Statement Dissenting from Approval of Proposed Rule Changes to List and Trade Spot Bitcoin Exchange-Traded Products

Today the Securities and Exchange Commission approved a series of proposed rule changes that will allow for the listing and trading of bitcoin-based products on national securities exchanges.[1] These Commission actions are unsound and ahistorical. And worse, they put us on a wayward path that could further sacrifice investor protection. I cannot agree that these actions serve either our statutory or foundational investor protection mandates and, as such, I dissent from today’s Order.

1. Background

The proposed rule changes were filed pursuant to Section 19(b)(1) of the Securities Exchange Act of 1934 (“Exchange Act”) and applicable rules thereunder to list and trade shares of trusts that would hold spot bitcoin (the “exchange traded products” or “ETPs”).[2] The Commission must find that such proposals are consistent with the Exchange Act in order to approve them, which requires that the rules be designed to “prevent fraudulent and manipulative acts and practices” and “protect investors and the public interest.”[3]

Despite an ample and growing body of evidence indicating that the proposed rule changes are not reasonably designed to prevent fraudulent or manipulative acts and practices, or to protect investors or the public interest, the Commission’s Order finds that this standard is met. For the reasons discussed below, I strongly disagree.

2. The Global Spot Markets Underlying the Bitcoin ETPs are Marred by Fraud and Manipulation, Concentrated, and Without Adequate Oversight

The ETPs that will be enabled by today’s Order are inextricably tied to the bitcoin spot markets. Fraud and manipulation that impacts the price of spot bitcoin surely impacts the price of the spot bitcoin held in the ETPs. So, our investor protection inquiry necessarily begins with the spot bitcoin markets. Are those markets safe? Substantial evidence indicates that the answer is no.

The spot markets that trade bitcoin are located all around the world. U.S. regulators, such as the Commission, have limited visibility into these spot markets. What little information we do have, however, is not reassuring.[4]

Fraud and Manipulation. Spot bitcoin markets are subject to fraud and manipulation.[5] One form of manipulation that appears to be pervasive in the crypto markets (and specifically bitcoin markets), is wash trading, a practice whereby traders seek to increase the appearance of high trading interest by both selling and buying the same products at the same time, often driving up prices, and then selling to unwitting third party market participants at inflated values. Wash trading distorts price and volume, causes volatility, reduces investor confidence and participation in financial markets, and of course, results in investor harm.[6] One analysis of 29 major crypto exchanges found that wash trading was, on average, as high as 77.5% of the total trading volume on unregulated exchanges.[7] The same researchers estimated that wash trading was present in over $4.5 trillion of crypto spot market trading and $1.5 trillion in crypto derivatives trading in the first quarter of 2020 alone.[8] Likewise, the Commission’s complaint against Binance and its affiliates alleges that the Defendants failed to implement trade surveillance or manipulative trading controls on the Binance.US platform (despite the fact that such controls were touted to investors); and, that the lack of such controls enabled Binance affiliates to engage in wash trading in select cryptocurrencies in order to artificially inflate trading volume.[9]

Specifically with regard to bitcoin, an analysis of 157 crypto exchanges found that 51% of the reported daily bitcoin trading volume was likely bogus.[10] In fact, though reporting regarding bitcoin frequently discusses the enormous size of the market, one market participant who now seeks to sponsor a spot bitcoin ETP has admitted that “approximately 95%” of the data used by many participants are “fake and/or non-economic.”[11] Indeed, in one salient example, according to testimony by one of his co-conspirators, the former CEO of FTX may have engaged in bitcoin price manipulation in an effort to keep its price under $20,000, presumably to the benefit of his company and himself.[12] In short, prices and demand for bitcoin may not actually be what they appear to be.

Indeed, just yesterday, prior to the issuance of our approval Order, one of the SEC’s social media accounts was compromised, and an unauthorized post falsely indicated that we had approved spot bitcoin ETFs.[13] Unsurprisingly, the price of spot bitcoin suffered “whiplash” in the minutes and hours following the false tweet.[14] While the facts underlying this misconduct hopefully will be uncovered by law enforcement in the future, I will be monitoring what may be yet another attempt to profit from wrongdoing in this market.

Concentration of Ownership. Concentration of ownership among spot bitcoin holders also leaves bitcoin investors (and now spot bitcoin ETP investors) vulnerable to the whims and trading practices of a few. Analysis shows that mining and holdings of bitcoin are highly concentrated.[15] This concentration may impact price movements in unpredictable ways. Investors have few resources to learn about and price these risks. And, large entities can create volatility and move the price of bitcoin through the exploitation of arbitrage opportunities among a small group of interconnected parties.[16] This concentration is ironic given that bitcoin was touted as the product to decentralize finance.

Lack of Unified Oversight. Among the reasons that crypto markets – including bitcoin spot markets – appear to be Petri dishes of fraudulent conduct is because there is little to no systemic oversight of these markets, nor other sufficient mechanisms in place for the detection and deterrence of fraud and manipulation. Spot trading of bitcoin is fragmented and scattered across different international trading venues, with many markets not subject to meaningful regulation. According to the Department of the Treasury, “[u]neven and often inadequate regulation and supervision internationally allow [virtual asset service providers] and illicit cyber actors to engage in regulatory arbitrage and expose the U.S. financial system to risk from jurisdictions where regulatory standards and enforcement are less robust.”[17] Additionally, even in the U.S., oversight of spot bitcoin markets is limited (at best).[18]

Evidence has shown that spot bitcoin trading underlying these products is so susceptible to manipulation, so rife with fraud, so subject to volatility, and so limited in oversight that we cannot credibly say that the proposed rule changes approved today were designed to prevent fraud and manipulation or that there are adequate investor protections in place. The Order does not meaningfully address or reconcile these critical issues. Rather, the Order “acknowledges these concerns,” and sidesteps them entirely stating (rather blithely) that the Commission does not apply a “cannot be manipulated’ standard.”[19] While that may be true, we also do not apply a “bury our heads in the sand” standard. The Order does not even begin to address these issues in the spot markets. Today’s analysis simply ignores important investor protection concerns.

In light of the above, it is no surprise that we have consistently disapproved proposed rule changes that would allow listing and trading spot bitcoin ETPs in the past. It has been the consistent and decided judgment of this Commission over the past five years that these products are unsafe and unfit for investors without the adequate guardrails in place. So, what has changed?

3. Grayscale Investments, LLC v. SEC

In August of this year, the D.C. Circuit found that the Commission had not adequately explained the difference between two registered bitcoin futures ETPs, approved for listing and trading by the Commission in Spring 2022, and the disapproval of Grayscale’s proposal to list and trade a spot bitcoin ETP.[20] The Court found that it “is a fundamental principle of administrative law that agencies must treat like cases alike,”[21] and found that the Commission did not adequately explain its purportedly disparate actions. Of course, “like cases should be treated alike” is black letter administrative law.[22] The problem here, however, is twofold. First, there are important investor protection differences between the two species of products that justify disparate treatments. Second, the “correlation” analysis provided by Grayscale and relied upon by the Court, as well as the Commission’s correlation analysis, are inadequate to conclude that fraud or manipulation that impacts prices in spot bitcoin markets would likely similarly impact Chicago Mercantile Exchange (“CME”) bitcoin futures prices, such that a surveillance sharing agreement with one regulated market (i.e., the CME bitcoin futures market) would necessarily assist in surveilling for fraud in another market (i.e., the spot bitcoin market).

A. Futures ETPs and Spot ETPs are Not the Same Products

As the Court pointed out, the Commission previously approved certain ETPs that hold bitcoin futures, but not ETPs holding “spot” or “physical” bitcoin.[23] There are important differences between those products and the ones that will be listed as a result of our Order today. Those existing products hold bitcoin futures, cash-settled financial contracts betting on the price of bitcoin at some point in the future. The parties to these contracts are regulated entities trading on a U.S.-registered and regulated exchange.

On the other hand, the exchange traded products that will be listed as a result of our Order today hold “physical” or “spot” bitcoin rather than bitcoin futures contracts. Unlike products that only participate in the futures market, there is no primary regulator for the bitcoin spot markets. Spot bitcoin ETPs will be participating in an unregulated, fragmented, continuously traded, global free-for-all. Even if there were a primary regulator for this market, much of it could be beyond the reach of U.S. regulation. Thus, even if the Commission or exchanges were to identify specific fraud and manipulation there might be little to no recourse for investors. As one commenter put it, the difference between buying a bitcoin futures ETP and a bitcoin spot ETP “is like the difference between buying a lottery ticket from the state of New Jersey and buying a lottery ticket from Tony Soprano.”[24]

The D.C. Circuit was fundamentally correct to say that like products should be treated alike. These products, however, are not alike. It is today’s action that departs from well-grounded precedent, that bears characteristics of arbitrary decision-making, and that will restrict our future ability to protect investors.

B. Arguments that Rely on “Correlation” With Other Surveilled Markets Will Not Protect Investors

When considering whether a proposed rule change to list bitcoin-based ETPs is designed to prevent fraudulent and manipulative practices, consistent with Section 6(b)(5) of the Exchange Act, the Commission has historically considered whether the listing exchange can demonstrate that it has entered into a comprehensive surveillance-sharing agreement with a regulated market of significant size related to the underlying or reference bitcoin asset.[25] Today’s Order concluded that it was “unable to make [] a finding” that the CME (the relevant market) is a market of “significant size” related to spot bitcoin.[26]

Because it cannot make such a finding under the traditional test, the Commission contorts itself to find “other means” have been demonstrated to satisfy the statutory obligation that an exchange’s rules be designed to prevent fraudulent and manipulative acts and practices.[27] It relies on evidence of “correlation” between the CME bitcoin futures market, and the spot bitcoin market to conclude that adequate investor protections are in place to approve the proposals.[28] The “correlation” argument theorizes that fraud or manipulation that impacts prices in the spot bitcoin markets would likely similarly impact CME bitcoin futures prices, such that a surveillance-sharing agreement between a spot bitcoin ETP’s listing exchange and the CME reasonably can be expected to assist in surveilling for fraud and manipulation that may impact the spot bitcoin ETPs.[29] In other words, surveillance of the CME bitcoin futures market should carry over to protect the bitcoin spot market. The idea is that to the extent the bitcoin spot market shows price activity that is the result of fraud, the bitcoin futures market would reflect that. This is incorrect.

First, today we are creating a new standard – but it is not clear exactly what this standard is. Never before have we found that a proposed rule change satisfied Section 6(b)(5) obligations because of purported “correlation” between two markets. And even now, we do not describe what levels of correlation are sufficient and what is the basis for such a finding. Though the Grayscale opinion relies on unchallenged evidence of correlation, I do not read it to compel a new regulatory standard.[30]

Second, the correlation argument does not make sense here. Even if we could detect manipulation or fraud on the spot market because of perfect correlation with the surveilled CME – what could we do about it? As discussed above, much of the global spot market is altogether unregulated. That cannot be the basis for our investor protection findings.

Third, even assuming the argument did make sense, the Commission’s analysis relies on questionable data for a “subset” of selected spot bitcoin markets to examine the relationship between prices in the CME bitcoin futures market and the spot bitcoin market, but does not explain why such a subset is representative of the entirety of the spot markets worldwide. Indeed, it seems likely that the data we rely on suffer from selection bias – i.e., the venues for which we have data are those that chose to make it easily available; the data that we are lacking might suggest different conclusions about correlation. We do not learn much from even perfect correlation with incomplete data.

Fourth, the Order draws questionable conclusions from that questionable data. The Order states that the results of its correlation analysis support a finding that prices generally move in close (“although not perfect”) alignment, between the “spot bitcoin market” (again, there are many spot markets) and the CME bitcoin futures market; therefore, the Order concludes, fraud or manipulation that impacts prices in spot bitcoin markets would likely similarly impact CME bitcoin futures prices. But, what about the times when prices in the spot and futures markets are not aligned? Is that, in and of itself, indicative of fraud or market dislocation (and at precisely the time when market surveillance is giving us the least information)?

Fifth, the Commission’s analysis reveals that the percentage of correlation between the relevant markets consistently decreases as the time intervals get shorter.[31] But, many (if not most) market manipulation schemes happen only in matters of minutes.[32] While it may be true that problems or inefficiencies in Market A may be arbitraged away in Market B in the long run (over days or hours), it is also true that manipulation schemes often run in short bursts in an effort to evade detection. This sort of manipulation may show up as prices dislocating (that is, the spot price deviating from the futures price) for short periods of time.[33] Thus, significant correlation between the markets does not mean that manipulation schemes would necessarily be detectable.

Finally, correlation between two variables in the past does not necessarily mean those variables will continue to have a correlational relationship in the future. One could imagine that, as a result of the new listing of these ETP products, spot market activity will grow exponentially to eclipse the futures market, rendering the futures surveillance function meaningless to the un-surveilled spot market.

Today we rely on a questionable correlation between a disaggregated, unregulated spot market and a futures market that the SEC itself does not regulate.[34] As I noted, we rest our laurels on the idea, or hope, that whenever fraud and manipulation in that underlying spot market occurs it should hopefully become apparent in the surveillance of that futures market. I’m not convinced that such transparency will exist. And even if it did, we likely will not be able to remediate fraud beyond our reach.[35] I cannot make an investor protection finding on such attenuated protections.

4. The Order Does Not Consider the Broader Public Interest

Exchange Act Section 6(b)(5) requires exchange rule proposals be designed to protect the public interest. But the Commission also has not taken into account adequately broader public interest considerations. For example, it is well-documented that many criminals use bitcoin to evade U.S. financial sanctions. Many ransomware attacks demand payment in bitcoin, and analysis shows that these payments may end up funding our geopolitical rivals or adversaries.[36] And the ability of bad actors to use these assets freely can have catastrophic results for our interests and those of our allies, from funding rogue weapons programs to aiding attacks on civilians.[37] In approving these products for listing and trading on American exchanges, could we inadvertently be working at cross purposes with the goals of other arms of our government? Will the increased liquidity in the spot bitcoin market make it easier for criminals and terrorists to move money quickly, to evade sanctions, and to use their funds to harm civilians? Will the increased transaction volume make it harder for staff in other parts of the government to track these money flows? And if one of the funds involved with today’s approval transacts with a criminal or terrorist, will investors be harmed when it is sanctioned?

Only a few years ago, the Commission unanimously disapproved a proposed rule change by an exchange where commenters raised concerns about the potential for money laundering and the Commission had unresolved questions about the ownership structure of the exchange.[38] Given that the exchange proposals approved today raise similar questions, further consideration of these issues is warranted.

Separately, when FTX imploded in November of 2022, many among us breathed a sigh of relief that the downfall of one of the most central players in the crypto market had little impact on global markets more broadly. Will approval of today’s products provide the previously attenuated nexus to traditional markets that allows crises in largely non-compliant crypto markets to spill over? These questions are not considered in today’s Order.

5. Tomorrow’s Problems

And there are still other concerns about how these ETPs will operate now that they have been approved. For example, how will custody be handled when the market continues to press for in-kind creation and redemption processes?[39] Given that bitcoin has historically been subject to volatility, a fund holding a volatile asset like bitcoin could be expected also to be volatile.[40] What will happen if the price movements of a spot bitcoin ETP cause the ETP to enter a trading pause as a result of an exchange’s limit up-limit down mechanism?[41] In this case the underlying asset would not also be subject to the trading pause—rather, it would continue to trade, on a peer-to-peer basis and on a variety of exchanges around the world. Could the price of the underlying asset moving further away from the market price of shares of the spot bitcoin ETP result in investors being harmed when they are suddenly un-correlated, exposing them to risks they did not intend to take? These are just a few questions that our agency will likely encounter in the coming days, weeks, months and years. It is unclear to me that we have adequate answers in place.

6. Wasn’t Bitcoin Supposed to Solve This?

I am aware of the grand claims made by proponents of these and similar products. They are disintermediating the financial system. Banking the unbanked. Enhancing freedom. Changing the world. And when I read the whitepapers, it can be hard not to buy in. Many of the goals of the crypto ecosystem are goals I support. How can you be against freedom and prosperity? But when I look at products like the ones at issue in today’s approval, I have a simple question: wasn’t bitcoin supposed to solve this? If the technology is so revolutionary, why do so many of its uses seem to revolve around recreating the existing financial system, except with less regulation, more opacity, fewer investor protections, and more risk?[42]

Bitcoin is a peer-to-peer system.[43] Individual investors in the U.S. who want to invest in the product may already do so, either by mining it themselves or by setting up a wallet and buying it from someone else, each of which they are able to do from the comfort of their living room. That is the whole point of creating a new, censorship-resistant digital currency. So why is so much energy being expended on linking it to the existing financial system? I fear that our actions today are not providing investors access to new investments, but instead providing the investments themselves access to new investors in order to prop up their price. While this is in the interests of the sponsors of the ETPs, as well as the law firms and service providers who will get paid by them, my duty is to consider investors, markets, and the public, whose overall interests I do not believe are in fact well-served today.

* * *

I am deeply concerned about today’s actions. I am concerned that these products will flood the markets and land squarely in the retirement accounts of U.S. households who can least afford to lose their savings to the fraud and manipulation that appears prevalent in the spot bitcoin markets and will impact the ETPs. I am concerned that today’s actions will create the imprimatur of Commission approval and oversight of the underlying spot markets when really no such oversight exists. I am concerned that there will be confusion about what exactly these products are – (they are not ETFs registered under the Investment Company Act of 1940, the ubiquitous products that today are used by millions saving for retirement) – and that investors may infer protections that do not in fact exist.[44] I am concerned about what comes next – when new, potentially more speculative products bearing greater risks of investor harm seek to list, we will hear a chorus of well-heeled voices saying that the SEC’s hands are tied by the new standards that we have set. I fear that today we are setting ourselves up for tomorrow’s failure, and it will be the investors that we have a duty to protect who will ultimately pay the price.[45]