The U.S. Securities and Exchange Commission on July 26, 2018 formally disapproved the proposed rule change by Bats BZX Exchange, Inc. (BZX) seeking to list and trade shares of the Winklevoss Bitcoin Trust (Trust).1 In disapproving the proposed rule change, the SEC voted three-to-one against the proposal, with Commissioner Hester M. Peirce dissenting. The Commission found that BZX’s proposal failed to satisfy the requirements of Section 6(b)(5) of the Securities Exchange Act of 1934, which requires, among other things, 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.” Notwithstanding its disapproval, the Commission signaled that it was open to the possibility of approving similar products in the future as the markets for bitcoin “continue to grow and develop.” This was the second time BZX’s proposed rule change has been rejected.
BZX first filed its application for the proposed rule change in June 2016, three years after the Trust filed its initial registration statement. According to this registration statement, the Trust is “designed for investors seeking a cost-effective and convenient means of gaining investment exposure to bitcoin similar to a direct investment in bitcoin.” BZX sought to list and trade shares of the Trust under the exchange’s rule relating to “Commodity-Based Trust Shares.” In March 2017, the SEC’s Division of Trading and Markets (acting on Commission authority) disapproved BZX’s proposed rule change (March Disapproval Order). Shortly thereafter, BZX petitioned for review of the March Disapproval Order and the Commission reviewed the proposal de novo to determine whether the rule change was consistent with the requirements of the Exchange Act. In the full Commission’s disapproval order (July Disapproval Order) setting aside the earlier order, the SEC echoed many of the concerns raised by the Division of Trading and Markets in the March Disapproval Order.
BZX Arguments in Favor of Approval
In BZX’s appeal of the March Disapproval Order, it argued that the proposed rule change was adequately designed to prevent fraudulent and manipulative acts and practices as required by Section 6(b)(5). BZX offered several arguments in support of its petition, including that:
- The Commission’s concerns were misplaced because bitcoin markets are inherently difficult to manipulate;
- The March Disapproval Order placed too much significance on surveillance-sharing agreements, and the SEC did not apply the same standard in reviewing BZX’s petition as the SEC previously applied when reviewing and approving rule change proposals relating to other commodity-trust exchange-traded products (ETPs); and
- BZX’s and the Trust’s existing policies and procedures, as well as other traditional means of deterring fraud, were sufficient to satisfy Section 6(b)(5).
The Commission rejected each of BZX’s arguments and considered the various arguments that BZX and other commenters had presented in support of and against the proposed rule change.
Whether the Bitcoin Markets are Inherently Difficult to Manipulate
In support of its petition, BZX argued that the “geographically diverse and continuous nature of bitcoin trading markets makes it difficult and prohibitively costly to manipulate the price of bitcoin” and that “novel systems intrinsic to this new market provide unique additional protections that are unavailable in traditional commodity markets.” BZX argued that bitcoin spot markets are “generally less susceptible to fraud and manipulation than the equity, fixed income, and commodity futures markets.”
The Commission rejected these arguments, finding that bitcoin spot markets are just as susceptible to fraud and manipulation – if not more so – than other spot markets. In reaching this conclusion, the SEC cited various comment letters and academic studies, as well as the risk disclosure in the Trust’s own registration statement. Particularly, the Commission discussed the following risks, among others, associated with bitcoin spot markets:
- Malicious control of the Bitcoin Network;
- Collapse of the bitcoin exchanges and the effect on the general bitcoin industry;
- Trading based on material nonpublic information;
- Absence of a regulated market;
- Lack of identifying information regarding the owners of bitcoin;
- Low trading volume of bitcoin (in general and on the Gemini Exchange (Gemini), the closing auction price of which would be used to calculate the net asset value of the Trust);
- Absence of liquidity in bitcoin markets; and
- The estimated small number of individual holders of bitcoin worldwide.
Based on these risks, the Commission found that in order to meet its burden under Section 6(b)(5), BZX would need to show that it had entered into a surveillance-sharing agreement with a regulated market of significant size.2
Whether the SEC Over-Emphasized the Importance of Surveillance-Sharing Agreements
BZX argued that the Commission has granted proposed rule changes in the past relating to commodity- and derivatives-based ETPs where the requesting exchange had not entered into surveillance-sharing agreements with significant regulated markets for trading the underlying commodity or derivative. The SEC specifically rejected BZX’s assertion, indicating that in each of the instances to which BZX referred, the exchange had in fact entered into a surveillance-sharing agreement. The Commission stated that in order to list and trade shares of a commodity-trust ETP, an exchange “must, in addition to other applicable requirements, satisfy two requirements that are dispositive in this matter. First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated.”
Whether BZX’s Existing Arrangements Satisfy Section 6(b)(5)
BZX also argued that even if surveillance-sharing agreements are required, BZX has satisfied this requirement by entering into a surveillance-sharing agreement with Gemini. BZX argued that Gemini is a significant exchange in the U.S. bitcoin market, and the U.S. exchanges (including Gemini) are continuing to grow as a share of the world bitcoin market. Furthermore, BZX argued that Gemini is a regulated market because it is “a limited-liability trust company chartered by the State of New York and supervised by the New York State Department of Financial Services (NYSDFS).”
The Commission rejected these arguments, finding that Gemini is not a significant market for bitcoin based on its trading volume and overall share of the bitcoin market. The SEC also disagreed with BZX’s assertion that Gemini is a regulated market because it is supervised by NYSDFS. Furthermore, the SEC concluded that a regulated market for bitcoin does not exist today, and therefore, it is not possible for BZX to enter into a surveillance-sharing agreement with a regulated market sufficient to meet its burden under Section 6(b)(5).
Commissioner Peirce’s Dissent
In the July Disapproval Order, the Commission emphasized that its disapproval did not rest on an analysis of bitcoin’s value as an investment. However, in a dissenting opinion,3 Commissioner Peirce disagreed. She asserted that the Commission “erroneously reads the requirements of Section 6(b)(5)” and focuses too much on the underlying bitcoin spot market, rather than on BZX’s ability to oversee trading of and to deter manipulation in the Trust shares listed and traded on BZX. She stated her belief that the proposed rule change satisfies the statutory standard and that the Commission should permit BZX to list and trade shares of the Trust.
Commissioner Peirce claimed that in disapproving the proposed rule change, the SEC was engaging in “merit regulation,” and that its disapproval deprives investors of the opportunity to invest in bitcoin and bitcoin ETPs. In fact, Commissioner Peirce opined that the very issues in the bitcoin spot market cited by the SEC “would be mitigated by institutionalizing the market – a phenomenon that bitcoin ETPs would foster.” Commissioner Peirce’s dissent seems to suggest that the July Disapproval Order creates a chicken-and-egg problem. She stated that the order “suggests that approval for bitcoin ETPs will come only when bitcoin spot and derivatives markets have matured substantially, yet, at the same time, contributes to further delay in their maturation, as potential institutional investors may reasonably conclude that the Commission will continue to repress market forces for the foreseeable future.”
The Commissioner further stated that not only would she approve the proposed rule change, but she would “welcome the Commission’s consideration of other bitcoin-based ETPs that offer different pricing mechanisms, are pegged to bitcoin futures markets, [or] seek to be registered under the Investment Company Act of 1940...” In closing, the Commissioner stated: “I reject the role of gatekeeper of innovation – a role very different from (and, indeed, inconsistent with) our mission of protecting investors, fostering capital formation, and facilitating fair, orderly, and efficient markets.”
Notably, these statements are contrary to the position set forth by Dalia Blass, Director of the SEC’s Division of Investment Management, in a January 2018 letter to the President and CEO of the Investment Company Institute and the Head of the Asset Management Group of the Securities Industry and Financial Markets Association.4 In her letter, Director Blass expressed skepticism regarding how funds that hold cryptocurrencies and cryptocurrency-related financial instruments could fit within the current regulatory framework of the Investment Company Act. The SEC’s ultimate position on these innovative products remains to be seen.
1) SEC Release No. 34-83723 (July 26, 2018).
2) In determining whether to approve a request for listing of U.S. products based on underlying non-U.S. securities or indexes, the SEC may consider whether the U.S. exchange sponsoring the product has entered into surveillance agreements with the relevant foreign markets. A surveillance-sharing agreement is an agreement between a U.S. exchange and the relevant foreign market for the underlying non-U.S. assets, which provides that the U.S. exchange will receive sufficient information about the markets and trading activity from the non-U.S. entity.
3) Dissent of Commissioner Hester M. Peirce to Release No. 34-83723 (July 26, 2018).
4) For a discussion of Director Blass’ letter, please refer to Dechert OnPoint, SEC Staff Seeks Industry Engagement on Questions Regarding Development of Funds Holding Cryptocurrency-Related Products.