In the latest installment of Ropes & Gray’s ETF podcast series, asset management partner Paulita Pike and counsel Ed Baer discuss some of the recent developments relating to cryptocurrency ETFs and ETPs.
Ed Baer: Hello, and thank you for joining us today on this Ropes & Gray podcast. I'm Ed Baer, a counsel in the San Francisco office of Ropes & Gray. Joining me today is my colleague in the asset management practice group, Paulita Pike, the managing partner of our Chicago office. In this podcast, which is part of a series of podcasts on ETF issues, we will discuss some of the recent developments relating to cryptocurrency ETFs and ETPs. I want to begin with a word about terminology. Paulita, can you explain what we mean when we talk about ETFs and ETPs?
Paulita Pike: Thanks, Ed. Absolutely. Well, we generally use the term ETFs when we talk about traditional 1940 Act exchange-traded funds, and we use ETPs, or exchange-traded products, when we talk about non-1940 Act funds that invest physical or “spot” crypto assets and also for certain futures-based products. As we will touch on in more detail a little bit later, one of the keys issues in determining whether a fund is an ETF or ETP is what the fund invests in. Broadly speaking, ETFs invest in securities (typically stocks and bonds), while ETPs invest in “physical” commodities like gold or silver, futures contracts or currencies. With crypto assets, there is considerable confusion, or at least a debate about, whether crypto assets are actually securities.
Ed Baer: That’s right, Paulita. The status of crypto assets in the United States is quite confusing. A few years back, the then director of the SEC’s Division of Corporation Finance asserted that bitcoin and ethereum, the two biggest crypto assets by market value, were not securities. That has remained the prevailing view, at least with respect to bitcoin and ethereum, but for evaluating other crypto assets, the SEC relies on a decades old court case involving interests in an orange grove to determine whether crypto assets are “investment contracts” and therefore securities under the federal securities laws. And it seems the more the SEC looks at crypto assets, the more they look like securities.
Paulita Pike: I totally agree, Ed. I don’t think we want to get bogged down in the debate over whether various crypto assets are securities, so for the rest of our discussion, I think it does make sense to treat physical or “spot” bitcoin and ethereum – the two crypto assets on which various firms have attempted to launch exchange-traded products – as non-securities. The types of products that sponsors have unsuccessfully sought to bring to market in the U.S. – spot bitcoin or ethereum ETPs – and the crypto asset products that have successfully been brought to market in the U.S. – funds that invest in bitcoin futures and contracts – implicate the distinctions between securities and non-securities. Ed, given the role you have played, do you think you can provide a little bit about the history of efforts to bring crypto asset products to market?
Ed Baer: I would be happy to. Back in 2013, the Winklevoss twins filed a registration statement for an ETP that would invest in spot or physical bitcoin. The proposal involved a type of structure called a grantor trust that would hold bitcoin. This structure attempted to replicate the structure of Gold or Silver ETPs, where the grantor trust holds the physical metal and investors can trade shares of the ETP on an exchange. The assumption behind this structural approach was that bitcoin was not a security, so the ETP could not be registered under the 1940 Act. That filing meandered its way through the SEC for several years. When I joined Ropes in 2016, I was hired to help get the project through the SEC approval process. And it was looking like we were making progress. In order to list an ETP on an exchange like the NYSE or Cboe, the ETP has to have an effective registration statement and its shares must be eligible for listing under the exchange’s listing rules. The registration statement seemed to be making slow but meaningful progress in the SEC’s Division of Corporation Finance. However, since there was no precedent in the exchange listing rules for ETPs that hold bitcoin or other crypto assets, the proposed listing exchange (Cboe BZX) had to petition the SEC’s Division of Trading and Markets to change the listing rules to permit ETPs that hold bitcoin. And that’s where the hurdles to launching a spot bitcoin ETP really came into focus.
Paulita Pike: That’s right. In 2017, the SEC’s Trading and Markets staff denied Cboe BZX’s request to change its listing rules to permit the listing of a bitcoin ETP. Cboe appealed that decision to the full Commission, and in 2018, in a non-unanimous decision, the Commission affirmed the disapproval of Cboe’s proposed rule change. The Commission’s rationale, which has been repeated over and over in numerous subsequent rule change proposal denials – most recently this week, by the way, when the SEC denied Greyscale’s attempt to convert its Bitcoin Trust into a listed ETP – is that the proposed listing exchange, was not able to demonstrate that its rules are adequately “designed to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” At issue is whether the listing exchange has a “comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying or reference bitcoin assets.” In the Winklevoss and Greyscale denials, and in numerous other SEC denials, the SEC concluded that the global 24/7/365 nature of the spot bitcoin market cannot be adequately surveilled by the listing exchanges. Greyscale and other sponsors have argued that the existence of a surveillance sharing agreement with the CME, which lists bitcoin futures contracts, is sufficient, but the SEC does not agree that that is enough for a spot bitcoin ETP.
Ed Baer: Exactly. And this is where things get interesting. Recently, the SEC approved the listing of the Teucrium Bitcoin Futures ETP. The Teucrium ETP invests only in bitcoin futures contracts traded on the CME. In approving the Teucrium proposal, the SEC acknowledged that the CME bitcoin futures market is a “regulated market of significant size,” but only with respect to CME bitcoin futures contract, not with respect to the underlying bitcoin markets. As a result, exchanges like NYSE Arca and Cboe BZX have surveillance sharing agreements in place with a regulated market of a significant size, but not with respect to the assets the bitcoin ETPs will hold.
Paulita Pike: So where does that leave things? We know that there are bitcoin ETPs in Canada, Australia and other countries that seem to be working just fine. Is the SEC ever going to approve a spot bitcoin ETP?
Ed Baer: Well, at some point the SEC’s hand may be forced. Shortly after the NYSE Arca proposal was denied, Greyscale asked the D.C. Circuit court to review the SEC’s denial of the proposal. And while the request for review did not mention the Administrative Procedures Act, Greyscale has in the past argued that the SEC’s denial of listings to spot bitcoin ETPs is inconsistent with the APA due to the fact that 1940 Act ETFs that invest in bitcoin futures contracts have been permitted by the SEC to launch and list their shares. In addition, they point out that the pricing of the CME bitcoin futures contracts is derived from the same group of U.S.-based crypto exchanges that are used to value the Greyscale Bitcoin Trust’s bitcoin holdings.
Paulita Pike: That provides us with an excellent opportunity to discuss the bitcoin futures ETFs. These ETFs purchase bitcoin futures contracts to gain exposure to the price of bitcoin futures. Because most of the assets of the ETFs are U.S. Treasury securities, they are considered 1940 Act ETFs and they do not require SEC approval to list their shares on an exchange. The first bitcoin futures ETF launched in October of 2021 and quickly raised over $1 billion in assets. Several others have since been listed. Since these ETFs seek to track the returns of bitcoin futures contracts rather than bitcoin itself, they provide a different exposure than the proposed bitcoin ETPs, but they remain the only exchange-traded products to pass SEC muster.
Ed Baer: That’s right. And until the SEC either changes its view about spot bitcoin ETPs, the underlying spot bitcoin markets become more regulated or Greyscale or others successfully sue the SEC, it’s possible that nothing will change in the near term. We have heard that there are several U.S.-based crypto exchanges that are considering becoming registered with the SEC as exchanges or alternative trading systems, so it’s possible that one or more U.S. crypto exchanges could become regulated markets of significant size for spot bitcoin. But the global nature of bitcoin trading, where a vast majority of bitcoin trading takes place on unregulated non-U.S. exchanges, suggests that regulation of U.S. crypto exchanges might not be the deciding factor. And litigation against the SEC, even if successful, will likely take years. It’s possible that the greatest hope to break the impasse is for the make up of the Commission, or at least the Commission Chair, to change, and that’s unlikely without a change in administration.
Paulita Pike: Well, that brings us to the end of the podcast. Ed and I want to thank all of you for joining us on this discussion of cryptocurrency ETFs and ETPs. For more information on the topics that we’ve discussed or other topics of interest to asset managers and ETF sponsors, please visit our website at ropesgray.com, where we have links to some additional materials regarding these topics. To help you better understand the current ETF landscape, we will be issuing several additional podcasts designed to provide a greater depth of analysis on important and timely ETF issues. If you have any questions regarding the topics we addressed or anything else, please don't hesitate to get in touch with one of us or whomever you have a working relationship with at Ropes & Gray. You can also subscribe and listen to the series of podcasts wherever you regularly listen to podcasts, including on Apple and Spotify. Thank you again for listening.
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