While many in the crypto community seem confident that SEC approval for a Bitcoin ETF is just around the corner, analysis of the Commission’s latest refusal reveals that ‘getting to yes’ will be much harder than most people realize

The Winklevoss Bitcoin Trust, better known as the “Winklevoss Bitcoin ETF”, was rejected for a second timeby the Securities and Exchange Commission (SEC) following a proposed rule change by BATS BZX Exchange, the exchange that had planned to list the exchange-traded fund.

After the SEC had rejected the Winklevoss’ first attempt to list their Bitcoin ETF in March 2017, the BATS BZX Exchange filed a petition for a review of that decision in another attempt to receive approval for the ETF listing. The SEC agreed to the review, and did so ‘de novo’ which is a legal term that basically means ‘from scratch’.

However, on July 26, 2018, the SEC announced in a filing that it had decided against the listing of a publicly-traded Bitcoin ETF, and reiterated the concerns it highlighted when it initially rejected the Winklevoss Bitcoin Trust.

Why is the SEC not ready for a Bitcoin ETF yet?

In very simple terms what it all boils down to is this. The SEC thinks the bitcoin price is vulnerable to manipulation — and it is not buying into any arguments to the contrary. Drilling down, the SEC’s reasons for the rejection concern potential market manipulation, a lack of traditional means of detecting and deterring fraud and manipulation, and the lack of adequate surveillance-sharing agreements for the bitcoin market.

BZX had argued that the very nature of the bitcoin market made price manipulation “difficult and prohibitively costly” and produced several letters supporting this position. Not good enough said the SEC — citing a lack of data to support these claims — and concluding that “there is an insufficient basis in the record before it, to decide that the bitcoin spot markets are inherently resistant to manipulation.

”Moreover, the SEC held that BZX had not been able to demonstrate that in the absence of traditional means of detecting and deterring market manipulation — through a surveillance-sharing agreement with a regulated bitcoin market of substantial size — that the exchange’s own trade surveillance measures would suffice to prevent market manipulation.

“[...] If BZX had demonstrated that bitcoin and bitcoin markets are inherently resistant to fraud and manipulation, comprehensive surveillance-sharing agreements with significant, regulated markets would not be required, as the function of such agreements is to detect and deter fraud and manipulation.

But because the underlying commodities market for this proposed commodity-trust ETP is not demonstrably resistant to manipulation, BZX, as the ETP listing exchange, must enter into surveillance-sharing agreements with, or hold Intermarket Surveillance Group membership in common with, at least one significant, regulated market relating to bitcoin,” the SEC added.

However, since that is not in place, the SEC’s requirement for trade surveillance was not met by BZX.

To conclude its rejection, the SEC stated: “Although the Commission is disapproving this proposed rule change, the Commission emphasizes that its disapproval does not rest on an evaluation of whether bitcoin, or blockchain technology more generally, has utility or value as an innovation or an investment.

Rather, the Commission is disapproving this proposed rule change because [...] BZX has 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 the Exchange Act Section 6(b)(5), in particular the requirement that its rules be designed to prevent fraudulent and manipulative acts and practices."

The Hester Peirce dissent

One aspect of the decision that has buoyed the hopes of many that SEC approval is just a matter of time is that the Commission’s decision to disapprove the Winklevoss ETF was not unanimous. And in fact, one of the four Commissioners, Hester Peirce, actually published a dissent where she spelt out why she thought her fellow Commissioners were wrong.

In a statement, Peirce said: “I respectfully dissent from the Commission’s order disapproving a proposed rule change, as amended, to list and trade shares of the Winklevoss Bitcoin Trust on Bats BZX Exchange, Inc. (“BZX”). [...] Contrary to the Commission’s determination, I believe that the proposed rule change satisfies the statutory standard and that we should permit BZX to list and trade this bitcoin-based exchange-traded product (“ETP”).

Accordingly, I would set aside the action the staff took by delegated authority in this matter and approve the proposed rule change.

”“I am concerned that the Commission’s approach undermines investor protection by precluding greater institutionalization of the bitcoin market. More institutional participation would ameliorate many of the Commission’s concerns with the bitcoin market that underlie its disapproval order,” she added.

Peirce also had strong words for her colleagues' decision to disapprove the ETF on the grounds that they had erroneously read the requirements of Section 6(b)(5) of the Exchange Act, which requires exchanges to be able to adequately surveil trading to prevent the occurrence of market manipulation.

Instead, she says the SEC has focused its decision on the unregulated and opaque nature of the underlying bitcoin spot market as opposed to an individual exchange’s ability to ensure fair trading, which she said it should have according to the Exchange Act.

Peirce believes that “the rules of the exchange satisfy the Section 6(b)(5) standard,” and that the exchange-traded product should thus be approved. She also believes that the disapproval of a bitcoin ETF dampens innovation and hampers the institutionalization of bitcoin, which, in turn, would help bitcoin to develop into an investor-friendly asset class. 

Peirce has since been tagged “Crypto Mom” by bitcoin users on Reddit and has received praise by the bitcoin community for her progressive thinking. That said, she remains a lone voice on the Commission and there is much that ETF proponents will still need to do in order to alter the majority’s clearly stated position.

What can other Bitcoin ETF applicants do better?

In a staff letter published in January 2018, the SEC’s Director of the Division of Investment Management, Dalia Blass, stated:“Until the questions [on valuation, liquidity, custody, and potential market manipulation] can be addressed satisfactorily, we do not believe that it is appropriate for fund sponsors to initiate registration of funds that intend to invest substantially in cryptocurrency and related products.

”These concerns have been partly reiterated in the latest rejection of the Winklevoss Bitcoin Trust.

Hence, when it comes to getting a Bitcoin ETF listed, the SEC has made it abundantly clear that it is looking for an investment vehicle whose value is determined by an asset that is traded on regulated exchanges with ample liquidity - and that the exchanges can prove that they possess sufficient risk management and AML/KYC procedures to alleviate the potential risk of market manipulation.

Furthermore, crypto asset custodians need to be arranged to ensure the criteria of regulated custodianship is met. To ensure asset valuation meet the regulator's criteria, the industry and the market should ideally agree on one reference index for bitcoin-related financial products.

Additionally, the largest bitcoin exchanges across the globe would need to work together and set up market surveillance sharing agreements to ensure that market manipulation could be reduced and deterred as per the SEC’s ruling. However, to what extent that would really make an impact is questionable given that OTC bitcoin trading volumes are higher than those on exchanges.

Bitcoin ETF providers who manage to address these primary concerns stand a better chance of getting their bitcoin ETF over the line than the Winklevoss Bitcoin Trust did with its filing.

Conversely, ETF applicants who file without comprehensively addressing all these concerns are unlikely to be successful.