-30; 26 July 2018 (Bats 2018);

(3) Dissent of Commissioner Hester M. Peirce to Release No. 34-83723; File No. SR-BatsBZX-2016-30; 26 July 2018 (Bats 2018 Dissent);

(4) SEC Release No. 34-88284; File No. SR-NYSEArca-2019-39; 26 February 2020 (USBT 2020);

(5) Dissenting Statement of Hester M. Peirce in Response to Release No. 34-88284; 26 February 2020 (USBT 2020 Dissent);

(6) SEC Release No. 34-94620; File No. SR-NYSEArca-2021-53; 6 April 2022 (Teucrium 2022);

(7) SEC Release No. 34-94853; File No. SR-NASDAQ-2021-066; 5 May 2022 (Valkyrie 2022); and

(8) SEC Release No. 34-95180; File No. SR-NYSEArca-2021-90; 29 June 2022 (Grayscale 2022).

Based on these decisions, along with previous discussions in this Blog Series, I will set out a range of potential “options” for readers which illustrate different ways in which US Bitcoin spot ETF markets might potentially develop in the future.

OPTION 1: The Reverse Bitcoin Spot ETF Approach

In short, instead of US Bitcoin spot ETF markets catalysing global Bitcoin spot ETF markets, this happens in reverse. As a result, this is one of the slowest options. This is because it relies on evolutionary developments in global ETF markets to first catalyse retail and institutional Bitcoin futures and spot ETF investments, which then subsequently facilitate the launch of Bitcoin spot ETFs in the US. In Bats 2017, the SEC noted that Bitcoin was still in the relatively early stages of its development, and over time regulated Bitcoin-related markets of significant size were sure to develop (Bats 2017, p. 38). At present, a number of Bitcoin futures and spot ETFs have been listed on different exchanges around the world, including in:

(1) Australia (e.g., 3iQ CoinShares Bitcoin Feeder ETF (BT3Q), 21Shares Bitcoin ETF (ABTC), Cosmos Bitcoin ETF (CBTC));

(2) Brazil (e.g., QBTC11);

(3) Canada (e.g., Evolve Bitcoin ETF (EBIT), CI Galaxy Bitcoin ETF (BTCX), Purpose Bitcoin ETF (BTCC));

(4) Dubai (e.g., 3iQ Bitcoin Fund (QBTC)); and

(5) Europe/EU (e.g., Jacobi Bitcoin ETF (BCOIN)) (Akhtar 2021; Anahit 2021; Chawla 2021; Maishera 2021; Coghlan 2022).

As more and more of these types of ETFs are launched and traded globally, Bitcoin-related markets of significant size traded on regulated exchanges will increase and expand. I believe the speed of expansion is likely to increase, owing to the diversity of underlying assets on which such ETFs are based. For instance, ETFs not only for Bitcoin, but also potentially for hundreds of other cryptocurrencies such as Ethereum (ETH), Litecoin (LTC), and Ripple (XRP), as well cryptocurrency index ETFs, and decentralised finance (DeFi) ETFs, e.g., the Brazilian Hashdex DeFi Index ETF (Johnson 2022). As a result, it would only be a matter of time before external global crypto spot ETF markets become sufficiently developed to facilitate SEC approval of an internal US Bitcoin spot ETF - likely somewhere between 3 to 6 years.

OPTION 2: The Traditional Exchange Driven Approach

In this option, the development of the Bitcoin spot ETF market in the US is potentially driven by traditional securities exchanges situated worldwide. Many global crypto investors may not be familiar with the ‘Intermarket Surveillance Group’ (ISG). However, it is an institution that was established in 1981 to effectively detect and prevent unfair transactions across markets through market information sharing among its group members (ISG 2022). The ISG’s membership covers 60 major self-regulatory bodies, such as Bourse de Montreal Inc.; Cboe Global Markets; Chicago Mercantile Exchange (CME) Group; Eurex; Hong Kong Exchanges & Clearing Ltd. (HKEX); ICE; London Stock Exchange; Nasdaq; and New York Stock Exchange (NYSE) (ISG 2022).

Past SEC decisions have confirmed that ISG membership will generally be sufficient per se to satisfy regulatory obligations relating to SSAs (Bats 2018, p. 53; Teucrium 2022, p. 11). This means, that in theory, any future crypto ETF products listed on any ISG member exchanges, should in general satisfy SEC requirements relating to SSA obligations. In 2021, Eurex, the Frankfurt based exchange, launched its Bitcoin Exchange Traded Note (ETN) futures product in Europe, which it touted as its first step in its portfolio of crypto derivatives (Eurex 2021; Basar 2021). Eurex also lists ETH ETNs, LTC ETNs, and Bitcoin Cash (BCH) ETNs. In theory, Eurex listed products could be offered on other ISG exchanges around the world, such as HKEX, or in the US via Nasdaq or the NYSE, e.g., dual-listed products.

The launch of such crypto derivatives products as well as potential crypto spot ETFs on ISG member exchanges, may very well lead to greater global market competition between traditional exchanges. However, it is also possible that it may lead to collaboration between traditional ISG exchanges. In theory, a Bitcoin spot ETF launched on an ISG member exchange could also be made available on a US ISG member exchange. This type of exchange collaboration could help to catalyse the launch of Bitcoin spot ETF markets in the US. So, say if in the future Euronext Amsterdam Exchange became an ISG member, it could potentially list the Bitcoin spot ETF BCOIN on Nasdaq in the US, thereby facilitating the launch of a Bitcoin spot ETF in the US.

OPTION 3: The Crypto Exchange Driven Approach

In this option, certain crypto exchanges that are strategically intelligent may realise that they will need to become fully licensed to expand their product offerings and comprehensively compete on global crypto markets, i.e., both retail and institutional investors. It is these crypto exchanges that could in theory drive the evolution of crypto spot ETF markets in the US. Historically, traditional securities exchanges and modern crypto exchanges have operated as distinctly separate trading venues.

Generally, the former developed extremely sophisticated technology infrastructures over decades of operations, which has resulted in them maintaining huge orders books that now covers masses of different asset classes and financial instruments, e.g., shares, bonds, derivatives (forwards, futures, options, swaps), foreign exchange instruments, indexes. In contrast, modern crypto exchanges developed operational structures that facilitated trading of a narrow core range of assets, i.e., digital assets such as cryptocurrencies (exchange tokens), asset-backed tokens, utility tokens, security tokens, and stablecoins (stable tokens) (Ankney 2019; Veksler 2020; Little 2022).

Whilst these have generally only developed over the past decade, the volumes of transactions they process have massively increased over a relatively short period of time. As a result, their operational infrastructures have become more sophisticated. Three reasons provided why incumbent market infrastructures have not yet merged with crypto and digital asset trading venues are: (1) the majority of crypto exchanges operate under low regulatory licensing or oversight; (2) the technological infrastructure of some crypto exchanges does not fulfil institutional-grade requirements; and (3) there is still a significant divergence between client groups, i.e., institutional clients (traditional exchanges) and retail clients (crypto exchanges) (Roth 2022).

However, crossover between the two is now clearly underway. On the one hand, traditional exchanges are now issuing crypto futures, spot ETFs, and other hybrid crypto derivative products to enable institutional clients to build exposure in crypto assets (Roth 2022). On the other hand, crypto exchanges are now venturing into the regulated market framework because of regulatory requirements imposed relating to know-your-client (KYC) and anti-money laundering (AML) regulatory obligations (Roth 2022). Some believe crypto exchanges may not wish to register with domestic regulators as fully licensed exchanges, or enter into SSAs, as this reflects a centralisation commercial strategy which clashes with the decentralised industry concept of cryptocurrencies (CNBC 2022).

For me, this represents a somewhat myopic philosophy. Crypto exchanges that focus only on facilitating trading in cryptocurrencies essentially retain narrow business models with limited scope for business expansion activities. At present, this means hundreds of crypto exchanges are fiercely competing for the same small slice of the pie. For instance, for the top 100 cryptocurrency exchanges by volume listed for July 2022, only two exchanges held a market share larger than 2% - these were Binance (n=6.88%) and CITEX (n=2.71%) (Statista 2022). All the rest generally hold less than 1% market share each, i.e., highly inefficient business models.

At the same time, traditional exchanges have the technological infrastructure, resources, and capabilities to aggressively launch masses of new crypto products over the next few years. And I am quite certain that they will. This means they will likely secure and control institutional crypto markets en masse. Crypto exchanges that are strategically intelligent will understand this, and they may potentially seek to fully register as exchanges and enter into SSAs, so as to aggressively compete for a future share of crypto institutional investors. Those crypto exchanges that do so may be able to offer Bitcoin spot ETFs in the US and expand their commercial market product strategy.

OPTION 4: The Greyscale Legal Appeal Approach

The SEC only very recently rejected the proposal by Grayscale Investments, LLC (Grayscale) to convert its existing Grayscale Bitcoin Trust into a spot ETF (Benjamin 2022; Grayscale 2022). As a result, Grayscale has now launched a legal appeal of this decision with the US Court of Appeals, District of Columbia Circuit (NG 2022; Palma and Langley 2022). It is possible that a legal appeal approach such as the one invoked by Grayscale, may be one way that a Bitcoin spot ETF is ultimately launched in the US. I have not had the opportunity to review the substantive legal appeal it filed. However, I believe that a substantive law point raised previously in the dissenting opinions of SEC Commissioner Hester M. Peirce does have legal merit.

Commissioner Peirce believed that the SEC had previously read the requirements of section 6(b)(5) of the 1934 Act erroneously (Bats 2018 Dissent). She argued the SEC disapproval order had focused on the characteristics of the Bitcoin spot market, instead of the ability of the exchange to surveil trading and deter manipulation in ETP shares listed and traded on the exchange (Bats 2018 Dissent). Consequently, Commissioner Peirce contended that the focus of the wording within the legislation was clear, and it said nothing about the SEC looking at underlying markets. This could form the basis for a substantive law appeal based on legislative interpretation. In a subsequent dissenting opinion, Commissioner Peirce asserted the SEC had wrongly applied a unique, heightened standard under section 6(b)(5) of the 1934 Act (USBT 2020 Dissent).

She considered that the SEC had not looked to the rules of the listing exchange, but had reviewed the quality (i.e., merits) of the underlying Bitcoin spot or futures market instead, which reflected a ‘heightened market quality standard’ akin to a type of ‘merit regulation’ (USBT 2020 Dissent). I believe this is a substantive interpretative point of law that could and should be reviewed by the US courts to definitively assess which approach to interpreting the legislation is correct. If Commissioner Peirce is correct, it would mean that in theory Grayscale’s Bitcoin spot ETF could and should be approved, thereby paving the way for the introduction of additional Bitcoin spot ETFs in the US.

OPTION 5: The SEC Approach to US Bitcoin Spot ETF Authorisation

The current SEC approach to US Bitcoin spot ETF authorisation can be discerned from relevant SEC decisions. When an exchange files a PRC the SEC must determine whether the PRC is consistent with statutory provisions and the rules and regulations applicable to national securities exchanges (Valkyrie 2022, p. 2). The SEC asserts that it will apply the same standard used to consider Bitcoin commodity trusts and Bitcoin trust issued receipts (Valkyrie 2022, p. 6).

Section 6(b)(5) of the 1934 Act

An exchange that lists a Bitcoin ETP can meet its obligations under section 6(b)(5) of the 1934 Act, by demonstrating that it has a comprehensive SSA with a regulated market of significant size (MSS) related to the underlying or reference Bitcoin assets (Valkyrie 2022, p. 7; Teucrium 2022, p. 9). For example, for CME Bitcoin futures contracts, the analysis focuses on whether Nasdaq has a SSA with a regulated MSS related to CME Bitcoin futures contracts (Valkyrie 2022, p. 9). The SSA is required to demonstrate the ‘hallmarks’ of a SSA, which are:

“…that the agreement provides for the sharing of information about market trading activity, clearing activity, and customer identity; that the parties to the agreement have reasonable ability to obtain access to and produce requested information; and that no existing rules, laws, or practices would impede one party to the agreement from obtaining this information from, or producing it to, the other party” (Teucrium 2022, p. 10).

To establish a market is a MSS in relation to the underlying assets, it must be proved that a market is one where: (1) there is a reasonable likelihood that someone attempting to manipulate the ETP would have to trade on that market to successfully manipulate the ETP (so a SSA would assist in detecting/deterring misconduct) (Prong 1); and (2) it is unlikely trading in the ETP would be the predominant influence on prices in that market (Prong 2) (together the MSS Test) (Teucrium 2022, p. 11). As this definition is not exclusive, there are other ways in which an exchange could potentially prove the MSS Test, i.e., to prove sufficient means to prevent fraudulent and manipulative acts and practices (Teucrium 2022, p. 11).

STEP 1

The exchange must demonstrate it has a SSA in place with a relevant market. The relevant crypto exchange must therefore be either an ISG member, or it must put in place an SSA that is functionally and substantively equivalent to an ISG SSA – this is a very strict alternative test and will not be easy to meet.

STEP 2

The exchange must prove the MSS Test using the substantive tests set out in Prong 1 and Prong 2. To prove Prong 1, an exchange must either: (1) provide enough evidence to prove that the market is sufficiently large that someone would have to trade on that market to try to manipulate the ETP; or (2) prove that the surveillance by an exchange is sufficient (i.e., can be reasonably relied upon) to identify both direct and indirect attempts to manipulate prices of contracts (Valkyrie 2022, pp. 12-13).

To prove Prong 2, an exchange must prove that ETP trading would not be the predominant influence on prices, for instance, by demonstrating this through inter alia significant volumes in Bitcoin futures or spot markets, significant liquidity in futures or spot markets (Teucrium 2022, p. 17), or evidence establishing a lead-lag relationship where the Bitcoin spot market is led by a relevant market (USBT 2020, p. 61).

STEP 3

As an alternative to proving the MSS Test, an exchange can prove that the Bitcoin market as a whole, or the relevant underlying Bitcoin market, is uniquely and inherently resistant to fraud and manipulation, i.e., the underlying market inherently possesses a unique resistance to manipulation (Grayscale 2022, p. 9). Such resistance must be shown to be novel and beyond protections that exist in traditional commodity or securities markets (Grayscale 2022, pp. 10-11). This is a very difficult substantive and operational test that must be met, and in Grayscale 2022 this test was not met. However, with the right market and operational data, I believe that this test can be met in certain circumstances.

Final Comments

As can be seen, the SEC, has in actual fact, set out a legal test and approach that must be followed in order for an exchange to successfully submit a PRC to list a Bitcoin spot ETF in the US. Once you have read a range of the SEC decisions in depth, you can see that what is absolutely the most crucial aspect of any Bitcoin spot ETF application, is the relevant supporting market data. Yet, in each and every one of the rejected Bitcoin spot ETF applications the SEC has identified a clear lack of data in support of such applications.

What seems to have happened, is that these applications have been driven by representative US law firms that have predominantly focused on a traditional US securities type approach which centres on legal arguments. This is not what is required. In fact, the likelihood is that this type of antiquated traditional law firm approach will invariably not work. What is required, is a financial market data, crypto data, and Big Data Analytics approach when applying for a new Bitcoin spot ETF.

Virtually all US law firm applications in the SEC decisions I have analysed seem to be distinctly lacking this type of approach – they do not seem to be sufficiently equipped to do this in terms of the required data and technological expertise and personnel, as they focus on legal arguments instead of data-driven arguments (I would be happy to prove this if necessary). Yet, as Christopher Matta, President of 3iQ (US) stated, when the Canadian firm’s Bitcoin spot ETF application to the Ontario Securities Commission (OSC) was first rejected, “We battled the OSC, and we won using a data-driven approach” (Strack 2022). Ergo, the data-driven approach works. To successfully launch new Bitcoin spot ETFs in the US markets, firms need to find data and technology firms that can support a data-driven approach to SEC applications, rather than relying on antiquated US law firm arguments that seem to be going absolutely nowhere. 

I do hope that readers of this Blog Series have found the posts helpful, and that they have equipped readers with a more sophisticated understanding of the nature and future direction of crypto ETFs and Bitcoin ETFs.

If you have any questions regarding this blog, or any legal, data, or other issues raised in this blog, please contact Storm-7 Consulting Client Services.