By Brett Munster
Welcome back to The Node Ahead, a cryptocurrency and digital asset resource for financial advisors. Every other week, we discuss the latest crypto news and the potential impacts it may have on you and your clients.
In this edition, we’ll cover the following:
- Coinbase, the SEC, and Judge Failla
- GBTC and bitcoin’s falling price
- We have a bitcoin ETF—what asset is next?
Coinbase tries to get lawsuit dismissed
Last June, the SEC filed a lawsuit against Coinbase alleging that a number of the company’s services, including its exchange, its staking service, and the Coinbase Wallet, each constitute securities violations.
The problem with this lawsuit, as we covered in previous issues, is the SEC has yet to provide any legal framework, rationale, or clarity as to which assets it deems to be securities and which aren’t. Rather than issue formal guidance, explain what criteria the SEC used, and simply ask the exchanges to delist those assets, the SEC chose to skip all that and go straight to enforcement actions. As the first line of defense in this lawsuit, Coinbase filed to have the case dismissed on the grounds that the SEC has failed to prove that any of the alleged tokens are securities, the lawsuit has no legal merit, and the SEC is clearly overstepping its jurisdiction.
On January 17, New York federal Judge Katherine Polk Failla spent nearly five hours asking questions and listening to oral arguments from both sides to determine if the case should be thrown out or go to trial. It was clear from the outset that Judge Failla is not only well-versed in securities law but has a sophisticated understanding of the technology.
While Judge Failla prodded both sides on the merits of their respective arguments, the first 2 hours were spent exclusively questioning the SEC. During this time, the judge repeatedly expressed concerns that the SEC is misinterpreting U.S. securities laws and overstepping its bounds. “It is a real fear that I have, that your argument is just sweeping too broadly,” Judge Failla said to an SEC attorney.
The judge seemed to zero in on one of the SEC’s central claims that when someone buys a token, they are buying into an ecosystem with the expectation of profit. If that were the case, as Judge Failla homed in on in her questioning, it would potentially open up the possibility of treating collectibles or trading cards as securities. The SEC seemed to have a really hard time making a principled argument that tokens, which they admitted are not securities in and of themselves, should be regulated as securities when they trade.
Judge Failla also appeared to be sympathetic that the current securities laws are insufficient when it comes to crypto, which is in direct conflict with Gary Gensler’s public stance. During the hearing, Failla remarked, “We’ve had 90 years where these securities laws have been able to apply to these markets. But now we have something new.” Judge Failla also referenced Senator Cynthia Lummis’s proposal to create a national crypto regulatory framework multiple times, which would eliminate the SEC’s purview over most crypto projects and exchanges. At one point, in an effort to downplay the bill, an SEC attorney referred to Lummis as a random senator. Judge Failla quickly interrupted, “Okay, she’s not just a random senator. She’s someone deeply involved in the space and is a co-sponsor of legislation to implement a structure that she says is not found in the Howey Test.”
The judge also praised the amicus brief filed by the DeFi Education Fund, a crypto lobbying group, which explained in detail how the Coinbase Wallet and Coinbase’s staking programs work and why neither should fall under the SEC’s jurisdiction. “The DeFi people have what I think is a really fine amicus brief, explaining to me what the wallet really is and what staking really is. And that actually, in some respects, makes more sense to me than the Commission’s description of it in the complaint.”
All in all, it was a very encouraging day for Coinbase. That being said, to have the case dismissed, Coinbase must prove that the SEC’s claims are legally insufficient, which is a very high bar. It was always a long shot to get this case thrown out, and the most likely outcome is that the judge dismisses the motion, and the trial goes to discovery. However, the fact that the judge spent an unusually long amount of time going deep into the weeds of the SEC’s arguments, her apparent displeasure with the SEC’s answers, and her level of understanding of the technology bodes well for Coinbase even if the judge denies the motion and forces them to go to court. Expect the Judge to make her ruling within the next couple of weeks.
A win for Coinbase, either now or after the case goes to trial, would be a watershed moment for the industry. The SEC’s entire justification for their enforcement actions against the crypto industry rests on the assumption that digital assets are securities and thus fall under the SEC’s jurisdiction. A ruling in Coinbase’s favor would be a recognition by the federal courts that not all digital assets are securities and the laws as written are not sufficient for regulating crypto in the US. That would severely limit the SEC’s authority over the crypto industry and deal yet another damaging blow to the SEC’s credibility under Gensler’s leadership. If the SEC were to win, it could force Coinbase to delist tokens it deems to be securities and/or shut down certain Coinbase operations, which would have major ramifications for all U.S.-based crypto businesses. After the recent oral arguments, Coinbase should feel pretty good about its chances. So does Bloomberg’s senior litigation analyst, who put the odds of Coinbase ultimately winning this lawsuit at 70%.
GBTC strikes again
By just about every measure, the bitcoin ETF has been an enormous success. In the first two weeks, the ETF issuers not named GBTC saw inflows of over $5 billion, making the bitcoin ETFs collectively one of, if not the largest, ETF launches in history. Blackrock’s bitcoin ETF was the third fastest ETF in history to reach $1 billion in AUM, is already over $2 billion in AUM, and is doing more volume per day than all 500 ETFs that were launched in 2023 combined! For a typical ETF launch, reaching $500 million in the first month would be considered a blockbuster success, and yet, there are now four separate bitcoin ETFs (Blackrock, Fidelity, Bitwise, and Ark) that have crossed that mark in the first two weeks of trading. The daily volume of the combined bitcoin ETFs puts them in the top 1% of all ETFs, which includes behemoths like SPY and QQQ (keep in mind the average age of ETFs in the top 1% of volume is 14 years old; the bitcoin ETFs are less than 3 weeks old). Bitcoin ETFs are now the second largest commodity ETFs, ahead of silver and behind only gold.
The bitcoin ETF launch was simply unprecedented, and yet, bitcoin’s price fell as much as 15% in the weeks following the ETF launch before rebounding. The reason for the dip in bitcoin’s price, despite all the capital inflows, can be traced back to GBTC.
There were ten ETFs that started trading on January 11th. Nine of those were new sponsors starting with $0 in their ETF prior to their launching. The tenth was GBTC, an existing trust run by Grayscale that originally launched in 2013, already contained $27 billion worth of bitcoin and was converted to an ETF rather than starting from scratch. We have talked about GBTC in previous issues and how a lot of the turmoil from 2022 could be traced back to GBTC’s premium and discount to bitcoin’s spot price. GBTC seems to once again be at the heart of the crypto market turmoil.
Grayscale has seen over $6 billion flow out of its ETF in the last couple of weeks. That outflow from GBTC was initially greater than the inflow into the other ETFs, which led to a net selling of bitcoin in the first week. That is what caused bitcoin’s price to dip. There are three main reasons why there has been such an exodus from GBTC.
First, Grayscale decided to keep its fees significantly higher than all other ETFs. For anyone who owned GBTC in a tax-advantaged account, it made sense to sell GBTC and immediately buy back one of the other lower-fee ETFs. However, for anyone who held GBTC directly and wanted to switch to a lower-fee ETF, it’s likely they haven’t reinvested that capital back because of the wash trade rule. After 30 days, it’s likely we will see some of that GBTC outflow come back into other lower-fee ETFs.
The second reason has to do with the discount GBTC was trading at prior to its conversion to an ETF. Because GBTC existed as a trust structure since 2013, it was less liquid than an ETF and traded at a discount to bitcoin’s price. In December of 2022, the discount reached 47%. In other words, you could buy GBTC (which held bitcoin) at a price that was 47% cheaper than what bitcoin was trading on exchanges such as Coinbase. There were many investors who bought GBTC at a steep discount not because they wanted to invest in bitcoin but because they were betting GBTC would eventually be converted to an ETF, the discount would go to zero, and they would capture that spread. That is, in fact, what happened. Once this group realized the gains from the discount going to zero, they sold their position for a massive profit.
Third, FTX owned a fair amount of GBTC, and reports have come out that they have sold at least $1 billion worth of GBTC since its conversion to an ETF as part of its bankruptcy process.
As you can see, there were a lot of reasons why people wanted to sell GBTC, but none of them had anything to do with bitcoin’s fundamentals or adoption. This is why the recent drop in prices was a short-term phenomenon, and once that sell pressure subsided, the market was always likely to rebound. That’s exactly what happened last week. Every day last week, the outflows from GBTC got smaller and smaller. That led to a net inflow of capital to the ETFs, which meant net buying of BTC in the market. This is what caused bitcoin to rebound in recent days. As we have stated from the beginning, the real impact of the bitcoin ETF is going to play out over the course of the year, not in the first couple of weeks.
What’s the next ETF to launch?
The success of the bitcoin ETF now has many people wondering if we will see other crypto-based spot ETFs. Will we get an Ethereum ETF? What about other major tokens like Ripple and Solana? Will we have an ETF for every cryptoasset?
The most likely ETF to get approved next is Ethereum for a few key reasons. First, there are already a host of Ethereum ETF applications filed with the SEC, including the same sponsors that were approved for the bitcoin ETF. Blackrock, Fidelity, Bitwise, Ark, VanEck, and Grayscale all have filed applications for an Ethereum ETF. Second, it’s by far the largest cryptoasset other than bitcoin, and it only stands to reason that the next largest token after bitcoin would be approved next. Third, bitcoin was widely agreed upon as being a commodity even by the SEC. Though the SEC has refused to publicly state that ETH is a commodity, it’s notable that the SEC did not mention ETH in any of its lawsuits against crypto exchanges. The SEC went to great lengths to single out over 60 individual cryptoassets as being securities across various lawsuits but never once included ETH. This leaves ETH with a potentially much easier path for getting an ETF approved compared to other tokens.
But the main reason an Ethereum ETF might be approved in the near future has to do with Grayscale’s win in its lawsuit with the SEC. The rationale behind the SEC denying the bitcoin ETF for nearly a decade was that it had concerns about market manipulation. In its case, Grayscale was able to prove that spot and futures bitcoin markets are 99% correlated. The SEC ran its own internal correlation analysis and came to the same conclusion. This was vital to Grayscale’s win because 1) there had been no signs of market manipulation in the bitcoin futures market, and 2) the SEC had already approved a futures bitcoin ETF. To approve a futures ETF but deny a spot ETF makes no logical sense if they are so highly correlated. Furthermore, there had been plenty of spot bitcoin ETFs that had been operating in other markets, and none of them showed any signs of market manipulation either. That’s why the judge ruled the SEC acted “arbitrarily and capriciously.” Because of Grayscale’s lawsuit, the SEC could no longer deny bitcoin ETFs based on the logic they had been using for a decade.
Well, guess what? Ethereum also has a robust, regulated futures market, which is highly correlated with its spot price. The SEC has already approved futures-based Ethereum ETFs. There are spot Ethereum ETFs operating in other markets. The SEC will not be able to deny an Ethereum ETF based on fears of market manipulation like it did for bitcoin for all those years. The Grayscale lawsuit not only paved the way for a bitcoin ETF, but it also drastically increased the odds of an Ethereum ETF approval as well. SEC commissioner Hester Pierce even publicly said that a spot Ethereum ETF won’t need a court battle to get approval. It’s precisely this reason that some analysts give Ethereum a 70% chance of approval this year.
But just because the SEC can’t deny based on fears of market manipulation doesn’t mean the SEC couldn’t deny it for other reasons. The most notable difference between BTC and ETH is that Ethereum runs on a Proof-of-Stake consensus protocol. The SEC has expressed concerns regarding Proof-of-Stake as well as the concept of earning yield by staking. It’s also worth noting that the SEC has several outstanding lawsuits with crypto exchanges over their staking services. It’s almost certain that if an ETH ETF were to be approved, staking and staking yields would not be allowed in any of the approved applications.
Given there are applications on file currently, the SEC recently announced they decided to delay any decision on an Ethereum ETF approval for now, opting to take more time to make their decision. This came as no surprise to anyone following the space as the SEC is not under any pressure to approve any of the applications yet. That pressure won’t come until May 23, which is the deadline for the SEC to make a decision regarding Ark’s application. Similar to the bitcoin ETF, it’s unlikely the SEC would want to be seen as giving any individual applicant an advantage by approving one before the others. Ark’s deadline for its bitcoin ETF was January 10th, which turned out to be the date that the SEC approved them all. Had the SEC not done so, they would have had to deny Ark, which would have led to lawsuits. The same situation is unfolding this May. The SEC will have to make a decision, and unless they can come up with a legally justifiable reason to deny, they may just decide to approve them all at once, just like they did with the bitcoin ETF.
So, there is a high likelihood we will get an Ethereum ETF approved, perhaps as soon as this May. But what about other tokens? If ETH gets approved, does that open the floodgates for every other cryptoasset? In short, no.
It is extremely unlikely we will get any ETF other than Ethereum approved any time soon because none of the other cryptoassets have the pre-existing conditions that bitcoin and Ethereum have. There are no regulated futures markets in the U.S. outside of BTC and ETH. There are no futures-based ETFs for other cryptoassets in the U.S. In addition, many of the next largest candidates after BTC and ETH were named in various SEC lawsuits as securities. It’s very unlikely the SEC would sue the exchanges and then turn around and approve those very same assets they listed without requiring those assets to register with the SEC first (not that there is a way for cryptoassets to register with the SEC to begin with but that’s beside the point for this article).
It’s very likely that the SEC will work to carefully craft a precedent in the bitcoin and Ethereum approvals that allows them to retain some discretion in deciding which crypto ETFs will be allowed to enter the market. The bottom line is that there is no clear path for any asset other than ETH to be approved for a spot ETF. Maybe someday in the future, but definitely not in 2024, and unless one of the other cryptoassets is willing to take the SEC to court, not likely in 2025 either.
In Other News
Ethereum throughput reaches record high as burn rate drives down ETH supply.
BlackRock’s bitcoin ETF hits $1B AUM in one week.
DyDx becomes the top decentralized exchange by volume.
According to the Chainalysis report, crypto crime was down 29% last year, and illicit revenue was also down 54%.
FTX sold about $1B of Grayscale’s Bitcoin ETF, accounting for about half of the outflows of GBTC.
How Bitcoin mining saved Africa’s oldest national park from bankruptcy.
$3.1 trillion in illicit funds flowed through the traditional global financial system in 2023.
Bitcoin breaks back above $41,000 amid slowing GBTC outflows.