The SEC has rejected another crypto ETP, but applicants say approval is slowly approaching

The Securities Exchange Commission (SEC) blocked the last remaining bitcoin exchange trade fund (ETF) proposal last week, but industry players say approval is still on the horizon.

Industry sources say most innovative ETFs walked a meandering road to approval, with some taking years before the SEC finally relented – an assessment that perhaps makes the rejection-riddled path to a bitcoin ETF appear somewhat less discouraging.

The last hope – for now

Most recently, Wilshire Phoenix thought they'd cracked the code by seeking a solution to the volatility problem.

When the asset management group introduced its exchange trade product (ETP) proposal back in January of 2019, they proposed hedging volatile bitcoin with the stability of short-term Treasury bills, changing the allocations in the basket each month by tracking bitcoin price fluctuations. After the SEC delayed in December, the regulator rejected the proposal on Wednesday.

"As the Commission has explained, exchanges that list ETPs can meet their obligations under Exchange Act Section 6(b)(5) by demonstrating that there is a comprehensive surveillance-sharing agreement with a regulated market of significant size relating to the underlying assets,” read the decision. "Neither NYSE Arca nor the Sponsor challenges this standard."

Commissioner Hester Peirce disagreed, publishing a dissent that argued the regulator is continuing to apply an "inappropriate standard" concerning Section 6(b)(5). 

"As exchanges refine their filings to address the Commission’s concerns, the Commission responds by requiring increasingly granular analyses of the relevant markets and by requiring exchanges to establish that these markets possess characteristics that the Commission has required in no other market," read Peirce’s dissent.

Wilshire Phoenix supported Peirce’s argument, publishing a statement Friday that expressed disappointment. Peirce’s dissent encapsulated consumer frustration, according to the firm’s managing partner, William Herrmann.

Herrmann said that as of last week, Wilshire Phoenix is reviewing the details of the rejection order. As the group parses through the SEC’s decision, Hermann said the firm is "considering all possible routes" at this stage. 

Learning from failure

Still, a rejection isn’t all bad, according to Matt Hougan, global head of research at Bitwise and chairman of Inside ETFs.

With each rejection order, including the 76-page disapproval of the Wilshire Phoenix proposal, the SEC further clarifies the standards it is setting for crypto. Rather than moving the goalpost, these rejection orders further refine where it actually exists.

Peirce's dissent expressed otherwise, though, accusing the SEC of shifting standards out of skepticism.

"This line of disapprovals leads me to conclude that this Commission is unwilling to approve the listing of any product that would provide access to the market for bitcoin and that no filing will meet the ever-shifting standards that this Commission insists on applying to bitcoin-related products—and only to bitcoin-related products," she wrote.

While Hougan said he found Peirce's argument compelling, he also sees the SEC rejections as consistent, with each one honing in further on a particular sticking point.

"I'm also sympathetic to the staff, which is that pretty clearly in our [Bitwise] order and with increasing clarity and this Wilshire Phoenix order, you know what they are looking for," he said, adding:

"And people may say that that's different than what they looked for in prior orders on commodity ETF and all those sorts of things, and that may be true, but the Bitcoin market is also its own market."

A lineage of rejections

The increasing clarity can be traced through a lineage of rejections, according to Hougan.

The Winklevoss ETF rejection showed the burden as showing a market of significant size. The Bitwise bid included research that called into question what significant size meant, indicating that the bitcoin spot market was relatively small compared to the futures market of the Chicago Mercantile Exchange (CME). 

The Bitwise rejection further showed that relative size still wasn’t quite the heart of the concern; instead, it was a lead-lag relationship, with the SEC looking for evidence that CME often leads other markets. Hougan said this seems to remain the sticking point in the rejections.

"My personal read is they've been relatively consistent in what they want since the Winklevoss order, which said that they want a demonstration that a nationally regulated market, which effectively at this point just means the CME Bitcoin futures market, leads other markets some preponderance of the time," he said.

Wilshire Phoenix felt they demonstrated this within their proposal. Herrmann told The Block that the firm spent significant time and money to produce what they felt was sufficient analysis of the lead-lag relationship between the bitcoin futures market and the underlying spot market. Because the previous rejection orders highlighted the lead-lag relationship, Herrmann said they took pains to clear each test laid out by the SEC successfully.

"That was essentially ignored by the Commission, even though they said it was central to the analysis and prior rejection orders," he said. "So we took it very seriously. When we see and are told that it's central to an analysis that we spent a lot of time and money on preparing that analysis."

The Wilshire Phoenix proposal aimed to answer the market manipulation concerns and surveillance requirements by leveraging the surveillance already conducted on the price benchmark used to set CME bitcoin futures or by diminishing the market to those who contribute under the auspices of New York's BitLicense. According to Hougan, the SEC's rejection indicates that manipulation concerns will apply to the whole bitcoin spot market, not just key actors, and surveillance will need to be satisfied by more traditional surveillance agreements.

Some, like Peirce and Herrmann, perceive this continued clarification via rejection as a means of relocating the finish line. 

"The Commission keeps moving the goalposts every time there's a decision," said Herrmann. "So it looks to me as a sponsor or applicant, or whatever the case may be, it's an incredibly difficult process, especially when you have a Commission that isn't fully engaged with it as a sponsor or the listing exchange."

Eric Ervin, CEO of Blockforce Capital, saw similar challenges when applying for a bitcoin ETF. After filing the application in February 2019, Blockforce, then Reality Shares, withdrew the application days later, citing general opposition of the SEC staff to a crypto ETF. 

Ervin said that many of these recent applications had solved the concerns initially raised by the SEC at the start of the bitcoin ETF debate. Other, non-crypto ETFs trade baskets of futures and the growth of the crypto market and infrastructure has assuaged much of the custody and pricing concerns.

While at the time of the Winklevoss proposal, these concerns held more weight, at this point, Ervin said it does seem the rejection orders move the finish line with each decision. 

Worth the wait

Ervin is less optimistic about seeing an approval under the current administration. Just as Peirce’s dissent blasted the Commission’s so-called “stubbornness in the face of innovation,” Ervin pointed to a change in leadership as a route to approval. The eventual retirement of chair Jay Clayton could be a tide-turning moment, according to Ervin. 

Despite the frustration of the crypto community at the lack of approval, an extended wait-time is common in the ETF game, according to Ervin and Hougan. Ervin’s first ETF, based on dividend swaps, took nearly three years to gain approval. A gold ETF wasn’t approved until 2004.

Still, a years-long approval process is seemingly incompatible with a market that grows and innovates as fast as the crypto space. 

"We're used to instantaneous solutions, and the ETF space moves a little bit slower and that can be frustrating," Hougan said. "But I actually think sort of the pace of progress has been has been good."

Still, both Hougan and Ervin struck optimistic tones about an eventual approval. Hougan said it remains a question of when as opposed to if.

Ervin said products approved by other markets also incentivize the SEC, as domestic players point out the success of similar products. At this point, it’s mostly a matter of public opinion, according to Ervin.

"We're getting very, very close because a lot of the clearest objections have been solved," said Ervin. "And time is one of the things that heals a lot of this."