On Tuesday, August 29, 2023, The U.S. Court of Appeals, District of Columbia Circuit (Court) unanimously granted Grayscale’s petition for review of the Securities Exchange Commission’s (SEC) denial of Grayscale’s Bitcoin Exchange Traded Product (Grayscale ETP) and vacated the SEC denial order. The Court chastised the SEC for its “arbitrary and capricious” treatment of Grayscale’s ETP and its inconsistent treatment of substantially identical cases where it approved bitcoin futures ETPs from Teucrium and Valkyrie.
The following editorial was written by guest authors Wyatt Noble and Michael Handelsman for Kelman.Law
Brief Spot and Futures Markets Explainer
Those unfamiliar with spot and futures markets keep reading. However, feel free to skip ahead if you are already familiar with traditional financial markets and the two recently approved bitcoin futures.
Spot market is a term for cash markets of commodities or financial instruments. In a spot market, one can exchange cash for bitcoin and expect delivery immediately. However, in a derivatives market, the financial instruments being traded instead derive their value from the underlying spot market despite not being traded on that market. Futures are one of the derivatives that derive value from underlying spot markets. Specifically, futures are contracts to buy or sell assets at predetermined prices on specific later dates. Investors often use futures to hedge against risk, and trade on commodity futures exchanges, such as the Chicago Mercantile Exchange (CME). Such institutions in turn are regulated by the Commodity Futures Trading Commission (CFTC).
In recent years, the SEC has received and denied several proposals to list bitcoin ETPs. Each proposal (including the one at issue here) was denied because the SEC felt the ETPs in question were not “designed to prevent fraudulent and manipulative acts and practices” as required by the Securities Exchange Act of 1934. Nevertheless, in April 2022, the SEC approved the New York Stock Exchange Arca’s (NYSE Arca) proposal to list the Teucrium Bitcoin Futures Fund, and then a month later approved Nasdaq’s proposal to list the Valkyries XBTO Bitcoin Futures Fund.
How the Court Ruled and Why
Grayscale’s main argument was that the SEC acted arbitrarily and capriciously in denying the listing of Grayscale’s ETP while approving the listing of “materially similar bitcoin futures ETPs. The Court agreed because it found the Teucrium and Valkyrie futures ETPs “exposure to the spot market price is nearly identical to Grayscale’s proposed ETP,” and because the listing exchanges for Grayscale, Teucrium and Valkyrie’s ETPs all “have identical surveillance sharing agreements with the CME, on which bitcoin futures trade.” Ultimately, the Court felt Grayscale “demonstrated its proposed bitcoin ETP is materially similar, across relevant regulatory factors, to the approved bitcoin futures ETPs.”
The SEC attempted to distinguish Grayscale’s ETP and the two futures ETPs by application of the significant market test. The significant market test is the SEC’s method of requiring bitcoin-based ETPs “to address concerns of fraud and manipulation by having their listing exchanges enter into surveillance sharing agreements with markets that are (1) related to the listing exchange, (2) regulated, and (3) of significant size.”
Ultimately, the Court felt that “Grayscale’s evidence directly addressed the [SEC’s] concerns,” namely the SEC’s concern that trading in Grayscale would be the predominant influence on the CME futures market and assertion by the SEC that the Court said, “it failed to sufficiently explain . . . in light of the record.” The Court concluded by repeating the legal maxim that administrative adjudication must be consistent and predictable, meaning that similar cases should be treated similarly. Because the SEC did not adequately explain why it approved two bitcoin futures ETPs but not Grayscale’s, the Court granted Grayscale’s petition for review and vacated the SEC’s previous order.
What Happens Next
Now, both Grayscale and the SEC have 45 days to appeal if they choose. Given the Court ruled in Grayscale’s favor an appeal from them is almost certainly not forthcoming, but the SEC has yet to respond to requests for comment on the ruling. Should the SEC appeal, the case would either go to the U.S. Supreme Court or an en banc panel review.
While this case marks another high-profile loss for the SEC, it does not mean that the SEC must approve the Grayscale ETP. What it means, if the SEC does not appeal, is that the SEC must review Grayscale’s application again. Whether the SEC would now approve Grayscale’s application or find another avenue to reject it, is a question only SEC lawyers can answer concretely.
What Should You Do in the Meantime?
In light of ongoing regulatory uncertainty and the increasing frequency of enforcement actions by the SEC, it’s more important than ever to consult with legal experts well-versed in digital assets. Consulting with the lawyers here at Kelman PLLC early on is the most efficient way to ensure compliance with potentially applicable laws and regulations, and avoid legal pitfalls and expenses that could otherwise handicap your business
Fill out our contact form here to set up a free 30-minute consultation.
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