BlackRock’s spot BTC ETF is still a long shot

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BlackRock’s (NASDAQ: BLK) application to start a spot BTC exchange traded fund (ETF) has renewed optimism that such a product may finally make it past the U.S. Securities and Exchange Commission (SEC).

Since BlackRock’s filing on Friday, BTC has risen around 9%. The reason for the excitement is two-fold:

First, despite many attempts, no company has yet been able to convince the SEC to approve a digital asset-based ETF. Time and time again, the Commission has rejected such applications over concerns that the BTC spot market is too easily manipulated and subject to fraud.

Secondly, BlackRock has an impressive track record in getting ETFs approved by the SEC. According to Bloomberg analyst Eric Balchunas, the company has made 576 ETF applications over the years, and has been approved for all but one. That’s a 99.8% success rate.

But is the excitement justified?

The troubled history of BTC ETFs

An important note of clarity regarding the language surrounding these applications: it is the exchange the proposed ETF is to be listed on that must ultimately apply for authorization with the SEC. This is because exchanges must pass rule changes in order to list new products, and any rule change made by a registered exchange must be approved by the securities regulator. Rule changes must be consistent with Section 6(b)(5) of the Exchange Act, which requires that the rules of a securities exchange be designed “to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” Under the Act, the SEC is mandated to disapprove any rule changes which are inconsistent with those requirements.

It should be no surprise then that this has proven to be the choke point for hopeful BTC ETFs.

Spot BTC ETFs, like what BlackRock is proposing, should also be distinguished from ETFs that trade in BTC futures. The SEC has approved a number of products that fall into the latter category, while none which fall into the former category have ever been approved by the SEC.

The earliest attempt at getting a spot BTC ETF past the SEC was by Cameron and Tyler Winklevoss and their eponymous Winklevoss Bitcoin Trust. The ETF was intended to be listed on the Bats BZX. In support of the exchange’s application to the SEC, BZX argued that the “geographically diverse and continuous nature of bitcoin trading makes it difficult and prohibitively costly to manipulate the price of bitcoin” and that the BTC market “generally is less susceptible to manipulation than the equity, fixed income, and commodity futures markets.”

The SEC rejected the application. In its decision, it held that BZX had failed to demonstrate that the BTC market is inherently resistant to fraud and manipulation, particularly noting the nascent nature of the BTC market. In light of that, the only way BZX could satisfy the requirements of the Exchange Act is to enter into a surveillance-sharing agreement with at least one regulated market relating to BTC. It rejected BZX’s solution to enter into an agreement with the Winklevoss’ Gemini exchange because it is not neither a regulated market nor of a sufficient size in order to satisfy the Exchange Act requirements.

Following the Winklevoss denial, the SEC rejected the swathe of outstanding BTC ETF applications. The reasons were all similar: the market for the underlying BTC is not resistant to fraud and manipulation; BTC is not traded on any regulated market of sufficient size; the BTC market is in its early stages, and the SEC has no basis on which to predict how the market will develop over time.

The most recent and prominent of these attempts is, no doubt, the Grayscale Bitcoin Trust (GBTC). Operated by the Digital Currency Group (DCG)-owned Grayscale, the Trust holds BTC and, in theory, allows investors to gain exposure to the coin without holding it directly. The crucial distinction from an ETF, however, is that shares of GBTC can only be issued to accredited investors, and members of the public can only purchase on the secondary market—where it currently sits at a marked discount to the Trust’s net-asset value.

Grayscale has long promised that GBTC would eventually be converted into an ETF that would be listed on the BYSE Arca exchange. The SEC, however, has repeatedly rejected attempts to do so. The rejections ran along the same lines as those prior, though with the benefit of having experienced the past few years of turmoil in the industry. Among the factors listed were:

• the risk of wash trading in order to manipulate the BTC price,
• security vulnerabilities on the BTC network,
• the risk of insider trading or trading based on false or misleading information,
• potential manipulative activity enabled by stablecoins
• fraud and manipulation at BTC trading platforms

Grayscale, at least, seems ready to fight the SEC’s rejection to the bitter end. After yet another SEC rejection in July 2022, Grayscale sued the SEC on the basis that the rejection was a violation of the Administrative Procedure Act and the Exchange Act. In particular, they say that the SEC was wrong to reject their ETF while also approving ETFs that hold futures (futures-holding ETFs have been approved by the SEC on the basis that the futures are trading on a highly regulated and surveilled market, the Chicago Mercantile Exchange). The SEC explains the difference in treatment by saying that there is not sufficient evidence to conclude that manipulation on the spot market would be detected in the futures market.

BlackRock hopes

It is against that history that BlackRock enters the graveyard of BTC ETFs and hopes it can avoid the same fate.

In the proposal, BlackRock would establish the iShares Bitcoin Trust. BlackRock would partner with Coinbase (NASDAQ: COIN) to act as a custodian of the underlying BTC.

Indeed, even at this early stage, BlackRock is showing why the ETF proposal should be taken more seriously than prior attempts. According to the Nasdaq’s 19b-4 filing with the SEC, BlackRock has secured a surveillance sharing agreement between the exchange and a spot trading platform for BTC—a platform that BlackRock says represents a ‘substantial portion’ of U.S.-based BTC trading.

Taking BlackRock at its word, this means that BlackRock already has one significant advantage over prior ETF attempts. However, this spot platform is conspicuously not named by BlackRock, and the application makes clear that no such agreement is currently in place (“if the Exchange and the US BTC Spot Market Platform enter into such an agreement”). Until that happens, BlackRock’s chances should be considered as good as any of those who came before it.

Caution is especially warranted, considering that Coinbase’s name is all over the application. Coinbase, despite being the second-busiest exchange, is currently the subject of SEC charges over illegally listed digital asset securities. Coinbase was warned about this by both its internal risk assessment system and the SEC itself but continued to list assets it knew to be securities and now accuses the SEC of failing to provide clarity around securities rules. Analysts estimate that the action could wipe out more than 30% of Coinbase’s revenue—yet this is the company that BlackRock wants to hold all of the ETF’s BTC.

There’s also a world of difference between securing what BlackRock calls a surveillance sharing agreement and the kind of surveillance sharing agreement that would assuage the SEC’s concerns enough to secure its approval.

There’s another big question left functionally unanswered by the BlackRock application: how it plans on determining the BTC spot price in assessing the NAV of the Trust. The application says that the ‘Sponsor’ (BlackRock’s subsidiary) has the ‘exclusive authority’ to determine the Trust’s NAV, a power which it has delegated to an unnamed ‘Trust Administrator.’ That Administrator is responsible for calculating the value of the BTC held by BlackRock based on the CF Benchmarks Index. The CF Benchmarks Index is calculated each day by aggregating the notional value of BTC trading activity across ‘major’ spot exchanges.

Most importantly, however: BlackRock can decide ‘in its sole discretion’ not to use the Index at any point, and instead value the BTC in its holdings according to whatever policy BlackRock comes up with.

This is important because BTC’s spot price is heavily influenced by wash trading, insider trading, and, most significantly, routine price pumping via unbacked tethers. As has been conclusively shown by the New York Attorney General’s Office and continues to be shown by every subsequent attempt by Tether to show that its stablecoin is backed by real reserves, tethers are not fully backed by U.S. dollar or its equivalents. This means that all of tether’s regular billion-dollar prints are nothing more than printing fake money: the trouble is that exchanges like Coinbase are happy to accept them in exchange for BTC because it represents an enormous boost in trading activity, from which Coinbase skims its fees.

All this unbacked, worthless tether filtering through the system and artificially inflating asset prices provide a further boon to market participants who are happy to accept the lie. The SEC, on the other hand, will not.

Is there a chance?

The SEC’s primary focus in denying past ETF applications is the risk of market manipulation and wash trading in the spot market. Whether BlackRock’s Nasdaq application is accepted will largely come down to whether it can convince the SEC it has sufficiently mitigated these risks.

Unfortunately, BlackRock is now likely facing a sterner regulatory environment than even Grayscale faced in 2022. The FTX collapse shined a light on the audacious fraud taking place within the industry, even under the noses of regulators and lawmakers. The SEC, the great ETF gatekeeper, has since taken action against the two largest digital asset exchanges in the world on the basis of illegally selling digital asset securities. One of those exchanges, Binance, is specifically accused of market manipulation and wash trading. A report on digital asset wash trading at the end of 2022 by the National Bureau of Economic Research suggested that 80% of digital asset trading could be fraudulent. Concordantly, other regulatory and enforcement bodies have stepped up their own activities: the New York Attorney General took a similar action against the KuCoin exchange, while the U.S. Department of Justice is honing in on Binance over money laundering and sanctions violations.

If the largest exchange in the world is itself guilty of manipulating digital asset spot markets, then it’s tough to see the SEC ever being comfortable that the spot market is sufficiently resistant to warrant the approval of a spot ETF.

Worse still, despite being held up as a reason why the SEC should approve a spot ETF, there’s no joy to be found in the derivative BTC ETFs either. After launching to become the world’s first BTC-linked ETF in 2021, ProShares Bitcoin Strategy ETF (BITO) has lost 70% of its value, which is reported by the FT as being the sixth-worst-performing debut ETF of all time. Given that BTC was valued at $61,410 at the time, BITO has largely achieved its goal of allowing investors to gain exposure to the joys of BTC without holding it directly. However, that’s precisely the kind of success regulators are trying to protect investors from.

Speaking of investor protection, BTC as an asset is far less of a secure proposition than it was the last time the SEC was rejecting spot ETFs. Since Grayscale’s last rejection, the entire BTC Core partnership as well as exchanges Kraken and Coinbase, have been sued in the U.K. for ‘passing off’ BTC as the original Bitcoin. Should that case succeed (and there’s good reason to believe it will), then exchanges will be unable to list ‘BTC’ as Bitcoin and would likely end up paying existential amounts of restitution to both the inventor of Bitcoin and the countless investors they have essentially tricked into buying BTC. Faced with that prospect, is the SEC at all likely to give a rubber stamp to an ETF based entirely on BTC?

All in all, despite the market seeming upbeat about the BlackRock news, the deck is still heavily stacked against the proposed ETF.

It’s entirely possible BlackRock knows all of this, and isn’t giving the proposal much chance. BlackRock may simply have one eye on Grayscale’s case against the SEC, which is expected to resolve this year. This latest application may simply be about getting its foot in the door in the unlikely event that Grayscale makes progress in courts. You need only see the minor deluge of applications that came after BlackRock announced its new proposal for an example of this in action: the potential spoils of being among the first spot BTC ETFs are enormous, so any hint of regulatory concession on that front is going to cause a flurry of applications, just as the Winklevoss’ did in 2018.

With the Nasdaq’s filing of the 19b-4 form, the SEC is now obligated to issue a decision on the application within 240 days. It remains to be seen which side of the historical record will repeat itself: either the SEC rejects BlackRock’s ETF on the same basis it has rejected all those that came before it, or BlackRock continues its near-perfect record and secures the first-ever spot BTC ETF.

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