Federal appeals court judges in Washington grilled the Securities and Exchange Commission on its decision to reject a proposed Bitcoin exchange-traded fund when it had earlier approved a similar product based on Bitcoin futures.
Grayscale Investments wants to convert its $14 billion Bitcoin trust, the largest investment vehicle tied to the No. 1 cryptocurrency, into an ETF. The SEC rejected the plan in June, saying crypto markets are too ripe for fraud and manipulation. Grayscale sued, asking the Washington D.C. Circuit Court to overturn a decision the company called arbitrary and discriminatory because the SEC had already approved ETFs that track Bitcoin futures.
Chief Circuit Judge Sri Srinivasan, one of three judges on the appellate panel, asked during a hearing Tuesday why it wouldn't always be the case that manipulation of the spot Bitcoin market would show up in futures.
"It is just going to follow like the night follows the day," Srinivasan said while questioning an SEC lawyer.
Some of the judges pushed the SEC to explain why Grayscale is wrong to argue the risks of fraud and manipulation in the spot Bitcoin and Bitcoin futures markets are the same because they both rely on the same underlying pricing.
"One is essentially a derivative of the other," Judge Neomi Rao said. "They move together 99.9% of the time. So where's the gap in the commission's view?"
The share price of the Grayscale Bitcoin Trust, which trades under the ticker GBTC, rose by as much as 15% Tuesday, the biggest intraday gain since Jan. 12. The stock is up 50% this year, after tumbling 76% in 2022.
'Same risk'
Grayscale's attorney, Donald B. Verrilli Jr., argued there's little difference between the proposed ETF and already approved ETFs based on Bitcoin futures, which have been trading on the Chicago Mercantile Exchange since 2017.
Verrilli told the judges that the problem with the SEC denial is that it treats Bitcoin futures ETFs and spot Bitcoin ETFs differently even though they "pose the same risk of fraud and manipulation."
Verrilli said Bitcoin futures are correlated with spot prices 99.9% of the time, but that the SEC insists there is "reason to question" if CME surveillance would pick up fraud or manipulation in the underlying market. However, the agency never explained why, he said.
SEC lawyer Emily True Parise argued that futures, unlike spot Bitcoin, are traded on a public exchange with federal oversight, and that pricing and monitoring is stronger. She said the main question is whether fraud and manipulation in the spot market affects the CME futures market the same way.
"It's an unsupported empirical leap to go from a correlation of once-a-day futures prices to any fraud or manipulation in the spot market affects futures in the exact same way," Parise said. "The focus on once-a-day prices doesn't tell you what's happening to intraday prices and importantly, it doesn't tell you the causal relationship. It doesn't tell you which direction the relationship is moving."
CME surveillance
The SEC argued that an ETF based on Bitcoin, which trades on unregulated markets, doesn't meet the same standards for oversight as funds based on futures. The CME is regulated by the government and "performs extensive surveillance of the trading activity on its market," SEC lawyers said in court filings.
Parise said Grayscale hadn't provided enough data to show that fraud on the spot Bitcoin market would show up in the regulated futures market.
"What kind of data would they have to show?" Rao asked. "It seems there's quite a bit of information here," she said. "It seems the SEC has to explain why they are wrong and the evidence that they have wrong."
The legal battle has big implications for the crypto industry because it could clear the way for similar ETFs, fueling a major expansion of the market by making it easier for everyday investors to bet on the success or failure of digital assets.
"Allowing an ETF means anybody with a brokerage account — which is basically available to anybody who can fog a mirror in the U.S. — can now speculate on Bitcoin," said James Angel, an associate finance professor at Georgetown University. Angel signed on to one of the amicus briefs in support of Grayscale.
The court case is a major test for the SEC, which has taken an aggressive stance toward the crypto industry, including through increased enforcement following the collapse of several companies, including FTX, last year. The SEC has claimed that most digital assets are securities that have to be registered with the agency.
U.S. regulators are concerned the next crypto disaster might have greater repercussions if digital-asset businesses grow large enough to affect the broader financial system, which was mostly insulated from the current crisis.
For Grayscale, the stakes are high. The trust has effectively operated as a closed-end fund that didn't redeem shares when prices fell, which left the trust trading at discounts of more than 40% to its underlying Bitcoin. The structure of an ETF allows shares to be created and redeemed to keep pace with shifting demand.
A conversion could unlock $6 billion in value, according to Elliott Stein, senior litigation analyst with Bloomberg Intelligence. After the hearing, Stein predicted Grayscale would win its appeal. "The question is how much room the court will give the SEC to revisit the application and potentially reject again," he said.
The steep discount on the Bitcoin trust, which trades under the symbol GBTC, has been at the center of recent lawsuits. Rival Osprey Funds claims Grayscale misled investors by saying the conversion to an ETF was a "forgone conclusion." Investment firm Fir Tree Capital Management claims there's no legal reason that stops the trust from allowing investors to exit.
Grayscale called the Osprey suit "frivolous" and said in response to Fir Tree that it remains "100% committed to converting GBTC to an ETF, as we strongly believe this is the best long-term product structure for GBTC and its shareholders."
'Preventing redemptions'
Alameda Research, the bankrupt trading arm of FTX, also sued this week, alleging "exorbitant management fees" and accusing Grayscale of "improperly preventing redemptions" from the Bitcoin and Ether trusts it manages. Grayscale said the claim was "misguided" and that it "has been transparent in our efforts to obtain regulatory approval" for the conversion to an ETF.
The case against the SEC is also important for Grayscale's parent company, Digital Currency Group, which has a separate business unit that's going through bankruptcy proceedings. Grayscale is a lucrative part of the DCG empire, raking in millions of dollars in fees each year. Its Bitcoin trust holds about 3.3% of all Bitcoin in circulation as of Dec. 31, according to a company filing.
The D.C. Circuit judges are likely to reach their decision in the coming months, meaning a resolution could come as early as this summer. Even then, however, the case could be far from over as Grayscale has indicated it's willing to appeal all the way to the U.S. Supreme Court if needed.
