The legal regulatory logic behind Bitcoin spot ETFs

Written by: Will 阿望

After a decade of arduous approval processes, the BTC ETF has finally seen the light of victory. At 4 AM on January 11, 2024, the U.S. Securities and Exchange Commission (SEC) simultaneously approved 11 spot BTC ETFs, including: Bitwise, Grayscale, Hashdex, BlackRock, Valkyrie, Invesco, Ark, VanEck, WisdomTree, Fidelity, and Franklin.

All of this should be credited to Grayscale's legal victory. On August 29, 2023, a ruling by a U.S. federal court allowed Grayscale to win its lawsuit against the SEC for rejecting its application for a spot BTC ETF. This move accelerated the process for traditional financial giants like BlackRock and Fidelity to apply for BTC ETFs in recent months.

This article will examine the SEC's change in attitude following Grayscale's victory (actively recognizing market manipulation risks) from a regulatory perspective, the logic behind the approval of BTC ETFs, and the SEC's continued stance that other crypto assets are securities, indicating a cautious approach to market risks.

1. Court Ruling Accelerates SEC Approval Process

The SEC previously did not approve BTC ETFs due to concerns about market fraud and manipulation. All rejected ETF applications cited the securities law's focus on "protecting investors from market fraud and manipulation" (the products were not designed to prevent fraudulent and manipulative acts and practices).

The SEC first allowed trading of futures BTC ETFs in 2021, stating that futures products are harder to manipulate because the market is based on futures prices from the Chicago Mercantile Exchange (CME), which is regulated by the Commodity Futures Trading Commission (CFTC).

In the case, Grayscale argued that the logic for approving futures BTC ETFs should be equivalent to that for approving spot BTC ETFs; otherwise, all futures BTC ETF applications should be revoked. The judge agreed, finding that the SEC's rejection of Grayscale's application was arbitrary and without basis (acting arbitrarily and capriciously) because the SEC failed to explain how it treated similar ETF products differently. The court deemed this differential treatment a violation of administrative law, agreeing with Grayscale's request and overturning the SEC's rejection.

It wasn't until after the Grayscale case that the SEC's attitude completely shifted from passively denying applications to actively reviewing them, stating in a 22-page approval document: This order approves the Proposals on an accelerated basis.

2. What Risks Does the SEC Identify for BTC ETFs?

As a long-established compliant financial product, ETFs face no legal barriers, and BTC is the only asset defined by U.S. regulators (especially the SEC) as a "non-security." So where are the risks for BTC ETFs?

In the 22-page approval document, the SEC informs us that the risks stem from the uncontrollable trading market of the ETF's underlying assets—specifically, the manipulation risks in the BTC spot market.

While each ETF has signed surveillance sharing agreements with compliant regulatory exchanges (like CME) to monitor the risks in the BTC futures market, the BTC spot market itself does not trade on CME, meaning monitoring cannot cover the BTC spot market.

BTC futures on CME are already compliant products. Therefore, demonstrating the price correlation between BTC spot and BTC futures on CME is the best option. Consequently, the SEC compared the BTC prices from two crypto exchanges, Coinbase and Kraken, with CME futures prices starting from 2021 and found a high correlation between the two. This means that if fraudulent or manipulative behavior occurs in the BTC spot market, it is likely to also affect the futures market, which would be detected by CME's monitoring system, allowing regulators to intervene and control risks.

3. Market Manipulation in the BTC Spot Market

The risk of market manipulation in the BTC spot market primarily comes from market makers or participants trading on centralized exchanges (CEX). If U.S. regulators can cover CEX with oversight, they can manage risks relatively effectively.

To this end, U.S. regulators have taken steps to ensure compliance by overseeing Coinbase and Kraken, while also "targeting" the largest trading volume exchange, Binance, successfully establishing compliance controls.

4. Neutral SEC and Cautious Gary Gensler

Thus, the neutral SEC evaluates whether the rules submitted by national securities exchanges comply with the Securities Exchange Act and its provisions, including whether they aim to protect investors and the public interest. At 4 AM on January 11, 2024, the SEC approved 11 spot BTC ETFs, including: Bitwise, Grayscale, Hashdex, BlackRock, Valkyrie, Invesco, Ark, VanEck, WisdomTree, Fidelity, and Franklin.

More importantly, the SEC stated in its press release:

This SEC ETF approval is limited to ETFs holding one "non-security" commodity (BTC). It should not imply that the SEC is willing to approve any other crypto asset securities' listing standards. The approval does not indicate the SEC's views on the status of other crypto assets under securities law or the current situation of certain crypto asset market participants not complying with securities law.
As I have said before, the vast majority of crypto assets are investment contracts and thus fall under securities law.
While the SEC is neutral, I must point out that the underlying assets in precious metals ETFs have consumption and industrial uses, whereas BTC is primarily a speculative, volatile asset, also used in numerous illegal activities, including ransomware, money laundering, evading sanctions, and financing terrorism.
Although the SEC approved the listing and trading of spot BTC ETFs today, we have not approved or endorsed BTC. Investors should remain cautious regarding BTC and products related to crypto assets.

5. Pressure on Coinbase—Defining Crypto Assets

Gary Gensler's statements are very clear: BTC is not a security, and market risks can be controlled, so approval is possible. Other crypto assets are securities, which is another story and has no relation to whether BTC ETFs are approved.

This still circles back to Gary Gensler's continued avoidance of directly answering the question, "What types of crypto assets are securities?" This is a regulatory compliance issue for the SEC concerning the three largest exchanges: Kraken, Coinbase, and Binance, as well as a political game regarding the responses required from U.S. judicial and legislative bodies.

Coinbase has been at the forefront of the fight against the SEC, shouldering this heavy burden. Judge Katherine Polk Failla previously referred to ETH as a commodity in the Uniswap case. Considering that this judge is also presiding over the SEC v. Coinbase case, her response regarding whether crypto assets are "securities" was: "This situation is not determined by the court, but by Congress," throwing this ultimate question back to the U.S. legislative body—Congress.

However, the legislative process in Congress will be very lengthy, and the 2024 election year is worth looking forward to.

6. GM BTC ETF

Regardless of how the SEC performs, the approval of BTC ETFs is historically significant, allowing those of us who harbor the ideals of crypto punks or dreams of overnight wealth to be part of it, adding a vibrant splash of color to the torrent of history.

As Wang Chuan said: "January 10, 2024, in the context of world monetary history, looking back, it may be comparable to August 13, 1971 (when Nixon announced the decoupling from gold) and January 18, 1871 (when Germany unified, leading European countries and the U.S. to join the gold standard system in the following years)."