Weekly Thoughts #12: Takeaways from the SEC news


​AUGUST 8, 2018

At press time, the price of bitcoin is trading at $6500, -4% in the past 24 hours and -15% in the past week. It’s a giant sea of red for the entire digital asset marketplace today, with the most obvious catalyst being yesterday’s SEC announcement to delay their decision on the VanEck/SolidX Bitcoin ETF. ​This was in hindsight a remarkably significant event. Some viewed it as positive, others less so. Regardless, this event moved the market and has quite possibly set into motion some negative market drift for the short term. And as we’ve been accustomed to seeing accompany any large market move, the talking heads came out in full swing proclaiming “I told you so” and calling for new lows or, in some cases, calling the bottom (enjoy catching that knife). Our team at Element spends a great deal of time trying to understand investor sentiment and market psychology with cryptocurrencies. Unlike other mature asset classes that have very metrics based fair value models that tend not deviate much from one another, the concept of fair value with bitcoin can have a huge variance. How large market participants that are organic in the supply chain interpret news events such as yesterday is more likely to drive short term price action than any single person or entity preaching technical levels or evangelizing the value of bitcoin using theoretical models (yup, shots fired). Anyway, that is why we have decided to focus the entirety of this week’s Weekly Thoughts on our takeaways from the SEC news. Hope you enjoy everyone.

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1. A bitcoin commodity-based ETF approval is unlikely under the current environment. ​We reviewed the SEC’s 92 page decision to disapprove the BAT BZX Exchange’s application to list the Winklevoss bitcoin ETF as well as Commissioner Pierce’s dissent. Based on the SEC’s comments, we believe any commodity-backed bitcoin ETF is unlikely to be approved in the near future. The SEC’s past practice for evaluating other commodity-based ETFs is to first examine whether the underlying spot market is resistant to manipulation. Although many listing exchanges have presented some convincing qualitative arguments for why it is difficult to manipulate the price of bitcoin, thus far, in the SEC’s view, no listing exchange or comment letter has met the burden of proof to demonstrate that bitcoin and bitcoin markets are resistant to manipulation.

If the SEC feels that there is insufficient proof to claim that the underlying spot market is resistant to manipulation, it could still approve the ETF if the listing exchange has entered into a “comprehensive surveillance-sharing agreement with a regulated market of significant size”. The surveillance-sharing agreement refers to specific terminology that the SEC uses. A “surveillance-sharing agreement” means that the listing exchange and an underlying market will be able to share data on which entities made trades, in what amounts, and at what times, so that in the event of suspected market manipulation, regulators can “review the tape” and investigate any suspicious trades. The SEC feels that if they have this capability, it will deter any potential manipulators even if the the underlying spot market is susceptible to manipulation.

  • The SEC’s definition of a “regulated market” is ambiguous, but the standard they are using a national exchange that is regulated by federal institutions like the SEC or CBOE. BZX, in it’s application, had entered into a surveillance-sharing agreement with Gemini. In its decision, the SEC did not consider Gemini to be a regulated market even though it acknowledged that it was under the supervision of the New York State Department of Financial Services.
  • The SEC’s definition of a “market of significant size” refers to a market that a person that attempting to manipulate the ETF would also have to trade on in order to succeed. In the context of bitcoin, this would include the top exchanges that trade bitcoin on spot markets or the exchanges that list bitcoin derivative products. Although BZX has a surveillance-sharing agreement with Gemini, the SEC did not consider Gemini to be a market of significant size given its current trading volumes and global market share. Furthermore, while acknowledging that the there are regulated markets for the bitcoin derivatives market (LedgerX, CME, and CBOE), the SEC’s view is that these markets are not yet of significant size.

This means that under the current environment, the burden of any commodity-based bitcoin ETF listing exchange will be to convince the SEC that the underlying spot market is resistant to manipulation or have a surveillance agreement in place with one or several of the top exchanges, including some that are non-US based and wouldn’t be willing to do this (Binance, OKex, Huobi). Both options are unlikely in the current environment and so the bar is set very high for commodity-based bitcoin ETFs. Our view is that any commodity-based ETF will not be approved any time soon.

Commissioner Pierce’s dissent to the decision was based on her opinion that the SEC shouldn’t be looking at the underlying spot market to see if its resistant to manipulation but instead look at the ability of the listing exchange to prevent manipulation on the shares of the exchange traded product itself. However, the SEC has always looked at the underlying spot market in its analysis of previous commodity-based ETFs, so this is the historical precedent and hard to change. The SEC commissioners are all lawyers, and lawyers rely on historical case law, so the precedent will never change until there’s something really big that warrants changing it.

2. Bitcoin ETF approval chances depend in large part on trading volumes on CME and CBOE bitcoin futures. ​We think it’s much more likely that a futures-based bitcoin ETF will be the first type to be approved. The bar is set lower here, since a listing exchange could enter into a surveillance agreement with CBOE or CME (which are regulated markets). The listing exchange just needs to convince the SEC that they are of “significant size” in that a manipulator would need to trade in the futures market and not only in the spot market to manipulate prices of the ETF. At current volumes, the SEC still views the CBOE and CME markets as not of significant size but volumes are slowly growing. Eventually, it is likely that there will be enough volume on bitcoin futures and combined with a comprehensive surveillance-sharing agreement, the SEC would be willing to approve.

3. The SEC can extend the time period for approval three times and can take up to 240 days to issue an approval or disapproval on any ETF application. ​All ETFs go through a standard approval process by the SEC:

  1. The national securities exchange that wants to list the ETF files with the SEC for a “proposed rule change”
  2. As soon as it is practical, the SEC publishes notice of the rule change in the Federal Register, the official journal of the federal government, and solicits comments.
  3. Within 45 days of the publication, the SEC must either approve, disapprove, or initiate proceedings to determine whether the proposed rule change should be disapproved. The SEC may also extend the time period for 45 days.
  4.  If the SEC does not outright approve or disapprove the proposed rule change, the SEC will give notice to the listing exchange it’s reasons for considering disapproval and allow time for the listing exchange to address grounds for disapproval. This process must be concluded not later than 180 days after publication.
  5.  However, the SEC may extend this time period an additional 60 days if it determines a longer period is appropriate. This means that the SEC can take up to 240 days to issue an approval or disapproval if it elects to use all of its extensions.

Given the ramifications of a bitcoin ETF, the SEC has historically taken the maximum amount of time available to them to evaluate the various bitcoin ETFs. Therefore, yesterday’s market reaction to the SEC utilizing it’s first extension of 45 days on the VanEck SolidX ETF should have been widely expected. Given the magnitude of the sell off, this appears to not have been priced in.

There are three futures-based ETFs that are still being considered by the SEC. To the best of our knowledge, each filing will be nearing the end of the maximum 240-day period. The three filings up for approval or disapproval are Proshares on August 23, GraniteShares on September 15, and Direction on September 21. Given the SEC’s view that the CBOE and CME markets are not of significant size, it is unlikely that these ETFs will be approved as well. Any disapproval or negative comment from the SEC will lead to further selling.

4. New commissioner appointments may meaningfully change the likelihood of ETF approval. ​There’s some interesting developments at the SEC which may affect the likelihood that an ETF will be approved. At full strength, there are five commissioners that serve staggered terms. Each commissioner is appointed by the President, with the advice and consent of the Senate, for five year terms. At the present moment, there are only four commissioners since the President and Senate are deliberating on an appointee. Furthermore, Commissioner Stein, one of the four current commissioners, is due to be replaced, and the White House is considering appointing Allison Lee. So in the near future, we will replace one old commissioner and add two new commissioners.

The Winklevoss ETF was rejected with a 3-1 vote. Adding two new commissioners could materially change the SEC’s views on the upcoming ETFs.

Thanks for reading everyone. Questions or comments, just let us know.

Portfolio Management Team

Thejas Nalval  | Kevin Lu


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