BTC ETF and the Legal Regulatory Logic Behind It

After a decade-long arduous approval process, BTC ETF has finally seen the dawn of victory. In the early hours of January 11, 2024, the U.S. Securities and Exchange Commission (SEC) simultaneously approved 11 spot BTC ETFs, including Bitwise, Grayscale, Hashdex, BlackRock, Valkyrie, Invesco, Ark, VanEck, WisdomTree, Fidelity, and Franklin.

All of this should be attributed to Grayscale’s successful lawsuit. On August 29, 2023, a ruling by a U.S. federal court granted Grayscale a victory in its lawsuit against the SEC’s rejection of its spot BTC ETF application. This accelerated the process for traditional financial giants like BlackRock and Fidelity to apply for BTC ETFs over the past few months.

This article will examine the change in the SEC’s attitude after Grayscale’s victory from a legal and regulatory perspective (proactively identifying market manipulation risks), the logic behind BTC ETFs, and the subsequent cautious stance of the SEC, which still considers other cryptocurrencies as securities and warns about market risks.

1. Court Ruling Forces SEC to Accelerate Approval Process

The SEC previously denied BTC ETFs due to concerns of market fraud and manipulation. All rejected ETF applications cited the reason of “protecting investors and preventing market fraud and manipulation” as stated in securities laws.

In 2021, the SEC approved the trading of BTC futures ETF for the first time, stating that futures products are more difficult to manipulate because the market is based on the futures prices of the Chicago Mercantile Exchange (CME), which is regulated by the U.S. Commodity Futures Trading Commission (CFTC).

In the case, Grayscale argued that the logic behind approving BTC futures ETFs should be the same as approving spot BTC ETFs, otherwise all BTC futures ETF applications should be revoked. The judge agreed, stating that the SEC’s rejection of Grayscale’s application was arbitrary and lacked basis, as the SEC failed to explain how it treated similar ETF products differently. The court found that this differential treatment by the SEC violated administrative law, agreed with Grayscale’s request, and overturned the SEC’s denial of the application.

It was only after the Grayscale case that the SEC’s attitude completely changed from passive denial to active review, as stated in the 22-page approval document: “This order approves the Proposals on an accelerated basis.”

2. What are the risks of BTC ETF according to the SEC?

ETFs themselves, as long-established compliant financial products, do not have legal barriers. BTC is also the only asset defined as “non-security” by US regulators, especially the SEC. So what are the risks of BTC ETF?

In the 22-page approval document, the SEC tells us that the risk comes from the uncontrollable nature of the underlying asset trading market for the ETF, namely the manipulation risk of the BTC spot market.

Although each ETF has a surveillance sharing agreement with compliant regulated exchanges (such as CME) to monitor the risk in the BTC futures market, BTC spot itself is not traded on CME, so the monitoring cannot cover the BTC spot market.

BTC futures on CME are already compliant products. Therefore, proving the correlation between BTC spot and BTC futures prices in CME is the best choice. As a result, the SEC compared the correlation between BTC prices on Coinbase and Kraken, two cryptocurrency exchanges, and CME futures prices since 2021 and found a high correlation between the two. This means that if there is fraud or manipulation in the BTC spot market, these actions are likely to also affect the futures market, which can be detected by CME’s monitoring system, allowing regulators to intervene and control the risk.

3. Market Manipulation in the BTC Spot Market

The risk of market manipulation in the BTC spot market mainly comes from market makers or market participants trading on CEX. If US regulations can cover the regulation of CEX, then it is possible to achieve relative control over the risk.

In this regard, the approach taken by US regulators is to implement regulatory compliance coverage on Coinbase and Kraken, the two cryptocurrency exchanges, while also conducting targeted investigations into Binance, the exchange with the largest trading volume, and successfully establishing compliance control.

4. Neutral SEC and Cautious Gary Gensler

As a result, the neutral SEC evaluates whether the rules submitted by national securities exchanges comply with the Securities Exchange Act and its regulations, including whether they are designed to protect investors and the public interest. In the early hours of January 11, 2024, the SEC also approved 11 physically-backed BTC ETFs, including Bitwise, Grayscale, Hashdex, BlackRock, Valkyrie, Invesco, Ark, VanEck, WisdomTree, Fidelity, and Franklin.

（https://www.sec.gov/news/statement/gensler-statement-spot-bitcoin-011023）

The more important thing is SEC’s statement in the press release:

“..today’s Commission action is cabined to ETPs holding one non-security commodity, bitcoin. It should in no way signal the Commission’s willingness to approve listing standards for crypto asset securities. Nor does the approval signal anything about the Commission’s views as to the status of other crypto assets under the federal securities laws or about the current state of non-compliance of certain crypto asset market participants with the federal securities laws. As I’ve said in the past, and without prejudging any one crypto asset, the vast majority of crypto assets are investment contracts and thus subject to the federal securities laws….

…Though we’re (SEC) merit neutral, I’d note that the underlying assets in the metals ETPs have consumer and industrial uses, while in contrast bitcoin is primarily a speculative, volatile asset that’s also used for illicit activity including ransomware, money laundering, sanction evasion, and terrorist financing.

While we(SEC) approved the listing and trading of certain spot bitcoin ETP shares today, we did not approve or endorse bitcoin. Investors should remain cautious about the myriad risks associated with bitcoin and products whose value is tied to crypto.”

5. Pressure to Coinbase - Characterizing Crypto Assets

Gary Gensler’s speech is very clear: BTC is not a security, market risks can be controlled, and it can be approved. Other cryptocurrencies are securities, which is a different story and has no relation to the approval of BTC ETF.

This brings us back to Gary Gensler’s consistent avoidance of directly answering the question of “what types of cryptocurrencies are securities.” This is a regulatory compliance issue for the three largest exchanges, Kraken, Coinbase, and Binance, and it is also a political game that the SEC requires a response from the US judiciary and legislative institutions.

Coinbase has always been at the forefront of the battle against the SEC, and it is imperative to shoulder this heavy responsibility. Judge Katherine Polk Failla previously referred to ETH as a commodity (Crypto Commodities) in the Uniswap case. Considering that this judge is also presiding over the SEC v. Coinbase case, her response regarding whether encrypted assets are “securities” or not is: “This is not a decision for the court, but for Congress,” throwing this ultimate question to the legislative body of the United States - Congress.

However, the legislative process in Congress will be lengthy, and it will be worth looking forward to in the 2024 election year.

6. GM BTC ETF

No matter how the SEC puts on a show, the approval of a BTC ETF holds great historical significance. It allows us, who carry the ideals of crypto punks and overnight wealth fantasies, to be a part of it and add a vibrant touch to the rushing tide of history.

As Wang Chuan said, “when we look back in the future, January 10, 2024, in the context of world monetary history, it might be compared to August 13, 1971 (when Nixon announced the decoupling of the US dollar from gold) and January 18, 1871 (when Germany was unified and led European countries and the United States to adopt the gold standard system within a few years).”

The End

This article is for study and reference only. I hope it will be helpful to you. It does not constitute any legal or investment advice. DYOR.

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