SEC faces unusual dilemma as court confirms Grayscale order

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The U.S. Court of Appeals for the D.C. Circuit has issued a formal mandate confirming its earlier decision ordering the Securities and Exchange Commission (SEC) to review its rejection of the Grayscale spot Bitcoin exchange-traded product (ETP).

The original decision was made on August 29, with the U.S. Court of Appeals ruling that the SEC had not adequately explained its denial of the ETP application. In particular, the three-judge panel ruled that Grayscale’s proposed fund was ‘materially similar, across relevant regulatory actors’ to the already-approved ETPs that hold Bitcoin futures. As a result, the SEC would have to go back and review the Grayscale application.

The SEC’s deadline to appeal passed last week with no action from the commission, triggering a seven day window for the court to issue the formal mandate confirming its decision—which the court did today.

Though the filing has no effect other than to confirm August’s decision, it does highlight the unique situation currently faced by the SEC. At the time of that decision, the SEC was reviewing multiple applications that are fundamentally the same as that made on behalf of Grayscale, including from BitWise, BlackRock, and iShares. Those decisions were expected imminently at the time of the Grayscale ruling. Presumably, the SEC would have denied those applications on the same or similar grounds as the Grayscale one.

On that basis, it makes sense to assume that the decision—in effect—sent the SEC back to the drawing board with respect to those other applications, too. Indeed, shortly after the August decision, the SEC notified the other ETP applicants that it was extending the deadline for a decision by 45 days. The decisions were subsequently pushed into January of 2024, but a surprise Grayscale approval would likely make those applications a foregone conclusion.

However, decisions on these applications are falling due to a highly charged time for the digital asset industry, and politicians are becoming increasingly involved in the conversation around the SEC and its approach to digital assets.

Just last month, a group of U.S. politicians wrote to Gary Gensler and the SEC, urging them to immediately grant the outstanding ETP requests. The letter ran extraordinarily close to the language used in Grayscale’s own filings against the SEC, and their interpretation of the August judgment ordering the SEC to re-do its decision-making is charitable, to say the least:

“In its decision, the Court of Appeals held that Grayscale’s proposed bitcoin ETP is ‘materially similar, across relevant regulatory factors, to the approved bitcoin futures ETPs.’ It further found the SEC’s ‘unexplained discounting of the obvious financial and mathematical relationship between the spot and futures markets falls short of the standard for reasoned decision making.’ The Court of Appeals concluded that ‘in absence of a coherent explanation, this unlike regulatory treatment of like products is unlawful.’ The court’s finding underscores the fundamental point. A spot bitcoin ETP is indistinguishable from a bitcoin futures ETP. Thus, the SEC’s current posture is untenable moving forward.”

The letter somehow overstates the decision of the Court of Appeals. The court’s sole focus was on the adequacy of the explanation contained in the SEC’s rejection. Even then, the ruling ultimately focused on a failure by the SEC to explain why spot BTC ETPs should be treated differently from the already-approved futures ETPs as opposed to any failure to set out investor protection concerns arising from a spot BTC ETP. The ruling (as quoted directly in the letter) that the SEC had not provided an adequate explanation does not amount to a ruling that no adequate explanation exists.

It’s necessary to remember that in deciding whether to admit a proposed ETP, the SEC is mandated by law to decline any proposal unless it is consistent with the Securities Exchange Act, the legislation governing exchanges. In particular, any proposal must be ‘designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade’ and ‘to protect investors and the public interest.’

At the same time, the Administrative Procedure Act (APA) prevents public decision-makers from making ‘arbitrary and capricious’ decisions, which meant that the primary focus of the court in reviewing the SEC’s Grayscale rejection was on its earlier decision to grant the futures ETP.

The first Bitcoin futures ETP was approved in October 2021, and in the time since, the digital asset industry has undergone a dramatic upheaval thanks to multiple high-profile collapses (Terra and Three Arrows Capital [3AC] along with the FTX crash—to name a few) arising from fraud. It’s impossible to know if the SEC would have approved the futures ETPs with the knowledge they have today, but either way, the SEC’s hands are somewhat tied by their earlier decision thanks to the APA. It’s conceivable that it’s impossible for the SEC to adequately justify an ETP refusal in 2023, given it must be consistent with its own decision made back in 2021, effectively forcing it to approve a product that may involve significant risk to investors.

The four politicians who signed the recent letter to Gensler fail to grapple with these nuances and urge the immediate granting of the ETP applications on the basis of ‘investor protection.’ Those pleadings might ring hollow given that Sam Bankman-Fried was playing both sides of the political aisle with donations—to apparent great effect—right up until his fraud was exposed to the public and leaving many red faces in D.C. Given that the letter also takes more or less the exact line taken by other companies facing off against the SEC—like Coinbase (NASDAQ: COIN)—it’s fair to wonder where these politician’s concerns are really coming from.

In any case, it appears that Gary Gensler and the SEC are going through the motions of re-reviewing the Grayscale application and the other filings despite pressure from government and industry groups. He was recently interviewed by Bloomberg, where he said:

“What we have in front of us, just so that the viewing public understands, we have not one, but multiple, I think it’s eight or ten filings that the staff, and ultimately the Commission, is considering,” he said.

“When an asset manager is seeking to take something public, these exchange-traded products need to register with the SEC, and they go through a filing, somewhat similar to going public, like an IPO.”

“And so it’s really the work of our Division of Corporation Finance that gives feedback. Our Division of Trading and Markets, of course, looks at the filings. This is a time-tested process that goes back decades. The staff of the SEC, it’s called the Disclosure Review Team, but in that group, they respond and give feedback to potential issuers.”

Given that new revelations about rampant non-compliance within the digital asset industry appear seemingly every week, it surely won’t be difficult for the SEC to provide adequate reasons why a Bitcoin ETP should not be allowed. Whether it is able to square that decision with its previous ruling about Bitcoin futures ETPs is another question.

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