Tuesday, September 05, 2023

SEC should have approved Grayscale application, DC Circuit says

By Rodney F. Tonkovic, J.D.

The D.C. Circuit has vacated the SEC's rejection of Grayscale Investment's proposed bitcoin exchange-traded product. The task before the court was to determine whether Grayscale demonstrated that its product was similar to two bitcoin futures ETPs that were approved while the Grayscale proposal was pending. The panel concluded that Grayscale showed substantial evidence that it should have received the same regulatory treatment and that there was no coherent explanation of why this was not so. The panel accordingly concluded that the denial of Grayscale's proposal was arbitrary and capricious because the Commission failed to explain its different treatment of similar products, the panel concluded (Grayscale Investments, LLC v. SEC, August 29, 2023, Rao, N.).

Proposal to trade. On October 19, 2021, NYSE Arca filed a proposed rule change to list and trade shares of Grayscale Bitcoin Trust which tracks movements in the price of an underlying commodity—Bitcoin. An amendment replacing the proposal in its entirety was filed in April 2022.

The SEC disapproved the proposed rule change on June 29, 2022. The order explained that NYSE Arca failed to meet its burden under the Exchange Act and the Commission's Rules of Practice to demonstrate that its proposal is consistent with the requirements of Exchange Act Section 6(b)(5), which requires that the rules of a national securities exchange be "designed to prevent fraudulent and manipulative acts and practices" and "to protect investors and the public interest." The Commission also said that Grayscale did not satisfy the "significant market" test. As the opinion notes, the Commission has come to the identical conclusion for every previous proposal to list a bitcoin exchange-traded product.

Grayscale petitioned the D.C. Circuit for review in June 2022. In support, the U.S. Chamber of Commerce submitted an amicus brief arguing that the rejection was an instance of the SEC making major policy decisions "in the shadows." The brief said that while the NYSE Arca proposal was pending, the SEC approved the listing of securities tied to bitcoin futures contracts but disapproved NYSE Arca’s proposal, despite NYSE Arca’s argument that because "bitcoin futures contracts rely on the same pricing data and present the same risk of fraud as securities tied directly to bitcoins," the SEC should approve its proposal for the same reasons. Other amici similarly argued that Grayscale Trust, according to the brief, clearly satisfies the SEC's standards and is "demonstrably less risky" than a wide range of SEC-approved products on the market.

ETPs. The panel explained that this case involves two kinds of exchange-traded products (ETPs): those holding bitcoins and those holding bitcoin futures. The crux of Grayscale's argument was that the Commission failed to treat like cases alike by denying the listing of Grayscale's proposed bitcoin ETP while approving two bitcoin futures ETPs. The task before the court, then, was to determine whether Grayscale demonstrated that its product was similar to the two approved ETPs.

Similarity to approved ETPs. The panel concluded that Grayscale showed substantial evidence that its proposed bitcoin ETP was similar to the approved bitcoin futures ETPs and that it should have received the same regulatory treatment. The panel agreed that the underlying assets—bitcoin and bitcoin futures—are closely correlated. In addition, the surveillance sharing agreements with the CME are identical and should have the same likelihood of detecting fraudulent or manipulative conduct in the market for bitcoin and bitcoin futures.

Significant market. In rejecting Grayscale's ETP, the Commission distinguished it from the futures ETPs by applying the significant market test. Briefly, a bitcoin-based ETP must address fraud concerns by having the listing exchanges enter into surveillance sharing agreements with markets that are related to the listing exchange, regulated, and of significant size; if there is fraud, the surveillance sharing agreement should be able to ferret out the problem.

NYSE Arca has a surveillance sharing agreement with the CME, which is related to Grayscale's proposed ETP and regulated by the CFTC. The Commission however concluded that Grayscale failed to meet the two prongs of the significant market test: (1) any person attempting to manipulate the ETP would have to trade on that market, rather than simply bypassing it, and (2) it is unlikely that trading in the ETP would be the predominant influence on prices in the surveilled market.

The panel concluded that the Commission failed to provide a "reasonable and coherent explanation" for why it treated Grayscale differently than the futures ETPs. First, the SEC did not explain how Grayscale owning bitcoins rather than futures affects CME's ability to detect fraud. "The Commission's unexplained discounting of the obvious financial and mathematical relationship between the spot and futures markets falls short of the standard for reasoned decisionmaking," the panel said. Plus, the Commission failed to explain why a surveillance sharing agreement with the CME was sufficient to protect bitcoin futures ETPs from potential fraud, but not Grayscale’s proposed bitcoin ETP when the spot bitcoin market and the CME bitcoin futures market are tightly correlated.

The Commission also applied the second prong of the test unreasonably. First, the Commission failed to explain how the proposed Grayscale bitcoin ETP would be the predominant influence on the price of bitcoin futures traded on the CME and dismissed evidence that could have mitigated concerns about Grayscale growing to have the predominant influence on bitcoin prices.

The Commission also failed to treat like cases alike. The Commission said that the CME bitcoin futures market had matured significantly so trading on a single ETP was unlikely to be the predominant influence on the CME, but, the court said, this reasoning applied equally to Grayscale. The panel noted that the spot market is deeper and more liquid than the futures market, so manipulation should be more difficult. The Commission's reasons for approving the futures ETPs seem to apply equally to Grayscale, but Grayscale’s listing was denied, the panel said.

Grayscale reacts. Grayscale's CEO, Michael Sonnenshein, said, "This is a historic milestone for American investors, the Bitcoin ecosystem, and all those who have been advocating for Bitcoin exposure through the added protections of the ETF wrapper." He added: "It’s incredibly exciting that we are one step closer to making a U.S. spot Bitcoin ETF a reality." Grayscale's Chief Legal Officer, Craig Salm, said that Grayscale would work closely with the SEC on the next steps.

The case is No. 22-1142.