Last week the U.S. Securities and Exchange Commission (SEC) refused
to approve nine different proposals for bitcoin exchange traded funds
(ETFs). This comes on top of a number of prior SEC refusals of bitcoin-based
funds, including the SolidX Bitcoin Trust and two separate denials of the
Winklevoss Bitcoin Trust, the first
in 2017 and the
second this summer.
Why have so many other U.S.-listed commodity ETFs been approved over the
years whereas bitcoin ETFs keep getting rebuffed? It is tempting to view the
SEC smackdown of these bitcoin ETF proposals as a sign of distaste for this
new and anarchic technology. But I don't think this reading is accurate. If
anything, SEC vs Bitcoin is less about Bitcoin and more about the SEC's
attempt to impose standards in an age where Wall Street is trying to package
almost everything into a broadly-available security.
Precious metals buyers will of course be familiar with ETFs. The
granddaddy of all commodity ETFs, the SPDR Gold Trust, or GLD,
has been around since 2004 and is currently backed by around US$29 billion in
physical gold, or 760 tonnes. All ETF units trade on a stock market. A
peculiar set of mechanics ensures that they replicate the price of their
underlying index or commodity. Using GLD as an example, if the price of the
ETF is above the current gold price, then special institutions (otherwise
known as authorized participants) can buy physical gold, exchange it for new
units of GLD, and sell those units at a profit. If GLD is trading below the
gold price, these same authorized participants can buy the underpriced GLD
units, redeem them for gold, and sell the commodity for a risk-free gain.
Competition among authorized participants for profit ensures that the two
prices do not diverge by very much. Regular investors do not have the ability
to convert units into gold, or vice versa. (For a more thorough explanation,
see Bullionstar's introduction
to gold ETFs.)
The SEC has approved ETFs that track gold, silver, platinum, palladium,
copper, oil, natural gas, coffee, as well as broader-based ETFs that track
baskets of commodities. Virtual currencies like Bitcoin, also known as
cryptocurrencies, have been defined by the U.S. Commodity Futures Trading
Commission (CFTC) to be commodities. The SEC's refusal to allow bitcoin ETFs
thus has nothing to do with bitcoin's underlying nature: like gold, silver,
and the rest, it is legally a commodity. Rather, the reason that the
Winklevoss Bitcoin Trust, the first of the proposed bitcoin ETFs, has failed
to make it through the SEC's doors is that the SEC doesn't like the way that
the market for bitcoins is structured.
Cooperation from crypto exchanges - A tall order
Specifically, the SEC is unhappy with
the inability of the the Bats BZX Exchange, the stock exchange on which the
Winklevoss Bitcoin Trust is seeking a listing, to secure information
sharing agreements (ISAs) with important bitcoin exchanges. An
information sharing agreement between the Batz BZX exchange and, say,
Chinese-based Binance, one of largest bitcoin exchanges, would obligate
Binance to share relevant data about market trading activity and customer
identities with Bats.
The SEC believes that information sharing agreements with significant
exchanges are key to compliance with the Securities Exchange
Act, the body of legislation that governs the SEC. Specifically, Section
6(b)(5) of the Act requires the SEC to ensure that the securities exchanges
it regulates, including Bats BZX, are designed to prevent fraudulent and
manipulative acts and to "protect investors and the public
interest."
The SEC has chosen to take a very strict interpretation of 6(b)(5) when it
comes to the listing of an overlying security, i.e. securities that derive their
value from some underlying security or commodity (much like how units of the
Winklevoss Bitcoin Trust overlie, or are underlain by, physical bitcoin). Not
only must an exchange like Bats BZX ensure that it has controls to prevent
manipulative behaviour of Bats-listed overlying securities, but it must also
take reasonable steps to ensure that the underlying instrument to which it is
linked is traded on an exchange that is held to the same standards. The SEC
deems that an information sharing agreement between the relevant exchanges is
sufficient to fulfill this requirement. That way, if there were to be
suspicions of manipulation of bitcoin on the Binance exchange, Bats BZX would
be able to get data from Binance and use it to conduct investigations into possible
trading violations.
In its second refusal of the Winklevoss Bitcoin Trust, the SEC maintained that
it has a long history of requiring information sharing agreements between
SEC-regulated exchanges that list overlying securities and exchanges that
list the underlying instrument. It points to a ruling it made in 1994 in
which it required that the CBOE, which wanted to list equity options on
American Depository Receipts (ADRs), would in certain cases be required to
have a formal mechanism for getting information from the overseas exchanges
trading the individual stocks underlying the ADR.
The SPDR Gold Trust as precedent
The SPDR Gold Trust (GLD) provides further precedent. When the SPDR Gold
Trust was approved in 2004, the sponsoring exchange, the New York Stock
Exchange (NYSE), was unable to establish information sharing agreements
linked to spot trading. Securing agreements was deemed
impossible since most gold spot exchanges occurs relatively informally
via the London over-the-counter gold market.
In lieu of information about spot exchanges, the SEC decided that two
factors were sufficient for the proposal to meet its requirements. First, it
claimed that gold OTC markets are very liquid and thus difficult to
manipulate. Second, the NYSE had
an information sharing agreement with NYMEX, whose COMEX division listed
the most popular set of gold futures contracts. Since the COMEX market is a
regulated exchange that the SEC deemed "significant", the sharing
of information between the NYSE and COMEX would help ensure that manipulation
could be caught. The meaning of "significant" is sizable relative to
overall trading volumes.
In the case of the Winklevoss Bitcoin Trust, the Bats BZX had entered into
an information sharing agreement with the the Gemini Exchange, a New
York-based bitcoin exchange that allows for spot trade. However, the SEC has
decreed that this agreement is not sufficient to meet its requirements. The
SEC maintains that bitcoin trading is dominated by unregulated non-US
exchanges (like Binance). In this context, Gemini accounts for only a small
fraction of global bitcoin trading, and therefore if a manipulation attempt
were to succeed in causing a large change in the price of bitcoin, it would
likely be carried out on a dominant exchange, like Binance, and not Gemini.
Thus, an information sharing agreement with Gemini simply won't be effective
for sniffing out manipulators.
A quick perusal of Coinmarketcap.com,
a website that tracks bitcoin trading statistics, confirms that unregulated
non-U.S. bitcoin exchanges dominate bitcoin trading (see screenshot below).
On 31 August 2018, for instance, Gemini ranked 74th in terms of 24-hour
bitcoin volume, at $18 million, whereas Binance clocked in near the top at
$295 million.
Nor is the existence of information sharing agreements with a regulated
bitcoin futures market sufficient to change the SEC's opinion. This is relevant
because two large U.S. futures exchanges, the CBOE Futures Exchange (CFE) and
CME, both launched trading of their bitcoin futures contracts in December
2017. Given that an information sharing agreement between the NYSE and NYMEX
was sufficient to allow GLD to list, would an equivalent agreement between
Bats BZX and either of these two futures exchanges constitute enough support
for the Winklevoss Bitcoin Trust to proceed? Not so, says the SEC. In
the case of other commodity ETFs like GLD, the SEC had sufficient evidence
that the U.S. futures market for that commodity was large enough to be
"significant." Regulated bitcoin futures still constitute a
relatively unimportant part of overall bitcoin trading.
This logic used by the SEC needn't just apply to bitcoin. It might explain
why there is no rhodium ETF in the U.S., for instance, whereas there is one
in both Europe
and South
Africa. Since there is no exchange that offers rhodium futures and the
spot market is relatively opaque, it would not be possible for an
SEC-regulated exchange to set up the information sharing agreements necessary
for SEC approval of a rhodium-based financial product. This echoes what I
said at the outset: the SEC's decision is less about bitcoin and more about
grappling with the complexity of market structure in an age in which
financial magicians are trying to package everything into an exchange-traded
product.
Dissent within SEC: underlying asset out of scope?
Interestingly, one of the four SEC Commissioners, Hester Pierce, dissented
from the regulator's decision to disallow the Winklevoss Bitcoin Trust to be
listed. Her reasoning is that a reading of Section 6 of the Exchange Act does
not permit the SEC to focus on the underlying market for a proposed security,
whether that underlying market be the bitcoin or gold spot market. Pierce
believes the SEC only has the right to regulate the market for the overlying
asset, i.e. units of a Bitcoin ETF or a Gold ETF. Pierce has previously advocated a
Hayekian view of markets, in which the dispersed nature of information leaves
no roll for a single "omniscient" regulator:
"Regulators are people, and they are people without great access to
information, so we're asking them to do a task that they're destined to fail
at... not because they don't have good intentions and not because they don't
work hard... they do... they're hard working people but they're just not
going to be able to succeed at the task."
Pierce's criticism would constitute not just a roll-back of the SEC's
bitcoin decisions, but would also throw out a decade or two of previous SEC
decisions related to information sharing practices of proposed
commodity-linked ETFs.
The next Bitcoin ETF - Further rejections likely
The next big bitcoin ETF that is slated for an SEC decision is the CBOE
Exchange's proposal to list the VanEck
SolidX Bitcoin Trust. Given that Pierce's dissent is unlikely to sway the
three remaining SEC commissioners, I don't expect this ETF to be approved.
Let's look at the part of the proposal that has to do with information
sharing agreements:
The creators of the VanEck SolidX Bitcoin Trust point to a number of
information sharing agreements into which the sponsor, the CBOE, has signed
(or expects to sign). We already know that those with the CME, which lists
bitcoin futures, and Gemini will not be sufficient to establish significance.
What about the agreements signed between the CBOE and Bitcoin
over-the-counter trading desks? The creators claim that the relevant OTC
markets account for around US$250–$500 million in trading per day. But with overall
exchange-related bitcoin volumes said to come in at around $4 billion per
day, it will be difficult for the creators to prove that OTC trading
constitutes 'significant'.
Lastly, the creators of the trust point to "other USD-bitcoin spot
markets." I interpret this to mean that they may succeed in getting
other U.S.-based bitcoin exchanges to join Gemini in sharing information. But
if it can't get some of the largest actors in the list above, say Binance,
Bitfinex, or OKEx, all of which are based outside of the US, it's hard to see
how the SEC will provide its stamp of approval.