Court Ruling On The Horizon: SEC vs Grayscale’s Battle Over Bitcoin Spot ETF
Introduction
A recent surge of applications for spot Bitcoin exchange-traded funds (ETFs) has led to their resubmission with the U.S. Securities and Exchange Commission (SEC). This development was followed by a groundbreaking announcement from BlackRock, the world’s largest asset management company, regarding their application for a spot Bitcoin ETF.
Over the past few years, the SEC has declined numerous applications for spot Bitcoin ETFs, citing deficiencies in meeting the prescribed criteria aimed at preventing fraudulent and manipulative activities. These criteria are designed to safeguard the interests of investors and the broader public.
Up to the present, the SEC has exclusively permitted the introduction of Bitcoin ETFs based on Bitcoin futures. Presently, three Bitcoin futures ETFs are operational, with the ProShares Bitcoin Strategy ETF leading the way by becoming the first to launch in October 2021. The notion of an ETF offering investors exposure to actual Bitcoin on a regulated U.S. stock exchange, thereby avoiding custody complexities, has evidently revitalized interest in Bitcoin.
Amidst the unfolding narrative of Bitcoin spot ETFs, a pivotal legal dispute has arisen involving Grayscale and the SEC concerning the conversion of Grayscale’s GBTC into a spot Bitcoin ETF. The outcome of this lawsuit, if favorably decided for Grayscale, could potentially herald the advent of the first-ever Bitcoin spot ETF in the United States.
Background
Grayscale Investments, an investment trust dedicated to passive BTC holdings, offers investors exposure to Bitcoin through a security, bypassing the complexities of direct Bitcoin acquisition, storage, and security. The trust, which manages approximately $18.3 billion in assets through its GBTC product, had submitted an application to the U.S. SEC on October 19, 2021, seeking authorization to convert its primary Bitcoin trust into an ETF based on spot prices.
However, in June 2022, the SEC rejected Grayscale’s proposal to transform its GBTC into a spot Bitcoin ETF. The regulatory authority justified its decision as a measure to safeguard investors and the broader public interest, highlighting that the application lacked evidence of being “designed to prevent fraudulent and manipulative acts and practices.” In response, Michael Sonnenshein, CEO of Grayscale, expressed deep disappointment and strong disagreement with the SEC’s denial.
In a countermove, Grayscale Investments initiated legal action against the SEC in light of the rejection of its bid to transition the Grayscale Bitcoin Trust into a spot-based Bitcoin ETF. The company’s senior legal strategist, Donald B. Verrilli Jr., a former U.S. solicitor general, lodged a formal petition for review with the United States Court of Appeals for the District of Columbia Circuit.
Verrilli contended that the SEC’s recent decision displayed signs of arbitrary and capricious behavior, characterized by an inconsistent approach toward analogous investment vehicles. Grayscale’s legal challenge is grounded in the assertion that the SEC violated the Administrative Procedure Act (APA) and the Securities Exchange Act (SEA). This legal pursuit aims to address alleged irregularities in the SEC’s conduct and its handling of Grayscale’s application.
The March Hearing: SEC vs Grayscale
In March 2023, a judicial panel convened to deliberate oral arguments presented in the legal case brought forth by Grayscale Investments against the SEC. The proceedings took place in the District of Columbia Circuit Court of Appeals, where Chief Judge Sri Srinivasan and Judges Neomi Rao and Harry Edwards presided.
Former U.S. solicitor general, Donald Verrilli Jr., represented Grayscale in these proceedings, while SEC senior counsel, Emily Parise, articulated the SEC’s stance. The context of the case revolved around Grayscale’s endeavor to transform its Grayscale Bitcoin Trust into an ETF. During the opening statements, Verrilli emphasized:
“The inherent issue with the current order lies in its contradiction of prior SEC orders that have approved Bitcoin futures ETPs with comparable susceptibility to fraud and manipulation, and equipped with the same CME surveillance framework to mitigate such risks.”
The SEC had previously given its approval to investment products linked to BTC futures from entities such as Teucrium, ProShares, VanEck, and Valkyrie.
Parise presented a counterargument asserting that the Grayscale proposal diverges from these offerings due to disparities in surveillance mechanisms. Specifically, she noted that the underlying spot markets for the asset in the proposed ETF are “fragmented and unregulated,” unlike the regulated CME which governs Bitcoin futures markets. Furthermore, Parise refuted the notion that the 99.9% correlation between Bitcoin spot and futures markets ensures immunity against manipulation, stressing that the causative relationship between these markets is not straightforward, particularly in the context of fraud and manipulation.
During the appeals court hearing, a skeptical tone emerged from the panel of judges — Chief Judge Sri Srinivasan and Judges Neomi Rao and Harry Edwards — questioning the SEC’s assertions. The focus of their inquiries centered around the SEC’s argument that futures prices, underpinning futures ETFs, were more resilient to manipulation compared to the potential for manipulation in spot Bitcoin markets, should a spot Bitcoin futures ETF be approved.
Judge Rao directed inquiries towards the relationship between futures and spot prices, probing the Commission’s comprehension of this dynamic:
“It appears to me that the Commission’s responsibility lies in clarifying its understanding of the correlation between bitcoin futures and the spot bitcoin price… One appears to be essentially a derivative of the other, moving in alignment 99.9% of the time. Therefore, where does the Commission perceive a distinction?”
Parise responded by indicating that the 99% correlation does not establish causality and clarified that this percentage pertains to once-a-day prices, not intraday fluctuations. She reiterated the SEC’s position that spot Bitcoin markets remain fragmented and unregulated, unlike Bitcoin futures that are exclusively traded on the regulated CME.
The judges continued to question the SEC, honing in on the pivotal point of how the Commission could assert that manipulation in the spot markets would not affect futures markets, consequently questioning the significance of the shared surveillance mechanism between these markets.
One judge inquired, “If we were to concur with the petitioners (Grayscale), would the Commission reconsider its approval of Bitcoin futures ETFs and entertain the approval of spot ETFs?” The SEC lawyer responded with uncertainty, avoiding a definitive answer and transitioning the conversation to legal considerations.
As the proceedings unfolded, another judge persisted in pressing the SEC lawyer for clarification, leading to a discernible display of unease in her responses, marked by a slight stutter and momentary fluster.
Anticipated Court Verdict Expected This Week
Grayscale Investments, which has been actively pursuing the transformation of its Bitcoin trust into a spot Bitcoin ETF, could receive a judgment regarding its legal action against the federal securities regulatory body before the conclusion of this week.
Scott Johnsson, a legal expert and general partner at Van Buren Capital, shared insights in an August 11 tweet, explaining that the turnover of law clerks in the United States District Courts typically takes place in August. This shift prompts judges to expedite their caseloads “prior to the arrival of the new personnel.”
Johnsson pointed out that, historically, the majority of cases from March 2021 and 2022 received hearings within 160 days of oral testimonies, coinciding with the August timeframe. Significantly, it has been 160 days since Grayscale presented its oral arguments on March 7 in the lawsuit against the United States Securities and Exchange Commission.
At present, only a limited number of cases argued in March remain unresolved, including Grayscale’s, according to Johnsson.
On another note, James Seyffart, a Bloomberg analyst, has suggested that the verdict could potentially be rendered as early as August 15. He has previously earmarked this date as his “theoretical Grayscale lawsuit decision date.” It’s important to mention that the final deadline is set for October 15.
Can Grayscale Secure a Victory?
Several experts in the industry, including Cathie Wood from ARK Invest and ETF analyst Nate Geraci, have expressed their expectation that Grayscale will emerge victorious from the lawsuit.
In June 2023, Elliott Stein, a senior litigation analyst, assessed the likelihood of Grayscale prevailing in its lawsuit against the SEC. Stein noted a revised estimate of a “70% chance of winning the lawsuit against the SEC over the company’s endeavor to transform the Grayscale Bitcoin Trust into a Bitcoin ETF.”
Stein revised his earlier estimation of 40% in light of the oral arguments, where three judges seemed to align with Grayscale’s position. Observing these indicators, Stein suggested that the SEC, along with its chair Gary Gensler, might be preparing for a potential setback and could be adopting a “backpedaling” approach by granting approval for a spot Bitcoin ETF around the same timeframe as the court’s verdict in August.
In our view, considering the recent hearing at the Court of Appeals for the District of Columbia Circuit, it seems increasingly probable that Greyscale is poised to achieve a favorable outcome.
Irrespective of the verdict’s outcome, the impending court decision bears significant implications for all entities considering the issuance of spot Bitcoin ETFs within the United States. Should Grayscale emerge victorious, the SEC might choose to contest the ruling in a higher court. Conversely, if Grayscale faces defeat, the company could seek an “en banc” hearing, a rarity where all judges of the D.C. Circuit participate in evaluating the case. Alternatively, Grayscale could opt to appeal the decision directly to the Supreme Court.
If Grayscale Wins: What’s Next?
In the event of a favorable outcome for Grayscale, it should be noted that such a “win” may not guarantee an immediate conversion of the Grayscale Bitcoin Trust or the approval of other spot Bitcoin ETF applications. Rather, it would signal a court determination that the SEC’s denial lacked adequate justification. Subsequently, the SEC might opt to decline GBTC’s conversion or other spot Bitcoin ETF applications, but using different rationale.
Alternatively, should the SEC be deemed to have erred in this context, it could decide to eliminate futures ETFs in order to achieve parity in its treatment of both asset categories. Although this response appears improbable, it is theoretically within the realm of possibility.
Another potential consequence of a Grayscale victory in the lawsuit against the SEC is that it might facilitate the approval of a spot ETF. Such an outcome could create a pathway for the regulatory acceptance of a spot Bitcoin ETF.
Conclusion
The outcome of this legal battle holds broad implications for the cryptocurrency market. If Grayscale secures a victory, it would not guarantee an immediate transformation of the Bitcoin Trust or the approval of other spot Bitcoin ETFs. Rather, it could signal a critical examination of the SEC’s rationale and may prompt the agency to review and refine its approach.
The verdict’s potential impact on the regulatory environment extends beyond Grayscale. It could influence the SEC’s stance on spot Bitcoin ETFs and shape the path for other cryptocurrency offerings.
It’s worth noting that a victory for Grayscale over the SEC is expected to have a positive impact on the market sentiment. The cryptocurrency market is likely to respond favorably, reflecting the potential for greater regulatory clarity and acceptance.
DISCLAIMER: The information contained in this article is for educational purposes only and does not constitute any form of advice or recommendation by Wheatstones, and is not intended to be relied upon by users in making (or refraining from making) any investment decisions.
