The Breakdown - Grayscale’s Legal Battle Against the SEC

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 sponsored by nexus.io, near NFTX, and produced and distributed by CoinDesk. What's going on, guys? It is Thursday, June 30th, and today we are talking about grayscale, suing the Securities and Exchange Commission of the United States of America. 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

Starting point is 00:00:49 breakdown pod. Also, a disclosure as always. In addition to them being a sponsor of the show, I also work with FTX. All right, friendos, I am back in the saddle for our everyday shows. I know you've had a show every day, but I record. them in advance, as you know, while I was traveling, but here we are. We are back to normal, and we have a big one today. A few weeks ago on June 11th, I released a show called Crypto's appetite for legal battles is growing. The thesis was basically that it seemed like a number of different firms and institutions in the space were coming to the conclusion that they were going to have to use courts to force decisions on important issues. A week later, on June 18th, I had

Starting point is 00:01:33 occasion to publish why Coin Center is suing the U.S. government. The advocacy firm's lawsuit was against the U.S. Treasury Department and the IRS, and is focused on what they argue is an unconstitutional surveillance provision in last summer's infrastructure bill. That is obviously going to be hugely important even for people who aren't just focused on the crypto industry. Still, the biggest motivation behind the thesis of that initial show was the announcement that Grayscale had retained Donald B. Verrilli Jr. as counsel surrounding the then-upcoming deadline of their proposal to convert the Grayscale Bitcoin Trust into a Bitcoin spot ETF. Varelli was the Solicitor General of the United States from 2011 to 2016. The Solicitor General is the fourth highest-ranking

Starting point is 00:02:19 official in the United States Department of Justice. They represent the federal government before the Supreme Court and report directly to the Attorney General. At the time of this announcement, it was widely seen as an indication that Grayscale was gearing up for an absolute battle should the SEC deny their application. Jake Chravinsky tweeted strong move, grayscale means business. The SEC's deadline to approve or deny the application to convert GBT 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. Mark your calendar. Well, last night, the SEC formally denied their application.

Starting point is 00:03:02 Less than an hour later, Grayscale announced that they were indeed suing. So let's get into what all this means and how we got here, but first of all, super fast, what is the Grayscale Bitcoin Trust? Like an ETF, it is a traditional market vehicle. It invests directly and exclusively in Bitcoin and then trades on the public market like a stock. This is important. It means that the price of GBT could be valued higher or lower than the value of the underlying Bitcoin in the fund. Why might that be the case? Well, in the bull run, GBTC was running above

Starting point is 00:03:32 Bitcoin. This was the GBTC premium. It's because there were lots of market participants who wanted exposure without all the hassle of the very different type of infrastructure needed to actually buy Bitcoin. In other words, there was a premium on buying Bitcoin from your brokerage account. In some cases as well, people might not be institutionally allowed to buy the underlying Bitcoin, but they could buy GBTC. However, as we've seen, the reverse is all also true. In times of falling prices where there is lower demand and lower liquidity, the instrument could trade at less than the value of Bitcoin. And that's exactly what we've seen. Right now, GPTC is trading at around a 30% discount to the net asset value of the underlying asset, which is, of

Starting point is 00:04:13 course, Bitcoin. This has lots of implications for the industry, such as, for example, debt positions collateralized with GBT. This was the case, it seems, for Three Arrow's Capital's collateral position with their BlockFi loan. Some meaningful chunk of it was in GPDC, which is now, of course, underwater. So that's a little bit about the Grayscale Bitcoin Trust, but to this application. Grayscale has long said that the intention of the trust was always to convert it to an ETF when the time was right. For many reasons, they decided that the time was right now. Remember, the SEC approved its first Bitcoin Futures ETF last fall, but has remained firmly against a spot Bitcoin ETF. Since the initial proposal that Grayscale put forward,

Starting point is 00:04:56 have been some updates, and while this gets a little into the legal weeds, I think it's kind of important. There are a couple of different old statutes that these type of investment products can be registered under or proposed under. There's the Securities Acts of 33 and 34, and then there is the 1940 Securities Act. SEC Chair Gary Gensler has historically said that he liked the 40 Act better as it had more investor protections. And so, the first futures ETFs were approved under the 40 rules. However, in April, a futures ETFs was approved under the 40 rules. However, in April, a futures from Tukrium was approved under the 33 Act, and it opened up a whole new legal argument. At the time, Greg Somm, the chief legal officer at Grayscale, wrote a threat about how they were updating

Starting point is 00:05:38 their proposal based on that approval. He writes, Our attorneys have sent a new letter to the SEC, updating our arguments that approval of Bitcoin futures ETFs, but not Bitcoin spot ETFs like GBTC, would be arbitrary and capricious, an unfair discrimination, in violation of the APA and exchange act. Act. This is another new supporting argument in the context of Bitcoin Spot ETFs that wasn't possible until the approval of the first Bitcoin Futures ETF registered under the same regulation that all Bitcoin Spot ETFs like GBTC would be registered. So what is the argument? Prior to last week, the SEC had only approved Bitcoin Futures ETFs registered under the Investment

Starting point is 00:06:18 Company Act of 1940 and denied all Bitcoin Spot ETFs that would be registered under the Securities Act of 1934 and the Securities Act of 1933. Why? The SEC cited the distinctions between the 40 Act and 34 as reasons to approve Bitcoin futures ETFs, but not Bitcoin spot ETFs. But as we've explained, those are distinctions without a difference in the context of Bitcoin ETFs. While the 40 Act certainly has additional investor protections, they do not protect against the types of harms the SEC has cited for denying Bitcoin ETFs, i.e. potential fraud and manipulation in the underlying Bitcoin market. That's because Bitcoin futures are priced based on spot Bitcoin markets.

Starting point is 00:06:59 So what does this all mean now? One, the SEC can no longer rely on the 40 Act as a reason to treat Bitcoin futures and Bitcoin spot ETFs differently. Two, the SEC has further paved a path forward to approve Bitcoin spot ETFs. It has conceded that it is not concerned with potential fraud or manipulation in the underlying Bitcoin markets, or at least not enough to deny Bitcoin ETFs. Otherwise, how could it have approved Tukrium? As a result, we believe that not approving the GBTC conversion to an ETF would be arbitrary and

Starting point is 00:07:29 capricious and unfair discrimination and therefore in violation of the APA and Exchange Act. Now, back to NLW here, it's worth noting that that language of arbitrary and capricious that they started to reference months ago is the exact language that they are now using today as well. It's worth noting, however, that it isn't just grayscale making these types of arguments. NXO lets you easily buy crypto with your bank card and earn industry-leading interest rates. Earn up to 16% on crypto and up to 12% on stable coins. Nexo makes passive income easy,

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Starting point is 00:09:15 One of the largest exchanges in the U.S. FDXUS is also the only leading exchange that supports both Ethereum and Solana NFTs. When you trade NFTs on FTCX, you pay no gas fees. Download the FTX app today and use referral code breakdown to support the show. By and large, the industry has agreed with the sort of randomness of how the SEC seems to be approving things or not. FTX US President Brett Harrison tweeted a thread about it yesterday that I think sums up a lot of what people have been thinking. He writes, next week is the deadline for the SEC to decide whether to reject Grayscale's application to convert GBT into an ETF. Here are the main reasons why it would be inconsistent not to.

Starting point is 00:09:58 to approve GBT and other spot Bitcoin ETFs. 1. The SEC has already approved BITO, the ProShare's ETF based on a basket of CME Bitcoin Futures and other similar futures-based ETFs. The SEC has approved these on the basis of the CME Bitcoin Futures having sufficient anti-manipulation protections. CME Bitcoin Futures settle to the CF Benchmark's Bitcoin Reference Rate, or BRR, which has composed of Bitcoin spot prices from eight global crypto exchanges. But the SEC has rejected spot ETFs whose net asset value would be computed using the same BRR out of manipulation concerns.

Starting point is 00:10:35 The clear inconsistency here comes from the fact that, A, the CFTC has approved Bitcoin futures based on the BRR, and B, the SEC has approved ETFs based on futures based on the BRR, but C, the SEC has rejected ETFs based directly on BRR. Two, SEC has generally rejected spot ETFs due to the fact that spot markets are not licensed, under a U.S. federal regulatory regime. There are a few ways in which this is inconsistent with other approved ETFs. ETS like EWJ, which is I-Share's MCSI, Japan, contain financial instruments regulated in non-U.S. jurisdictions. Bitcoin is regulated in many non-U.S. jurisdictions and trades on regulated exchanges

Starting point is 00:11:16 in non-U.S. jurisdictions. ETFs like YG, which is I-Share's high-yield corporate bonds, contain debt instruments that don't trade on any license exchange. ETSs like FXE, Invesco's Euro trust, contain fiat currencies, which have no markets regulator. Three, SEC has raised the concern in past spot ETF rejection decisions that spot markets do not yet have sufficient liquidity or trading volume. However, many corporate bond ETFs, eG, g. HYG, contain baskets whose constituents each trade a median of single-digit times per day. Ironically, approving a spot Bitcoin ETF would bring far greater regulatory oversight,

Starting point is 00:11:56 into spot Bitcoin markets and help achieve many of the SEC's stated goals for spot cryptocurrencies. A significant percentage of existing institutional liquidity, along with a huge influx of new participants' capital, would move into these highly regulated investment vehicles that trade primarily on SEC regulated securities exchanges, and surveillance sharing agreements between the fund issuers and the spot exchanges would additionally give the SEC greater oversight of their market activity, further ensuring the integrity and proper functioning of spot order books. I wanted to read that whole thing because it sums up so much of what you see day in and day out as arguments for this, but trying to just add even more kind of bullet points.

Starting point is 00:12:35 The reason that the rejection, according to Brett, is inconsistent with other SEC actions, include that the SEC has already approved futures ETFs, if they have approved them on the basis of the CME trading venues having sufficient anti-manipulation measures in place, and they've approved them on the base of settling against an index based on Bitcoin prices that all of the spot ETFs would use as well. The other point of contradiction would be the idea that Bitcoin spot markets are not regulated by a U.S. regulator, but there are plenty of other ETFs that are tied to financial instruments that, again, are not regulated by U.S. jurisdictions. They've also cited liquidity, which again just doesn't hold a candle when you actually look at the ETFs out there that have been approved.

Starting point is 00:13:13 This was the state of the discussion going into the announcement yesterday that the SEC was rejecting Grayscale's application to convert its $13.5 billion, dollar Grayscale Bitcoin Trust into an ETF. The SEC stated in its filing that Grayscale had failed to answer their questions about preventing market manipulation. They also cited the role of tether in the broader ecosystem and the lack of surveillance sharing agreements between a regulated market of sufficient size and a regulated exchange. Jeff Seyffart, an analyst at Bloomberg Intelligence, says, well, there it is. Certainly earlier than I expected, but the decision was as expected. Both Grayscale's GBTC and Bitwise Invest Spot Bitcoin ETFs were

Starting point is 00:13:53 disapproved by the SEC today. They mentioned surveillance sharing agreement a whopping 78 times in this GBTC denial. The whole thing is 86 pages. She should also mention that Tether was specifically mentioned seven times, which is also an increase from one or two in previous denials. Now, in the lead-up to this decision, Grayscale CEO Michael Sonenschine had stated that the company was, quote, preparing for all possible post-ruling scenarios. On the positive side, they had formed partnerships with firms like Jane Street and Virtue Finance to provide market making for the proposed ETF, but to the downside, as we heard before, they had hired a former solicitor general to lead litigation efforts should it go that way. Within minutes, I mean literally,

Starting point is 00:14:35 less than an hour of the SEC's announcement, Sonn and Shine tweeted, we filed a lawsuit against the SEC. It's almost like they were prepared for this possibility. Now, specifically, the filing asks the U.S. Court of Appeals for the D.C. Circuit to review the SEC's order. Sonn-Shine said Grayscale supports and believes in the SEC's mandate to protect investors, maintain fair, orderly, and efficient markets, and facilitate capital formation. And we are deeply disappointed by and vehemently disagree with the SEC's decision to continue to deny spot Bitcoin ETFs from coming to the U.S. Verrilli had told reporters earlier this month that the SEC's approval of the futures ETFs implies the underlying market should be seen as reliable.

Starting point is 00:15:17 quote, this is a place where common sense has a really important role to play. You've got a situation now in which you have certain kinds of exchange traded funds, one that is focused on Bitcoin futures, and the SEC has approved that. The SEC has given its seal of approval. In order to do so, it had to make a determination that giving this approval was consistent with the securities laws, and in particular that there wasn't a sufficient underlying risk of fraud and manipulation. Verili's formal statement last night pulled back those themes from that first thread we saw from Craig Somm so many months ago. The SEC is failing to apply consistent treatment to similar investment vehicles and is therefore acting arbitrarily and capriciously in violation of the Administrative

Starting point is 00:15:57 Procedure Act and Securities Exchange Act of 1934. There is a compelling, common-sense argument here, and we look forward to resolving this matter productively and expeditiously. So what does the industry think? Some honestly think that Grayscale just needs to wind down the fund. VJ. Boya Potty writes, a much better solution would be to wind down the fund and return the underlying Bitcoin to investors, who are currently being milked for an outrageous 2% per year. Do the right thing, Grayscale. Others are furious. Benjamin Cowan writes, looks like the SEC rejected Grayscale's spot Bitcoin ETF. I sleep well at night, knowing that the SEC is providing us silly investors from ourselves. Lily Francis wrote, the SEC took a bold step today in protecting

Starting point is 00:16:41 investors by rejecting the Bitcoin ETF. Retail investors should only be able to lose money in distinguished ways, like buying junior miners or Chimoth Spacks. I'm so glad they protect me from not having to pay roll yield to middlemen for no reason. Thankfully, they've never been allowed actual fraud to be traded, only sensible investments like gravity-powered rolling trucks. Other market participants are simply resigned. Jake Chavinsky again says the SEC has denied Grayscale's proposal to convert GBT to an ETF. Deeply disappointing. The point of the SEC is to protect investors and an ETF is unquestionably a better product for them. This decision defies both common sense and federal law. I hope it goes quickly to court. Sad that it comes to this after so many years of ETF debate,

Starting point is 00:17:24 but absolutely necessary. It does feel a bit to me like a unifying moment. Grayscale has repeatedly discussed the more than 11,000 comments the SEC received on their proposal, more than 99% of which were positive. Eric Balcunas from Bloomberg did a twin poll. He asked, who do you think will win, gray scale or the SEC, and among the 1,200 respondents, exactly two-thirds, 66.7% said the SEC, well, just one-third thought that Grayscale would win. However, in the follow-up tweet, he asked who are you rooting for, and in that, Grayscale flipped the tides entirely. 69.4% said that they were rooting for Grayscale, while only 30.6% said they were rooting for the SEC. The narrative problem here is, of course, the SEC protecting investors against their wishes. Will Clemente

Starting point is 00:18:11 writes, this Grayscale lawsuit against the SEC is the first time I've seen unity on this app in a long time. Poked the wrong nest. So there you have it, guys. This is now a thing. This battle is coming. And the important thing to note is that even if Grayscale doesn't win, there is going to be a lot of information and a lot of potential precedent that will help us have a much better understanding of where Bitcoin is going to stand in traditional financial markets. I agree with Jake's sentiment that this is regrettable but necessary, and I can't wait to keep bringing you guys the news as it happens as relates to this fight. For now, I want to say thanks again to my sponsors, nex0.io, near and FtX, and thanks to you guys for listening. Until tomorrow, be safe and take care of each other.

Starting point is 00:18:56 Peace.

The Breakdown - Grayscale’s Legal Battle Against the SEC

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