• Bitcoin ETF, SEC, Court of Appeals

    Grayscale SEC Victory

    As it’s known, Grayscale, the crypto asset trust platform, had applied to the U.S. Securities and Exchange Commission (“Commission”) to convert its Bitcoin trust into a bitcoin Spot Exchange-Traded Fund. This request was denied by the Commission, whereupon Grayscale appealed the denial to the United States Court of Appeals for the District of Columbia Circuit (“Court of Appeals”). Recently, a significant development occurred related to this case; the Court of Appeals overturned the Commission’s decision.

    In this legal alert, we will examine this important case for the crypto asset realm, along with some relevant concepts.

    1. Exchange-Traded Funds in General

    Exchange-Traded Funds (“ETFs”) refer to a basket of certain financial assets.

    Similar to mutual funds, ETFs allow individual investors to invest in various assets such as stocks, bonds, and commodities simultaneously and with a low entry fee. Through ETFs, which are generally managed by professional portfolio managers, individual investors can own multiple assets with only one product instead of purchasing the products within the ETF basket separately. In addition, they may also have the chance to own foreign assets that are not traded on their domestic stock exchanges. As a result, ETFs play a facilitative role in risk diversification for individual investors.

    However, unlike mutual funds, most of the ETFs are traded on the stock exchange just like stocks; meaning they can be bought and sold at real-time prices and within the same day.

    Lastly, ETFs can be specific to a particular index (e.g., S&P 500 ETF), asset class (Gold ETF) or sector (Technology Companies ETF). In this way, for example, individual investors who want to invest in the technology sector but are unsure which company stocks to buy, or do not have enough time to find out, or wish to avoid risk, can easily enter the sector by purchasing an ETF that includes these companies.

    1. What Do Crypto Asset ETFs Mean for Investors?

    Crypto asset ETFs refer to a basket of investment instruments that contain one or more crypto assets that can be traded daily on the stock exchange, just like traditional ETFs. Crypto ETFs will enable crypto assets that are not yet fully regulated to be legally traded on traditional exchanges.

    One of the reasons why the adaptation penetration of crypto assets among people has not reached desired levels may be attributed to various risks associated with owning crypto assets directly. Having a direct crypto asset brings several responsibilities. Especially after last year’s FTX scandal, individuals may be hesitant to entrust their crypto assets to underregulated platforms. Therefore, they might need to preserve the private keys to which the crypto asset is linked, purchase a hardware wallet, or store these private keys in a highly secure manner.

    As such, thanks to crypto asset ETFs, individual investors who are wary of security risks similar to those mentioned above will have the chance to add crypto assets to their portfolios indirectly, without contemplating on the gray areas crypto assets circulate in, without having to safeguard crypto wallet passwords, and without opening accounts on crypto asset platforms. This will allow crypto assets to reach a wider audience and increase the volume, depth and liquidity of the crypto asset market in the future.

    1. What are the differences between bitcoin ETFs and bitcoin Futures ETFs?

    Grayscale’s request to the Commission was to gain approval for a bitcoin Spot ETF (“bitcoin ETF”) to start trading on the stock exchange. As with all previous requests for bitcoin ETFs, the Commission had rejected this one as well. However, it had concurrently approved two different bitcoin Futures ETFs. So, what are the differences between these two types of ETFs?

    First, bitcoin ETFs are directly based on bitcoin. This means that when a person buys a bitcoin ETF, they are essentially buying an ownership stake in real bitcoins, much like Commodity ETFs. As a result, bitcoin ETFs are tightly bound to the real-time price of bitcoin, and the ETF’s prices will fluctuate in line with the underlying bitcoin. Additionally, a bitcoin ETF would be sold for cash and on the spot, just like traditional ETFs.

    Bitcoin Futures ETFs, on the other hand, are not directly based on bitcoin, and a person who buys these ETFs is not actually buying a share representing bitcoin. Instead, they become a partner in a futures contract to buy or sell bitcoin at a pre-agreed price on a specific future date. In other words, by buying a bitcoin Futures ETF, the investor is buying a futures contract certificate at a certain future price of bitcoin, instead of buying a bitcoin certificate at the real-time price of bitcoin. Moreover, bitcoin Futures ETFs are subject to regulation and are traded on the Chicago Mercantile Exchange (“CME”), which is regulated and supervised by the Commodity Futures Trading Commission (“CFTC”). Since such ETFs have their own regulatory structure and exchange, they are also affected by the unique characteristics of the futures exchange, and this is where things can get more complicated. Hence, these ETFs may appeal more to experienced investors who are familiar with the futures exchange than to individual investors.

    1. The Decision of the Court of Appeals

    4.1. Arguments of the Parties

    After the Commission rejected Grayscale’s application to convert its Bitcoin trust into a bitcoin ETF, Grayscale appealed the rejection to the Court of Appeals.

    While the Commission had recently approved other applications for bitcoin Futures ETFs, it had decided otherwise when the application was for a bitcoin ETF. Grayscale’s main argument was that these two products were virtually identical and therefore its application should have been approved by the Commission.

    In response, the Commission stated that Grayscale’s product did not meet the requirement under the US Securities Exchange Act (“Exchange Act“) to be adequately “designed to prevent fraudulent and manipulative acts and practices“. The Commission’s concern was that Grayscale’s product did not meet the “Significant Market Test” criteria.

    In order for an ETF application to be approved under the Significant Market Test, which the Commission applies to ETFs in general to prevent fraud and manipulation, a “Surveillance Sharing Agreement” must be entered into between the exchange on which the ETF will be listed and another exchange that meets the following three criteria.

    1. The other exchange must be related to the underlying assets of the ETF.
    2. The other exchange must be regulated.
    iii.        The other exchange must be of sufficient size.

    For Grayscale’s bitcoin ETF to meet the requirements of the Exchange Act, a “Surveillance Sharing Agreement” had to be in place between NYSE Arca (where the ETF would be listed) and another exchange that met the Significant Market Test criteria.

    Furthermore, in its previous decisions, when the subject of the application was a product based on bitcoin, the Commission had identified the CME, where bitcoin Futures ETFs are also listed, as the ‘related exchange’. Moreover, since the CME was regulated by the CFTC, it also met the second criterion of being a ‘regulated exchange’.

    In this context, there was already a Surveillance Sharing Agreement between NYSE Arca, where Grayscale would be listed, and the CME. However, the crux of the dispute was whether the CME met the third criterion of the Significant Market Test: being an exchange of sufficient size.

    The Commission, when evaluating bitcoin Futures ETFs applications, had stated that it didn’t need to delve into this third criterion since the exchange where such ETFs would be listed and the exchange hosting the underlying futures contracts were one and the same, i.e., CME, which is also regulated.

    Accordingly, with respect to the first two criteria, the Court of Appeal considered that there was a Surveillance Sharing Agreement between NYSE Arca and CME, that CME is an related exchange and that the Commission had acknowledged that CME is adequately regulated by the CFTC. The dispute became more pronounced on whether the CME met the third criterion, namely whether it is an exchange of sufficient size.

    4.1. The Core Issue: Stages of the Significant Market Size Criterion

    The third criterion of the Significant Market Test, termed “Significant Market Size”, consists of two stages:

    1. In the first stage, there should be a reasonable probability that someone attempting to manipulate the price of an ETF would have to trade on the related other exchange to achieve their objective.
      • The focus here is to determine whether trading on this other exchange would bring manipulation to light. The main goal is that the requisite to trade on the related exchange illuminates attempts at manipulation. Essentially, it is assessed whether someone wishing to manipulate the product can bypass the related exchange and thus avoid surveillance.
    2. In the second stage, the trading activities of an ETF should not have a dominant influence on the prices on the related other exchange. This is done to confirm that the selected associated exchange is sufficiently large.

    The Commission argued that Grayscale’s product did not meet either of these stages. For the first stage, it pointed out that if someone wanted to manipulate Grayscale’s bitcoin ETF, they wouldn’t have to trade on the related exchange, CME. This is because the underlying assets of Grayscale’s product were unregulated bitcoins instead of regulated bitcoin Futures Contracts, and bitcoin prices couldn’t be manipulated through the CME.

    For the second stage, paradoxically, the Commission contended that trading activities on Grayscale’s bitcoin ETF would exert a dominant influence on prices at the CME. As evidence, it showed that Grayscale’s total asset value was fifteen times larger than CME’s volume and that the potential volume of Grayscale’s bitcoin ETF would amount to a quarter of the total exchange volume.

    However, Grayscale demonstrated a significant correlation between bitcoin Futures Contracts and spot bitcoin prices. This argument was validated by the high substitutability of the indices used to calculate the prices of these two products.

    Another point Grayscale emphasized was that if these two criteria were viewed as the grounds for rejection, then two other applications concerning bitcoin Futures ETFs, which were recently approved, should also have been rejected for the same reasons. This is because due to the high correlation between bitcoin ETFs and bitcoin Futures ETFs, both products would face the same risks in the event of any manipulation. Indeed, the Court of Appeals also supported Grayscale’s arguments.

    4.2. Judgment

    As a result, the Commission failed to explain why, all else being equal, holding a bitcoin certificate instead of a futures contract certificate would affect CME’s ability to detect fraud and manipulation. This stance of the Commission constituted a violation of a fundamental principle of administrative law, namely “equal treatment of equals“.

    Consequently, the Court of Appeals’ final assessment was that the decision rendered by the Commission was “arbitrary and capricious and should therefore be vacated. The basis for this assessment was the Commission’s rejection of Grayscale’s bitcoin ETF application while approving two different bitcoin futures ETF applications in the same period, and its failure to adequately explain the reasons for the rejection. In addition, there were two very strong arguments in favor of Grayscale:

    1. The tight correlation between bitcoin ETFs and bitcoin Futures ETFs
    2. The inconsistency in deeming CME’s oversight sufficient for approved products but insufficient for Grayscale’s product.


    Although the Commission has yet to approve the application of any bitcoin ETFs, Grayscale’s “victory” could be a new milestone for the crypto asset world. The Commission’s stance on bitcoin ETFs, which has been quite strict in the past, may change in a positive direction. It could also be welcome news for many players, including Blackrock, who are in the process of applying to launch their own bitcoin ETFs. For individuals, investing in crypto assets might now become easier than ever, potentially facilitating the permanent integration of crypto assets into our daily lives.