Towards a Developed Cryptocurrency Market: Bitcoin-Based Exchange Traded Products

Sunday, October 8th, 2017 at 3:40 pm, by Andrew Astore

In March, the SEC rejected two proposals for bitcoin-based exchange traded products (“ETP”) from NYSE Arca and the Winklevoss brothers. Since then, changes in the economic, political and regulatory spheres may have shifted the ground to make such an ETP more likely to be approved. If approved, a bitcoin-based ETP would provide a vehicle for investors to have regulated and transparent access to the cryptocurrency, and potentially pave the way for the mainstreaming of bitcoin investment and investment in other cryptocurrencies.

The Winklevoss Bitcoin Trust proposed to list shares under BZX Rule 14.11(e)(4). This rule permits the trading of commodity-based trust shares, as securities that exist as shares of a trust which holds the commodity which may be redeemed, often in specified minimum quantities (here 100,000 shares), for the commodity itself. Similarly, NYSE Arca proposed to list shares of the SolidX Bitcoin Trust under NYSE Arca Equities Rule 8.201, which likewise lays out the structure of a commodity-based trust.

The SEC’s Reasons for Rejection: Lack of Large, Well-Regulated Bitcoin Markets with Which US Exchanges Can Enter into Surveillance-Sharing Agreements

In rejecting both proposals as inconsistent with Section 6(b)(5) of the Securities and Exchange Act, the SEC expressed concern about the potential for price manipulation. Section 6(b)(5) requires that all national exchanges be designed to prevent fraudulent behavior and manipulation. In applying this requirement to commodity-based trust shares, the SEC has traditionally required surveillance-sharing agreements between the exchanges listing the ETP and large, regulated markets for the underlying asset and its derivatives. In the case of bitcoin, the SEC found that, because most bitcoin trading occurs outside of the United States on undercapitalized, under-regulated markets (mostly in China), such information-sharing agreements were not possible. The lack of auditing and the potential for unethical trading behaviors in those Chinese markets led many investors who commented on the proposal to suggest that much of the price of bitcoin was a result of fraud or speculation. Meanwhile, United States markets, including the Gemini Exchange on which the Winklevoss Bitcoin Trust would be listed, have much lower trading volume, making efficient arbitrage between US and Chinese markets difficult, and decreasing liquidity.

Additional Concern: Underdeveloped Derivatives Market

An additional concern involved the underdeveloped nature of the bitcoin derivatives market, which could prevent the bitcoin market itself from being fully efficient since hedging and other market tools found in derivatives markets are not available to investors. The SEC found that TeraExchange, a US-based exchange for trading bitcoin derivatives that was registered with the CFTC, did not transact sufficient volume to satisfy their requirements for a well-developed derivative market.

Additional Concern: CFTC Enforcement of US Bitcoin Markets

The SEC found that CFTC enforcement of bitcoin spot markets to prevent manipulation was insufficient to satisfy the need for a large, well-regulated market. The CFTC has designated bitcoin as a commodity under the Commodities Exchange Act, and generally does not set rules or otherwise regulate bitcoin spot markets.

Under the Dodd-Frank Act, financed commodity transactions must be brought on exchanges, unless the commodity is actually delivered within 28 days, where actual delivery requires a transfer of possession and control of the commodity (CFTC v. Hunter Wise, LLC). The CFTC has brought enforcement actions against traders engaging in off-exchange leveraged bitcoin transactions, including BFXNA, Inc., a Hong Kong-based bitcoin exchange that had not registered as an exchange with the CFTC. However, bitcoin exchanges that are not financed are not required to register with the CFTC under the Commodities Exchange Act. Most bitcoin-related enforcement, however, has little to do with the nature of the cryptocurrency itself, except that it happened to be involved in an otherwise-unrelated crime (Boxerman and Schwerin, 2017).

New CFTC Enforcement Actions

In September, it filed its first antifraud enforcement action against Gelfman Blueprint, Inc., which allegedly promised returns to investors through the use of an advanced high-frequency trading strategy that traded in bitcoin, when in fact no such strategy existed, and no returns materialized (CFTC v. Gelfman Blueprint, Inc.). As the first explicitly anti-fraud action brought by the CFTC, this case may signal a turn towards increasing enforcement of bitcoin-related activity. A visible role for the CFTC in combatting cryptocurrency fraud may help satisfy investors – and the SEC – that bitcoin markets are beginning to be appropriately policed by US regulators.

The SEC’s Potential Pivot

The SEC announced in September the creation of a new Cyber Unit to focus on enforcement of cyber-related misconduct, specifically for the protection of retail investors. SEC Chairman Jay Clayton, sworn in this May, has expressed concern that most investors in Initial Coin Offerings do not understanding the significant risks associated with them, and this initiative seems to be in line with his desire to protect Main Street investors from various risks associated with investing in virtual currency by cracking down on fraudulent behavior. The new administration has signaled a desire to review many of the post-financial crisis regulations and deregulate the financial sector. While most of the attention has focused on the Volcker Rule, the change in leadership at the SEC may also promote a shake-up of its policy on Exchange Traded Funds.

The Existence of Large, Well-Regulated Markets with Which U.S. Exchanges Can Enter into Surveillance-Sharing Agreements as per the SEC’s Interpretation of Section 6(b)(5)

More dramatically, in the beginning of September China banned all bitcoin trading and initial coin offerings (Chang, CNBC). While it may have been a temporary political move in anticipation of the Communist Party’s National Congress in October, the crackdown appears to be in line with President Xi Jinping’s goal of curbing financial speculation. As a result, Japan, which only legalized trading the cryptocurrency in April, has become the largest bitcoin market in the world. Japan’s Financial Services Authority, which has had over 50 exchanges apply for licenses since April, announced that, beginning in October, it would commence full surveillance of the bitcoin market, which would monitor risk management and cybersecurity on the exchanges with the goal of fostering market development and ensuring regulatory enforcement (Japan Times). With the potential for a large, well-regulated bitcoin market in Japan in the very near future, surveillance-sharing agreements with exchanges hoping to list bitcoin ETFs are beginning to look like a more realistic possibility.