On June 29, 2022, the Securities and Exchange Commission (the “Commission”) rejected a proposed rule change submitted by NYSE Arca, Inc. (the “Exchange”) that would have allowed it to list and trade shares of Grayscale Bitcoin Trust (“GBTC”), the largest fund in the world devoted to holding Bitcoin.[1]  Grayscale Investments, LLC (“Grayscale”), the sponsor of GBTC, wasted no time in petitioning the D.C. Circuit Court of Appeals to review the Commission’s order—it sued the same day.[2] 

In this post, we discuss the latest development in this case; specifically, Grayscale’s August 1, 2022 Statement of Issues to be Raised, which articulates Grayscale’s position that the Commission committed four errors in denying the proposed rule change. 

Statutory Background:

Section 19(b)(2) of the Exchange Act of 1934 provides that the Commission “shall approve a proposed rule change of a self-regulatory organization if it finds that such proposed rule change is consistent with the requirements of [the Exchange Act and its implementing regulations]” and “shall disapprove a proposed rule change” if it does not find the proposed rule is consistent with the requirements of the Exchange Act.[3]  “The burden to demonstrate that a proposed rule change is consistent with the Exchange Act and the rules and regulations issued thereunder . . . is on the self-regulatory organization that proposed the rule change.”[4]  The rejection of a proposed rule change can be appealed to a federal circuit court.[5] 

One of the requirements of the Exchange Act with which any proposed rule change must comply is Section 6(b)(5).  Among other things, that section requires national securities exchanges to be “designed to prevent fraudulent and manipulative acts and practices.”[6]

The Disapproval Order:

Grayscale’s investment objective is for the value of GBTC shares “to reflect the value” of the underlying assets Grayscale then held, here “the bitcoins held by the Trust.”[7]  Unfortunately for Grayscale, shares of GBTC have traded at a persistent discount to the underlying value of the coins it holds.[8]  Grayscale hoped to solve this problem by turning GBTC into an ETF, or exchange-traded fund, into which more money could flow in response to increased demand.[9]  Grayscale has “argued that converting [GBTC] into an ETF would unlock as much as $8 billion in value for investors.”[10]

Finding an exchange willing to list GBTC was not a problem for Grayscale.  In October 2021, the Exchange filed a proposed rule change with the Commission to allow it to list and trade shares of GBTC.[11] 

However, after an April 21, 2022 amendment to the proposed rule filed by the Exchange and a period for public comment, the Commission disapproved the proposed rule, concluding that the Exchange had “not met its burden under the Exchange Act and the Commission’s Rules of Practice to demonstrate that its proposal is consistent with the requirements of Exchange Act Section 6(b)(5),” in particular, its requirement that “the rules of a national securities exchange be ‘designed to prevent fraudulent and manipulative acts and practices.’”[12]  

In determining that the proposed rule did not do enough to prevent fraudulent and manipulative acts, the Commission focused on the Exchange’s lack of a surveillance-sharing agreement with a sufficiently large and regulated market for spot Bitcoin.  According to the Commission, “an exchange that lists bitcoin-based [exchange-traded products, or] 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.”[13]  Such comprehensive surveillance-sharing agreements are thought to deter manipulation by facilitating “the availability of information needed to fully investigate a manipulation if it were to occur.”[14]  Indeed, the Commission noted in its order disapproving the Exchange’s proposed rule that every commodity-trust ETP it has approved to date for listing and trading entered into a surveillance-sharing agreement with “at least one significant, regulated market for trading futures on the underlying commodity,” or at least “held Intermarket Surveillance Group . . . membership in common with . . . [such a] market.”[15]  The Commission then concluded that the Exchange lacked such a comprehensive surveillance-sharing agreement with a regulated market of sufficient size because the market with which it had “the equivalent of a comprehensive surveillance-sharing agreement,”—the Chicago Mercantile Exchange (“CME”)—was not a “‘market of significant size’ related to spot bitcoin, the underlying bitcoin assets that would be held by the Trust.”[16] 

This conclusion rested in part on the Commission’s determination that the CME bitcoin futures market could only be a “market of significant size” in relation to spot bitcoin if there was “a reasonable likelihood that a person attempting to manipulate [Grayscale’s] ETP would have to trade on the CME bitcoin futures market to successfully manipulate the ETP.”[17]  The Commission evaluated the evidence on this point and determined that it did not demonstrate a reasonable likelihood that someone trying to manipulate GBTC would have to trade on the Chicago bitcoin futures market in order to successfully manipulate the trust.[18]  Thus, the Commission determined that Grayscale could not “rely on a surveillance-sharing agreement with the CME to provide sufficient protection against fraudulent and manipulative acts and practices.”[19]  

While all commodity-trust ETPs approved by the Commission to date have entered into a surveillance-sharing agreement with a significant, regulated market, the Commission has never before taken the position that such agreements are required to meet Section 6(b)(5)’s edict that national securities exchanges be designed to prevent fraud and manipulation.[20]  This gave Grayscale a second bite at the apple; according to the Commission, Grayscale could also comply with 6(b)(5) in the absence of a comprehensive surveillance-sharing agreement if it could demonstrate that “the bitcoin market as a whole or the relevant bitcoin market [was] uniquely and inherently resistant to fraud and manipulation.”[21]  After reviewing the record evidence, however, the Commission did not find that the bitcoin or spot bitcoin market was so “uniquely and inherently resistant to fraud and manipulation,” as to justify dispensing with the normal safeguard of a comprehensive surveillance-sharing agreement with a sufficiently large and regulated market.[22] 

In light of these findings, the Commission determined that the Exchange’s proposed rule change was not consistent with the strictures of Rule 6(b)(5).[23]

Grayscale’s Petition for Review:

In a recent court filing, Grayscale set forth four challenges to this analysis, all of which are rooted in its contention that the Commission’s denial was “‘arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law’ and/or ‘in excess of statutory. . . authority’. . . in violation of the Administrative Procedure Act, 5 U.S.C. § 706, and the Exchange Act of 1934.”[24]

First, Grayscale takes the position that the Commission erred in determining that the Exchange “lacks a comprehensive surveillance-sharing agreement with a regulated market of a significant size related to spot bitcoin.”[25]  Here, Grayscale is likely to argue, as it did before the Commission, that the CME bitcoin futures market is so connected with the spot bitcoin market, that to manipulate Grayscale’s proposed ETF, it is reasonably likely a person would have to trade on the CME.[26]

Second, Grayscale states that the Commission’s denial of the proposed rule change was arbitrary and capricious and otherwise unlawful because it “treats bitcoin future exchange-traded products differently than spot bitcoin exchanged-traded products without adequate justification.”[27]  Here, Grayscale may remount the argument it made to the Commission that “it would be inconsistent for the Commission to allow the listing and trading of ETFs and ETPs that provide exposure to bitcoin through CME bitcoin futures while disapproving [Grayscale’s] proposal.”[28]  The Commission may then reassert its finding from the disapproval order that the bitcoin future ETFs and ETPs that is has approved are not similarly situated to Grayscale’s proposal, not least because for every futures-based ETP it has approved, the listing exchange had entered into a “comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying bitcoin assets of the ETP.”[29]       

Third, Grayscale contends that the Disapproval Order incorrectly determined that the proposed rule was inconsistent with the Exchange Act’s requirements that the rules of national securities exchanges be “designed to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.”[30]  This may prove a heavy lift for Grayscale, particularly if the D.C. Circuit decides to defer to the Commission’s interpretations of the Exchange Act and its implementing regulations. 

Finally, Grayscale avers that the Commission’s disapproval order “violates the Exchange Act’s requirement that the rules of national securities exchanges must not ‘permit unfair discrimination between customers, issuers, brokers, or dealers.’”[31]  This appears to be a rehash of Grayscale’s second argument that its proposed security is being treated differently by the Commission than other, similar securities.    

Conclusion:

The world of crypto is already scarcely recognizable from Superbowl Sunday 2022, when Larry David implored America’s football-watching public to “get into crypto” and Bitcoin closed at $42,197.  (Six months later, it was trading at $24,424.)  The next six months to year could bring more market volatility, new regulations, and perhaps new rulings by the Commission on crypto listings, all of which could influence the D.C. Circuit’s consideration of Grayscale’s petition as this appeal progresses.