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The SEC’s Bitcoin ETF Standoff

Summary:
Another day, another application for a spot Bitcoin exchange-traded fund (ETF) rejected. Yesterday, the SEC rejected an application from Fidelity's Wise Origin Bitcoin Trust, the fifth such rejection in three months. Back in November, the SEC rejected an  application from Van Eck Bitcoin Trust, and in December it rejected applications from Kryptoin Bitcoin ETF Trust and Valkyrie Bitcoin Fund.And on 20th January, it rejected First Trust Skybridge Bitcoin ETF Trust's application.  Valkyrie had already had an application for a Bitcoin futures ETF approved by default. So the rejection of its spot ETF came as something of a surprise. Indeed, some analysts seem to have expected the SEC's default approval of Bitcoin futures ETFs for Valkyrie and ProShares in October to open the floodgates for

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Another day, another application for a spot Bitcoin exchange-traded fund (ETF) rejected. Yesterday, the SEC rejected an application from Fidelity's Wise Origin Bitcoin Trust, the fifth such rejection in three months. Back in November, the SEC rejected an  application from Van Eck Bitcoin Trust, and in December it rejected applications from Kryptoin Bitcoin ETF Trust and Valkyrie Bitcoin Fund.And on 20th January, it rejected First Trust Skybridge Bitcoin ETF Trust's application.  

Valkyrie had already had an application for a Bitcoin futures ETF approved by default. So the rejection of its spot ETF came as something of a surprise. Indeed, some analysts seem to have expected the SEC's default approval of Bitcoin futures ETFs for Valkyrie and ProShares in October to open the floodgates for approval of spot Bitcoin ETFs. 

But these are not the first spot Bitcoin ETFs the SEC has disapproved. The SEC has previously rejected applications from Winklevoss Bitcoin Trust, SolidX Bitcoin Trust, ProShares Bitcoin Trust and Granite Bitcoin Trust. In fact it has rejected every single application for a spot Bitcoin ETF. The only Bitcoin ETF applications the SEC has approved have been for futures ETFs, where the underlying futures are traded on regulated exchanges such as CME. 

Clearly, it's not the quality of the proposed ETFs themselves that is the problem. It's the nature of the Bitcoin spot market. The Bitcoin spot market is widely regarded as the Wild West of crypto trading. Unlike the regulated exchanges on which Bitcoin futures are traded, it is unregulated, opaque, volatile and fragmented. The bar for spot Bitcoin ETF approval is thus much higher than it is for futures ETFs. Not one of these applications has reached that bar.  

In its response to Winklevoss Bitcoin Trust's application (pdf), the SEC set the conditions that a spot Bitcoin ETF would have to meet for approval to be granted. Either the applicant must prove that both the Bitcoin spot market and Bitcoin itself are "inherently and uniquely" resistent to fraud and manipulation; or the ETF's methodology must include measures capable of identifying and counteracting fraud and manipulation in the Bitcoin spot market and Bitcoin itself; or there must be a surveillance-sharing agreement with a regulated market of significant size related to Bitcoin. The SEC examined the submissions in all of the recent applications for compliance with these conditions, and found them wanting.  

Firstly, the Bitcoin spot market. In its submission for Van Eck Bitcoin Trust, BZX Exchange argued that the Bitcoin spot market is extremely difficult to manipulate and that any fraudulent actors would be visible and hence easily avoided. It said that arbitrage would quickly eliminate any price disparities between trading platforms, and that the high cost of market manipulation would make it unsustainable. But it didn't provide any evidence in support of its argument.

The SEC was distinctly unimpressed. It said that efficient arbitrage was insufficient to prove that a market was "inherently and uniquely" resistant to manipulation, and pointed out that other markets with efficient arbitrage, such as equity options on exchange-traded securities, still had to have surveillance-sharing agreements. Furthermore, in the absence of evidence there was no reason to believe that fraudulent or manipulated trading would not affect prices, nor that market manipulation would be too costly for participants with deep pockets. 

The SEC concluded that BZX had failed to prove that the Bitcoin spot market was "inherently and uniquely resistant to manipulation". And it then went on to point out that there is significant evidence that the Bitcoin spot market is riddled with market abuse, security breaches and outright fraud. It listed seven significant risks in the spot Bitcoin market that it said it had identified previously but BZX's proposal had failed to address:

  • wash trading
  • persons with a dominant position in bitcoin manipulating bitcoin pricing
  • hacking of the bitcoin network and trading platforms
  • malicious control of the bitcoin network (51% attack)
  • trading based on material, non-public information, including dissemination of false and misleading information
  • manipulative activity involving the purported "stablecoin" Tether (USDT)
  • fraud and manipulation at bitcoin trading platforms.
These risks are of course far beyond BZX's capability to address. But you'd think, wouldn't you, that it would realise that since it can't mitigate these risks, it has not a hope in hell of convincing the SEC that the Bitcoin spot market is "inherently and uniquely" resistent to manipulation and fraud?

Hilariously, Van Eck itself had also identified a whole load of problems with the Bitcoin spot market, including the fact that a number of bitcoin trading platforms have been victims of cybercrime and that several have closed or faced "issues" because of fraud, failure and security breaches. The SEC, of course, listed these problems as further evidence that BZX's claim was fatally flawed. 

Van Eck also warned in its registration document that the unregulated nature of bitcoin trading platforms made fraud and failure more likely, and that this could compromise market-making and price discovery in the ETF's shares: 
if these spot markets “do not operate smoothly or face technical, security or regulatory issues, that could impact the ability of Authorized Participants to make markets in the Shares” which could lead to “trading in the Shares [to] occur at a material premium or discount against the NAV”

 The SEC sardonically pointed out that this hardly supported BZX's argument that the SEC should treat the Bitcoin spot market more favourably than regulated markets.  

Far from learning from this brutal indictment of the Bitcoin spot market and the flaws in its own submission, BZX repeated exactly the same arguments for Kryptoin and Wise. Why on earth it thought the SEC would respond favourably to arguments it had previously dismissed out of hand is a mystery. The definition of insanity attributed to Albert Einstein springs to mind. Anyway, the SEC didn't even bother to write new responses to these applications. It just cut and pasted the reasons for rejection from its previous orders. 

BZX's arguments didn't get any better when it discussed the proposed ETF's methodology. The methodology relies on price feeds from a small number of bitcoin trading platforms; BZX claimed that the fact that only a small number of highly-regarded trading platforms were involved, plus the use of a volume-weighted median and eliminatin of outliers, would make the prices resistent to fraud and manipulation. But the SEC pointed out that as these platforms are a subset of the whole market, and BZX had failed to show that the whole market was resistant to manipulation and fraud, BZX could not credibly claim that the prices provided by this subset of platforms would not be influenced by fraudulent or manipulated trading on other platforms.

And once again, Van Eck's own registration document undermined BZX's argument: 
...the Exchange’s assertions that the Benchmark’s methodology helps make the Benchmark resistant to manipulation are contradicted by the Amended Registration Statement’s own statements. In the Amended Registration Statement, the Sponsor states that the Benchmark is “based on various inputs which may include price data from various third-party exchanges and markets” and that these inputs may be subject to “technological error, manipulative activity, or fraudulent reporting from their initial source.
There are similar conflicts between BZX's submissions and the registration documents for both Kryptoin's and Wise's applications. 

Van Eck's Custodian, Gemini, then indulged in a fine piece of special pleading, arguing that market surveillance and controls on the subset of trading platforms used for price feeds were so good that manipulation was all but impossible. But implying that surveillance and control tools on regulated exchanges weren't as good as those on Van Eck's chosen Bitcoin trading platforms wasn't a sensible strategy. The SEC slapped it down: 
However, the level of regulation on the Benchmark’s constituent platforms is not equivalent to the obligations, authority, and oversight of national securities exchanges or futures exchanges and therefore is not an appropriate substitute....
It went on to explain the rules and reporting requirements that regulated exchanges must comply with, and observed that Bitcoin trading platforms comply with none of them. Ouch. 

And the pain continued. A few paragraphs further on, the SEC dismissed as contradictory BZX's argument that in-kind redemptions rendered the question of price manipulation moot. It also refused to accept that in-kind redemptions eliminated the need for surveillance sharing, on the reasonable grounds that in-kind redemptions are fairly common in ETF-land and don't eliminate the need for surveillance sharing by other exchanges.  

BZX's failure to establish that either the Bitcoin spot market or the proposed spot Bitcoin ETF were resistant to manipulation or fraud meant that approval would mean surveillance sharing.  But what is surveillance sharing, and how does it help to prevent fraud and market abuse?

When the market for the assets underlying a derivative product is small, unregulated, opaque or otherwise suspect, the SEC requires exchanges trading that product to enter into a surveillance-sharing agreement with a large regulated market in a related asset or derivative. The idea is that manipulation that wouldn't be visible in the unregulated market would be visible in the larger regulated market and could be controlled there. For this to work, however, the regulated market must influence the unregulated one, not the other way round - or, to put it another way, it must be impossible for a market participant to manipulate the unregulated market significantly without trading in the regulated one. Much of the discussion by the SEC and the applicants therefore centres on whether the regulated market leads or lags the unregulated one. 

For recent spot Bitcoin ETF applications, the proposed regulated market for surveillance sharing is CME's Bitcoin futures market. This is unquestionably a Bitcoin-related market of significant size, and BZX already has a relationship with it. So BZX's argument that it is suitable for shared surveillance is, on the face of it, not unreasonable. But once again, it founders on poor evidence.

The problem is that it is unclear exactly what relationship the CME Bitcoin futures market has with the spot market. BZX argued that the futures price leads the spot price, so a potential manipulator would have to trade in the futures market in order to significantly affect the spot price. It cited a research paper showing the futures market dominated price discovery in the spot market. So far, so good. But there's a problem. It doesn't dominate it consistently:
The paper finds that the CME bitcoin futures market dominates the spot markets in terms of Granger causality, but that the causal relationship is bi-directional, and a Granger causality episode from March 2019 to June/July 2019 runs from bitcoin spot prices to CME bitcoin futures prices. The paper concludes: “[T]he Granger causality episodes are not constant throughout the whole sample period. Via our causality detection methods, market participants can identify when markets are being led by futures prices and when they might not be.”
So not only is the CME Bitcoin futures market at times led by the spot market, but this helpful paper provides a means for would-be manipulators to find out when might be a good time to indulge in a spot of market abuse. Oops. 

BZX didn't provide any other evidence to support its claim that the CME Bitcoin futures market would act as an effective surveillance tool for the Bitcoin spot market. But the SEC did have other evidence - to the contrary. It had previously surveyed all the available academic research on this relationship and concluded that there was no evidence that a would-be manipulator would have to trade on the CME futures market to move the Bitcoin spot price. Double oops. 

This was the final nail in the coffin of Van Eck's application. It also meant that all the other applications that relied on that single research paper would fail. In addition to the four that have failed since the Van Eck application was disapproved, there are others awaiting the SEC's judgement, notably from ARKK and Bitwise. I expect these to fail as well. 

For me, the mystery is why BZX - and NYSE Arc, whose submissions are remarkably similar - thought  resubmitting arguments and evidence that the SEC had already dismissed and failing to provide any new argument or evidence would magically result in approval. But perhaps they didn't. Perhaps they want the SEC to disapprove everything. After all, if the SEC disapproves all applications, the problem isn't the applications, it's the SEC - isn't it?

There seems to be a profound difference of opinion between the SEC and those applying for spot Bitcoin ETFs. The applicants believe the spot Bitcoin market is resistant to manipulation simply because of the nature of Bitcoin, and don't see why they should have to provide evidence for what they consider to be self-evident. But the SEC believes the Bitcoin spot market is a hornet's nest, and in the absence of evidence to the contrary, sees no reason to change its view. 

At present, the available evidence supports the SEC's position. The seven risks in the Bitcoin spot market that the SEC identifies are well documented and create a serious hazard for investors and the general public. And the cavalier attitude to risk and disdain for regulation displayed by all the applicants does not inspire confidence in their products. Nor, frankly, does the carelessness so evident in the preparation of their submissions to the SEC. They will have to do a lot better if they are ever to reach the high bar that the SEC has set for approval of a spot Bitcoin ETF.

But I am not convinced they will reach it anyway without root and branch reform of the Bitcoin spot market. While market abuse and fraud remains rampant, the SEC is not going to approve any spot Bitcoin ETF, however responsible the applicant. The way forward for wannabe exchange-traded Bitcoin funds is not repeated applications to the SEC that they know will fail, it is campaigning for much better regulation and oversight of Bitcoin trading platforms and exchanges. 


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Image from Pond5.com

 



Frances Coppola
I’m Frances Coppola, writer, singer and twitterer extraordinaire. I am politically non-aligned and economically neutral (I do not regard myself as “belonging” to any particular school of economics). I do not give investment advice and I have no investments.Coppola Comment is my main blog. I am also the author of the Singing is Easy blog, where I write about singing, teaching and muscial expression, and Still Life With Paradox, which contains personal reflections on life, faith and morality.

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