Notes on the Grayscale ETF rejection

Deja vu for bitcoin spot ETFs

[Full disclosure: This blogger worked for a cryptocurrency exchange associated with a past Bitcoin ETF filing]

Few observers were surprised when the SEC rejected yet another bitcoin spot ETF filing in July, adding to a long line of failed attempts going back to the 2017 Winklevoss ETF decision. (Not to be confused with bitcoin futures ETFs, which have been already approved for trading.) Even the sponsor did not seem particularly optimistic about its odds of victory: Grayscale preemptively retained high-profile legal counsel in the week leading up the decision, gearing for a protracted court battle.

One silver lining is that the SEC itself emphasizes the procedural nature of the decision, as opposed to being a judgment on whether bitcoin is a suitable investment:

“The Commission emphasizes that its disapproval of this proposed rule change, as modified by Amendment No. 1, does not rest on an evaluation of the relative investment quality of a product holding spot bitcoin versus a product holding CME bitcoin futures, or an assessment of whether bitcoin, or blockchain technology more generally, has utility or value as an 12 innovation or an investment.”

In other words: this is not a reflection on the suitability of bitcoin as an asset class, or even the relative advantages of holding bitcoin directly compared to holding it indirectly via spot or futures ETFs. SEC did not jump on the not-your-keys-not-your-bitcoin bandwagon and endorse self-custody. The ruling is strictly concerned with structural issues at play for this one particular proposed ETF. Comforting words for the bitcoin faithful but hardly the resounding endorsement the sponsor was looking for. Grayscale Trust has been under increasing pressure to convert from its current structure into an ETF. Recent reversal of its tracking error only added increased urgency to this filing, raising the stakes for the SEC decision: while GBTC NAV used to float at a comfortable premium above the underlying price, it is now trading significantly below spot prices.

The song remains the same

In an 86 page decision heavy on references, the Commission lays out its rationale for the rejection. Looking at this document closer reveals an interesting mix of “recycled content” from past rejections of similar ETFs as well as some unique counter-arguments to claims advanced in this particular application. In case this distinguished heritage is not clear, there is footnote #11. Taking up most of the third page and spilling over into the next page, it presents a laundry list of past bitcoin ETF rejections: Winklevoss Bitcoin Trust, USBT, Wisdom Tree, Valkyrie Bitcoin Fund, Krypton, SkyBridge ETF, NYDIF Bitcoin ETF, GlobalX, ARK21, One River Carbon Neutral Bitcoin Trust, SolidX, Granite Shares, VanEck, the list goes on. Grayscale decision hinges on similar rationale: the applicant has not met its burden under the Exchange Act to demonstrate that the proposal is consistent with the requirements of section 6(b)(5), specifically that the venues where the underlying product—bitcoin— is traded are “designed to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.”

While the ruling cites prior events going as far back as 2017, it is also surprisingly current. One note cites cites recent work from Trail Of Bits on centralization of public blockchains. Another note cites a support letter written in support of the Grayscale application date 21st is— eight days before the timestamp of this document. SEC spends the first half of the document disputing two claims by NYSE Arca, the sponsor behind the Grayscale ETF. (Here we will use Grayscale as short hand to refer collectively to the trust and its sponsor, even though NYSE Arca is a distinct entity.)

1. That NYSE Arca has entered into a comprehensive surveillance sharing agreement with a regulated market of significant size
2. Other alternative countermeasure for market manipulation are in place due to the unique properties of cryptocurrency

Own goals

Several commenters writing to the SEC in support of the Grayscale application argued that bitcoin markets were somehow inherently resistant to manipulation either due to their scale or some unusual transparency property of blockchains. (A curious argument, considering that trading activity itself is not reflected on chain and takes place within the internal, closed ledgers of centralized exchanges.) In a deft move, the Commission uses words straight out of NYSE Arca itself to refute those arguments. On the subject of whether bitcoin markets can be manipulated:

“NYSE Arca acknowledges in its proposal that “fraud and manipulation may exist and that [b]itcoin trading on any given exchange may be no more uniquely resistant to fraud and manipulation than other commodity markets.”NYSE Arca also states that “[b]itcoin is not itself inherently resistant to fraud and manipulation” and concedes that “the global exchange market for the trading of [b]itcoins” […] also “is not inherently resistant to fraud and manipulation.”

That is not exactly helping the case. To be fair, even without this own-goal the SEC had plenty of ammunition to cast doubt on the premise that spot price is immune to manipulation. Among others:

• Tether, the gift that keeps on giving
• Continued allegations of wash-trading on offshore, unregulated exchanges
• Possibility of 51% attack or “hacking of the Bitcoin network”
  This constant refrain about hypothethical flood of hash-power colluding to rewrite history seems out of place here. While 51% attacks have always been a theoretical possibility, the security in proof-work comes from the difficulty of assembling the required level of resources to carry out such an attack. Blithely asserting that bitcoin is subject to 51% attacks is tantamount to saying a Bond villain with a trillion dollars could corner the market for baseball cards. Similarly the SEC ruling cites a statistic about 100 wallets controlling ~15% of all bitcoin in circulation. As previously discussed here, such statistics from on-chain address distribution can not be used to estimate the level of inequality in bitcoin ownership. One address does not necessarily equal one person or even one institutional investor, especially among addresses with highest balances that typically represent large omnibus wallets pooling funds.

Speaking of supporting letters, the SEC could not resist the temptation to nitpick some of these. Note #100 points out one letter from the Blockchain Association where the commenters claimed CFTC has been exercising anti-manipulation and anti-fraud enforcement authority over bitcoin futures market since 2014— which is a full three years before CFTC has overseen bitcoin futures.

Another example of an own-goal comes from Grayscale assertions concerning the “Index Price” and how the associated methodology for aggregating spot prices from multiple exchanges is resistant to manipulation. The SEC points out conflicting statements from the Registration Statement carrying a litany of caveats and qualifications:

“Moreover, NYSE Arca’s assertions that the Trust’s use of the Index helps make the Shares resistant to manipulation conflict with the Registration Statement. Specifically, the Registration Statement represents, among other things, that the market price of bitcoin may be subject to “[m]anipulative trading activity on bitcoin [trading platforms], which are largely unregulated,” and that, “[d]ue to the unregulated nature and lack of transparency surrounding the operations of bitcoin [trading platforms], they may experience fraud, security failures or operational problems, which may adversely affect the value of [b]itcoin and, consequently, the value of the Shares.”

Voluntary vs mandatory compliance

One interesting point made in the SEC ruling is that any mitigations implemented by “constituent platforms” (the five exchanges used for calculating the ETF price, namely: Coinbase Pro, Bitstamp, Kraken, and LMAX Digital) against market manipulation are entirely at their own discretion. These are not regulated platforms. They have no obligation to continue policing their order-books against suspicious trading activity and reporting bad actors to law enforcement:

“[…] these measures, unlike the Exchange Act’s requirements for national securities exchanges,117 are entirely voluntary and therefore have no binding force. The Constituent Platforms, including the platform operated by an affiliate of the Custodian, could change or cease to administer such measures at any time”

One counterpoint is that exchanges have very compelling incentives to maintain orderly markets since manipulative activity reduces investor confidence in the platform, resulting in loss of customers. On the other hand such profit/loss motivations do not carry the same weight as a binding regulation and may cut both ways. In good times it may well drive further investment in market surveillance to boost investor confidence in a bit to attract more risk-averse investors standing on the sidelines. But the same incentives could mean a troubled exchange facing crypto-winter will cut spending on compliance.

No exchange an island unto itself

While the Grayscale filing sings the praises of the Constituent Platforms and how robust they are against market manipulation, the SEC turns its attention to the rest of the bitcoin spot market. Rightly so— considering that the majority of spot bitcoin trading takes place on unregulated, off-shore exchanges outside these four platforms:

“NYSE Arca focuses its analysis on the attributes of the Constituent Platforms, as well as the Index methodology that calibrates the pricing input generated by the Constituent Platforms […] What the Exchange ignores, however, is that to the extent that trading on spot bitcoin platforms not directly used to calculate the Index Price affects prices on the Constituent Platforms, the activities on those other platforms⸺where various kinds of fraud and manipulation from a variety of sources may be present and persist⸺may affect whether the Index is resistant to manipulation. Importantly, the record does not demonstrate that these possible sources of fraud and manipulation in the broader spot bitcoin market do not affect the Constituent Platforms that represent a slice of the spot bitcoin market.”

This is spot on. Even if a particular index is designed to ignore signals from offshore exchanges on the theory that they are easier to manipulate, trading activity on those platforms can still affect “Constituent Platforms” as long as overlap exists in market participants. Suppose a market-maker simultaneously operates on one of CP and one of the off-shore exchanges— this is a very common scenario, since such strategies are typically rooted in exploiting price discrepancy across multiple venues. In that case price manipulation taking place on the sketchy offshore platform will also impact prices on the regulated venue because market-making algorithms will continue to exploit the price difference until it is arbitraged away or until they run out of liquidity. The contagion of price manipulation can not be confined to one venue in an efficient, interconnected market. (Ironically, trying to argue against this point by insisting that bitcoin markets are so disconnected from each other to violate the Rule Of One Price is self-defeating. It would mean the bitcoin spot market is too inefficient and immature to serve as the basis for any ETF.)

Tracking errors

The ruling also points out a subtle point about pricing: while the Grayscale Trust may use the reference index price to evaluate itself, there is no guarantee this is the same valuation the shares will trade at. (In fact there is another, third price that may drift from these two— the value that Authorized Participants in the fund buy/sell bitcoin on the open market when they are creating/redeeming baskets. Recall that the reference price is a synthetic creation, not an actual quote from an actual exchange where you can can execute trades at that price.) Again the SEC points to the historic track record of GBTC having significant tracking errors, trading as high as 142% (!!) over the underlying value of bitcoin holdings and at other times trading as low as 21% below the same benchmark. The source of these figures? The Registration Statement and 10-K filings from Grayscale. Converting GBTC into an ETF is expected to reduce these over/under tracking errors, but in making that case for approval, Grayscale unwittingly provided the SEC with even more ammunition to question the defense against price-manipulation.

Back to the futures ETF?

If the intrinsic properties of bitcoin or market-surveillance agreements— to the extent they even exist at all Constituent Platforms— are insufficient to deter price manipulation, what else could work? Here the Grayscale filing pinned its hopes on the existence of previously approved bitcoin futures ETFs such as the ProShares Bitcoin Strategy ETF which tracks CME futures. This argument rests on two premises:

1. CME futures are traded on highly-regulated venues with well established market-surveillance and information sharing agreements, greatly reducing the risk of market manipulation
2. Any successful manipulation of the proposed ETF must also manipulate the CME futures market in order to affect the price

That would appear to do the trick. No need for additional “surveillance-sharing agreements” or “market of significant size” within the spot market, when any manipulation attempts will be caught by the parallel mechanisms operating in the futures market.

That second argument did not fare well with the SEC. Leaving aside the relative volumes of the spot and futures markets, the main objection concerns lack of evidence around any causal relationship between prices in the two different markets. Here again Grayscale’s own words come back to haunt them: “… there does not appear to be a significant lead/lag relationship” between CME futures and the spot price. This is significant because if spot leads futures, a dishonest participant does not have to trade in the latter in order to influence the former. (On the contrary, their actions in spot markets will eventually also manipulate the futures market as a downstream effect.) Even the comment letters are not helping the cause, with one acknowledging there is “no clear winner” or even noting a bidirectional link were either market can move the other. In an interesting side-discussion the commission also clarifies what the expectation of future “leading” spot market means. Contrary to the straw-man version presented in another comment letter, the SEC criteria does not mean that futures always move first and the spot market responds in a perfectly predictable way afterwards. It is the existence of a statistical relationship that is sought, not a deterministic recipe for 100% reliable arbitrage between two markets.

False equivalences, take #2

Grayscale tried another variant of this strategy of arguing by comparison to already-approved futures ETFs. Suppose that instead of relying on futures ETFs as a bulwark against price manipulation, the premise is turned on its head and we asking whether the spot ETF is any easier to manipulate. Here Grayscale argued that if someone could manipulate the spot ETF, they could also target the futures ETF using the exact same mechanism since they rely on very similar price calculations. Ergo, GBTC is no more susceptible to such activity than an investment product previously approved by the SEC. Taking this one step further, disapproving GBTC while having approved the comparable futures ETF would constitute “arbitrary and capricious administrative action.”

On its face this is a compelling argument but the SEC is having none of it. First the order points out that the Bitcoin Reference Rate (BRR) used by CME futures serves a very different purpose:

“While the BRR is used to value the final cash settlement of CME bitcoin futures contracts, it is not generally used for daily cash settlement of such contracts, nor is it claimed to be used for any intra-day trading of such contracts. In addition, CME bitcoin futures ETFs/ETPs do not hold their CME bitcoin futures contracts to final cash settlement; rather, the contracts are rolled prior to their settlement dates. Moreover, the shares of CME bitcoin futures ETFs/ETPs trade in secondary markets, and there is no evidence in the record for this filing that such intra-day, secondary market trading prices are determined by the BRR.”

Also noted in passing: there are two additional spot exchanges (Gemini and ItBit) incorporated into the BRR not present in the GBTC reference price, further casting doubt on the assertion of “almost complete overlap.” Yet these are minor quibbles compared to what SEC points as the fundamental flaw in the GBTC filing:

“… the Commission’s consideration (and approval) of proposals to list and trade CME bitcoin futures ETPs, as well as the Commission’s consideration (and thus far, disapproval) of proposals to list and trade spot bitcoin ETPs, does not focus on an assessment of the overall risk of fraud and manipulation in the spot bitcoin or futures markets, or on the extent to which such risks are similar. Rather, the Commission’s focus has been consistently on whether the listing exchange has a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying bitcoin assets of the ETP under consideration, so that it would have the necessary ability to detect and deter manipulative activity.”

Even more telling is note #201: An ETF applicant was never required to demonstrate that cryptocurrency possesses some “unique resistance to manipulation” missing from other assets. Such unique properties could serve as an alternative to the original golden standard that the SEC seeks: “surveillance-sharing agreements with a market of significant size.” It is precisely the lack of such compressive market surveillance in bitcoin spot market that has lead GBTC on a wild-goose chase to identify some magic properties in blockchain assets rendering them intrinsically safe against manipulation techniques.

CP