Overview
The U.S. Court of Appeals for the District of Columbia Circuit ruled in late August that the Securities and Exchange Commission (SEC) must review its rejection of Grayscale Investments' application to convert its Grayscale Bitcoin Trust (GBTC) into an exchange-traded fund (ETF). The ruling is a major victory for Grayscale and the cryptocurrency industry, which has been lobbying the SEC to approve a spot bitcoin ETF for years.
The SEC has denied several applications for spot bitcoin ETFs in the past, citing concerns about market manipulation and investor protection. However, the appeals court found that the SEC's reasoning was "arbitrary and capricious" and that the agency had not adequately explained its decision.
The ruling does not guarantee that the SEC will approve Grayscale's application, but it does increase the chances of a spot bitcoin ETF being approved in the near future. A spot bitcoin ETF would allow investors to gain exposure to bitcoin without having to buy and store the cryptocurrency themselves. This would make it easier for more people to invest in bitcoin and could help to boost the growth of the cryptocurrency market.
U.S. Spot ETF Challenge
ETFs are a popular investment vehicle in traditional finance and their entry into the cryptocurrency space marked a significant milestone. However, the journey has not been smooth, especially for bitcoin spot ETFs in the U.S., which have faced rejection from the Securities and Exchange Commission (SEC) for nearly a decade.
As per the data from Bloomberg, there are ~150 cryptocurrency exchange-traded products globally in 2023. Cumulatively, these products command assets amounting to a staggering ~$7 billion. Several developed economies, namely Canada, Switzerland, Sweden, and Germany, have not just taken notice but also acted upon this trend by greenlighting spot cryptocurrency exchange-traded products.
Yet, the landscape in the United States paints a slightly different picture. While eight products exist in the American market, each of these is anchored to Bitcoin futures as their fundamental asset. The spectrum ranges from products that employ a short strategy and a 2x leveraged fund to those that incorporate option overlays.
Before delving into the challenges faced by spot BTC ETFs, it is crucial to understand the difference between bitcoin futures ETFs and bitcoin spot ETFs. "Spot" in financial markets refers to the immediate purchase of an underlying instrument, such as buying bitcoin on an exchange and then withdrawing it to your wallet using Bitcoin's blockchain. In contrast, purchasing a bitcoin futures contract only exposes the buyer to the price movements of bitcoin without the ability to withdraw the underlying bitcoin.
This distinction implies that buying bitcoin futures is akin to price speculation while purchasing spot bitcoin allows the owner to own and use the bitcoin for native economic activities. Essentially, investors buy futures to bet on bitcoin's price, whereas people buy spot to own and use bitcoin.
So, why does spot matter? While bitcoin futures ETFs have been approved, there is a strong argument that they have not significantly impacted bitcoin adoption, particularly because bitcoin's price has not advanced notably in the two years since its introduction. The key reason lies in the nature of futures ownership; it does not drive underlying demand for the digital commodity, making it challenging for speculative demand to drive bitcoin adoption fully.
Purchasing spot bitcoin is the only way to affect the demand for bitcoin directly. A spot ETF would attract committed capital from investors to buy BTC in the market. This is precisely what Grayscale has done for almost a decade with its Bitcoin Trust (GBTC), albeit in the private markets without the liquidity advantages of an SEC-approved instrument.
In the United States, bitcoin futures ETFs have been approved and actively traded since 2022. However, spot ETFs have faced repeated denials from the SEC, which has consistently argued that spot bitcoin is susceptible to market manipulation and a reliable price cannot be established. This argument appears puzzling, given that bitcoin futures and spot prices are intrinsically linked, leading some, including a federal judge, to question the SEC's reasoning.
GBTC Product
Grayscale's participation via a spot vehicle, the Grayscale Bitcoin Trust (GBTC), has undoubtedly contributed to driving underlying bitcoin demand. However, the dynamics changed a few years ago when the price relationship of GBTC to the underlying bitcoin started to decline. Today, GBTC represents a massive hoard of bitcoin (about 3% of all bitcoin in circulation) that is arguably impeding the entire ecosystem due to its ongoing regulatory battle.
Since March 2021, during the bull market, GBTC has traded at a notable discount to Bitcoin. The discount reached its zenith at -50% last December, following the insolvency of FTX. The bet that GBTC and BTC prices would eventually align has proven disastrous, contributing to the demise of Three Arrows Capital and other entities. However, after the court decision, the discount narrowed to around 20%, a multi-year record, making GBTC the best-performing cryptoasset year to date.
The Dilemma of Converting Grayscale Trusts to ETFs
While converting the Grayscale trusts to ETFs is undoubtedly in the investors' best interests, it may not necessarily be in the issuer's best interests. Grayscale is a subsidiary of the beleaguered Digital Currency Group (DCG), and the digital currency trusts are the group's most lucrative business line. It is anticipated that if these trusts were converted to ETFs, fees would need to be significantly reduced from the current 2%, and there would be fierce competition from Blackrock, a dominant player in the financial market.
The conflicting incentives here are that DCG might profit more by not converting unless they are significantly underwater on a large number of GBTC units. A full breakdown on the situation can be found here. This situation presents a complex decision for DCG, as they must weigh the potential benefits and drawbacks of converting the trusts to ETFs, considering both their profitability and the best interests of their investors.
The trading discount of GBTC to Bitcoin has had significant implications for investors and has contributed to the downfall of investment firms betting on price convergence. The recent narrowing of the discount following a court decision indicates a positive trend for GBTC. However, the decision to convert Grayscale trusts to ETFs presents a dilemma for the issuer, as it involves balancing the best interests of investors with the potential impact on profitability and competition. Ultimately, the decision will have far-reaching implications for the broader cryptocurrency market and the investment landscape.
Grayscale Lawsuit and Ruling
In October 2021, Grayscale made an application to transform its GBTC into an ETF to be listed on the New York Stock Exchange’s Arca market. However, the SEC rejected the application in June 2022, leading Grayscale to file a lawsuit shortly after under the Administrative Procedures Act. Grayscale contended that the SEC's approval of futures-based ETPs while denying its spot ETF was arbitrary and unfair. The Court sided with Grayscale, finding no distinction between futures and spot ETFs and criticizing the SEC for failing to acknowledge the clear financial and mathematical relationship between the spot and futures markets, which fell short of the standard for reasoned decision-making.
The SEC has consistently rejected past spot ETF applications due to the absence of surveillance-sharing agreements covering a regulated market of adequate size. Addressing this, the Court noted that the surveillance-sharing agreements with the CME are identical and should, therefore, have the same probability of detecting fraudulent or manipulative activities in the bitcoin and bitcoin futures market. Supporting this view, quants at FMR (Fidelity) provided evidence in a 2021 filing for the Wise Origin bitcoin ETF, indicating that the CME bitcoin futures market has consistently been a leader in Bitcoin price discovery across global USD bitcoin markets. This suggests that monitoring futures markets should be adequate to prevent market manipulation.
This landmark ruling by Judge Neomi Rao of the DC Circuit Court of Appeals is pivotal for several reasons:
Arbitrary and Capricious Decision-Making by the SEC: The court found that the SEC's denial of Grayscale's proposal was arbitrary and capricious because the Commission failed to explain its different treatment of similar products. Grayscale had demonstrated that its proposed bitcoin ETP was materially similar to the approved bitcoin futures ETPs. This decision aligns with criticisms from the crypto industry, senior politicians, and top lawyers that the SEC takes an arbitrary and high-handed approach, failing to explain its reasoning.
Similarity Between Spot and Futures ETPs: The court held that fraud in the spot market would present the same risks to holders of shares in both a spot Bitcoin ETP (which was denied) and a Bitcoin futures ETP (of which two were approved by the SEC). This undermines the SEC's argument that the surveillance regime made Bitcoin futures ETPs more resistant to manipulation than a spot Bitcoin ETP.
Legal Principle: The ruling reinforces the fundamental principle of administrative law that agencies must treat like cases alike, highlighting the inadequacy of the SEC's approach in differentiating between similar products.
Implications for the SEC: The ruling raises questions about the SEC's fitness to regulate the crypto industry. The court's decision essentially states that the SEC did not consider the relevant issues and failed to adequately explain its decision, echoing sentiments of many industry participants.
Potential Impact on the Crypto Industry: Approval of a spot BTC ETF is seen as a bullish unlock for the crypto industry as it would allow investors to circumvent the challenges of crypto custody and become the go-to investment vehicle for US retail and institutions seeking exposure to the asset. This ruling suggests that spot ETFs are now free and clear for approval, although the exact timing and impact are unknown.
In conclusion, this ruling is a significant development for the cryptocurrency industry, as it challenges the SEC's inconsistent and arbitrary treatment of similar products. It underscores the need for the SEC to reevaluate its approach to regulating the crypto industry and may pave the way for the approval of spot ETFs, although the exact timing and impact remain uncertain. This decision is a positive step towards greater regulatory clarity and fair treatment of cryptocurrency-related products.
What’s Next for BTC ETFs
The decision by the DC Circuit Court of Appeals in the Grayscale case represents a pivotal moment for the future of Bitcoin ETFs. It indicates that if the SEC wants to deny Bitcoin ETFs, they will have to develop a new line of reasoning that is not invalidated by the court's decision. This is a significant hurdle for the SEC as it will have to convince an appellate court to agree with its decision to distinguish between Bitcoin futures and Bitcoin spot ETF products, despite both being valued based on the same underlying asset.
Moreover, the involvement of financial giants like BlackRock and Fidelity in the spot Bitcoin ETF business is a strong indicator that the industry is evolving. These institutions manage more money than the GDP of most nations, and their entry into this space is a sign that they have done their homework on the regulatory hurdles and have likely lobbied the appropriate bureaucrats and politicians to ensure ultimate approval. Although the SEC roadblocks are significant, they are seen as temporary obstacles rather than insurmountable barriers. Bloomberg's prediction of a 75% likelihood of approval by the end of this year and 95% by the end of next year aligns with this optimistic perspective. While it is difficult to predict the exact timing, there is a growing sense of inevitability that the approval of a spot Bitcoin ETF is on the horizon.
On September 1st, the SEC announced it will delay deciding on the spot bitcoin ETF applications from WisdomTree, Invesco Galaxy, and Valkyrie Digital Assets. The delay in the applications has had a negative impact on the price of bitcoin, causing it to fall further.
Seminal NFT Ruling
The SEC recently charged Impact Theory for conducting an unregistered offering of crypto asset securities during their "Founders Keys" NFT launch in 2021, where they raised approximately $30 million. The SEC's enforcement action against Impact Theory for selling an NFT as an unregistered security represents a landmark regulatory development for US-based NFT issuers.
Previously, the SEC has been actively cracking down on unregistered securities offerings in the crypto space, but NFTs had largely been overlooked. Although Impact Theory settled the charges by paying $6.1 million without admitting any wrongdoing, this case highlights that the SEC considers crypto tokens, regardless of whether they are issued in ERC-20 (fungible) or ERC-721 (non-fungible) format, as securities if they are perceived as an investment in a business. This decision does not imply that the SEC considers all NFTs, such as art-based NFTs, as securities, even if the purchaser's motive is to profit from others' speculation on the collection.
Despite strong dissent from SEC Commissioners Hester M. Peirce and Mark T. Uyeda, who questioned the inconsistency of the SEC's approach and emphasized the need for a clear regulatory framework from the outset, the action against Impact Theory could serve as a precedent for NFT collections to navigate regulatory challenges.
In conclusion, while the SEC's actions may guide NFT collections in avoiding regulatory pitfalls, a transparent regulatory framework is essential for the NFT space. This will enable founders to develop their brands without fear of regulatory repercussions and support the growth of the NFT market as it seeks to recover from a downturn. Otherwise, regulatory enforcement will continually threaten its expansion.
Our Take
At Event Horizon Capital (EHC), we believe select cryptoassets will outperform all other asset classes over the next five, ten, and possibly even twenty years due to their superior qualities as new money/assets for the internet age. Because of this, we seek the best risk-adjusted exposure to protocols that personify the blockchain benefits outlined above. With crypto markets being one of the world’s most dynamic markets, our agile and active management provides the flexibility required for swift, decisive action while also never compromising on security.
EHC’s multi-strategy approach is built upon:
Qualitative fundamental research,
Quantitative tools and valuation metrics
Narrative and sentiment-driven market swings
This newsletter from Event Horizon Capital is intended for informational and illustrative purposes only and has been prepared to provide insights on the market. It should not be construed as an offer, solicitation, or recommendation to buy or sell any security or financial instrument, nor participate in any investment strategy. The opinions and information expressed in this newsletter are as of the date it was written and are subject to change without notice due to various factors, including changing market conditions and regulations. This newsletter is not intended as investment advice and should not be considered as such. Third-party data presented in this newsletter is sourced and deemed reliable, but no guarantee is made as to its accuracy or completeness. All investments carry risk, and there is no assurance that any specific investment, strategy, or product referenced directly or indirectly in this publication will be profitable or suitable for your portfolio.
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