The SEC’s long-awaited green light for spot bitcoin ETPs is welcomed by the market, but the ambivalent decision raises more questions than it answers.

On January 10, 2024, the Securities and Exchange Commission (SEC) issued, on an accelerated basis, an Omnibus Approval Order (the Order) for proposed NYSE Arca, Nasdaq, and Cboe BZX rule changes seeking to list and trade shares of 11 spot bitcoin trusts. Spot bitcoin trusts hold actual bitcoin, as opposed to bitcoin futures trusts, which hold derivatives tied to the price of bitcoin.

The approval of these rule change requests represents a green light for spot bitcoin-based exchange traded products (ETPs) to trade on national securities exchanges for the first time in bitcoin’s 15-year history, after a decade of attempts by market participants to obtain such approval.

In the Order, the SEC found the proposals to be “consistent with the Securities Exchange Act of 1934 (the Exchange Act) and rules and regulations thereunder applicable to a national securities exchange,” including the requirement that the exchanges’ rules be designed to “prevent fraudulent and manipulative acts and practices.”

Cash Versus In-Kind Creation and Redemption

The 11 trusts formed in the wake of the Order manage pools of bitcoin and issue shares to the public representing beneficial interests in their net assets. Notably, all of the trusts are cash creation and redemption models rather than in-kind creation and redemption models. Therefore, when demand is high for the ETP’s shares, authorized participants (registered broker-dealers functioning as market makers for these ETPs) tasked with ensuring an appropriate level of publicly available shares deliver cash to the trust in return for ETP shares. The trust then buys bitcoin with that cash. Conversely, if demand is low or net negative, the market makers deliver ETP shares back to the trust. The trust then sells some bitcoin holdings, and returns the cash to the market maker.

This cash model is different than an in-kind model. Under an in-kind model, shares would be created with the delivery of bitcoin to the trust, or shares would be redeemed with the delivery of bitcoin to the market makers. Market participants generally prefer this model, and physically-backed commodity ETPs commonly use it for its various operational, pricing, and tax efficiencies. However, this model is practically unworkable because the SEC does not permit broker-dealers to engage with bitcoin (for more information, see these Latham blog posts here and here).

The Significant Market Test Preserved or Jettisoned?

In its previous disapprovals of spot bitcoin ETP applications, the SEC found that the exchanges could not adequately prevent manipulative acts and practices because the bitcoin market was subject to manipulation. In those instances, the SEC employed a novel “significant market” test to make its determination. According to the SEC, a “significant market” can be defined as a market (or group of markets) in which (a) there is a reasonable likelihood that a person attempting to manipulate the ETP would also have to trade on that market to successfully manipulate the ETP, so that a surveillance-sharing agreement would assist in detecting and deterring misconduct, and (b) it is unlikely that trading in the ETP would be the predominant influence on prices in that market.

Specifically, the SEC required an exchange to establish “a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying or reference bitcoin assets.” It asserted that because the bitcoin futures markets were not “markets of significant size” there was no practical ability to enter into a sufficient surveillance-sharing agreement.

In October 2022, Grayscale Investments, LLC (a sponsor of one of the newly created spot bitcoin ETPs) filed a judicial challenge opposing the SEC’s disapproval. Grayscale maintained that its bitcoin futures ETPs, which were subject to a surveillance-sharing agreement with the Chicago Mercantile Exchange (CME) with respect to CME’s bitcoin futures markets, were “materially similar” to the spot bitcoin ETPs and thus the spot ETPs deserved similar treatment. Grayscale also maintained that the SEC’s application of the significant market test to bitcoin futures ETPs versus spot ETPs was in itself arbitrary and capricious:

As to the futures ETPs, the Commission applied an exceedingly lax version of the test, essentially admitting that the test was not strictly satisfied but approving those ETPs anyway. But in disapproving the proposed spot bitcoin ETP here, the Commission applied an exceedingly stringent version of the test—going so far as to make findings that directly contradict findings that it made in its orders approving the bitcoin futures ETPs. That stark arbitrariness cannot be justified. . . . The Commission has . . . failed to satisfy the APA’s requirement of reasoned decisionmaking because it has not applied the test evenhandedly to both categories of ETPs.[i]

On August 29, 2023, the US Court of Appeals for the District of Columbia agreed with Grayscale and vacated the SEC’s disapproval. The court held that the SEC failed to adequately explain why it disagreed that the bitcoin futures and spot markets are highly correlated or why it ultimately allowed for the listing of two bitcoin futures ETPs but not Grayscale’s proposed spot bitcoin ETP. The court noted, “Grayscale presented uncontested evidence that there is a 99.9 percent correlation between bitcoin’s spot market and CME futures contract prices.” Grayscale also demonstrated identical surveillance sharing agreements to detect fraud or manipulation in the market, and material similarity “across relevant regulatory factors.”

The court held that the approval of one and the denial of the other was arbitrary and capricious under the Administrative Procedure Act because “[i]n the absence of a coherent explanation [from the SEC], this unlike regulatory treatment of like products is unlawful.” (For more information, see this Latham blog post).

In the current approval Order, the SEC continues to apply the significant market test and concludes (as in previous disapproval orders) that the test is not satisfied, but states that there are other ways to meet the Exchange Act requirement:

The Commission also has consistently recognized, however, that having a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying or reference bitcoin assets is not the exclusive means by which an ETP listing exchange can meet this statutory obligation under Exchange Act Section 6(b)(5). A listing exchange could, alternatively, demonstrate that “other means to prevent fraudulent and manipulative acts and practices will be sufficient” to justify dispensing with a surveillance sharing agreement with a regulated market of significant size.[ii]

Grayscale previously criticized the “other means” test as well: “although the Commission has stated that some ‘other means’ might theoretically suffice, the Commission has set the bar so high in that regard that the promise of an alternative route to rule-change approval is illusory.” In the current order, however, those “other means” of detecting fraud or manipulation in the market appear to be very similar to the significant market test, focusing on the correlation between the bitcoin futures market and spot bitcoin prices, except that applicants no longer need to establish that the futures market is one of significant size. Indeed, the SEC holds the line in maintaining that the bitcoin futures market is still not one of significant size.

Yet the SEC is now willing to grant blanket approval because the applicants’ comprehensive surveillance-sharing agreement with the highly aligned futures market can be reasonably expected to assist in surveilling for fraud and manipulation. Referencing correlation statistics provided by the applicants, as well as the SEC’s own “robust correlation analysis,” the SEC concluded that the proposals have demonstrated adequate prevention of fraudulent and manipulative acts and practices and protection of investor and public interest consistent with Section 6(b)(5) of the Exchange Act. The SEC did not explain why such a high correlation was not previously sufficient to warrant approval.

The Commissioners Weigh In

The Order failed to garner unanimous support among the commissioners.

• Chair Gary Gensler published a statement supporting the Order, albeit extremely qualified. He said the applications for proposed rule changes were “similar to those [the SEC has] disapproved in the past.” Based on recent developments (primarily the D.C. Circuit Court’s decision vacating the SEC’s most recent disapproval, discussed above), Chair Gensler held that approval is the “most sustainable path forward.” While approving the Order, he also reminded market participants that the SEC is “merit neutral,” and that approval of the proposals in no way indicates approval or endorsement of the underlying asset, custody arrangements, crypto trading platforms, or intermediaries. Chairman Gensler also reminded market participants offering spot bitcoin ETPs of their ongoing compliance obligations, including full, fair, and truthful disclosure about the products; prevention of fraud, manipulation, and conflicts of interest; and adherence to standards of conduct such as Regulation Best Interest (when broker-dealers recommend ETPs to retail investors), and fiduciary duty obligations under the Investment Advisers Act (for investment advisers).
• Commissioner Hester M. Peirce published a statement supporting the Order, but made some pointed comments in the process. She said the SEC’s track record of disapprovals has been “unnecessary” and tantamount to “obstruction,” and likely would have continued but for the D.C. Circuit Court’s decision to “call[] [the SEC’s] bluff.” She noted the various ways that the SEC’s disapprovals have caused harm to the SEC and to investors, including reputational harm and diminished public trust in the SEC as an institution; requiring disproportionate attention and diversion of agency resources; fomenting “artificial frenzy” and a “circus atmosphere” in the markets; and stifling innovation generally in the US through signaling “regulatory prejudice against new products and services.”
• Commissioner Mark Uyeda published a statement concurring with the Order’s approval, but raised three critical concerns about the Order’s analytical merits:
  • The Order “improperly attempts to validate” the application of the significant market test that the D.C. Circuit Court determined to be arbitrary and capricious. He notably called out the SEC for obscuring the court’s very specific criticism of the SEC’s differential application of the significant market test by introducing a release valve that is not present in the judicial opinion (“an applicant could obtain approval if it demonstrated that there were ‘other means’ to prevent fraudulent and manipulative acts in the event that the ‘significant market’ test was not satisfied”). Commissioner Uyeda said he was concerned that the SEC, by muddying the waters, is preserving a “license . . . to continue to differentially apply the ‘significant market’ test without any additional explanation.”
  • The Order “invents a novel, previously unarticulated standard to form the basis for approval,” namely the “other means” test. Commissioner Uyeda pointed out that this new test merely removes the need for applicants to establish that the futures market is one of significant size. He criticized the SEC’s creation of this relaxed standard (as if “with the wave of a wand”), and laments the years and resources that applicants spent attempting to satisfy the seemingly insurmountable significant market test.
  • The Order disguises the SEC’s motivation for accelerating the approval of the applications, which he asserted is to prevent a first-mover advantage among spot bitcoin ETPs.
• Commissioner Caroline A. Crenshaw published a statement of dissent, stating that contrary to the Order’s findings, the proposals “are not reasonably designed to prevent fraudulent or manipulative acts and practices, or to protect investors or the public interest.” Fraud and manipulation (particularly wash trading), she asserted, are rampant in the global bitcoin market. She also criticized bitcoin’s volatility, concentration of ownership, lack of transparency, and lack of systemic market oversight. Finally, she objected to the SEC’s correlation analysis as both highly flawed and insufficient to warrant approval of the proposals. She said she fears that the SEC’s Order does not serve to “provid[e] investors access to new investments, but instead provid[es] the investments themselves access to new investors in order to prop up their price.”
• Commissioner Jaime Lizárraga dissented, but did not publish an accompanying statement.

SEC Reversal

As noted above, Chairman Gensler maintained in his statement that approval is the “most sustainable path forward,” but does not explain why. The SEC’s shift from the seemingly insurmountable (in this case) “significant market” test as a minimum standard to the more lenient “other means” test as its new baseline would appear to indicate that disapproval was never an overwhelmingly appropriate response to the spot bitcoin ETP applications. Approval may have been the result of a grudging realization that the distinction between the bitcoin futures market and bitcoin spot market was not “sustainable.”

The Order’s analysis, both upholding and hollowing out the SEC’s significant market test, caused Commissioner Uyeda to “wonder whether the Grayscale decision forced the Commission’s hand, causing the Commission to search for a basis of approval that satisfied the court without admitting that the “significant market” test was improper and flawed.”

Proponents of digital assets are cheering the Order as a watershed moment, and hope for increasing institutional and retail adoption of bitcoin. Market participants will also continue to advocate for approval of in-kind ETPs. Whether and how the SEC will approach in-kind creation and redemption models seems to be the next hurdle in the bitcoin ETP saga.

Endnotes

[i] Brief of Petitioner at 20, 34, Grayscale Investments, LLC v. Securities and Exchange Commission, No. 22-1142 (D.C. Oct. 11, 2022), available at https://storage.courtlistener.com/recap/gov.uscourts.cadc.38827/gov.uscourts.cadc.38827.1208460857.0.pdf.

[ii] 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, 89 Fed. Reg. 3008, 3009 (January 10, 2024), available at https://www.govinfo.gov/content/pkg/FR-2024-01-17/pdf/2024-00743.pdf.