/>iOn January 10, 2024, the U.S. Securities and Exchange Commission (SEC) approved the launch of several BTC Exchange-Traded Funds (ETFs).[1] The approval order resolves the critical legal and regulatory issues entailed in launching a BTC ETF. Shares in trusts holding BTC can now be bought and sold on SEC-regulated exchanges, although other issues remain.
It may be that the SEC did this only because it was basically ordered to do so by three federal judges, and we note that its approval follows more than twenty disapprovals of other similar funds over the last six years.[2] But for once we see forward-looking progress rather than “regulation by enforcement.”
James Gorman, recently retired CEO and now Executive Chairman of Morgan Stanley, allows that Bitcoin has a role to play, albeit a “very small” one, in a rich person’s portfolio.[3] Meanwhile, Jamie Dimon, CEO and Chairman of JPMorgan Chase, has long held, to the contrary, that Bitcoin is “worthless.”[4] Between these two grand old men of traditional finance (TradFi), who’s right and who’s wrong about Bitcoin?
Asked to decide, the SEC – to its credit — has decided not to decide. Rather, the SEC will let the markets decide. Specifically, the SEC will insist on full disclosure regarding Bitcoin ETFs, then let investors decide whether they want to invest.
In this piece, we explain how the stage for this development was set by Grayscale Investments’ victory over the SEC in the U.S. Court of Appeals for the District of Columbia Circuit. Next, we explain what the SEC has now approved, and why. Then we comment on what’s to come and what it all means.
Grayscale Investments v. SEC
The SEC’s order approving these BTC ETFs (Approval Order)[5] follows in the wake of Grayscale Investments’ August 2023 victory in the D.C. Circuit, in which a unanimous court (appointed by Presidents from both parties) ruled that the SEC was “arbitrary and capricious” in rejecting Grayscale’s application to convert its Grayscale Bitcoin Trust into a BTC ETF listed on NYSE Arca.[6] The SEC had approved applications for the listing of two ETFs based on BTC futures contracts. The court found these futures-based ETFs to be materially similar to Grayscale’s BTC ETF such that they all should have received the same regulatory treatment. The court’s decision turned on two elements: the underlying assets (BTC futures and BTC cash) being closely related and the exchanges being expected to have the same controls in place for detecting fraudulent or manipulative market misconduct.
Bitcoin is a commodity. Like other commodities, it trades both in cash markets and in futures markets. In the BTC cash market, cash is exchanged for BTC, with delivery expected speedily. In the futures market, cash is exchanged for a contract to buy or sell BTC at a predetermined price on a specific later date. The contracts are traded on a designated contract market, more commonly known as a futures exchange. For example, BTC futures contracts trade on the Chicago Mercantile Exchange (CME). Again, the court found that the assets underlying each kind of ETF – the BTC futures ETF and the BTC ETF — were closely related.
The SEC had denied Grayscale’s application – and more than twenty other applications to list a BTC ETF – on the ground that such a product is not “designed to prevent fraudulent and manipulative acts and practices” as required by the Securities Exchange Act of 1934 (Exchange Act).[7] In approving the two BTC futures ETFs, however, the SEC had found that each of them had satisfied legal requirements with a surveillance sharing agreement between the listing exchange and the CME.[8] The listing exchanges for Grayscale and for the BTC futures ETFs have identical surveillance sharing agreements with the CME. The court found, therefore, that there should be the same likelihood of detecting fraudulent or manipulative conduct in the market for BTC as in the market for BTC futures.
The Approval Order
In its Approval Order, the SEC approved the listing and trading of several BTC ETFs, marking a significant step in BTC’s integration into TradFi markets. The ETFs that were approved by the Approval Order include the Grayscale Bitcoin Trust, the Bitwise Bitcoin ETF, the Hashdex Bitcoin ETF, the iShares Bitcoin Trust, the Valkyrie Bitcoin Fund, the ARK 21Shares Bitcoin ETF, the Invesco Galaxy Bitcoin ETF, the VanEck Bitcoin Trust, the WisdomTree Bitcoin Fund, the Fidelity Wise Origin Bitcoin Fund, and the Franklin Bitcoin ETF.
To justify its conclusion, the SEC focused on the high correlation between spot BTC prices and CME BTC futures prices. The SEC relied on data submitted by applicants showing that the prices of spot BTC and of CME futures BTC have been highly correlated over the past 2.5 years.[9] From this, the SEC reasoned that manipulation in spot BTC markets would affect CME BTC futures prices and that CME surveillance would help detect any such manipulation. The SEC concluded that CME surveillance can effectively detect manipulation,[10] thereby justifying approval of the BTC ETFs.
As part of the Approval Order, the SEC accelerated the approval process of the applications, noting that the proposed rule changes to list and trade shares of BTC ETFs do not present novel regulatory issues. Notably, the SEC stated that the proposed rule changes to allow for the listing and trading of shares of BTC ETFs are consistent with the applicable requirements of the Exchange Act.[11]
What’s Next?
The Approval Order resolved the critical legal and regulatory issues entailed in launching a BTC ETF. Shares in trusts holding BTC can now be bought and sold on SEC-regulated exchanges, but other issues remain.
Critically, there will be a brutal battle for market dominance. It is often the case in the ETF industry that the first mover precludes competition by gaining so much market share early on that no one else can get traction. It is unclear that such will be the case here. Even before the BTC ETFs were approved, sponsors were competing against one another by cutting prices. Price competition will likely continue. Other factors such as name brand recognition and commitment to the crypto asset industry – or to disruptive technologies more generally – might also prove important. Among investment banks, likewise, price will matter, but so too will market power, especially retail distribution. Because these are single-asset funds, analyst prowess would seem to be relatively unimportant.
The Approval Order covers BTC ETFs only. It does not cover ETH funds, AVAX funds, Solana funds, or any other possible single-crypto-asset funds, nor does it cover multiple-crypto-asset funds. All of these, however, are theoretically possible. In his separate statement, Chair Gensler reiterated his well-known opinion that the “vast majority” of crypto assets are securities. But the federal courts have sometimes disagreed with him.[12] And even when he is right, an ETF can be brought to market if the SEC staff is directed to work with the applicant to craft a structure that will fit within the law.
We are optimistic about the development of additional cash market ETFs, as well as derivative and futures products and competitive private funds. In the realm of public funds, of course, the sponsor will need to apply to the SEC for relief and work with an exchange to obtain relief, fitting within the existing literature (now including the Approval Order) or arguing persuasively for an extension of existing precedents.
Our Perspective
The SEC’s approval of BTC ETFs is historic because it has been sought by so many for so long and because the potential market for BTC ETFs is multiple trillions of dollars. BTC ETFs are not a new asset class. The ETF is a new (and possibly better) wrapper for an existing asset, which is BTC – the first and most dominant asset among the US$1.7 trillion class of crypto assets. BTC was doing fine before BTC ETFs were approved, having doubled yet again in the last twelve months, and it has spread globally.
Chair Gensler himself noted in his separate statement that the Approval Order does not “signal anything about the Commissions views as to the status of other crypto assets under the federal securities laws or about the current state of non-compliance of certain crypto asset market participants with the federal securities laws.” The SEC has not changed course from its current positions regarding this asset class, but rather seems to have acknowledged the legal requirements that it treat like cases alike and let the market decide.
This SEC action is extremely encouraging. For one thing, it shows SEC obedience to the rule of law. Chair Gensler in his separate statement asserted twice that his SEC is “merit neutral,” which is indeed its legally required perspective.[13]
Even better from the viewpoint of technology innovation, this SEC action enables more of a United States retail market to develop for BTC, and probably other crypto assets, which until now has been foreclosed by administrative fiat. We will not be surprised if, years hence, crypto assets as an asset class have grown well beyond their current range and if this SEC action is viewed in hindsight as a watershed event because it enabled U.S. retail investors to buy, sell, and hold crypto assets in their IRAs, 401Ks, and brokerage accounts. That has been our experience with other financial innovations, including ETFs in particular.
We have been legal counsel for the structuring and regulatory approval of several pathbreaking ETFs, including the first foreign exchange funds and the first actively-managed fund. The ETF industry, which was alternately ridiculed and ignored in its infancy (like crypto), has grown since then to rival the larger mutual fund industry.
Sponsors and investment banks will now contend with one another to demonstrate to the United States retail investing public that their specific BTC ETF products, customer platforms, and prices are superior to their competitors’ offerings and therefore deserve market acceptance. More sponsors and banks will probably seek market entry and gain it, at least on paper. From among many approved BTC ETF sponsors, only a few are likely to emerge victorious. But that is a commercial and market fight, not a legal and regulatory one.
We would be remiss were we not to remind readers — as in ending this paper we will do — that good governance by crypto-savvy, ETF-savvy officers and directors, and expert SEC legal advice by counsel, will all be necessary for sustainable market success in this industry. The digital assets industry is still a young and highly creative technology sector that is fraught with perils identified as legal and regulatory “risk factors” in several BTC ETF prospectuses.
ETFs are complex. Crypto assets are beyond complex. Sponsors and banks should not seek SEC approval for a crypto asset ETF, nor should a bank, broker, or RIA contract with a crypto asset ETF sponsor or authorized participant, unless led and advised by crypto-savvy, ETF-savvy officers, directors, and legal counsel. This is especially true for sponsors themselves, who need TradFi experience combined with DeFi experience on their boards and in their trenches.
FOOTNOTES
[1] In this paper, we generally refer to Bitcoin traded in the cash market by its ticker symbol, which is “BTC.” Exchange-traded funds or other exchange-traded products, all of which have many features of mutual funds but issue shares that trade on SEC-registered stock exchanges, are commonly referred to as “ETFs” or “ETPs.” An ETP whose portfolio is largely or entirely Bitcoin is referred to in this paper as a “BTC ETF.”
[2] See Gensler, G. “Statement on the Approval of Spot Bitcoin Exchange-Traded Products,” U.S. Securities and Exchange Commission, 10 January, 2024
[3] See “Former Morgan Stanley CEO Says Bitcoin Is Not Going Away,’” CoinMarketCap, accessed 10 January 2024.
[4] In an interview with FOX Business, Jamie Dimon reiterated his claim that BTC “doesn’t have value” even as JPMorgan Chase was named as an authorized participant in Blackrock’s proposed BTC ETF. Authorized participants are the wholesale distributors of ETF shares. Essentially they underwrite the shares for resale to the general public. The Block Daily Newsletter, Jan. 10, 2023.
[5] See “SEC Order Granting Accelerated Approval of Proposed Rule Changes, as Modified by Amendments Thereto, to List and Trade Bitcoin-Based Commodity-Based Trust Shares and Trust Units, Release No. 34-99306 (January 10, 2024)”, referred to as the “Approval Order” in this paper.
[6] Grayscale Investments, LLC v. SEC, No. 22-1142 (D.C. Cir. 29 August 2023).
[7] 15 U.S.C. § 78f(b)(5).
[8] Teucrium Order, 87 Fed. Reg. 21,676 (Apr. 12, 2022); Valkyrie Order, 87 Fed. Reg. 28,848 (May 11, 2022).
[9] See supra note 5,at 8.
[10] See id. at 9.
[11] See id. at 21.
[12] See, e.g., SEC v. Ripple Labs, Inc., 20 Civ. 10832 (United States District Court for the Southern District of New York, 13 July 2023).
[13] Republicans on the House Financial Services Committee have criticized Chair Gensler for exceeding his legal authority in numerous hearings held in 2023. The SEC has lost several cases against the crypto industry. And the GAO concluded that the SEC had violated the Congressional Review Act by issuing Staff Accounting Bulletin 121, relating to crypto asset accounting, without submitting a report to Congress or the Comptroller General as required by law. The longest-serving member of the SEC, who is Commissioner Peirce, has criticized the Commission majority for blocking digital asset development by engaging in merit regulation. See, e.g., Dissent of Commissioner Hester M. Peirce to Release No. 34-83723 (relating to the Winklevoss Bitcoin Trust), July 26, 2018, (“the Commission is engaging in merit regulation”); Commissioner Hester M. Peirce, “On the Spot: Remarks at ‘Regulatory Transparency Project Conference on Regulating the New Crypto Ecosystem: Necessary Regulation or Crippling Future Innovation?’” June 14, 2022, text accompanying note 4 (“the Commission has many subtle ways of exercising merit regulation, often without a clear legal basis for doing so”).
