The ruling dismantles the SEC's core argument against a spot bitcoin ETF thus far, but Grayscale's victory does not necessarily mean ETF approval is imminent.
In a decision handed down on Tuesday, the United States Court of Appeals for the District of Columbia ruled in favor of Grayscale Investments, LLC in its case against the U.S. Securities and Exchange Commission (SEC). The court found that the SEC’s denial of Grayscale’s application for a bitcoin spot ETF was “arbitrary and capricious,” thereby violating requirements of the Administrative Procedure Act (APA). This decision is an important milestone. It thoroughly dismantles the reasoning the SEC has used to deny all proposals for a spot bitcoin ETF over the past decade. In the wake of this ruling, approval of the first spot bitcoin ETF in the U.S. may, finally, be on the horizon.
Exchange-traded products (ETPs), including exchange-traded funds (ETFs), are financial instruments that are traded on public stock exchanges, much like individual stocks. They can encompass a range of asset classes, from traditional equities to commodities. Being classified as an ETP is important because issuers of ETPs offer continuous share redemptions and creations, making the trading process more fluid and potentially more lucrative for investors relative to “closed-end” products. For companies like Grayscale Investments, the absence of SEC approval for its bitcoin trust, GBTC, to trade as an ETP has yielded significant ramifications, with its shares trading at a significant discount—sometimes as much as 30 percent—to the net asset value of the bitcoin that it holds. According to Grayscale in its filings before the DC Circuit, this pricing discrepancy effectively “leaves over $4 billion on the table for its investors,” relative to the presumable value of GBTC once approved as an ETF.
The SEC has been historically wary of approving spot bitcoin ETFs, citing concerns over the sufficiency of the surveillance-sharing agreements (SSAs) with the exchanges on which the underlying asset is traded. This concern was first articulated in 2013 when the Winklevoss twins first applied for a spot bitcoin ETF. The SEC rejected their application, stating that the SSAs were insufficient to prevent fraudulent and manipulative acts and practices. Over the years, this became a recurring theme, with the SEC regularly rejecting all spot bitcoin ETF applications on similar grounds. However, in a surprising turn of events, the SEC approved multiple bitcoin futures ETFs in 2021, including the ProShares Bitcoin Strategy ETF and the Valkyrie Bitcoin Strategy ETF. These futures ETFs do not invest directly in bitcoin, but rather in bitcoin futures contracts traded on the Chicago Mercantile Exchange (CME), which the SEC considers to be a regulated market with adequate surveillance-sharing agreements. The approval of these futures ETFs, while continuing to reject spot bitcoin ETFs, raised questions about the consistency and fairness of the SEC’s decision-making process, ultimately leading to the recent court decision in favor of Grayscale.
The SEC requires bitcoin-based ETPs, including spot and futures ETFs, to address concerns of fraud and manipulation by having the exchange that the ETP would be listed on enter into SSAs with at least one market that is (1) related to the listing exchange, (2) regulated, and (3) of “significant size.” In the case of both the issuers of the bitcoin futures ETFs that the SEC approved in 2021 and the proposed Grayscale application for a spot ETF, each had identical SSAs with the CME, which has a liquid market for bitcoin futures contracts. As relevant to Grayscale’s case before the DC Circuit, both Grayscale and the SEC agreed that these SSAs satisfied the first two requirements. Therefore, the entirety of Grayscale’s case turned on whether the CME futures market was of “significant” size in order for Grayscale’s proposed SSA to prevent fraudulent activities and market manipulation by bad actors.
“Significant size,” with regard to a surveilled market, is a legal term of art. Whether or not such a market qualifies as “significant”depends on a legal test has two main prongs: (A) it needs to be the case that a would-be manipulator would likely need to trade on the surveilled market in order to be able to manipulate the proposed ETP’s price, and (B) the ETP’s own trading activity should not be able to dominate the price action within the surveilled market.
For the approved bitcoin futures ETFs, which only hold CME bitcoin futures contracts as their underlying assets, the SEC deemed that prong (A) had been met because any manipulation of the futures ETFs would inherently involve manipulation of the underlying CME futures that they held—and thus of the CME market that was subject to the SSA. The SEC also found that prong (B) of the "significant market test" was met for the futures ETFs because those futures ETFs would only hold a small subset of the total bitcoin futures that trade on the CME, thereby preventing trades on the relatively smaller ETF from manipulating the broader bitcoin CME futures market as a whole.
In contrast, in the case of Grayscale’s application for a spot ETF, the SEC concluded that Grayscale’s SSA with the CME did not meet either prong of the “significant market test.” With regard to prong (A), the SEC reasoned that a would-be manipulator could sidestep the CME market and instead manipulate spot prices on cryptocurrency exchanges like Coinbase or Binance in order to manipulate the price of the proposed spot ETF. And with regard to prong (B), the SEC expressed concerns that trading of GBTC, which holds approximately $30 billion worth of bitcoin as compared to the $1.7 billion value of the outstanding CME bitcoin futures, could potentially dominate or significantly influence the CME market. The SEC also noted that GBTC’s current trading volume is about 25% that of the CME and would likely increase if GBTC were approved to trade as an ETF.
Under the APA, federal agencies like the SEC are required to treat like cases alike. Grayscale challenged the SEC’s above inconsistent treatment of spot and futures ETFs, arguing that the SEC’s approval of bitcoin futures ETFs, while simultaneously denying its spot bitcoin ETF application, was arbitrary and capricious. The “arbitrary and capricious” standard is a key provision of the APA, and requires courts to set aside agency actions, findings, or conclusions found to be “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” For a court to overturn an agency decision under this standard, the challenging party must demonstrate that the agency failed to consider important aspects of the problem, offered an explanation for its decision that runs counter to the evidence, or is so implausible that it could not be ascribed to a difference in view or the product of agency expertise. This is a high bar to meet, and it was a significant hurdle for Grayscale's lawyers to overcome.
However, even under this difficult-to-meet standard, the D.C. Circuit Court found the SEC’s arguments regarding the difference between the adequacy of the SSAs for the spot and futures bitcoin ETFs unconvincing and illogical. With regard to prong (A), the Court noted that there is a 99.9% correlation between the bitcoin futures markets and bitcoin spot markets, such that any fraud originating from the bitcoin spot market would also be reflected in the CME. Therefore, to the extent that a manipulator could fraudulently move the bitcoin price on spot exchanges, thereby manipulating the proposed Grayscale ETF, this concern would apply equally in the case of the approved futures ETFs, whose prices reflect the same underlying spot price of bitcoin. With regard to prong (B), the court reasoned that because Grayscale doesn't actually hold any CME futures securities to influence the CME, the only way for a Grayscale bitcoin ETF to impact the CME price would be to manipulate the spot market for bitcoin, and Grayscale only holds about 3.4% of the outstanding spot market, such that it could not be said to dominate the price action of bitcoin futures.
Consequently, the Court vacated the SEC's denial of Grayscale’s Bitcoin ETF application, citing the Administrative Procedure Act’s mandate to treat similar cases alike and directed the SEC to reevaluate Grayscale's application. While this does not mean that future applications for spot bitcoin ETFs will automatically be approved—and, in fact, there are reasons such as the security of private keys that the SEC could still use to justify future denials—the D.C. Circuit’s opinion thoroughly dismantles the specific arguments that the SEC has been using for the past decade to deny applications for spot bitcoin ETFs, and this may very well herald a shift in the SEC’s decision-making with regard to such applications in the future.