Fending off the Regulatory Barrage
Level 2 - Value Investor
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2023 has been a wild ride, hasn't it?
One minute, it's all doom and gloom with regulators like the SEC swinging their sword at the industry’s neck. The next minute, we're popping champagne because Crypto scores some major wins. While it’s impossible to truly win when the regulators turn their eyes on an industry, this post has more champagne than not (something cheap — it’s a bear market).
SEC’s Denial of Grayscale BTC ETF Unlawful
Background: last year, the SEC rejected Grayscale’s initial application to convert its Bitcoin trust (GBTC) to an ETF. Grayscale argued that the SEC had acted arbitrarily and cited to the agency’s approval of a similar product - Bitcoin futures ETFs.
On Tuesday, the Court upheld Grayscale’s appeal in a major win for crypto.
Sidebar: Why does converting to an ETF matter?
The publicly traded trust (GBTC) has no mechanism to convert shares to real Bitcoin. An Exchange Traded Fund (ETF) has a creation and redemption mechanism whereby authorized participants can deposit the asset (BTC) and receive ETF shares ; or redeem ETF shares for the underlying asset. Although retail participants cannot convert their shares to the underlying asset, arbitrage ensures that the ETF remains fairly priced most of the time. By contrast, with no redemption mechanism, GBTC trades at a substantial discount to the value of the BTC it holds. This means that investors who wish to sell are forced to accept an unfair price - or remain invested in the trust and continue paying management fees for a product which has underperformed its reference asset.
GBTC has traded at a significant discount to Bitcoin since March 2021 (during the bull market). The discount reached its widest at -49% last December following the FTX insolvency. Betting that GBTC and BTC prices would converge has been a widowmaker trade, contributing to the downfall of Three Arrows Capital and others. Following the court decision, the discount narrowed to a multi year record of around 20%, making GBTC the best performing cryptoasset year to date.
Converting the Grayscale trusts to ETFs is obviously in the best interest of investors. However, it is not necessarily in the best interests of the issuer. Grayscale is part of the embattled DCG group - the digital currency trusts are the group’s most profitable business line. We expect that if these trusts converted to ETFs, fees would need to reduce significantly from the current 2% and there will be heavy competition from Blackrock, the 500 pound gorilla. The twisted incentives here are that DCG likely stands to profit more from not converting (unless they are underwater on a metric ton of GBTC units).
Speaking of DCG, we have a key update on the bankruptcy process of their company Genesis on Saturday for paid subscribers. Don’t miss it!
We wouldn’t recommend investing in GBTC at a ~20% discount in the hope of eventually exiting at par. This could take years, and the discount could increase meanwhile. The case is even worse for ETHE, as the product does not benefit from the ~5%/year Ethereum staking yield.
The Court Decision
It is important to note the scope of the Court’s remit in considering an application for judicial review of a decision made by a government agency. The Court does not put itself in place of the agency to decide the question afresh on the merits - instead it considers whether the agency had violated the law in some way when reaching its decision - including by acting arbitrarily, capriciously, or by abusing discretion.
This ruling therefore goes to a question that the crypto industry has been asking loudly for several years: is the SEC fit to regulate us?
We have previously covered criticisms of the SEC by senior politicians and top lawyers, including the SEC’s own staff - notably SEC commissioner Hester Pierce has dissented from many of the agencies actions.
This week an appellate court found that the SEC had failed to follow the law when refusing Grayscale permission to create a Bitcoin ETF. The SEC did not consider the relevant issues and failed to adequately explain its decision. This latest ruling echos the sentiments of many industry participants that the SEC takes an arbitrary and high-handed approach, failing to explain its reasoning.
The Opinion is concise:
It is a fundamental principle of administrative law that agencies must treat like cases alike. The Securities and Exchange Commission recently approved the trading of two bitcoin futures funds on national exchanges but denied approval of Grayscale’s bitcoin fund. Petitioning for review of the Commission’s denial order, Grayscale maintains its proposed bitcoin exchange-traded product is materially similar to the bitcoin futures exchange-traded products and should have been approved to trade on NYSE Arca. We agree. The denial of Grayscale’s proposal was arbitrary and capricious because the Commission failed to explain its different treatment of similar products.
The SEC has previously denied every proposal to list a Bitcoin exchange traded product and in each case cited to a rule requiring products to be designed to “prevent fraudulent and manipulative acts and practices”.
In Depth
The SEC’s decision to approve exchange traded products based on Bitcoin futures, but not physical Bitcoin, turned on its interpretation of the surveillance regime that it requires. The Bitcoin futures ETPs only hold CME Bitcoin futures contracts. There is a surveillance sharing arrangement between NYSE Arca (where the ETPs are traded) and CME (where the products held by the ETPs are traded). This, in the SEC’s view, makes it unnecessary to consider whether an actor attempting to manipulate the price of the Bitcoin futures ETPs would need to trade on the CME.
However, it is clear that there are ways to manipulate the spot market for Bitcoin without trading on CME, and so avoiding the surveillance. In a nutshell, the SEC’s position has been that because Bitcoin is a global product not subject to total surveillance by the US regulatory regime (through regulated exchanges like NYSE and CME Group), the price could be illegally manipulated and the manipulators could evade detection. Therefore Bitcoin isn’t a suitable underlying asset for an ETF.
This argument is a technical one, but it breaks down when you consider that CME Bitcoin futures settle against the spot market - more precisely the Bitcoin Reference Rate which aggregates the spot price from 6 major spot crypto exchanges. The value of both the Bitcoin futures ETPs and the spot Bitcoin ETP would be based on the market price of spot Bitcoin, making them substantially similar products.
The Court held that fraud in the spot market would present the same risks to holders of shares in both a spot Bitcoin ETP (which was denied) and a Bitcoin futures ETP (of which two were approved by the SEC).
The Commission’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
What Does This Decision Mean For A Bitcoin ETF?
If the SEC wanted to deny Bitcoin ETFs, they’d have to come up with a new line of reasoning which isn’t caught by the court decision. This new argument may face another appeal, so the agency is faced with the challenge of convincing an appellate court to agree with its decision to distinguish Bitcoin futures and Bitcoin spot ETF products, despite that they are both valued based on the same underlying asset.
Whether the SEC makes such an argument or not, we doubt courts will be convinced.
An alternative would be to approve Grayscale’s application.
Market heavyweights including Blackrock and Fidelity have submitted applications with the information sharing agreements required by the SEC. We think it very likely that one or both of these applications is approved in the next year, although this wouldn’t automatically give Grayscale the green light to convert. For now we’d advoid the Grayscale trust products.
The market impact of a Bitcoin spot ETF approval likely depends on market sentiment and positioning at the time it’s released. From that perspective, 2024 would be better for price appreciation. Two days after the court decision was published, Bitcoin has given back its 6% gain on the day of the news and is now trading lower than when the decision became public. Other ETF applications have been delayed.
tl;dr - a Bitcoin ETF in the United States now seems inevitable, but price impact will depend on sentiment in the short term and net inflows in the longer term. And this defeat may spark some high level policy changes in the SEC. Crypto products need to be regulated according to the law, not in an arbitrary and capricious manner which seems to reflect a bias against the industry held by some senior SEC personnel.
DeFi DEX Programmers Not Liable For Third Party Scams
In another win for DeFi, the US District Court for the Southern District of New York dismissed a class action against Uniswap Labs, founder Hayden Adams, and VC investors in Uniswap.
The class had suffered financial loss from investing in scam tokens traded on Uniswap. As the identities of the scammers are unknown and probably unknowable, the plaintiffs sought to hold the exchange responsible.
Lawyers for the plaintiffs advanced arguments that Uniswap is centralized because:
Uniswap Labs controls and licences source code under a Business Source Licence
Uniswap Labs can restrict (delist) tokens through its frontend
~88% of UNI is controlled by the top 10 wallets, which are alleged to be controlled by parties closely linked to founders and major VC investors, making decentralized governance a sham
They then advanced various legal theories of liability based on violations of the securities laws and being an unregistered broker-dealer.
However, the Court was specifically concerned about “holding parties liable under the federal securities laws for designing a platform which does not implicate the federal securities laws”. After detailed analysis, the Court dismissed all claims.
Here the SDNY respects the legal distinction between writing software and operating a securities exchange, a welcome development we’d like to see applied in other DeFi cases. It’s good news for developers!
In Depth
The court distinguished the plaintiff’s use of the core and router contracts - capable of being used for a lawful purpose - with the factory pools created to swap the fraudulent/memecoin securities which could be unlawful. The plaintiffs were not entitled to rescission of their contracts made with the core of the Uniswap protocol, to which they presumably sent ETH before the fraudulent contract (not deployed by Uniswap) was executed to exchange the ETH for the fraudulent securities.
The core and router contracts serve as a base, and token-specific factory pools terms are created by the token issuer who deploys them. As this is decentralized and permissionless, Uniswap Labs isn’t liable for wrongs committed by third party token issuers despite that the tokens are traded using Uniswap’s software.
The judge in this case, Distrct Judge Katherine Polk Failla is also overseeing SEC v Coinbase. The judge blamed lack of crypto regulation for the victims not having a legal remedy and suggested that congress, rather than the courts, is the appropriate forum for them to complain. We see this as an implicit criticism of the poor regulatory environment - the lack of rulemaking - and the failure of the legislature to design a comprehensive legal framework for crypto. This may be remedied by the Crypto Regulatory Framework Bill which was endorsed by the House Financial Services Committee last month.
NFTs Can Represent Securities
This is a short update as anyone interested in crypto knows about the Howey Test (contracts concerning oranges can be securities, so why not contracts concerning NFTs or any other item, tangible or digital?)
The SEC issued and simultaneously settled charges that the entertainment company Impact Theory had conducted an unregistered offering of crypto asset securities in respect of their “Founders Keys” NFT launch in 2021. The Company raised around $30 million allegedly as the result of encouraging potential investors to consider the NFTs as an investment in the business.
Impact Theory paid $6.1 million to settle the charges without admitting wrongdoing.
This case is straightforward as the Company promised that it would deliver “tremendous value” to NFT purchasers. A settlement sets no legal precedent and there’s no novel point at issue here. It was already known that crypto tokens can be securities - whether they are issued in ERC-20 (fungible) or ERC-721 (non-fungible) format isn’t relevant.
The decision to charge Impact Theory does not mean that the SEC believes other NFTs, e.g. art based NFTs are securities, even if the motive of the purchaser is to make a profit from others speculating on the collection.
Existing Laws Effective Against Crypto Fraud
Although regulators have arguably stifled innovation and harmed investors by imposing unfair costs on crypto businesses, and they seemed to be asleep at the wheel for the politically connected media darlings formerly known as SBF and FTX, they do a reasonable job of policing low level crypto crime.
Enforcement actions have recovered investor assets from hacks, exit scams, and other confidence tricks and punished perpetrators.
In a recent example, the SEC obtained emergency relief including asset freezes and restraining orders against the promoters of Debt Box, a fraudulent scheme which sold “mining node licences” to victims who believed they could mine valuable cryptocurrencies. In fact, the tokens were created by the Debt Box promoters, and contrary to claims they were not linked to any real world business activities. Investors had been convinced that they were mining tokens tied to revenues from gold mining, oil drilling, beverage sales, and other “commodity projects”.
Around $49 million was solicited from thousands of investors and funneled through a complex network including at least ten shell companies registered in the USA and UAE. Further details about the scam can be found in press releases and court documents linked from the Debt Box Receiver’s website.
Fed Releases Further Stablecoin Guidance for Banks
In the absence of Congressional movement on stablecoins since shelving a bill in late July, the Federal Reserve Board recently provided additional information on the process for a state bank supervised by the Federal Reserve to follow before engaging in certain dollar token or stablecoin activity. We’re keeping up with this news as part of monitoring Frax Finance, a DeFi stablecoin protocol with the potential to become a one stop shop for both onchain yield (Ethereum staking) and offchain yield (tbills).
DeFi Team Views
Regulation is here to stay but it seems the tide may be turning from a politically hostile approach to one motivated by core American values like rule of law and free enterprise. In practice this means a consolidation of the crypto industry in the US under the aegis of the most powerful players - Blackrock, Fidelity, Coinbase…
In the long term this is bullish - the owners of capital demand a return and this means increasing transaction volumes to generate fees, increasing the asset allocation to crypto, and developing new business lines (stablecoins, custody solutions, ETFs, Real World Assets, DeFi primitives).
More money and more mindshare to crypto means “number go up”.
Although only the most powerful centralized entities have been able to challenge government agencies in Court (and win!), DeFi will also reap the benefits of a less hostile climate - the dismissal of the claims against Uniswap being a good example.
Decentralization is now more important than ever as powerful legacy institutions will attempt to use their influence in crypto to secure profits including by extracting economic rent. For those who can understand the technology, intermediaries are obsolete. But onboarding, security, and UI/UX remain major barriers to achieving adoption at scale. A major risk is that walled gardens (think Apple’s App Store, Coinbase’s Base chain) capture the majority of mindshare and capital from retail users, leaving independent developers of applications out in the cold.
To avoid costly errors in an uncertain and rapidly changing regulatory environment, it’s essential to stay up to date. Legal opinions can be dry, and analyzing them is time consuming. That’s where DeFi Education comes in. Earlier this year, our regulatory research identified Coinbase stock as undervalued at $50 based on our prediction:
If there was any crypto company with the political and financial clout to take on the SEC and get a favorable outcome, we think it would be Coinbase.
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We think we’re being adequately compensated to take on those risks. We’ve established a core position earlier in the week and are open to adding to it in the future if there is a significant favorable outcome in the dispute with regulators.
To keep up with significant regulatory updates or if you’re interested in helping to build the future of finance, become a paid subscriber to access our deep dives.
Disclaimer: None of this is to be deemed legal or financial advice of any kind. These are opinions from an anonymous group of cartoon animals with Wall Street and Software backgrounds.
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Between reading a handful of other blogs/articles and listening to several podcasts around these topics (particularly ETF), you guys consistently deliver the best and most concise information.