How Big Is Big Enough? The SEC Rejects Cryptocurrency ETF Applications Based on Limited Market Size and Resulting Concerns Over Oversight/Monitoring.

The SEC is being cautious. Correction. To paraphrase my children, the SEC is being super-cautious.  This time over the approval of cryptocurrency-based ETFs (or ETPs). Most recently, in a set of companion orders, the SEC has refused to approve for listing and trading several cryptocurrency based ETFs.  The SEC's orders denying these requests run 20+ pages long each, and are filled with the exchanges' analysis in support of the listing of these funds and the SEC's rationale for denying approval. However, at the end of the day, it appears to come down to a deceptively simple reason -- the regulated market size for cryptocurrency-based ETFs and futures was not sufficiently large enough to provide the SEC with comfort that the various exchanges' rules around trading these products would be designed to allow prevent fraudulent and manipulative conduct. This note attempts to simplify some of the detailed concepts addressed in the SEC's orders, while also providing my personal views on the future of cryptocurrency and the securities laws, specifically cryptocurrency-based ETFs. I hope you find it helpful.

SEC View - The Devil Is Always In The Footnotes

My first supervisor as a junior Staff Attorney at the SEC's Division of Enforcement once told me (to paraphrase) 'if you don't know what's in the footnotes, you don't know the case.' Very true here. 

According to one of the three published orders, "the Exchange has not met its burden…to demonstrate that its proposal is consistent with the requirements of the Exchange Act Section 6(b)(5), in particular the requirement that a national securities exchange’s rules be designed to prevent fraudulent and manipulative acts and practices."  https://www.sec.gov/rules/sro/nysearca/2018/34-83912.pdf. In addressing this concern, the SEC's analysis focused on the fact that presently, there does not exist a regulated bitcoin securities or futures market of a "significant size" sufficient to allow for cross-market/exchange monitoring of potential fraud or manipulation. The absence of such a market, for the time being, appears to be a deal-breaker for the SEC. What the orders did not expressly provide, in any meaningful way, is direction on a way forward. 

Digging a little deeper, in one order the SEC said that "if the listing exchange for an ETP fails to establish that other means to prevent fraudulent and manipulative acts and practices will be sufficient, the listing exchange must enter into a surveillance-sharing agreement with a regulated market of significant size because '[s]uch agreements provide a necessary deterrent to manipulation because they facilitate the availability of information needed to fully investigate a manipulation if it were to occur.'"Id.  According to one order, that exchange proffered two bases in support of a positive finding: (i) its existing surveillance procedures (including its ability to review activity by its members) and; (ii) its ability to share surveillance information with U.S. futures exchanges. Id.  The SEC rejected both arguments. 

The SEC dismissed point (i) fairly quickly. Specifically, it said "[w]hile the Exchange would, pursuant to its listing rules, be able to obtain certain information regarding trading in the Shares and in the underlying bitcoin or any bitcoin derivative through registered market makers, this trade information would be limited to the activities of market participants who trade on the Exchange. Furthermore, neither the Exchange’s ability to surveil trading in the Shares nor its ability to share surveillance information with other securities exchanges trading the Shares would give the Exchange insight into the activity and identity of market participants who trade in bitcoin futures contracts or other bitcoin derivatives or who trade in the underlying bitcoin spot markets."Id.

The SEC spent a significant amount of effort discussing point (ii). Accompanied by footnote 34, the SEC provided an "illustrative", but "not exclusive" definition of what it means to be a significant market. Id.  Citing the previous Winklevoss Order (31, 83 FR at 37594), the SEC said that it interprets "the terms 'significant market' and 'market of significant size' to include a market (or group of markets) as to which (a) there is a reasonable likelihood that a person attempting to manipulate the ETP would also have to trade on that market to successfully manipulate the ETP, so that a surveillance-sharing agreement would assist the ETP listing market in detecting and deterring misconduct, and (b) it is unlikely that trading in the ETP would be the predominant influence on prices in that market."Id.   Boiling this down, that market has to be one that a want-to-be manipulator would need to trade on in order to manipulate the market, and the market would need to likely be able to withstand those attempts. If both criteria are met, that is a market of "significant size."

Significantly on this point, the SEC noted that hit had requested information on whether the CME and CBOE bitcoin futures markets are markets of significant size, but had not received responses. The SEC also noted comments by CFTC Chairman Giancarlo in which he characterized the volume of the bitcoin futures markets as “quite small.” Furthermore, the SEC cited a statement by an executive of a prominent futures exchange to the effect of how it does not appear that the exchange has the ability, at present, based on current bitcoin futures trading volumes to support ETFs seeking 100% long or short exposure to bitcoin.

My Take - An Enforcement Lawyer's Take on a Regulatory "Pickle"

Reading the orders in their totality, it is clear that what the SEC wants is the ability of a regulator or regulated entity to be able to conduct cross-market monitoring, specifically including an established market in cryptocurrency-based securities or assets, in order to ensure that the market for that asset is sufficiently protected from fraud and/or manipulation. There needs to be a "go to market" that is deep and resilient enough to withstand manipulation attempts. The punchline here is that, at present, the SEC believes that neither the securities nor futures markets are sufficiently deep enough to pass muster.  What is less clear from the SEC's order is how they expect a market of sufficient depth to grow in the absence of SEC-approved cryptocurrency products.  Is the SEC just going to wait for the cryptocurrency-based futures market, currently regulated by the CFTC to grow, and then bootstrap from there?  That seems to be a fair question, but I doubt it is an option the SEC wants to pursue given the territorial "debate" between the SEC and CFTC on this issue.

The key here is that the SEC has hedged and has clearly left open room for other applicants to proffer additional factors, including those not addressed in previous denial orders, in support of a cryptocurrency ETF.

All is not lost if you dig.  While at first blush the orders are silent on a way forward to approval, it makes sense to refer back to the January 18, 2018 letter from the Director of Investment Management, Dalia Blass, in which she provided a list of 5 main issues, with several considerations under each issue, that need to be considered when seeking SEC approval of cryptocurrency-based funds: (i) issues around how the cryptocurrencies would be valued; (ii) issues around their liquidity; (iii) issues around safeguarding custody; (iv) issues around arbitrage; and (v) protecting against manipulation and fraud.  https://www.sec.gov/divisions/investment/noaction/2018/cryptocurrency-011818.htm

To this former SEC enforcement lawyer, now in private practice, this would be the place that I start.

We will continue to monitor these developments, including any guidance the SEC offers.