The SEC failed to prove that dog wags tail, court rules

Receive free Bitcoin updates

We’ll send you a myFT Daily Digest email rounding up the latest Bitcoin news every morning.

A panel of three judges ruled today that the Securities and Exchange Commission was “arbitrary and capricious” in its decision that . . . spot markets are fundamentally different from futures markets?

Hold on.

For some background: a US district court vacated the SEC’s decision that prevented Grayscale from converting its closed-end GBTC fund into a spot bitcoin ETF. Grayscale had been trading at a persistent discount to the net asset value, under the presumption that investors wouldn’t be able to claim their bitcoin legally.

Bitcoin is up 7.5 per cent Tuesday. Grayscale’s Bitcoin Trust is up 18 per cent. Even Coinbase is rallying, up 16 per cent.

But the court’s decision, on its face, is a little odd. Judge Neomi Rao writes:

RAO, Circuit Judge: It is a fundamental principle of administrative law that agencies must treat like cases alike. The Securities and Exchange Commission recently approved the trading of two bitcoin futures funds on national exchanges but denied approval of Grayscale’s bitcoin fund.

Petitioning for review of the Commission’s denial order, Grayscale maintains its proposed bitcoin exchange-traded product is materially similar to the bitcoin futures exchange-traded products and should have been approved to trade on NYSE Arca. We agree. The denial of Grayscale’s proposal was arbitrary and capricious because the Commission failed to explain its different treatment of similar products. We therefore grant Grayscale’s petition and vacate the order.

Similar products . . . wait, what type of similar products do they mean?

In this case, the court means Bitcoin futures ETFs:

“This tight correlation is not a coincidence: bitcoin futures prices are ultimately based on spot market prices. Bitcoin futures trade based on predicted settlement prices that are in turn calculated using the Bitcoin Reference Rate. The Reference Rate, like the CoinDesk Index, aggregates spot prices from multiple exchanges. Id. at 40,317. Four of the six exchanges are shared between the indices. See id. at 40,318. A study conducted by a finance professor and expert on derivative contract valuation found the CoinDesk Index and the Reference Rate are ‘near perfect substitutes.’”

In other words, the bitcoin market’s arbitrageurs have done a good job arbitraging. (As their reward for this, they are getting more opportunities for arbitrage.)

But was the SEC’s issue with a Grayscale ETF really about whether the spot market and futures market trade closely enough?

Or is it that there is no reasonable way to ensure that a global over-the-counter market gets appropriate surveillance, and that by allowing Grayscale to further liquefy it, the US is helping the types of sketchy stuff that can happen in a global over-the-counter market?

From the ruling:

When approving the bitcoin futures ETPs, the Commission acknowledged the risk of fraud to bitcoin futures from “trading outside of the CME bitcoin futures market,” such as trading in the spot market. Teucrium Order, 87 Fed. Reg. at 21,679; Valkyrie Order, 87 Fed. Reg. at 28,851. Huh.

This was an important problem to address for the futures ETPs because futures markets “are hard to manipulate . . . because of actual and potential competition from the cash commodity,” so the primary risk is often in the spot market. See Frank H. Easterbrook, Monopoly, Manipulation, and the Regulation of Futures Markets, 59 J. Bus. S103, S103 (1986). Fraud and manipulation in the bitcoin spot market pose a similar risk to both futures and spot products. Because the spot bitcoin market and the CME bitcoin futures market are so tightly correlated, a price distortion in the spot market will be reflected in the price of the futures market. After all, futures are derivatives of the spot market.

The SEC did not suggest the 99.9 per cent correlation was coincidence or caused by some third variable. We recognise the basic principle that mere correlation does not equal causation. But here the correlation was based on the logical and mathematical connection between the spot and futures markets. In this context, the almost perfect correlation was at least strong evidence of causation. And the Commission failed to explain why a surveillance sharing agreement with the CME was sufficient to protect bitcoin futures ETPs from potential fraud, but not Grayscale’s proposed bitcoin ETP.

Wait, what?

It’s definitely reasonable to say that bitcoin futures face risk from manipulation or fraud in the spot bitcoin market, of course.

But to say that spot bitcoin markets are sufficiently regulated because the CFTC regulates its futures markets seems . . . odd. Wouldn’t that mean the CFTC implicitly regulates every market where it lists futures, through some weird transitory property of arbitrage? For example, few would argue that the CFTC’s regulation of Treasury futures makes it unnecessary for the SEC to oversee Treasury-trading platforms. (In fact, the Treasury flash rally in October 2014 provides a helpful demonstration of what can go wrong in unregulated cash trading.)

There is, however, one actual example of an ETF trading today that is similar to a spot bitcoin ETF: the SPDR Gold Trust, which listed in November 2004 and is backed by gold bullion held in a vault.

What gold and Bitcoin have in common is that they are both money-transfer vehicles that are said to be popular for money laundering, crime, and cross-border capital flight. They are both quite popular in libertarian political circles, and trade on global over-the-counter markets that are impossible to thoroughly surveil.

If anything, gold markets are actually tougher to regulate than bitcoin because — lest we forget — bitcoin is pseudonymous, not anonymous.

If State Street can float a gold ETF backed by physical gold in a vault, it doesn’t seem unreasonable to think that Grayscale can make its fund of spot bitcoin into an ETF.

Now, one could pretty easily argue use this argument to say that the US shouldn’t be listing ETFs backed by spot gold.

Or you could take the other side, like Doug Cifu of Virtu Financial:

“Political Gary getting pants again” is an inspired turn of phrase from [at]Dougielarge.

It’s rather esoteric, of course . . . what does “getting pants” mean? Does he mean “getting pantsed”, as in the thing where a middle-school bully pulls someone’s pants down between classes?

And most important: does “Political Gary [Gensler]” imply the existence of an “Apolitical Gary [Gensler]”?