Disclosure: Everything here is my own opinion and does not reflect the opinions of any entity I may be affiliated with. Do your own research and don’t make any financial decision solely based on the content here. 🤷

TL;DR — A Bitcoin Spot ETF probably isn’t getting approved any time soon. Applicants are stuck between a rock and a hard place trying to meet requirements, and the SEC seems to be holding ETF approval hostage as a tactic to induce crypto exchanges to become regulated by the SEC.

What is stopping the SEC from approving a Bitcoin Spot ETF?

This is a question that I was wondering about recently, so I decided to spend a little time understanding why.

I read through NYSE Arca’s recent application and subsequent SEC disapproval, a few other disapprovals, along with Hester Pierce’s most recent remarks on the subject.

Note: You may see this type of product referred to as an “ETF” or an “ETP” — they generally refer to the same thing. Which one were talking about depends on how the underlying asset is classified, security (ETF) vs. commodity (ETP). I believe ETP is the more correct term related to a Bitcoin exchange-traded product, but I’ll just use ETF for simplicity because that’s what mostly everyone else is using.

What good is a Bitcoin Spot ETF anyway?

Before I dive in, it’s helpful to wonder why we would want one of these things anyways. As far as I can tell, a Bitcoin Spot ETF would provide the following:

• More voices can weigh in on the price of Bitcoin by allowing retail investors exposure to the asset through their brokerage accounts
• Investment advisers would be able to help clients gain exposure in a more traditional and straightforward way
• Lower costs than existing alternative Bitcoin Future ETFs like ProShares (BITO)
• Convenience of not having to self-custody the underlying (if that’s not your cup of tea) and/or having to open up an account with crypto exchanges

A Bitcoin Spot ETF would not be without its drawbacks, however:

• Management fees charged by the fund
• Restricted trading hours limited to the hours which the exchange is open
• Pricing differences between the underlying asset and the ETF due to indirect ownership of the underlying (institutional arbitrage would help keep it close though)
• Can’t self-custody the underlying asset

But generally, these are issues with ETFs. Not specifically a Bitcoin Spot ETF.

What does the SEC require of applicants?

The delay in listing so far has not been due to the question on the validity of any specific Bitcoin Spot ETF offering or their proposed structures / mechanics. The sticking point has been related to the exchanges that want to list the ETF. The SEC requires applicants — the exchanges with whom would like to have an ETF trade — to demonstrate that their exchange be designed to prevent fraud & manipulation to protect investors and the public interest.

How?

1. The exchange applicant can show a comprehensive surveillance-sharing agreement with a regulated body of market participants of significant size
2. OR, the exchange applicant could show that the market is uniquely resistant to fraud & manipulation

To date, the SEC has completely rejected arguments for #2. To the point where they don’t even respond to recent applications making this argument, only refering back to previous disapprovals which is what they did in NYSE Arca’s most recent application to allow for trading of One River Carbon Neutral Bitcoin Trust. From the Commision’s disapproval:

Such resistance to fraud and manipulation, however, must be novel and beyond those protections that exist in traditional commodity markets or equity markets for which the Commission has long required surveillance-sharing agreements in the context of listing derivative securities products.

The SEC categorically denied the application without much further elaboration on the above, and without taking into account the expanded arguments of NYSE Arca regarding the distributed nature of trading Bitcoin, nor the method used to calculate NAV, nor the evidence of other jurisdictions that have approved similar products.

So if the SEC rejects the argument that the underlying market for bitcoin is not susceptible to manipulation, that only leaves option #1 for applicants - a surveillance-sharing agreement with a related body of market participants of significant size.

What a Surveillance-Sharing Agreement really means

At first glance, it sounds reasonable. Get together with other market participants (i.e. crypto exchanges) and agree to share information to help prevent market manipulation.

An acceptable agreement would provide for unimpeded data sharing on market trading activity, clearing activity, and customer identity. “Significant market size” is a bit vague, but generally requires the applicant to argue that to successfuly manipulate the ETF, a person would likely have to trade on that exchange’s market. Considering that the SEC has approved a Bitcoin Futures ETF, and that the pricing mechanisms for the two are similar, this implies that what can be done to prevent manipulation for a futures ETF should also apply to a spot ETF. Ok, sounds doable.

The problem, however, lies within the fact that most spot Bitcoin trades on unregulated (in the eyes of the SEC) exchanges. First, because Bitcoin is distributed and not an asset that only exists in US markets, major spot markets are not necessarily subject to the laws of the United States. Major spot markets like Binance, FTX, Huobi, and OkEx, while they have US counterparts, do the majority of their volume with their non-US entities and are outside the scope of the SEC.

Second, the US has not specified which regulating entity gets to regulate crypto, so major spot markets that do operate within the US have differening views on whom they should be regulated by, if anyone. Is it money tranmission, banking, or securities law? The SEC would like to regulate all crypto exchanges, just like they do securities exchanges. But since there is no clear mandate from US legislators that crypto belongs to the SEC, they cannot be so overt without facing significant legal challenges from said exchanges. Which means the SEC has to use the power at their disposal — the approval of a Bitcoin Spot ETF — to induce exchanges to voluntarily register with and become regulated by the SEC. So even if NYSE Arca was to put together a consortium of significant US market participants to do exactly what the SEC requires related to surveillance, the application would still be denied because said consortium would be made of participants outside the scope of the SEC regulations.

What’s next?

It’s not clear how an applicant is supposed to proceed. There aren’t great options for implementing a surveillance-sharing agreement that would be approved by the SEC and the SEC won’t provide further clarity on what would make them reconsider the Bitcoin market’s resitance to fraud & market manipulation.

NYSE Arca has applied for the Grayscale Bitcoin Trust (GBTC) to be converted into a Bitcoin Spot ETF. The deadline for an SEC response is July 7th. It’s hard to see how the SEC would approve this conversion with it’s stance dug so firmly into the ground, however.

A non-exhaustive list of options that changes the landscape for a Bitcoin Spot ETF:

• The SEC stops holding the process hostage by accepting that the Bitcoin market is unique compared to traditional equities / commodities, and does not require a surveillance sharing agreement (not likely)
• Legislation at the federal level is passed determining who gets to regulate crypto, moving exchanges to become regulated under a unified set of laws and opening up the ability to meet the surveillance-sharing requirement (medium likely)
• An ETF administrator like Greyscale files a lawsuit against the SEC and attempts to get the court force the SEC’s hand, which would take multiple year (most likely)

Let’s see in a year or two how these thoughts age.

Update: Jun 30, 2022

We didn’t have to wait for July 7th — the SEC released their disapproval the day after I published this. Greyscale was ready for this, with an immediate filing of a petition with the US Court of Appeals to litigate the decision. Their criticism primarily focuses on the consistency of the SEC’s analysis of a Bitcoin Spot ETF compared to similar instruments.

If regulators are comfortable with ETFs that hold derivatives of a given asset, they should logically be comfortable with ETFs that hold that same asset.

I don’t disagree with the sentiment, but it also seems Greyscale’s incentives may be misaligned here and that this lawsuit is more of a dog & pony show than a real effort. Ryan Selkis from Messari had a great breakdown of the specific situation for added context.

The scenarios here:

1. Greyscale wins, ETF conversion is allowed.
2. SEC relents, ETF conversion is allowed.
3. Greyscale relents, ETF conversion is disallowed.
4. SEC wins, ETF conversion is disallowed.

Scenario 1 would set precedent and open the flood gates for more ETFs. Scenario 4 would mean that the SEC has a strong leg to stand on with its requirement of a surveillance-sharing agreement from regulated market participants. Either way, litigating with the SEC is likely to take years. It’s going to be quite a while before we see a resolution.