Law360 (October 23, 2019, 4:01 PM EDT) --The U.S. Securities and Exchange Commission has dealt yet another blow to those hoping for a bitcoin exchange-traded fund. On Oct. 9, the SEC rejected Bitwise Asset Management’s bitcoin ETF application in a 112-page decision, striking doubt as to whether the current administration will allow a cryptocurrency-based ETF in the near future.
The SEC’s decision rests on its uncertainty in the integrity of the bitcoin market and the lack of regulation over the major cryptocurrency exchanges. The rejection closes the door on the possibility of a bitcoin ETF in 2019.
Background
On Oct. 9, the SEC rejected NYSE Arca Inc.’s proposal to list a bitcoin ETF sponsored by Bitwise Asset Management. The SEC found that NYSE Arca did not:
[Meet] 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). Specifically, it held that the exchange did not satisfy the requirement that the rules of a national securities exchange be "designed to prevent fraudulent and manipulative acts and practices."
This latest rejection further signals that bitcoin ETF applications will face an uphill battle under current SEC Chairman Jay Clayton.
Bitwise, a cryptocurrency index and fund provider, filed a Form S-1 with the SEC in January to form the Bitwise Bitcoin ETF Trust. In conjunction with this filing, NYSE Arca sought the SEC’s approval to list and trade shares of the bitcoin ETF under NYSE Arca Rule 8.201-E. In its application, Bitwise stated that all bitcoin would be held by a third-party custodian.
In September, Bitwise filed an amendment to its application naming Bank of New York Mellon Corp. as the transfer agent and administrator for the proposed ETF.
The SEC has considered, and previously rejected, similar applications. In July 2018, the SEC released what has become known as the Winklevoss Order, rejecting an application for a bitcoin ETF filed by Cameron and Tyler Winklevoss, co-founders of the cryptocurrency exchange Gemini Trust Co. LLC.
Through its denials, the SEC has outlined two ways to establish a bitcoin ETF that satisfies Exchange Act 6(b)(5). A provider must show either:
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Bitcoin is: “inherently resistant to fraud and manipulation, or that other means to prevent fraudulent and manipulative acts and practices will be sufficient”; or
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The listing exchange has entered into a surveillance agreement with a “regulated market of significant size” because “such agreements provide a necessary deterrent to manipulation because they facilitate the availability of information needed to fully investigate manipulation if it were to occur.”
Bitwise’s Application and the SEC’s Denial
Bitwise attempted to distinguish itself from its predecessors by arguing that its (1) pricing mechanism, (2) custodial arrangement, and the (3) established and regulated futures market adequately addressed concerns raised by the SEC in previous denials.
The SEC rejected Bitwise’s argument that its pricing mechanism was sufficient to prevent fraudulent and manipulative acts.
In support of its application, Bitwise conducted a study that determined that of the $6 billion in bitcoin trading volume reported by the top 81 exchanges, only 4.5%, or $273 million, was “real” volume. The remaining 95% of the market was dominated by fake and non-economic activity.
Further, only 10 of the top 81 exchanges contained the real volume. Across those 10 exchanges, Bitwise said the price of bitcoin traded incredibly tightly, and price discrepancies greater than 1% were rare and were quickly arbitraged away.
Bitwise further argued that the use of 10 exchanges to determine price mitigated risk because (1) the failure of any individual exchange would not materially affect pricing; and (2) any malicious actor would need to manipulate multiple platforms. Bitwise proposed to base its pricing mechanism on the real bitcoin market.
The SEC found that Bitwise had effectively conceded that bitcoin is not inherently resistant to manipulation by admitting that (1) 95% of the bitcoin market consists of fake and non-economic activity; and (2) the early bitcoin market may have been subject to market manipulation.
Further, Bitwise failed to establish that the real bitcoin market — identified as the 5% of real trading activity taking place over 10 exchanges — was isolated from the fraudulent and manipulative activity occurring throughout the rest of the bitcoin market. In making this determination, the SEC concluded:
[The] record does not demonstrate that the identified characteristics of the "real" spot market, such as the claimed effectiveness of arbitrage and the presence of some degree of regulation, establish that the segment of the market ... [is] uniquely resistant to manipulation sufficient to justify dispensing with the detection and deterrence of fraud and manipulation provided by surveillance-sharing agreements with significant, regulated markets.
The existing regulatory scheme does not protect against fraud and manipulation.
In its application, Bitwise and NYSE Arca touted the evolving regulatory scheme, and specifically argued that bitcoin exchanges have regulatory requirements imposed by the U.S. Department of Treasury's Financial Crimes Enforcement Network and the New York State Department of Financial Services.
FinCen requires that cryptocurrency exchanges in the U.S. register as money services businesses. NYSDFS requires cryptocurrency exchanges that do business in New York to obtain a BitLicense, which, among other things, requires that the exchange submit audited financial statements to NYSDFS.
The SEC concluded that FinCen and NYSDFS regulation were insufficient to protect against potential fraud and manipulation. By way of example, the SEC used Binance, which represented 39% of the real bitcoin market, according to Bitwise’s study. Binance is based in Malta, and is not required to register as a money services business with FinCen or required to obtain a BitLicense with NYSDFS.
Therefore, the regulatory schemes marketed by Bitwise as preventing fraud and manipulation could not monitor the largest exchange in the real bitcoin market. Further, the SEC pointed out that half of the platforms representing the real bitcoin market did not utilize any internal market surveillance tools, and it was unclear whether NYSE Arca had any power to compel the cryptocurrency exchanges to share the surveillance data that they did collect.
NYSE Arca’s surveillance agreement with the CME futures market was insufficient.
Bitwise and NYSE Arca contended in their application that NYSE Arca’s surveillance agreement with the Chicago Mercantile Exchange Inc. futures market was significant in size compared to the real bitcoin trading market that Bitwise’s pricing mechanism was based upon. Further, they argued that the CME futures market is regulated by the U.S. Commodities Futures Trading Commission.
The SEC concluded that NYSE Arca’s surveillance-sharing agreement was not sufficient given the lack of an interrelationship between the bitcoin ETF and the bitcoin futures market.
Moving Forward With a Bitcoin ETF: What’s Next?
While the door is closed to a bitcoin ETF in 2019, Bitwise and other providers have indicated that they will try again in the future. Importantly, in the Oct. 9 denial, the SEC reminded providers that its continued disapproval for a bitcoin ETF “does not rest on an evaluation of whether bitcoin, or blockchain technology more generally, has utility or value as an innovation or an investment.”
Just two days before the Bitwise SEC decision, Clayton gave an interview on CNBC in which he asked the question that future applications will have to answer: “[Given] that [bitcoins] trade on largely unregulated exchanges ... how can we be sure that [Bitcoin] prices aren’t subject to significant manipulation?”
This article first appeared on Law360 on October 23, 2019. Click hereto read the article on the Law360 website.
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