The Securities and Exchange Commission declined on August 22 to approve rule amendments proposed by NYSE Arca, Inc. and Cboe BZX Exchange, Inc. to authorize the listing and trading of shares of nine exchange-traded funds that planned to seek exposure to some or all of the bitcoin futures contracts traded on the Chicago Mercantile Exchange, Cboe Futures Exchange and/or any other US exchange that subsequently traded such contracts. This denial was by the SEC’a Division of Trading and Markets pursuant to “delegated authority.” However, on August 23, the Commission stayed staff’s denial and indicated it would review the delegated action (click here for a sample stay order).

Generally, said the SEC, where there is risk of manipulation in a market relevant to an ETP, the listing securities exchange should have a surveillance-sharing agreement with a regulated market of significant size in order to “provide a necessary deterrent to manipulation because [such agreements] facilitate the availability of information to fully investigate a manipulation if it were to occur.”

However, although acknowledging that both CME and CFE are markets regulated by the Commodity Futures Trading Commission, SEC staff said they were not markets of significant size because of their relative newness and low volume. Thus, claimed SEC staff, surveillance-sharing agreements with CME and CFE did not meet the SEC’s requirements.

In evaluating the CME and CFE bitcoin futures contracts, the SEC considered the median daily notional trading volume from the contracts’ inception in December 2017 through August 10. However, on CME, the daily notional value of bitcoin futures contracts traded materially increased 93 percent from the first to second quarter, averaging a notional volume of 17,885 bitcoins and an open interest of 12,025 bitcoins/day during the second quarter. (Click here for further details; each CME bitcoin futures contract is based on five bitcoin.) The SEC said it was difficult to compare the notional size of the CME and CFE bitcoin futures markets with the overall size of the spot bitcoin market.

Earlier this month, the SEC disapproved a proposed rule change by the Bats BZX Exchange, Inc. to permit its listing and trading of shares of the Winklevoss Bitcoin Trust. The SEC denied BZX’s application, claiming that its proposed rule change was not consistent with requirements of applicable law, mainly “to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” (Click here for background in the article “SEC Says 'No' to Winklevoss Bitcoin Trust While NFA Says 'Yes' to Intermediaries’ Crypto Businesses but Requires Disclosures” in the August 5, 2018 edition of Bridging the Week.) In a dissenting opinion, Commissioner Hester Peirce criticized the Commission for focusing its attention on spot markets in bitcoin, and not on the ability of the exchange listing the relevant ETP to detect and deter potential manipulation. (Click here to access Ms. Peirce's opinion.)

My View: I am not clairvoyant and have no crystal ball that tells me whether bitcoin or any altcoin will succeed or fail. Likewise, I have no particular insight into whether bitcoin or any altcoin traded peer to peer on a relevant blockchain or on any particular spot exchange is more or less susceptible to manipulation than any other commodity on which a futures contract today may be based. That being said, certainly on some spot crypto exchanges – those licensed by the New York Department of Financial Services – there is an express obligation for regulated entities to surveil markets for potential improprieties. (Click here for background in the article “NYS Financial Services Regulator Ups the Obligations of State-Licensed Virtual Currency Entities” in the February 11, 2018 edition of Bridging the Week.)

However, in any case, the proposed ETPs disallowed by the SEC are not based on spot bitcoin prices; they are based on bitcoin futures prices derived from trading on exchanges regulated by the CFTC.

Although there may be reasonable doubt as to the surveillance capabilities of spot bitcoin exchanges at this point despite evolving requirements, both CME and CFE, as part of their self-certification process to be allowed to trade bitcoin futures, affirmed that their contracts complied with relevant law and CFTC requirements, including that their contracts were not readily susceptible to manipulation. The CFTC did not challenge this self-certification. Moreover, the exchanges’ certification reflected their acknowledgment that they had “the capacity and responsibility to prevent manipulation, price distortion, and disruptions of the delivery or cash-settlement process through market surveillance, compliance practices and procedures.” (Click here to access Core Principle 4 for designated contract markets, Appendix B to CFTC Part 30 rules.)

Additionally, as part of the self-certification process of CME’s and CFE’s bitcoin futures contracts, both exchanges apparently “agreed to significant enhancements to contract design and settlement … at the request of Commission staff, as well are more information sharing with the underlying cash bitcoin exchanges to assist [the exchanges] and the CFTC in surveillance.” (Click here for background in the “CFTC Statement on Self-Certification of Bitcoin Products by CME, CFE and Cantor Exchange," (December 1, 2017). Click here for a related CFTC Backgrounder.)

Notwithstanding, SEC staff declined to approve ETPs based on such bitcoin futures contracts because, supposedly, NYSE Arca and Cboe BZX Exchange did not have surveillance sharing agreements with markets of significant size. The SEC cited the low volume and open interest of CME’s and CFE’s relatively new bitcoin futures contracts to support its position. However, very few new futures contracts start with very high volume and at least the CME’s bitcoin futures contract appears to be growing in popularity.

In light of applicable CFTC requirements, it seems reasonable where an ETP is based on a futures contract traded on a CFTC-regulated exchange, that an information sharing agreement with such an exchange should be sufficient to satisfy a listing securities’ exchange’s obligation to ensure its rules are “designed to prevent fraudulent and manipulative acts and practices [and] to protect investors and the public interest.” (Click here to access Securities Exchange Act Rule § 6(b)(5), 15 U.S. Code § 78f(b)(5).) Hopefully, when the full Commission reconsiders its staff’s determination, it will give more deference to the CFTC’s requirements and practices and at least not use the purported lack of a surveillance sharing agreement with a market of significant size as a basis to decline these new products.