Introduction

The U.S. Court of Appeals for the D.C. Circuit (the “Court”) issued a major ruling against the Securities and Exchange Commission (“SEC”) on August 29, 2023, holding that the SEC acted arbitrarily and capriciously when it disapproved the listing of Grayscale Investments, LLC’s (“Grayscale”) proposed spot bitcoin exchange-traded product (“ETP”) while approving two bitcoin futures ETPs.¹ The decision, which the press has described as a “bombshell,”² marks a significant victory for the digital asset ecosystem. Even more, it puts the SEC between a rock and a hard place: (i) cave and approve Grayscale’s ETP, which will open the floodgates to more market entrants in the ETP space; (ii) invoke new rationales for rejecting the listing and prepare for even higher stakes litigation now that the D.C. Circuit has concluded that the SEC’s original actions in disapproving Grayscale’s listing did not comply with the law; or (iii) invoke the “nuclear option” and retract their approval of the Bitcoin futures ETPs, with all the messy fallout one can expect from such an action. With all eyes on the SEC, the SEC has stated it is delaying its decision on all spot bitcoin ETP applications until October, with Grayscale pushing back that the SEC needs to approve its ETP immediately.³

Background

Bitcoins are a form of cryptocurrency whose transactions are recorded on a blockchain maintained by a decentralized network. As with commodities, there are spot and futures markets for bitcoin. In the spot bitcoin market, cash is exchanged for bitcoin with delivery expected immediately, whereas in the bitcoin futures market, cash is traded for a contract to buy or sell bitcoin at a predetermined price on a specific later date on commodity futures exchanges generally regulated by the Commodity Futures Trading Commission.

Over the past years, industry participants have submitted proposals to register ETPs providing exposure to bitcoin as an asset class, both through spot bitcoin and bitcoin futures strategies. An ETP may be listed and traded on a national exchange and may offer continuous share redemption and creation, thereby allowing arbitrage to prevent the product’s price from deviating too far from the value of its underlying assets.

To date, the SEC has denied every proposal to list a bitcoin ETP on the ground that such a product is not “designed to prevent fraudulent and manipulative acts and practices” as the Exchange Act requires. Even though the SEC has required a surveillance sharing agreement with a related and regulated market of significant size to prevent fraud, the SEC has found that every bitcoin ETP failed its significant market test.
On June 29, 2022, the SEC rejected Grayscale’s proposal to convert its existing bitcoin trust, Grayscale Bitcoin Trust, to a bitcoin ETP in which each share would represent a proportional interest of each of the trust’s assets by reference to an index price.

Proving fatally problematic for the SEC, however, it had, previously approved two bitcoin futures ETPs, the Teucrium Bitcoin Futures Fund and the Valkyrie XBTO Bitcoin Futures Fund, where the SEC found that both products had satisfied the significant market test with their surveillance sharing agreement between their listing exchanges and the Chicago Mercantile Exchange ("CME"). Given this inconsistent approach, Grayscale announced its intention of appealing the SEC’s decision on the same day as the SEC’s denial.

The Court’s Decision

Grayscale’s primary argument was that the SEC acted arbitrarily and capriciously by denying the listing of its proposed bitcoin ETP while approving the listing of materially similar bitcoin futures ETPs. The Court unanimously agreed.

The Court first determined that Grayscale’s proposed bitcoin ETP was “similar across the relevant regulatory factors” to the two bitcoin futures ETPs that the SEC had previously approved and therefore should have received the same regulatory treatment. The Court reached this conclusion because (1) the underlying assets—bitcoin and bitcoin futures—are closely related; and (2) the listing exchanges have identical surveillance sharing agreements that should have the same likelihood of detecting fraudulent or manipulative conduct in the market for bitcoin and bitcoin futures.

After finding that Grayscale’s proposed bitcoin ETP to be similar to bitcoin futures across the relevant regulatory factors, the Court then considered whether the SEC provided an adequate explanation for approving the two bitcoin futures ETPs but disapproving Grayscale’s proposed bitcoin ETP. The Court noted that the SEC distinguished bitcoin ETP and bitcoin futures ETP solely through the application of the significant market test, which has the following two prongs: First, there must be a reasonable likelihood that a person attempting to manipulate the ETP would have to trade on the related market to successfully manipulate the ETP. Second, it must be unlikely that trading in the ETP would be the predominant influence on prices in the surveilled market. The SEC had decided that all proposed bitcoin ETP failed to meet both prongs while the two bitcoin future ETPs satisfied the significant market test.

First Prong

The Court decided that the SEC failed to provide the necessary “reasonable and coherent” explanation for its inconsistent treatment of the two products. Specifically, even though the SEC found that Grayscale’s proposed bitcoin ETP failed the first prong because there was not a reasonable likelihood that a person attempting to manipulate the ETP would have to trade on the CME, it decided that it was “unnecessary for the bitcoin futures ETPs to establish a would-be manipulator would have to trade on the CME.” Noting that the spot and futures markets are highly correlated and that the respective ETPs are functionally identical, the Court found that fraud and manipulation in the spot bitcoin market pose a similar risk to both futures and spot products.

Second Prong

The Court also disagreed with the SEC’s application of the second prong to differentiate the proposed bitcoin ETP with the two bitcoin futures ETPs. The Court reasoned that the SEC not only failed to explain the reasons why Grayscale’s proposed bitcoin ETP did not meet this prong, but also failed to treat like cases alike. The Court found that the SEC’s reasoning for concluding that this prong was satisfied for the two bitcoin futures ETPs, namely, that CME bitcoin futures market had progressed significantly so trading on a single ETP was unlikely to influence the CME predominantly, applied equally to Grayscale.

Takeaway

Having been handed a major unanimous defeat by a highly prestigious court, the SEC appears to have boxed itself into a corner: (i) concede error, (ii) double down and reject Grayscale’s and other pending ETPs, or (iii) retract its approval of the Bitcoin futures ETPs, with all the cascading consequences that unraveling its approval would have on the very market participants the SEC is mandated to protect. With no clear path forward, the SEC has some difficult decisions ahead. Even more, although the SEC has been rejecting spot bitcoin ETPs, other foreign jurisdictions, such as Europe and Canada, have approved similar products, thereby adding further pressure to the SEC as it weighs its next move.

As the legal drama unfolds, what is clear is that the Court’s decision in the Grayscale matter marks a significant development in industry efforts to define a path towards offering U.S. investors access to digital assets through SEC-registered ETPs.

Footnotes

1. Grayscale Investments, LLC v. SEC (2023)
2. SEC Hesitant; Delays ETF Rulings as Grayscale Wins Lawsuit (September 1, 2023).
3. SEC delays decision on spot bitcoin exchange-traded funds. What that means for investors (September 1, 2023).