On July 26, 2018, the US Securities and Exchange Commission (SEC) denied an application for the Winklevoss brothers—of Facebook fame (and fortune)—to launch the first bitcoin-based exchange-traded fund (ETF) that would allow investors to invest in bitcoin without actually owning the cryptocurrency.1 The SEC originally disapproved their Bats BZX Exchange, Inc. (BZX) proposal in March 2017 but granted their petition for review. Following a de novo review of the proposal, the SEC again rejected it, by a vote of 3-1 (Commissioner Michael Piwowar had already departed).

In a 92-page order, while noting that it was not passing judgment on bitcoin itself, the SEC rejected BZX’s proposal to track the price of bitcoin on a proprietary crypto-exchange platform known as Gemini Exchange. The SEC concluded that the exchange had not met its burden of demonstrating that the proposed plan complied with Section 6(b)(5) of the Exchange Act, which requires that national securities exchanges be “designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest.”2

The SEC previously found that in order to meet this standard an exchange that lists and trades shares of commodity-trust exchange-traded products, like the ETF at issue, must have surveillance-sharing agreements with significant markets for trading the underlying commodity, and those markets must be regulated.3 BZX argued that a surveillance-sharing agreement with the listing exchange and significant regulated markets is not the only way to satisfy the requirement that the exchange be designed to prevent fraud and manipulation; rather, traditional measures to detect and deter manipulation are sufficient.

The SEC disagreed, finding that bitcoin is susceptible to manipulation thereby necessitating a surveillance-sharing agreement with at least one significant, regulated bitcoin market. But since the significant worldwide markets for bitcoin are not regulated, any surveillance-sharing agreements would not address fraud and manipulation concerns.

BZX argued that such concerns are exaggerated and that the bitcoin market is actually less prone to fraud and manipulation because the round-the-clock nature of bitcoin trading and the decentralized blockchain on which bitcoin is built “makes it difficult and prohibitively costly to manipulate the price of bitcoin.”4 But the SEC was not persuaded that the bitcoin market is sufficiently resistant to manipulation. While it found that bitcoin’s unique features may mitigate certain concerns, they do not eliminate the need for surveillance-sharing agreements to monitor for fraud and manipulation. Finally, the SEC noted that it could be open to a bitcoin ETF in the future, acknowledging that “regulated bitcoin-related markets may continue to grow and develop” to allow exchanges to achieve the type of surveillance information necessary to secure approval for such a product.

Commissioner Hester Peirce offered a vigorous dissent to the SEC’s order.5 She argued that the SEC erred in its ruling and, in fact, exceeded its authority. Peirce noted that the SEC’s mission has historically been to ensure that investors have the information they need to make intelligent investment decisions and that the rules of the exchange are designed to provide transparency and prevent manipulation. Yet Peirce argued that the SEC went beyond this limited role and engaged in “merit regulation” by focusing “on the quality and characteristics of the markets underlying a product [i.e., the bitcoin market] that an exchange seeks to list.”6

Peirce further argued that the SEC’s concerns that bitcoin’s underlying markets are subject to manipulation apply to many other previously approved exchange-traded products. By rejecting the bitcoin ETF, she said that the SEC did not consistently apply its rules. Finally, Peirce argued that the SEC’s decision would be harmful to investors by denying them the opportunity to explore investments in the burgeoning cryptocurrency space on a regulated exchange and would possibly stifle regulated growth of this asset class. She concluded:

If we were to approve the ET[F] at issue here, investors could choose whether to buy it or avoid it. The Commission’s action today deprives investors of this choice. I reject the role of gatekeeper of innovation—a role very different from (and, indeed, inconsistent with) our mission of protecting investors, fostering capital formation, and facilitating fair, orderly, and efficient markets.7

Cryptocurrencies have made significant strides into mainstream investing in the past several years, including obtaining recognition and regulation by the SEC and other federal regulators. But approving an investment product based on the underlying bitcoin market was apparently one step too far for the SEC. While it seems likely that cryptocurrency-based investment products will be available on regulated exchanges in the future, the current exchanges and markets for bitcoin and cryptocurrencies need to develop further before the SEC can gain comfort that any such exchanges or products meet the requirements of federal securities laws.