Why the SEC Keeps Rejecting Spot Bitcoin ETFs (And Why Grayscale Investments Will Also Be Rejected)

The ultimate crypto investment product is an ETF that directly holds bitcoin.

This would be especially appealing to those who want to invest in bitcoin in their tax-sheltered retirement accounts. And institutional investors would also be interested in a direct bitcoin ETF, since it would allow them to side-step the issues of custodying bitcoin and related transaction fees.

While the Securities and Exchange Commission (SEC) has approved ETFs trading bitcoin futures contracts, these bitcoin futures funds have some serious problems. Investors are still waiting for a direct or spot ETF that holds bitcoin itself and trades on an American stock exchange.

U.S. investors are frustrated that direct or spot Bitcoin ETFs/ETPs have been already available in Europe since 2019 and in Canada since early 2021:

But the world’s largest financial markets and institutions are in the United States. And since 2017, the U.S. Securities and Exchange Commission (SEC) has rejected 12 applications for ETFs/ETPs that would allow both retail and institutional investors to have convenient, mediated exposure to bitcoin. Six of these rejections happened in just the past three months:

Today, the SEC delayed its decision on whether or not to accept Grayscale Investments’ plea to change their popular Bitcoin Trust (GBTC) into an ETF.

With $23.4 billion in AUM (as of 2/4/22) and 8.5 years of experience custodying bitcoin, many believe that Grayscale has the best chance at SEC approval.

However, we believe that Grayscale will be rejected, just as the 12 others before them. Here’s why…

What does the SEC require for the approval of a spot Bitcoin ETF?

It is no mystery what the SEC requires for approval. Their requirements have been spelled out clearly in every publicly available SEC Disapproval Order since 2017 (see SEC releases above).

These documents span hundreds of pages, so we offer an executive summary with our commentary:

1. Compliance with Section 6(b)(5) of the Securities Exchange Act of 1934:

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 and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, 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 by virtue of any authority conferred by this title matters not related to the purposes of this title or the administration of the exchange”

In all the Disapproving Orders (see links above), the SEC has particularly highlighted the following phrases: “The rules of the exchange are designed to prevent fraudulent and manipulative acts and practices [and] to protect investors and the public interest.”

Every single rejected application has been found non-compliant with this government statute. Compliance with Section 6(b)(5) of the Securities Exchange Act of 1934 is the golden key to unlocking SEC approval.

2. The language of Section 6(b)(5) of the Securities Exchange Act of 1934 is non-specific and vague, but the SEC has spelled out in detail what compliance would look like:

“An exchange that lists bitcoin-based exchange-traded products (“ETPs”) can meet its obligations under Exchange Act Section 6(b)(5) by demonstrating that the exchange has a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying or reference bitcoin assets.” (Order Disapproving First Trust Skybridge Bitcoin ETF, pp. 2-3)

This statement is the holy grail for a Bitcoin ETF, but so far, no one has been able to satisfy its requirements.

For clarity's sake, "exchange" here refers to the stock market exchange that lists the potential ETF (e.g. NYSE), not a cryptocurrency exchange.

We can break down this SEC statement into three parts:

2.1 The listing exchange has a comprehensive surveillance-sharing agreement(CSSA) with a regulated market of significant size.

The SEC defines “surveillance-sharing agreement” very clearly in their Disapproval Orders: “The hallmarks of a surveillance-sharing agreement 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.” (Order Disapproving First Trust Skybridge Bitcoin ETF, p. 4)

The problem here is obvious: worldwide cryptocurrency exchanges have little to no government regulation, especially outside of the United States. Even reputable U.S. exchanges like Coinbase sometimes refuse to reveal customer identity to government organizations requesting information (FBI, ICE, SEC, IRS), despite requiring new customers to provide photo ID during sign-up.

Part of the appeal of cryptocurrencies is anonymity. Crypto enthusiasts often have a libertarian view of government and see bitcoin as a means to fight back against the Federal Reserve’s and the U.S. government’s inflating of the money supply.

Therefore, any crypto exchange that has surveillance-sharing agreements will likely receive backlash from a significant number of crypto traders (although institutional investors would probably welcome such surveillance-sharing agreements).

And no single cryptocurrency exchange would probably qualify as a “market of significant size,” so any securities exchange listing a bitcoin ETF would need to enter into surveillance-sharing agreements with multiple crypto exchanges. And there is the additional problem that most of the large exchanges are not based in the U.S. And regulation and compliance are generally much looser outside of the U.S.

Applicants for a spot bitcoin ETF have attempted to argue that there are other means of preventing fraud and manipulation besides a surveillance-sharing agreement, but these arguments have not been successful. For example, some have argued that bitcoin’s market cap and liquidity have grown so large since 2017 that attempts to manipulate bitcoin’s price are now very expensive and difficult (Order Disapproving First Trust Skybridge Bitcoin ETF, pp. 13-14). But the SEC remains unpersuaded by these arguments and continues to insist on surveillance-sharing agreements as the only means of preventing fraud and price manipulation.

2.2 The CSSA is made with a “regulated” market of significant size.

Every bitcoin ETF application has explained that they will track and discover the price of bitcoin through some sort of averaging of bitcoin price on multiple cryptocurrency exchanges. For example, applications from First Trust Skybridge, Wise Origin, VanEck, Valkyrie, Kryptoin, and WisdomTree would have used five exchanges: Bitstamp, Coinbase, Gemini, itBit, and Kraken (Order Disapproving First Trust Skybridge Bitcoin ETF, p. 10; Order Disapproving WisdomTree Bitcoin Trust, p. 9; Order Disapproving Wise Origin Bitcoin Trust, p. 10; Order Disapproving VanEck Bitcoin Trust, pp. 9-10; Order Disapproving Valkyrie Bitcoin Fund, p. 9; Order Disapproving Kryptoin Bitcoin ETF Trust).

Earlier attempts listed fewer or different exchanges. For example, the Winklevoss Bitcoin Trust would have only tracked the price of bitcoins on Gemini, a clear conflict of interest since the Winklevoss brothers started the Gemini exchange (Order Disapproving Winklevoss Bitcoin Trust, p. 4). The SolidX Bitcoin Trust would have used Bitfinex, Bitstamp, GDAX (now known as Coinbase Pro), itBit, and OKCoin (Order Disapproving SolidX Bitcoin Trust, p. 3).

The Bitwise Bitcoin ETF Trust listed no specific exchanges, but instead asserted that the bitcoin price would derive from “selected platforms that trade bitcoin in the bitcoin spot market . . . that the Sponsor asserts currently account for substantially all of the ‘real’ spot global volume of bitcoin traded on such platforms, excluding trading in capital-controlled countries.” (Order Disapproving Bitwise Bitcoin ETF Trust, p. 8).

These are reputable exchanges, yet none of them are officially registered by the SEC, despite selling products that are essentially securities (i.e., buyers expect what they buy to increase in value). Some of them have varying amounts of self-regulation, but the SEC is dissatisfied since the SEC wants to have direct authority over cryptocurrency exchanges.

The SEC has said repeatedly: “The level of regulation of the Constituent Platforms [the group of exchanges] is not equivalent to the obligations, authority, and oversight of national securities exchanges or futures exchanges and therefore is not an appropriate substitute. . . . national securities exchanges are subject to [SEC] Commission oversight of, among other things, their governance, membership qualifications, trading rules, disciplinary procedures, record keeping, and fees. The Constituent Platforms, on the other hand, have none of these requirements (none are registered as a national securities exchange).” (Order Disapproving First Trust Skybridge Bitcoin ETF, pp. 33-34)

Therefore, until Bitstamp, Coinbase, Gemini, itBit, Kraken (or other large crypto exchanges) register with the SEC as national securities exchanges and submit to SEC regulation, it is unlikely that the SEC will approve a spot bitcoin ETF.

The exchanges could do this voluntarily, or Congress could pass a law forcing cryptocurrency exchanges in the United States to register with the SEC. But Congress and the SEC would have no authority over non-U.S. exchanges (such as Bitstamp, KuCoin, Bitfinex, and Binance) and non-U.S. exchanges still dominate the global market for cryptocurrency exchanges.

Ultimately, applicants for bitcoin ETFs have no control over the cryptocurrency exchanges, whether U.S. exchanges will register with the SEC, and whether non-U.S. exchanges will crack down on illegal activities, so it is a steep and difficult road to SEC approval of a spot bitcoin ETF.

An initial step towards the approval of a spot bitcoin ETF would be for Congress to force U.S. cryptocurrency exchanges to register with the SEC, but no such legislation is forthcoming. Yet even the U.S. has no jurisdiction over non-U.S. exchanges such as Binance, which makes up the vast majority of crypto trading.

2.3 The CSSA is made with a regulated market “of significant size.”

While no crypto exchange has a surveillance-sharing agreements with any major stock exchange, there is one bitcoin market that is “regulated” and has a “surveillance-sharing agreement” with the major American stock exchanges (NYSE, NASDAQ, CME) – the Chicago Mercantile Exchange (CME) bitcoin futures market.

The CME bitcoin futures market is regulated by the Commodity Futures Trading Commission (CFTC), so this fulfills the SEC’s requirement that the market be “regulated.” Current SEC chair Gary Gensler actually served as the chair of the CFTC from 2009 to 2014, so he is obviously familiar with the regulation of the CFTC and was himself influential in creating such regulation.

Furthermore, because the CME and NYSE are members of the Intermarket Surveillance Group (ISG), the SEC considers such common membership in the ISG as fulfilling the requirement that the listing Exchange for a bitcoin ETF have a surveillance-sharing agreement with a regulated market (Order Disapproving First Trust Skybridge Bitcoin ETF, p. 23). Thus, the CME bitcoin futures market satisfies the two of the SEC’s requirements – it is a “regulated” market and it has a “surveillance-sharing agreement” with American stock exchanges.

However – the question is whether the CME bitcoin futures market is “of significant size.” The SEC says no, based on two arguments:

  1. Someone attempting to manipulate the proposed ETF would not have to trade on the CME bitcoin futures market to manipulate the proposed ETF. Contrary to what various applications have argued, the CME bitcoin futures market is very small since its daily volume is so small compared to global crypto exchanges.
  1. The proposed ETF could become the predominant influence on prices in the CME bitcoin futures market and even potentially on the broader bitcoin spot market. If the proposed ETF had billions of dollars in AUM, it could become a predominant influence on bitcoin price (Order Disapproving First Trust Skybridge Bitcoin ETF, p. 40: “there is no limit on the number of bitcoins that the Trust may acquire . . . if the number of bitcoins acquired by the Trust is large enough relative to global bitcoin supply and demand, further creations and redemptions of Shares could have an impact on the supply of and demand for bitcoins and that such an impact could affect the price of bitcoin”)

The SEC makes clear that this applies to both trading bitcoin by the ETF (i.e. the ETF’s fund managers buy/sell bitcoin on unregulated crypto exchanges) and trading Shares in the ETF (i.e., traders buy/sell the ETF on the NYSE, which forces the ETF’s fund managers to buy/sell bitcoin). See Order Disapproving First Trust Skybridge Bitcoin ETF, pp. 37-43.

Trading in the fund is just as dangerous as trading by the fund. What if someone placed a $5 million buy order for GBTC -- would Grayscale have to fill that order immediately? That would surely influence the price of bitcoin. In other words, the SEC would probably like to see daily limits on trading in the fund, perhaps limiting themselves to buying 500 or so bitcoins per day, so as not to influence the price of bitcoin.

But there is the additional problem of the size of a spot bitcoin fund:

Any fund that becomes too large relative to the total bitcoin market poses its own danger for price manipulation. This is particularly problematic for Grayscale’s proposed bitcoin ETF. As of 2/4/22, Grayscale controls 643,606 bitcoins (3.1% of all bitcoins that will ever be in existence). A corrupt fund manager at Grayscale Investments could manipulate the price of bitcoin because of how many bitcoins Grayscale controls.

The elephant in the room that the SEC and applications for spot bitcoin ETFs ignore is the fact that non-U.S. crypto exchanges are the largest markets for bitcoin.

The crypto exchange Binance by itself has more weekly visits and more volume than the next 14 largest cryptocurrency exchanges! Binance was initially based in China, but now is registered in the Cayman Islands. And Binance is under investigation by the U.S. Department of Justice and IRS for money laundering and tax offenses.

To summarize the SEC’s arguments in this section:

  • While the CME bitcoin futures market is “regulated” and has a “surveillance-sharing agreement” with American stock exchanges, it is not a market “of significant size.” The bitcoin markets “of significant size” are the unregulated crypto exchanges, which do not have surveillance-sharing agreements with American stock exchanges.
  • Applicants for a bitcoin ETF need to show that the ETF itself would not become a predominant influence on the price of bitcoin. A bitcoin ETF with billions of dollars in AUM could become a predominant influence on bitcoin price (such as Grayscale’s Bitcoin Trust).

Conclusion and Volt Equity’s Commentary

The issues needing to be addressed largely cannot be controlled or changed by applicants for a bitcoin ETF:
  • Crypto exchanges must enter into a “surveillance-sharing agreement” with American stock exchanges. This seems highly unlikely because of the loss of anonymity and customer privacy.
  • Crypto exchanges must be considered “regulated” according to the SEC; the current self-regulation is insufficient according to the SEC. Therefore, crypto exchanges must either voluntarily register with the SEC (none have done so yet), or Congress needs to force crypto exchanges to register with the SEC (no such legislation is pending).
  • Non-U.S. crypto exchanges (especially Binance) dwarf U.S. crypto exchanges in volume and the American government has no authority to force regulation upon non-U.S. crypto exchanges.
  • While the CME bitcoin futures market is “regulated” and has a “surveillance-sharing agreement” with American stock exchanges, it is not a market “of significant size.”
The requirements for SEC approval are extremely high, making us wonder whether any bitcoin ETF will be approved any time soon. We believe that many fund managers are conveying more optimism regarding a spot bitcoin ETF than is warranted based on a careful reading of the SEC’s Disapproving Orders.