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By Dan Hoover, Chief Operations Officer — Castle Funds
Some cryptocurrency advocates heralded recent developments in the Security and Exchange Commission (SEC)’s court case against cryptocurrency platform Grayscale as a “big win” for the company. Since competitors have been watching this case closely and revising their own applications accordingly, some proponents imagine that a spot Bitcoin ETF — and all the first-to-market advantages — is just around the proverbial corner.
However, these hopes are likely overblown. Granted, the D.C. Circuit Court of Appeals has questioned why the SEC rejected Grayscale’s application to turn Grayscale Bitcoin Trust (GBTC) into an exchange-traded fund (ETF), but the court did not order the SEC to approve this conversion. Rather, it has merely required the SEC to issue a more detailed explanation for why it denied this application while approving substantially similar futures-based products.
Understanding this distinction is necessary to gauge the true importance of the recent Grayscale ETF decision, as well as to predict future developments accurately.
The Grayscale case explained
Grayscale has been offering shares of the GBTC since 2013, using investor cash to purchase Bitcoin (BTC) and charging 2% of assets per year. As structured, GBTC shares cannot be sold for six months after issuance and cannot be redeemed for either BTC or USD. In other words, money can enter the Trust but cannot leave. While Grayscale could offer a redemption program that would comply with Regulation M prohibitions on potentially manipulative transactions, the company seems to believe this would be administratively impossible and would not provide the necessary arbitrage mechanism.
Grayscale has therefore applied repeatedly to the SEC for permission to convert GBTC into an ETF, which would allow money to come out of the Trust. Establishing such an ETF would also enable the company to attract investors with other key advantages. For example, since qualified custodian banks with cybersecurity infrastructure and insurance would hold the Bitcoin inside of the proposed ETFs, the ETFs promise a greater level of security for investors’ assets than buying BTC directly and holding them at a dealer such as Coinbase.
The SEC has denied these applications every time.
In a novel turn of events, however, the D.C. court’s recent decision has paused the SEC’s latest denial. In addition, this ruling has implications for companies other than Grayscale, indicating that, if the SEC were to reject another company’s spot Bitcoin ETF application on the same grounds as it did for Grayscale, it would also need to provide a more detailed explanation backing up this decision.
The SEC will likely respond to the court order by more fully explaining its rationale. There are multiple reasons to believe this more detailed reasoning could well prove persuasive to the court should Grayscale lose again and appeal the SEC’s ruling to the same court on similar grounds.
Grayscale still faces problems
A number of barriers stand in the way of Grayscale winning this court case and gaining the SEC’s approval for GBTC.
First and foremost, a spot Bitcoin ETF sponsor has the burden of assuring the SEC that the sponsor can detect and prevent attempts to manipulate the price of Bitcoin. In other commodity-based ETFs (such as silver, gold, and Bitcoin futures-based products), this is done through a surveillance-sharing agreement with a sizable regulated market. To fulfill this requirement, Grayscale (as well as the other companies) proposes surveillance-sharing agreements with Coinbase, an online platform for cryptocurrency transactions and accounts.
Yet, the SEC is actively suing Coinbase for allegedly acting as an unregistered broker and illegally merging the brokerage, clearing, and settlement functions in Bitcoin trading. Why would the SEC approve agreements between Grayscale and a cryptocurrency exchange that has not acknowledged its oversight authority? The D.C. court’s recent decision in no way resolves these allegations.
Meanwhile, regulators have legitimate grounds for denying Grayscale’s application. The GBTC’s assets are not held by a bank under the supervision of a nationally recognized regulator, such as the Treasury’s Office of the Comptroller of the Currency (OCC). In addition, no third-party entity has yet emerged as willing to be responsible for certifying that all BTC in the ETF is free of money laundering or counter-terrorist-financing concerns.
These outstanding issues make it unlikely that GBTC will quickly secure SEC approval.
In the meantime, other companies’ recent applications — like BlackRock’s and ARK’s, for instance — are unlikely to swoop in and get the SEC’s green light, either. The SEC still isn’t under any obligation to approve the rule changes that would be required to allow the listing of Bitcoin ETF shares on a regulated securities exchange. Even if an ETF sponsor was able to build from scratch the entire set of regulated service providers required to make the ETF run, applicants would still need to demonstrate how they intend to comply with financial-crime laws, such as anti-money laundering, sanctions, and counter-terrorist financing laws.
Until these issues are resolved in a satisfactory manner, applications for aspiring spot Bitcoin ETFs are likely to fail.
Setting more realistic expectations for spot Bitcoin ETFs
Modernizing financial regulations is a process that takes many years. Unless Congress intervenes, this modernization is often advanced through enforcement lawsuits and the appeals process.
For instance, it took over 25 years for the no-action relief governing ETFs to be formalized under the ETF Rule in 2019. It took nearly 20 years before Congress formalized the Over-The-Counter (OTC) swaps market with Dodd-Frank in 2010, and implementation of some of those rules was delayed until at least 2021, an additional 11 years later.
Likewise, cryptocurrency companies should not expect the government to endorse their aspirations overnight. The market has been through many cycles of anticipation and disappointment around these approval events, and the risk of poor outcomes (or extended timelines) is significant. Understanding the limits of the recent court decision should moderate some of the market’s exuberance and place more realistic expectations on the future of spot Bitcoin ETFs.
The future of spot Bitcoin ETFs
So, what does the future hold? Since SEC applications for these ETFs are unlikely to gain approval quickly, it’s possible that a set of credible, independent service providers could emerge that will be able to engage with US regulators successfully. These would include qualified custodians, banking providers, accountants and auditors, compliance monitoring, and qualified tax advisors.
To address its woes, Coinbase could spin off (or build through a joint venture with a partner) the market infrastructure needed for regulated products to function, such as the clearing and settlement of Bitcoin transactions. This could make the company an acceptable partner for surveillance-sharing agreements, assuming that the spun-off company was able to comply with applicable regulations.
Developments like these would address the SEC’s key concerns as expressed in the Coinbase and Binance enforcement actions, as well as the issues raised in its previous rejections of listing applications. In this way, spot Bitcoin ETFs could one day become a reality.
Dan Hoover is the Chief Operating Officer and Chief Compliance Officer of Castle Funds. He has extensive experience in investment analysis, portfolio management, and risk management. Prior to joining Castle Analytics LLC in 2020, he was at BlackRock for more than 11 years in a variety of client service and strategic planning roles, including the ETF and institutional-client businesses. He joined BlackRock in 2008 after working as an engagement manager for the consulting practice of EY LLP, where he advised asset management, private equity, broker-dealer, and endowment clients on risk management and regulatory compliance best practices. He began his career as a portfolio manager at Wells Fargo. Mr. Hoover earned an undergraduate degree in Political Science and Economics from the University of California, San Diego, and an MBA from the University of Notre Dame.
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