Two national securities exchanges found coal under their Christmas trees on December 22, 2021, in the form of disapproval orders by the Securities and Exchange Commission of their applications to amend exchange rules to list and trade shares of bitcoin exchange-traded funds. In both cases the SEC concluded that the proposed rule amendments were not adequately "designed to prevent fraudulent and manipulative acts and practices" and "to protect investors and the public interest." 

The two exchanges were NYSE Arca, Inc., which was seeking to list and trade shares of the Valkyrie Bitcoin Fund, and Cboe BZX Exchange, Inc. that was looking to list and trade shares of the Kryptoin Bitcoin ETF Trust. Both funds proposed to hold only bitcoin and track the price of the virtual currency as reflected by the CF Bitcoin US Settlement Price (an index created and administered by CF Benchmarks Ltd., currently relying on prices of bitcoin traded on Bitstamp, Coinbase, Gemini, itBit and Kraken).

In disapproving both exchanges' applications, the SEC claimed that neither platform had entered into a "comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying or reference bitcoin assets" nor had "established that other means to prevent fraudulent and manipulative acts and practices are sufficient to justify dispensing with the requisite surveillance-sharing agreement." The SEC said it was required to consider the exchanges' proposals in light of these standards in accordance with applicable law. (Click here to access Section 6(b)(5) of the Securities Exchange Act of 1934, 17 U.S.C Sec. 78f(5).)

NYSE Arca and Cboe BZX each presented numerous arguments why they believed that the bitcoin market overall or the bitcoin market as represented by the CF Bitcoin Settlement index was "uniquely and inherently resistant to fraud and manipulation." NYSE Arca's arguments included that that the bitcoin market has expanded rapidly in recent years and that billion-dollar transactions have occurred without materially disrupting the marketplace. Among other points, Cboe BZX referenced fragmentation across bitcoin trading platforms, the relatively slow speed of bitcoin transactions and the large capital that would be required to manipulate each trading platform as factors that would make manipulation of bitcoin prices challenging. Both exchanges argued that, because of arbitrageurs in the marketplace, the manipulation of bitcoin on any particular market "would likely require overcoming the liquidity supply of such arbitrageurs who are potentially eliminating any cross-market pricing differences." 

The SEC rejected all these assertions, generally claiming that the exchanges did not provide adequate evidence to support their propositions. Moreover, the SEC also suggested that certain boilerplate risk factor statements regarding bitcoin and bitcoin marketplaces in each of funds' registration statements constituted the funds' own acknowledgement that bitcoin markets were not inherently resistant to fraud and manipulation.

The SEC additionally rejected Cboe BZX's argument that, by having a common membership with the Chicago Mercantile Exchange -- home of bitcoin futures and options contracts -- in the Intermarket Surveillance Group, it had satisfied the SEC's alternative requirement that it enter into a "comprehensive surveillance-sharing agreement with a regulated market of significant size relating to the underlying assets." Despite CME's large increasing volume and open interest with its bitcoin futures contract, the SEC said CME was not a market of significant size "as the term is used in the context of the applicable standard here." This is because, said the SEC "[t]he evidence does not demonstrate that there is a reasonable likelihood that a person attempting to manipulate the proposed [exchange-traded product] would have to trade on the CME bitcoin futures market to successfully manipulate it."

NYSE Arca did not identify any market as a potential market of significant size with which it entered into a requisite surveillance agreement, claimed the SEC.

The SEC discounted both exchanges' arguments that authorizing listing and trading of Bitcoin ETFs would enable retail clients to gain exposure to bitcoin in a safer manner than through at least some cryptocurrency trading platforms. The SEC said that no matter what the benefits, the exchanges had to satisfy the requirements for a listing exchange under applicable law. Since, in its view, the exchanges did not satisfy either potential path to listing, the SEC "is unable to find that the proposed rule change is consistent with the statutory standard."

The SEC has not yet approved any exchange's proposed rule amendments to list and trade shares of bitcoin exchange-traded funds. Recently, however, it has approved exchanges' proposed rule amendments to list and trade shares of bitcoin futures exchange-traded funds. (Click here to access the article "U.S. bitcoin ETF debuts but legal hurdles remain," Reuters Legal News, October 22, 2021.

Although the SEC "again emphasize[d]" that its disapproval of NYSE Arca's and Cboe BZX's applications did not "rest on an evaluation of whether bitcoin, or blockchain technology more generally, has utility or value as an innovation or an investment," its wholesale rejection of arguments posited by the exchanges can reasonably be seen as suggesting a contrary view.

(Click here to access the SEC's disapproval order to NYSE Arca and here to access the Commission's disapproval order to Cboe BZX.)