On Tuesday, August 29, 2023, Bitcoin once again loomed large over financial markets after the D.C. Circuit Court of Appeals vacated an SEC order that rejected Grayscale Investments’ (“Grayscale”) application to list a spot Bitcoin exchange-traded fund (“ETF”) on NYSE Arca. The price of Bitcoin initially jumped almost seven percent on the news. But as of this writing, the market has erased nearly all those gains.
With the increased prevalence of digital assets, the SEC received numerous applications to list and trade shares of digital assets as ETFs on various exchanges. As the most well-known digital asset, Bitcoin represents the focal point for many of these applications. The key distinction between these applications is whether the ETF is based on the spot or the future market.
In the Spring of 2022, the SEC approved two Bitcoin futures ETFs. These products trade on both the NYSE Arca and the Nasdaq. But, in approving both futures ETFs, the SEC indicated that the approval of Bitcoin spot ETFs was not imminent. In fact, the SEC has consistently rejected applications to list Bitcoin spot ETFs, including applications filed by ARK, Fidelity, and Invesco. The SEC based each of these rejections largely on investor protection grounds.
Last year, the SEC rejected NYSE Arca’s application to list the Grayscale Bitcoin Trust as an ETF on its exchange because it believed that Grayscale was not “designed to prevent fraudulent and manipulative acts and practices.” Grayscale appealed the SEC’s decision directly to the D.C. Circuit Court of Appeals.
The D.C. Circuit holds that the SEC’s rejection of Grayscale’s Bitcoin spot ETF was arbitrary and capricious
Ultimately, the Court focused largely on the similarities between Grayscale’s proposed Bitcoin spot ETF and the Bitcoin futures ETFs already approved by the SEC. The Court reasoned that the SEC was required to treat “like cases alike” and found that Grayscale’s proposed Bitcoin spot ETF was “materially similar” to the Bitcoin futures ETFs. Consequently, the Court vacated the SEC’s rejection of Grayscale’s proposal as arbitrary and capricious because the SEC did not adequately explain the difference in treatment between the Bitcoin spot and futures products.
The Court conducted a two-step analysis to determine whether the SEC’s decision was arbitrary and capricious. First, the Court considered whether Grayscale demonstrated that its spot ETF was similar across the relevant regulatory factors to the futures ETFs already approved by the SEC. The Court reasoned that “dissimilar treatment of evidently identical cases is the quintessence of arbitrariness and caprice.” (internal citations omitted). Second, the Court considered whether the SEC provided an “adequate explanation for approving the two Bitcoin futures [ETFs] but denying Grayscale’s Bitcoin [ETF].”
The Court holds that the spot and futures products are “materially similar“
In determining that Grayscale’s proposed Bitcoin spot ETF and the Bitcoin futures ETFs already approved by the SEC are “materially similar,” the Court reasoned that their prices are highly correlated and their identical surveillance agreements have the same likelihood of detecting fraud and manipulation.
The Court first considered how the individual products derive their value. Both products track the spot price of Bitcoin. Grayscale holds Bitcoin in its trust and calculates its value using the CoinDesk Price Index, which tracks the spot trading value across four major Bitcoin platforms. Conversely, Bitcoin futures “trade based on predicted settlement prices . . . calculated using the Bitcoin Reference Rate.” The Reference Rate aggregates the spot prices of Bitcoin from multiple exchanges. The CoinDesk Index and the Reference Rate track the same four out of six total exchanges used to value Bitcoin. The Court considered evidence from a public comment that showed that the CoinDesk Index and the Reference Rate were “near-perfect substitutes.”
Further, Grayscale presented evidence “that there is a 99.9 percent correlation between Bitcoin’s spot market and CME futures contract prices.” Crucially, the SEC failed to contest this evidence.
Then, the Court considered to what extent Grayscale’s proposed Bitcoin spot ETF would be exposed to manipulation and fraud. The Court gave great weight to the fact that “the listing exchanges for Grayscale and the Bitcoin futures [ETFs] have identical surveillance sharing agreements with the CME” because the SEC previously stated that fraud in either the spot or the futures market for Bitcoin could be detected by surveillance of the CME futures market. Therefore, the Court reasoned that the identical surveillance-sharing agreements would have the same likelihood of detecting fraud or manipulation in either market.
The SEC failed to explain its rejection of Grayscale’s Bitcoin spot ETF adequately
The SEC acknowledged that: (1) NYSE Arca has a surveillance sharing agreement with the CME; (2) the Bitcoin futures market is related to Grayscale’s proposed Bitcoin spot ETF; and (3) the CME is adequately regulated by the Commodity Futures Trading Commission. However, the SEC distinguished the two products through the application of the significant market test, which is used to analyze whether market manipulation will be detected in a surveilled market.
The significant market test has two prongs. First, the SEC considers whether a person attempting to manipulate an ETF could bypass the related market and circumvent surveillance. Second, the SEC considers whether trading in the ETF “would be the predominant influence on prices in the surveilled market.”
The SEC failed to explain why Grayscale owning Bitcoin rather than Bitcoin futures affects the CME’s ability to detect fraud
The SEC asserted that it would be difficult to detect fraud in the proposed Bitcoin spot ETF market because it would not be traded on the surveilled exchange. This, the SEC argued, was a “significant difference” because the Bitcoin futures ETFs trade on the exchange being surveilled. But, the Court notes the SEC did not provide any support for this claim.
Instead, the Court cited the undisputed evidence showing that the spot and futures markets for Bitcoin are 99.9 percent correlated to support the proposition that fraud or manipulation in one market would “present identical problems” in the other. Consequently, the Court reasoned that the SEC “failed to explain why a surveillance sharing agreement with the CME was sufficient to protect Bitcoin futures [ETFs] from potential fraud, but not Grayscale’s proposed Bitcoin [ETF]” when the products are materially similar.
The SEC unreasonably concluded that Grayscale would be the predominant influence on prices
The SEC argued that Grayscale’s approximately $30 billion in assets would dwarf the CME market for Bitcoin futures, which has approximately $1.7 billion of open contracts. However, the Court noted that Grayscale holds only 3.4 percent of outstanding Bitcoin and no Bitcoin futures contracts. Therefore, the only way Grayscale could impact the futures market is through the spot market. And the SEC did not argue that Grayscale can dominate the price of Bitcoin itself.
Furthermore, the Court noted that the market for Bitcoin is “deep and liquid,” with an average daily trading volume of approximately $45 billion.” Similarly, NYSA Arca provided evidence that Grayscale experienced an inflow of $7 billion over a two-year period, while the market capitalization of Bitcoin grew by $721 billion over the same period of time.
All of this suggests that trading in Grayscale would have a minimal impact on the spot price of Bitcoin and, consequently, on the futures price as well. The SEC failed to explain its concerns in light of this evidence. The Court ultimately held that the SEC’s failure to adequately explain why it treated these two products differently was arbitrary and capricious.
After determining that the SEC’s decision was arbitrary and capricious, the Court vacated the SEC’s order, rejecting Grayscale’s application to list a spot Bitcoin ETF on NYSE Arca. Ultimately, this is a narrow holding and it remains to be seen whether this is a lasting victory for advocates of digital currency. The SEC has the option to seek a rehearing of the Court’s decision or to appeal the decision to the U.S. Supreme Court. Alternatively, the SEC could reject the application on different grounds with more robust reasoning for the rejection.
Interestingly, the SEC has already extended the deliberation of other Bitcoin ETF applications filed by BlackRock, Bitwise, VanEck, WisdomTree, Invesco, Fidelity, and Valkyrie for another 45 days. So, while a Bitcoin spot ETF might be closer to approval, it may still not be imminent.
 Grayscale Investments, LLC v. Sec. & Exch. Comm’n, — F.4th—, 2023 WL 5536704, at *1 (D.C. Cir. Aug. 29, 2023).
 CME stands for “Chicago Mercantile Exchange,” which is a global derivatives market regulated by the Commodity Futures Trading Commission. Both Bitcoin futures ETFs approved by the SEC have a surveillance-sharing agreement with the CME.