For those of you who have been following along thus far, the U.S. Securities and Exchange Commission (“SEC”) and the SEC’s Division of Trading and Markets (“SEC Staff”) have been wrestling since December 2017 with whether to approve or disapprove exchange-traded funds (“ETFs”) that invest in bitcoin futures contracts.  On August 22, 2018, the SEC Staff decided to reject three proposals that included a total of nine bitcoin futures ETFs, possibly.  Just one day later, the SEC issued stays of all three rejections and elected to review the SEC Staff’s decisions.  With no clear decision, it is worth looking at the reasons for the SEC Staff’s rejection of the three proposals, particularly in light of the SEC’s recent split decision on the rejection of a bitcoin ETF (the “Bitcoin ETF”).

The three rejection orders came against two proposals by NYSE Arca, Inc. (“NYSE Arca”) and one by Cboe BZX Exchange, Inc. (“Cboe BZX”).  The ETFs themselves would predominantly hold bitcoin futures contracts in lieu of holding “physical” bitcoin.  The result would create exposure to the price fluctuations of bitcoin, but the futures-based ETFs would seek to invest in a more “traditional” asset (i.e., a futures contract) that is traded on established futures markets such as the Chicago Mercantile Exchange (“CME”) and Cboe Options Exchange, Inc. (“Cboe”).

Many of the SEC Staff’s reasons for rejecting the three proposals for bitcoin-futures ETFs echo the SEC’s causes for concern in its rejection of the Bitcoin ETF.  Like the earlier rejection order, the SEC Staff evaluated the proposals on whether there were sufficient means under each of the securities exchanges’ rules to sufficiently prevent fraudulent and manipulative practices relating to the ETFs’ shares.  Specifically, the SEC Staff sought to determine if the exchanges had surveillance-sharing agreements with a regulated bitcoin futures market of “sufficient size.”

In all three instances, the SEC Staff determined that the exchanges fell short on both elements.  The exchanges’ surveillance agreements with the securities markets only provided information on traders of the ETFs’ shares and not on traders of futures contracts or bitcoin itself.  In addition, even though all three securities exchanges had surveillance agreements with CME and Cboe, the SEC Staff found no evidence on the record that CME’s or Cboe’s bitcoin futures markets were markets of “significant size.”  The SEC Staff acknowledged that either market could eventually grow large enough, but it declined to explain when or how either market might meet the “significant size” threshold.  Since CME and Cboe are the two largest bitcoin futures markets in the United States, the SEC Staff’s hesitance to find either to be of “significant size” could preclude the success of any bitcoin futures ETF until the volume in such futures contracts increases significantly.

In the wake of Commissioner Hester M. Peirce’s dissent on the Bitcoin ETF, and at the direction of commenters, the rejection orders all briefly touched upon the issue of whether the approval of bitcoin-related investment products would help foster safer markets for bitcoin and bitcoin futures.  The SEC Staff even acknowledged that, compared to trading in unregulated bitcoin spot markets, trading a bitcoin-based ETF on a national securities exchange may provide some additional protection to investors.  However, the SEC Staff ultimately dismissed this proposition on the basis of that any benefit must still be weighed against whether the rules of the national securities exchange are adequately designed to prevent fraudulent and manipulative acts and practices, which the SEC Staff found to be inadequate in all three proposals.  To that point, Commissioner Peirce also argued that the particular exchange in the Bitcoin ETF proposal had adequate rules to prevent fraud and misconduct.  The SEC Staff did not address the Commissioner’s dissenting arguments in any of the three orders.

The fate of the three proposals now sits in the hands of the SEC’s four current commissioners. Since many of the issues from both the prior rejection of the Bitcoin ETF and Commissioner Peirce’s dissent are applicable in these three rejection orders, all eyes will be on whether the commissioners have shifted their thinking since the July 26, Bitcoin ETF determination.

Good Day. DR2.