Grayscale, a major digital asset manager, sued the U.S. Securities and Exchange Commission (SEC) for denying the former’s spot Bitcoin ETF application. The company initiated the lawsuit in June 2022, and investors are still waiting for the results of the proceedings.
The digital asset manager has more than 600,000 BTC in custody under its flagship project, the Grayscale Bitcoin Trust(GBTC). Grayscale wanted to convert all of it to spot Bitcoin ETF (Exchange Traded Fund) but was denied. The application was filed in October 2021 but was rejected by the SEC in June 2022.
There is no court decision yet, but let us explore the possible reasons why the SEC denied it and explore some counter-arguments.
What is Grayscale Bitcoin Trust?
GBTC stands for Grayscale Bitcoin Trust, which is a way to invest in Bitcoin (BTC) through the stock market. It is a trust that holds Bitcoin as its underlying value. It is traded in the OTCQX. The OTCQX is a marketplace for the over-the-counter trading of stocks.
Investing in GBTC means that investors don’t have to buy, store, or safe keep Bitcoin, which can be too complicated and risky for some. Investors get exposure to the price movements of BTC without having to deal with cryptocurrency exchanges or wallets.
Why did the SEC deny the Spot BTC ETF application of Grayscale?
In June 2022, the SEC rejected Grayscale’s proposal to convert its GBTC holding into a Bitcoin spot ETF. The regulator cited that it failed to meet consumer protection requirements which should have included measures that are designed to prevent fraudulent and manipulative acts and practices.
The SEC also argued that the NYSE Arca – the intended marketplace for the proposed BTC ETF – did not have an agreement to monitor the price of BTC for manipulation with another regulated market that trades a substantial amount of BTC.
What exactly is a BTC ETF?
We need to define what exactly a spot BTC ETF is. A spot BTC ETF is a type of exchange-traded fund that would track the actual market price of Bitcoin. This investment instrument holds actual BTC in a trust or a custodian, and the shares of the ETF represent fractional ownership of BTC in custody.
We also have to remember that there are already several Futures Bitcoin ETFs that have been approved by the SEC. A futures BTC contract is a contract to trade Bitcoin at a predetermined price at a specified time in the future. It allows investors to take positions or bet on the price without owning any Bitcoin.
The first one is the Proshares Bitcoin Strategy ETF (BITO), launched in October 2021. The others are:
- ProShares Short Bitcoin ETF (BITI)
- VanEck Bitcoin Strategy ETF (XBTF)
- Valkyrie Bitcoin Strategy ETF (BTF)
The Counterargument for the SEC
The SEC’s mission is to “protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation”. It is within its mandate to ensure consumer protection and prevent market manipulation. However, is the SEC correct in saying that Grayscale’s spot BTC ETF proposal does not have the proper safeguards to ensure fraud and manipulative practices?
We have to remember that spot BTC ETF holds actual Bitcoins, and the status of each crypto asset is easily verifiable on-chain. The Bitcoin Network is protected by a consensus mechanism that is resistant to hacking and tampering because it would take huge computing power to do so. All transactions are recorded on a transparent digital ledger, which will display the provenance and number of BTC involved. Any collusion to manipulate the market can be traced.
Multi-sig wallets will probably be used for the assets representing the spot BTC ETF. This will entail using multiple keys to approve transactions, and holders of these keys can be held accountable for any infraction. Hacking of the said wallets will be difficult since offline hard wallets will be used. These hard wallets can also be secured in different locations, making it harder for bad actors to have access to them. It can be argued that it will be easier to rob a bank than to access these wallets unless key employees are coerced or willfully facilitate hacking the funds. These wallets can also be viewed on-chain to prove that it contains the right amount of BTC.
The transparency of blockchain technology makes it hard to commit fraud without leaving a permanent record.
Why Approve Futures but Not Spot BTC Futures?
An article from the influential Bank for International Settlements (BIS) gave an insight into one of the possible reasons why the SEC hasn’t approved a spot BTC ETF.
“So far, the Securities and Exchange Commission (SEC) has delayed or declined applications to launch an ETF investing directly in bitcoin, due mainly to concerns that the asset is predominantly traded on non-regulated exchanges. BITO is the first SEC-approved bitcoin ETF, largely because the fund is based on futures contracts that are traded on the regulated Chicago Mercantile Exchange (CME).”
Karamfil Todorov (2021)
This statement from BIS was posted in 2021 but it makes so much sense now, because the SEC does not think highly of crypto exchanges. The SEC is currently on a warpath against exchanges and considers the industry to be full of fraudsters and scam artists. For the SEC, assets on crypto exchanges can be subjected to market manipulation.
What does the Judge on the Grayscale Spot BTC ETF Think?
The first two minutes of the video below give us a glimpse of how the Judge handling the case thinks.
Judge Neomi Rao was wondering why the SEC approved the futures BTC ETF, but not the spot variant. She said, “it seems to me that the commission really needs to explain how it understands the relationship between Bitcoin futures with the spot price of Bitcoin… one is essentially derivative of the other. They move together 99.9% of the time. So where is the gap in the commission’s view? “
Judge Rao echoed the sentiment of Grayscale and supporter of the spot BTC ETF. Why approve the futures ETF while denying the spot ETF? They are dealing with the same asset class. Is it because the SEC is more concerned with spot-based assets, and all futures contracts are with the CFTC, which is the one tasked with regulating the futures market? If that is the case, then is the SEC saying that only the CFTC is competent enough to regulate a digital asset like Bitcoin? Or are they saying that they haven’t hashed out concrete regulatory guidance that would govern the spot trading of digital assets?
Only the Court Can Decide
The SEC is arguing that offering a spot BTC ETF does not have the necessary safeguards for investors. However, it can be argued that Bitcoin’s primary traits are security and transparency. On the other side, Grayscale is trying to register a product as a sign of good faith and that it is willing to comply with pertinent laws. It is not asking for an exemption but rather submitting to regulatory standards. The SEC also needs to answer why it rejected the spot application while approving futures ETFs. Both instruments are basically trading the same underlying asset.
The Grayscale BTC ETF vs SEC case is a crucial test for the future of Bitcoin. Ultimately, the court is the unbiased institution and the last resort that will decide the fate of this innovative financial product.
