Star Crossed: The Failure of Gemini’s ETF

Note: This is not legal advice, but rather one lawyer’s observations

As was widely reported, the SEC has rejected Gemini’s application for a Bitcoin ETF by issuing its Order Disapproving (“Order”), sending shockwaves through the bitcoin community, particularly hitting investors who had watched bitcoin’s value against USD surpass all-time highs, going so far as to push past the price of 1 oz. of gold. Why? An ETF would have allowed most investors to buy exposure to actual bitcoins through their conventional trading accounts (think Schwab or E*Trade) and would have required that the ETF issuer actually hold bitcoins. The market forecast a mass purchase event if the ETF was approved. Having failed, the exchanges have seen steep drops of about 20%, followed by see-saw volatility, and some exchanges suffered full outages caused presumably by the crush of bitcoin speculators rushing to cash out, or maybe buy up cheap coins.

Why did it happen? (aka, here’s the TLDR)

The Opinion rejected the ETF because (a) bitcoin is not traded on a suitably regulated market and (b) it was unable to properly surveil bitcoin, and therefor it’s (c) too susceptible to market manipulation to allow the ETF to be approved. Specifically, the Opinion states

Section 6(b)(5) of the Exchange Act, which requires… that the rules of a national securities exchange be designed to prevent fraudulent and manipulative acts and practices and to protect investors and the public interest. The Commission believes that, in order to meet this standard, an exchange that lists and trades shares of commodity-trust exchange-traded products (“ETPs”) must, in addition to other applicable requirements, satisfy two requirements that are dispositive in this matter. First, the exchange must have surveillance-sharing agreements with significant markets for trading the underlying commodity or derivatives on that commodity. And second, those markets must be regulated.

Based on the record before it, the Commission believes that the significant markets for bitcoin are unregulated. Therefore, as the Exchange has not entered into, and would currently be unable to enter into, the type of surveillance-sharing agreement that has been in place with respect to all previously approved commodity-trust ETPs—agreements that help address concerns about the potential for fraudulent or manipulative acts and practices in this market—the Commission does not find the proposed rule change to be consistent with the Exchange Act.

What is a regulated market?

The Opinion notes that the significant markets for the prior approved ETF’s have been well-established regulated futures markets for the underlying commodity, and that such markets are not present for bitcoin, whose trade activity happens across a globally distributed set of exchanges and a likely as significant set of non-public exchange brokers.

Gemini argued it is a suitably regulated market because it is subject to, and fully compliant with, the NYDFS promulgated BitLicense, which includes regulation on capitalization, AML/KYC compliance, consumer protection and cybersecurity.  The Opinion rejected this argument, on the basis that Gemini captures an insignificant percentage of the market, lacks sufficient volume to be representative of the market, and even though it complies with the NYDFS BitLicense, lacks a number of needed regulatory elements including:

  • rules that are “designed to prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling, processing information with respect to, and facilitating transactions in securities, to remove impediments to and perfect the mechanism of a free and open market and a national market system, and, in general, to protect investors and the public interest.”
  • Not subject to SEC oversight of
    1. governance
    2. membership qualifications
    3. trading rules
    4. disciplinary procedures
    5. recordkeeping
    6. fees

… and that Gemini is not subject to the similar requirements of the CFTC.

Thus, the SEC concluded that Gemini is not an appropriately regulated exchange.

What’s this about surveillance?

Before you flip back in your mind to the Wikileaks outing of the CIA’s stunning array of zero day exploits, the surveillance at issue here is different. In this context, surveillance means the ability of the regulator to monitor the pricing and activity of the underlying asset through what’s referred to as a surveillance sharing agreement with the market maker(s) that permits the regulator to investigate manipulation or fraud. Specifically:

As a general matter, the Commission believes that the existence of a surveillance sharing agreement that effectively permits the sharing of information between an exchange proposing to list an equity option and the exchange trading the stock underlying the equity option is necessary to detect and deter market manipulation and other trading abuses. In particular, the Commission notes that surveillance sharing agreements provide an important deterrent to manipulation because they facilitate the availability of information needed to fully investigate a potential manipulation if it were to occur. These agreements are especially important in the context of derivative products based on foreign securities because they facilitate the collection of necessary regulatory, surveillance and other information from foreign jurisdictions.

And…

It is essential that the SRO have the ability to obtain the information necessary to detect and deter market manipulation, illegal trading and other abuses involving the new derivative securities product. Specifically, there should be a comprehensive ISA [information-sharing agreement] that covers trading in the new derivative securities product and its underlying securities in place between the SRO listing or trading a derivative product and the markets trading the securities underlying the new derivative securities product. Such agreements provide a necessary deterrent to manipulation because they facilitate the availability of information needed to fully investigate a manipulation if it were to occur.

The SEC has also stressed the importance of these surveillance-sharing agreements comprehensively covering trading of underlying assets, which means the agreements, would have to cover the majority of the trading activity. In derivatives, this is accomplished by being a common member of the Intermarket Surveillance Group or entering into an ISA with each market trading the underlying security.  This type of group arrangement does not exist in bitcoin, and thus, the regulator cannot monitor the trading activity for manipulation.

The SEC expressly rejected Gemini’s proposed surveillance sharing arrangements as inadequate because they failed to address trading activity on other exchanges and fails to address derivatives and futures trading in bitcoin. The Order also notes that the majority of spot trading happens outside the US and on unregulated markets in jurisdictions lacking regulation, and that no bitcoin exchange is a member of the Intermarket Surveillance Group, or any ISA.

The Opinion also rejected the notion that the CFTC’s regulation of exchanges that offer futures and derivatives is adequate because those exchanges do not adequately address the spot markets for bitcoin trading.  The Opinion was also concerned about bitcoin whales manipulating prices, and variety in pricing at any given time among exchanges signaling manipulation for the purpose of arbitrage.  Finally, the Opinion suggested that Gemini had too small of a market share to represent the market, or to offer a relevant, representative surveillance agreement.

So what actually happened here?

The SEC said, point blank, they can’t get enough data to attempt to prevent investors in a bitcoin ETF from falling victim to market manipulation, or to adequately investigate any allegations of manipulation, because bitcoin’s spot markets are distributed and mostly unregulated and that, because the majority of trading activity is unregulated, they cannot adequately monitor activity based on monitoring of Gemini.

This is a symptom of bitcoin’s structure- it’s peer to peer in a way that most other assets are not. This means that, because there’s no trusted third party required to report the transaction, it may be impossible for the SEC to ever have full market surveillance. Markets like LocalBitcoins will be “forever dark.” Although the blockchain records transfers of bitcoin, it does not record the consideration (i.e. the price paid or value given) for any given transfer. Thus, unless there is a centralized self-reporting movement within bitcoin, or a large amount of trading exchanges band together to comply with regulation AND to permit surveillance, it is unlikely that a proper market will exist.

Who might win where Gemini lost?

Interestingly, a fully compliant, CFTC licensed futures or derivatives platform may inch closer to approval.  The Order specifically alluded to the argument that CFTC regulations may be sufficient, but stated that no commodities trading platform is doing bona fide commodities trading  at volume (and rather, that these platforms are typically regulated after being subject to enforcement actions, only) and even if they are, the trading volume is currently insignificant.

IF, a platform is to be created that captured a thriving derivatives market, and IF that platform actually complied with CFTC regulation, and IF that platform captured a significant percentage of bitcoin trading along with derivatives and futures, then maybe the SEC would view it as a regulated market. However, even a perfect derivatives market would only solve part of the problem; the SEC would likely still require adequate surveillance into the spot markets.

The Good News:

Although the stars did not align for Gemini, bitcoin did not crumble.  Although prices have receded from prior all-time highs, at press time, Bitcoin’s value remains within 20% of all-time highs and, most critically, far above the amount needed to properly incentivize miners to continue operating the network. Bitcoin soldiers on.

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