Is Grayscale’s Court Victory the Tipping Point for Bitcoin?

On Tuesday, August 29, 2023, Grayscale Investments, LLC (“Grayscale”) obtained a significant court victory in its battle with the Securities Exchange Commission (“SEC”) for approval of an Exchange Traded Product (“ETP”) based upon the spot price of Bitcoin.[1]

In a 3-0 ruling, the D.C. Circuit Court of Appeals ruled that the SEC’s denial of Grayscale’s request to convert its closed-end fund to an exchange-traded product (“ETP”) was arbitrary and capricious, thereby sending the application back to the SEC for further review. Whether the SEC will now approve the ETP or will attempt to come up with new reasons for its denial is an open question. However, because the Court’s opinion was based upon the fact that the SEC cannot treat Grayscale’s application differently than the two Bitcoin futures ETPs that the SEC previously approved, the Court’s opinion appears to give the SEC very little room to come up with new reasons for the denial of the application. Short of a successful appeal by the SEC, the Court’s opinion is likely to pave the way for the approval of an ETP based on the spot price of Bitcoin.

Grayscale has managed a trust known as GBTC for several years, which currently holds approximately 3.4% of all mined Bitcoin. Initially, this trust presented many investors with a straightforward avenue to invest in Bitcoin without the need to register on platforms like Coinbase. However, because the trust is structured as a closed-end fund for accredited investors and its shares are not traded on an exchange, the trust trades at a discount to its underlying asset’s valuation. This divergence became especially pronounced in January 2023, when the discount reached 48%. Grayscale has long argued that conversion of the trust to an ETP will benefit investors by eliminating the discount to NAV. The Court appeared to agree, noting that “[a]n exchange-traded product may offer continuous share redemption and creation, allowing arbitrage to prevent the product’s price from deviating too far from the value of its underlying assets. Listing on an exchange is desirable because it helps eliminate this discount.”    

Over the last two years, Grayscale and others sought SEC approval for an ETP based on the spot price of Bitcoin. The SEC denied all of the applications for the same reason – namely that the applications failed to show that the product was “designed to prevent fraudulent and manipulative acts and practices” and “failed to satisfy the significant market test.” In denying these applications but approving the futures ETP,  the SEC reasoned that the Bitcoin futures market was relatively free from the risk of price manipulation and could be sufficiently monitored for fraud, and therefore, the futures ETPs did not have to make a showing that they had satisfied the significant market test. Conversely, the SEC claimed that Grayscale and other applicants had failed to demonstrate that the spot price market could be properly surveilled, was relatively free from the risk of price manipulation, and failed to make the proper showing under the ‘significant market test.’

From Grayscale’s perspective, the SEC’s position made little sense because it believed there was no meaningful difference between its ETP and the two ETPs (Teucrium and Valkyrie) approved by the SEC that held Bitcoin futures contracts. It seemed obvious to Grayscale that the SEC was treating its application inconsistently with the two ETPs trading Bitcoin futures. The Court agreed.

According to the Court, Grayscale “advanced substantial evidence that its proposed bitcoin ETP was similar to the Teucrium and Valkyrie bitcoin futures ETPs and therefore should have received the same regulatory treatment.” Most persuasive was Grayscale’s uncontested evidence that there is a 99.9 percent correlation between Bitcoin’s spot price market and CME futures contract prices. Given this correlation, Grayscale argued, and the Court agreed, that any fraud in the spot price of Bitcoin would be reflected in the futures market. And because the exchanges for the futures ETPs and the listing exchanges for the proposed Grayscale ETP have identical surveillance sharing agreements with the Chicago Mercantile Exchange (“CME”), manipulation in either market will affect the price of bitcoin futures.   

The Court found “salient” similarities between the Grayscale proposed ETP and the futures ETPs, leaving the SEC to try and justify its disparate treatment solely through the application of the “significant market test.” Grayscale successfully argued that the SEC’s application of the significant market test was arbitrary and capricious because the SEC never required the futures ETPs to make a showing that they had satisfied the test.

For example, the SEC reasoned that the Bitcoin futures ETPs did not need to show whether a person attempting to manipulate the futures ETPs would have to trade on the CME, presumably based on the SEC’s belief that the spot market could not manipulate the futures market. Indeed, the futures ETPs never addressed the question of whether a person attempting manipulation of the futures products could do so through trading Bitcoin. Yet, with the Grayscale application, the SEC required Grayscale to address this first prong of the test. The Court ruled that this amounted to inconsistent treatment, and the SEC’s reasoning for the inconsistent treatment was arbitrary and capricious.

Similarly, the SEC required Grayscale to demonstrate that the futures market leads the spot market. Because the evidence of the lead/lag relationship was inconclusive, the SEC discounted the connection between the two markets. Again, the Court ruled that because the SEC failed to require the same showing by the two futures ETPs and was unable to explain why it treated the two differently, its denial of Grayscale’s application was arbitrary and capricious.    

The Court concluded by stating that the SEC’s “reasons for approving the Teucrium and Valkyrie ETPs seem to apply equally to Grayscale, but Grayscale’s listing was denied. Lacking a “reasonable and coherent explanation for the[se] seemingly inconsistent results, the Commission’s order in this case is arbitrary and capricious.”

The Court’s decision leaves the SEC with three choices: (i) appeal; (ii) attempt to come up with new reasons for the inconsistent treatment that are not arbitrary or capricious; or (iii) approve the Grayscale application. It will be extremely difficult for the SEC to come up with new reasons to deny the application, given the Court’s reasoning and the fact that the SEC approved the two futures ETPs. This leaves them with appeal or approval. Given the tremendous pressure from financial institutions and investors for approval and little reason to believe the SEC will be successful on appeal, it seems likely that the SEC will eventually approve the Grayscale application and that this decision is the “tipping point” for Bitcoin’s mainstream acceptance as an investment asset.