The Breakdown - Fireworks in the Grayscale Bitcoin ETF Lawsuit as Judge Visibly Rattles SEC Attorney

Starting point is 00:00:04 Welcome back to The Breakdown with me, NLW. It's a daily podcast on macro, Bitcoin, and the big picture power shifts remaking our world. The breakdown is produced and distributed by CoinDess. What's going on, guys? It is Tuesday, March 7th, and today we are giving the full background on Grayscale's case against the SEC. Before we get into that, however, if you are enjoying the breakdown, please go subscribe to it, give it a rating, give it a review, or if you want to dive deeper into the conversation, come join us on the Breakers, Discord. You can find a link in the show notes or go to bit.ly slash breakdown pod. All right, guys, important things happening today, good things even. And no, I'm not referring to Jerome Powell's testimony on the Hill, although that's

Starting point is 00:00:50 certainly the thing with the biggest impact on markets. Joe Wisenthall from Bloomberg summed up, Powell comes in hawkish and brings 50 basis point moves back to the table, and the S&P 500 falls just half a percent. We'll have the full story on that tomorrow and perhaps even later today on the Breakdown's YouTube channel, which, by the way, if you are not subscribed to, I've started producing content just for YouTube again, which will sometimes get you news even faster than the pod can. Go search the Breakdown NLW or just Nathaniel Whitamore on YouTube, and I'm sure you'll find it. Anyway, no, the important thing happening today is a hearing in the case of Greyscale suing the SEC around the denial of its application to convert the

Starting point is 00:01:26 Grayscale Bitcoin Trust into a Bitcoin Spot ETF. Now, this is certainly relevant to the industry in the specifics of the case. The dynamics around GPTC have a huge implication for the Bitcoin market as a whole. But I also think that it's relevant in a larger sense in that it's a company actually taking on an antagonistic, overreaching regulator in the SEC. All the way back on September 14th, 2021, Crypto-Twitter legal stalwart Jake Trevinsky wrote, Many people underestimate the likelihood of this Supreme Court filling gaps in the federal

Starting point is 00:01:55 securities laws by limiting not expanding the SEC's jurisdiction. I believe that for at least a couple of years now, regulatory agencies in the crypto industry have been on a collision course that only courts or Congress could solve. And since Congress doesn't do much of anything these days, courts seem like the only avenue. So today we're going to look at the background, the substance of this case, and what early indications are about the hearing, which is happening as I'm prepping the show. The history of attempts to launch a Bitcoin ETF stretch back right to the early days of Bitcoin. In 2013, the Winklevoss Twins applied to launch a Bitcoin fund called the Winklevoss Bitcoin Trust. The price of Bitcoin at that time was around $100, having just come off its first major bill run. The fund was always intended to operate as an ETF. At the time, there was one other

Starting point is 00:02:39 Bitcoin fund, but it was only available to accredited investors. The Winklewoss ETF was not approved by the SEC that year, so the Twins got busy building out the infrastructure they would need to obtain regulatory approval. So, in that light, the following year, the twins launched a Bitcoin price index. One of the regulatory requirements for SEC approval of an ETF is having two indices tracking a reference price for the underlying assets. An issue with the existing price indices was a lack of operating Bitcoin markets. Mount Cox had declared bankruptcy in 2014, leaving the indices with only two exchanges to reference price from.

Starting point is 00:03:10 Later in 2014, a wide range of new exchanges would launch, including the offering from the Winklevoss twins, which was Gemini. Ultimately, the SEC simply wasn't ready to bring a Bitcoin ETF to public markets. The Winklevoss application would drag on until 2017 before being rejected. The SEC cited concerns that most Bitcoin exchanges were unethical. unregulated, as well as, quote, the potential for fraud or manipulative acts and practices in this market. The price of Bitcoin had surged to a then-record high of $1,300 on speculation that the Winklevoss application might be successful. Now, alongside the Winklevoss Twins' very public push to launch a Bitcoin

Starting point is 00:03:41 ETF, a much smaller Bitcoin Trust was launched by Grayscale in September of 2013. The Grayscale Bitcoin Trust, or GPTC, was initially only available to accredited investors and only traded on over-the-counter or OTC venues. Due to these factors, the trust was able to launch without SEC registration. GBT was listed for public trading in 2015, making it available for investors who were uncomfortable interacting with Bitcoin exchanges, as well as those who wanted to purchase Bitcoin with tax-advantage retirement accounts. GBT developed a hefty premium during this era, typically trading at more than a 50% premium to spot Bitcoin prices throughout late 2017 and 2018. In the following years, there was relatively little drive to register Bitcoin

Starting point is 00:04:18 ETFs with the SEC. During the Winkleboss application, the regulator had proved itself to be willing to entertain applications, but unwilling to proceed all the way to an approval. That'll changed in 2021, with Bitcoin back in a raging bull market and retail investors with stimulus checks burning a hole in their pockets. The first successful applications were overseas. Purpose investments successfully launched their Bitcoin ETF on the Toronto Stock Exchange in February 2021. The fund held spot Bitcoin on behalf of investors and proved wildly successful, accumulating over $1 billion in assets during its first month, making it one of the fastest growing ETFs ever. What followed was a glut of UTF applications in the U.S. Valky, Vanek, Invesco, and ProShares all put

Starting point is 00:04:55 forward proposals for the SEC's approval, jostling to be the first to hit the markets. Having learned from the Winklevoss's attempt, these funds did not hold any Bitcoin, but instead held Bitcoin futures contracts trading on the Chicago Mercantile Exchange or the CME. The SEC's 2017 objections to a spot Bitcoin ETF were still largely true. There was still no Bitcoin exchange that was registered with the SEC, and there were still broad concerns surrounding market manipulation and fraud on some of the offshore exchanges that contributed to the Bitcoin price indices. In contrast, the CME was a well-established venue for commodities and derivatives trading. It held regulatory approval from the CFTC, enforced trading rules, and monitored for price

Starting point is 00:05:29 manipulation in its markets. The only problem was that the CME Bitcoin contracts settled based on the price indices gathered from offshore exchanges that did not conduct these market integrity measures. In other words, even when it came to a futures ETF, the price indices underlying it were still intrinsically linked to the markets that the SEC had been concerned about back in 2017. It was then somewhat to the shock of market participants that the SEC approved ProShare's Bitcoin ETF to begin trading on the 19th of October 2021. Proving the pent-up demand, this launch was one of the most successful ETF launches of all time. The fund accumulated $1.2 billion in its first week of trading and notched the fastest run to a billion dollars in assets on records, achieving

Starting point is 00:06:06 the milestone in just two days. Volumes were massive, with ProShare's fund registering the second most heavily traded ETF launch in U.S. market history. Followed closely behind pro shares was the launch of similarly structured futures ETFs from Vanek and Valkyrie. By the end of October, there was not one but three newly launched Bitcoin futures ETFs. Now, while the launch of the first Bitcoin tied ETFs was unquestionably a milestone, the futures-based structure left a lot to be desired.

Starting point is 00:06:30 The high cost of maintaining short-term futures positions meant that the funds did not keep pace with the price of Bitcoin, decaying at between 5% and 10% annually. The ETFs were fined for traders, but what most market participants seemed to want was exposure to spot Bitcoin through a convenient ETF wrapper. Jamie Seyfart at Bloomberg Intelligence said, quote, there is an appetite for a spot Bitcoin ETF. A spot Bitcoin ETF would be the preferred option for Bitcoin exposure for anyone using the traditional financial rails. It's the most efficient way to get exposure and will actually hold the asset. Now, bringing it back to Grayscale. On the same day that ProShare's debuted their ETF,

Starting point is 00:07:05 Grayscale filed their application to convert GBT into an ETF. The plan was a long time coming with the trust having been initially launched in an appropriate legal structure, which had been successfully converted in the past by other companies. Remember, for many buyers of GBTC, it was their way to get Bitcoin exposure without having to work with crypto exchanges. In February of 2021, the longstanding GBTC premium had flipped into a discount, as a popular carry trade involving locking up Bitcoin to create new GBT shares oversaturated the market.

Starting point is 00:07:34 GBT's structure as a closed-end fund meant that new shares could be created to capture the premium, but no shares could be easily redeemed to arbitrage the price back in line once it had fallen into discount territory. In an ETF structure, shares can be freely created and redeemed to collect the underlying assets by approved market makers. This means that theoretically, shares of ETS tend not to drift far from the value of the assets under management. Anyway, when I mentioned that the specifics of this case hold relevance for the Bitcoin market as a whole, all in all, the popular trade around GPDC meant that the trust now holds more than 3% of all Bitcoin in circulation. Join CoinDesk's Consensus 20,

Starting point is 00:08:10 The Most Important Conversation in Crypto and Web3, happening April 26 through 28th in Austin, Texas. Consensus is the industry's only event bringing together all sides of crypto, Web3, and the Metaverse. Immerse yourself in all that blockchain technology has to offer creators, builders, founders, founders, entrepreneurs, and more. Use code Breakdown to get 15% off your paths. Visit Consensus.coindex.com or check the link in the show next. Now, when it came to their proposal to convert GPDC, it seemed as though with futures-based ETFs now up and running, Grayscale believed that the SEC was ready to approve the first

Starting point is 00:08:53 spot Bitcoin ETF that actually owned the underlying Bitcoin. Grayscale CEO Michael Sondenshine said at the time, we are of the firm belief that because the futures and the spot pricing for Bitcoin are inextricably tied, that we have the willingness to allow or clear the way for a Bitcoin futures ETF in the market and also clear the way for a spot ETF. However, in the following months, half a dozen similar spot-based from a variety of other asset management companies were refused authorization by the SEC. The reasoning voiced by the regulator was the same as it had been for years. That Bitcoin mostly trades on unregulated exchanges, and there are concerns around market

Starting point is 00:09:26 manipulation and fraud. While the other firms withdrew their applications, when it was clear they would not be accepted, Grayscale continued to press the issue. They spearheaded a letter writing campaign and pointed out that approval of the conversion to an ETF could protect investors who had seen the GBT premium drop to a discount. Unlike the other firms that could easily abandon their feudal applications, Grayscale appeared determined to put the SEC in a position of explicitly denying the ETF conversion and providing specific reasoning.

Starting point is 00:09:51 The SEC's final decision on the Grayscale application added some clarification of its position. The regulator considered the CME Bitcoin Futures product to be a regulated product that could be wrapped in an ETF, while it did not consider spot Bitcoin in the same light. Its arguments around potential fraud and market manipulation in Bitcoin markets was also honed down, with the SEC pointing out that the disparate exchanges had, quote, no adequate surveillance agreement, meaning that they did not share data to stamp out abusive market activity. The SEC remained steadfast, initially refusing to approve the conversion before finally rejecting Grayscale's application in June of last year.

Starting point is 00:10:23 The same day of the rejection, Grayscale filed a lawsuit against the SEC as it had threatened to do. Grayscale said at the time, the SEC is discriminating against issuers by approving Bitcoin Futures ETFs and denying Bitcoin Spot ETFs. Now, sad as it was, it was not like Grayscale didn't think this was the most likely outcome. And indeed, they had spent the proceeding months before the SEC finally denied their application, gearing up to fight the decision in court. When the lawsuit was announced, Grayscale CEO, Sean Insheim, said that the full resources of the firm were being redirected into it. They hired former U.S. Solicitor General Donald Verrilli to act as senior legal strategist.

Starting point is 00:11:00 Verrilli was the top government attorney during the Obama administration and successfully defended the government's position in the Supreme Court on controversial topics, including same-sex marriage and the Affordable Care Act. Even before the final disapproval, after announcing that they had retained Verrilli, Jake Chravinsky wrote, Strong move. Grayscale means business. The SEC's deadline to approve or deny the application

Starting point is 00:11:20 to convert GPDC to an ETF is July 6th. No doubt it should be approved. I don't see how the SEC survives a legal challenge, if not, especially one led by Don Verilli. In October of last year, Grayscale filed their first legal brief in the case, claiming the SEC's decision was, quote, arbitrary, capricious, and discriminatory. They even went so far as to call the decision,

Starting point is 00:11:39 quote, outside the Commission's authority. Grace Gills' chief legal officer Craig Somm said, the Administration Procedure Act and Exchange Act require rules and regulations to be applied without favoritism for one type of product or another. The legal argument was straightforward. Although Bitcoin futures trade on the CME, they are priced using Bitcoin indices which take data from the same offshore exchanges the SEC was so concerned about. Because both futures and spot Bitcoin ETFs would be referencing the same underlying markets, they're both subject to the same risks. Therefore, the SEC approving one while denying the other is unfair. Now, during this whole period, it's not like there hasn't been any external pressure around Grayscale. With crypto markets

Starting point is 00:12:14 falling into disarray, over the course of last year, the Grayscale discount had blown out to more than 40 percent, once patient investors began to get frustrated with how long it was taking Grayscale to resolve the situation. A shareholder's movement galvanized around comments from folks like Misari CEO Ryan Selkis and Bitcoin Magazine's David Bailey, who both demanded that Grayscale seek relief from the SEC's Regulation M, allowing Grayscale to make. a tender offer to shareholders. A tender offer would allow Grayscale to buy back and redeem shares out of the market, closing the discount by reducing the oversupply of shares available. Grayscale had made it clear, however, that the company considered this move a last resort.

Starting point is 00:12:46 The CEO committed to following through with the lawsuit and attempting to convert GBT into an ETF. Even going so far as to suggest that Grayscale may appeal any unfavorable decision all the way to the Supreme Court. In media appearances, Sonn and Shine claimed that putting forward a tender offer came with significant strings attached to the ongoing operation of the fund. In December, however, hedge fund manager Firtree partners press the issue, filing a lawsuit against Grayscale, accusing the firm of, quote, potential mismanagement of and conflicts of interest at GBTC. And then just yesterday, on the eve of this case, the FTX bankruptcy team threw their hat in the ring as well, filing a lawsuit on behalf of

Starting point is 00:13:19 bankrupt trading firm Alameda Research against Grayscale. That lawsuit demands redemption of their GBT holdings and as a byproduct, general redemptions available to all shareholders. Alameda claims to hold around 250 million in GBT shares, which it claims would be much more valuable if they were allowed to redeem for the underlying Bitcoin. Grayscale bit back at this, saying the lawsuit filed by Sam Bankman-Frieds hedge fund Alameda research is misguided. Grayscale has been transparent in our efforts to obtain regulatory approval to convert GBT into an ETF, an outcome that is undoubtedly the best long-term product structure. We remain confident in the common sense, compelling legal arguments that will be argued

Starting point is 00:13:53 tomorrow before the D.C.C. Circuit Court of Appeals. A fair number of people agreed with Grayscale's position here. Investor Adam Cochran retweeted Grayscale's response and said, honestly, incredibly bad faith and bad taste timing on the part of the FTX creditors in filing this just before Grayscale goes to court. If Grayscale wins their case, it solves the issue of the debt return as well. This may hinder it. All of which brings us back to what happened today. With filing's complete, Grayscale received an expedited hearing date. Oral arguments commenced this morning much earlier than initially expected. The Grayscale discount narrowed from 47% in mid-February to 42% today as the court date approached. Five amicus or friend

Starting point is 00:14:27 of the court briefs have been submitted in support of Grayscale's argument, including from Coinbase, the Blockchain Association, and even traditional exchange NYSE-Arca. That's the firm that manages the electronics communication network that underlies the New York Stock Exchange. Now, some remain pessimistic about Grayscale's chances. Brian Armore, director of passive strategies research for North America and Morningstar, whensofar is to call the lawsuit a way to delay redemptions from the deeply underwater fund. However, not everyone sees things that way. Jim Angel, an associate professor specializing in financial market structure at Georgetown, said that the SEC has a, quote, really weak hand in the case. Angel says, you need a microscope to tell the difference between the two.

Starting point is 00:15:04 They're both ETFs and track Bitcoin. The only difference is BITO, the futures ETF, does it in a very inefficient way using Bitcoin futures, and that creates a lot of transaction costs because you have to roll over the futures positions every month. Investor Nick Carter wrote, not knowing much about this stuff, I'm pretty optimistic in the Grayscale versus SEC case today. It's completely obvious that the SEC is stonewalling the spot ETF for arbitrary political reasons, and they're There's zero good reason to deny it. Any decent court should see that. The courts are generally our friends,

Starting point is 00:15:29 because oftentimes the crypto space finds itself politically stymied despite procedural and legally being in the right. It's just that the courts take forever. Now, audio of the hearing was streamed live, and many in the crypto industry were watching. Andrew at AP Abacus writes, Update, ongoing hearings for Grayscale versus the SEC. Grayscale arguments are very effective.

Starting point is 00:15:46 One judge on the panel, quote, we haven't seen any evidence that Grayscale's argument is flawed. Judge hammering Spot versus Futures. He sees no difference between Spot and Futures markets. Someone responded to Abacus's tweets saying, This could finally resolve this. Andrew responded, If you're listening to the hearing,

Starting point is 00:16:00 the SEC lawyer isn't enjoying herself. Adding a little more meat to that bone, Eric Balcunis, the senior ETF reporter from Bloomberg, was also listening. He writes, Interesting. So the SEC lawyer came out strong with opening argument, blah, blah,

Starting point is 00:16:12 but the judge interrupted her several times with a bunch of very educated questions regarding futures and spot relationships. SEC seems a bit rattled by the pro-grayscalee judge and her questions. Judges are now double-teaming the SEC with question variations of this main point. How can you guys argue that manipulation in spot wouldn't affect the futures? Thus, the surveilling-sharing agreements of futures isn't really meaningful, which is your whole point in disapproving spot ETFs.

Starting point is 00:16:36 Judge, if we were to agree with the petitioner's gray scale, would the commission look to approve spot ETFs or go back on its approval of Bitcoin futures ETFs? SEC lawyer says she can't say and quickly pivots to legal talk. Balcunis goes on, there is now a third judge trying to pin down the SEC lawyer on this, who is now starting to stutter, have her voice crack a bit in her answers, and sounds flustered. These questions are very detailed about market structure, not sure she totally knows or has good answers, keeps pivoting. SEC lawyer just says, okay, if there are no further questions in a way that was really

Starting point is 00:17:04 saying, don't ask me any more questions. Now, that was around the point where the hearing ended. Balcunas was quick to point out that it wasn't clear to him whether the judge was more making an argument for saying you have to approve spot ETFs or making an argument conversely, that you should unapproved futures ETFs. But what the judge clearly was saying was that there is an inconsistency in this logic. For my part, I retweeted Balcunis where he talked about the SEC lawyer starting to have a stutter and a voice crack in their answers and said, I'm sorry, but after every arrogant video, every obfuscating answer, every unwillingness to

Starting point is 00:17:37 proactively explain their positions, finally seeing someone in a position of power to call out the clear hypocrisy in the SEC's position is incredibly satisfying. And that's the way that I feel. not sure where this particular case goes. I think Eric is right that if you have the judge saying there's clearly the same underlying infrastructure, it's not impossible that the SEC goes the other direction and just says, actually, you're right, we were wrong, we shouldn't even have approved futures ETFs, which would obviously be not a good outcome for us. But it's pretty clear watching this that we're having the conversation in the right place now. And it's not just crypto people yelling on Twitter about the SEC's inconsistency. It's judges in federal courts who actually have the power to make

Starting point is 00:18:15 decisions. And that, my friends, is progress. Until tomorrow, guys, be safe and take care of each other. Peace.

The Breakdown - Fireworks in the Grayscale Bitcoin ETF Lawsuit as Judge Visibly Rattles SEC Attorney

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