The 'real' bitcoin market might not be real, and is still prone to manipulation: a look at SEC's rejection letter to Bitwise

The writing was on the wall that Bitwise's filing for a bitcoin exchange-traded fund would be denied.

For starters, the Securities and Exchange Commission (SEC) has never approved one before, so Bitwise's bitcoin ETF application being accepted would have been a precedent-setting first. Another harbinger came less than a month ago, when fellow applicant Van Eck withdrew its own bitcoin ETF application from consideration.

So it was perhaps no big surprise when Bitwise received its rejection earlier this week. But hope springs eternal in the world of digital assets, the firm noting that a denial at least forced the SEC to explicitly outline its qualms about ETFs tied to the crypto market. Specifically, the agency's 112-page rejection letter provides clarity that could pave a path forward for Bitwise and its peers to eventually obtain the elusive approval, according to Bitwise head of research Matthew Hougan. 

Here are the key takeaways from the agency's rejection letter:

Bitcoin is not inherently resistant to market manipulation

In March, Bitwise made headlines with its research finding that “95% of bitcoin trading volumes are fake.” The dichotomy of “fake” vs. “real” volumes was a core point in Bitwise’s proposal. The firm's argument is, even though there are "fake" volumes in bitcoin trading, the remaining "real" market is manipulation-resistant and efficient. However, the SEC cast doubt on Bitwise's research, questioning whether the 5% market the firm identifies is indeed “real.” 

Moreover, since Bitwise admitted that wash trading and price manipulation permeates the 95% “fake” market, the SEC is concerned that misleading prices in the “fake” trading volumes could influence price discovery on the “real” market.

The SEC thus concludes that bitcoin is not inherently resistant to market manipulation, as Bitwise claimed in its March report. Consequently, the agency feels the need to have a surveillance mechanism in place to guarantee investors are protected against fraud and price manipulation in the cryptocurrency market.

Surveillance-sharing agreement

The SEC observes that currently, there are no surveillance-sharing agreements in the cryptocurrency trading market. Surveillance-sharing agreements allow a group of exchanges to share their data to detect and prevent fraud and market manipulation. The regulator argues that having such an agreement in place would protect consumers even when the manipulated prices from the "fake" market influence the "real" one. 

To be sure, derivatives marketplace CME and NYSE Arca have an existing surveillance-sharing agreement, mostly for trading traditional assets. However, the SEC found this agreement insufficient. 

According to the SEC, a surveillance-sharing agreement can suffice only when it is made with “a regulated market of significant size.” In other words, the agreement NYSE Arca has with CME, a derivatives platform, is only effective when the derivatives market plays a major role in price discovery. On the other hand, if the majority of price discovery is done on the spot market, a surveillance-sharing agreement between spot exchanges is needed. 

Since it is unclear to the SEC whether the size of the derivatives market is "significant" enough to lead the price discovery, the regulator deems it necessary for spot exchanges to enter into a surveillance-sharing agreement. 

Next Steps

Although no one knows whether a surveillance-sharing agreement or better proof of bitcoin's inherent resistance to manipulation can win the SEC's approval, one thing is certain: Bitwise will not give up on a bitcoin ETF.

“There is nothing fundamental in the bitcoin market that precludes it from having a bitcoin ETF,” Hougan told The Block. 

Asked if the inverse was true, that there is also nothing fundamental in the bitcoin market that necessitates a bitcoin ETF, Hougan conceded, saying that bitcoin can perform well with or without an ETF. However, he stressed that a bitcoin ETF could give retail investors exposure to an asset class that seems intimidating at times. 

“We are fundamentally bullish on bitcoin,” Hougan said.