SEC Points to 'Unregulated' Spot Market in First Oral Arguments Against Grayscale

Government regulators argued that bitcoin's unregulated nature leaves investors open to fraud Tuesday, as Grayscale Investments continues to fight to convert the largest Bitcoin investment fund into an exchange-traded fund (ETF).

The asset manager is seeking to overturn a previous ruling that prohibited it from converting its Grayscale Bitcoin Trust (GBTC) into an ETF. Grayscale Investments and the Securities and Exchange Commission (SEC) presented their first oral arguments to the U.S. District Court of Appeals Tuesday morning, and the asset manager is hoping to get a ruling before the July 6 deadline for the SEC to accept or reject its application.

SEC Bases Its Defense on ‘Unregulated’ Spot Markets

In Grayscale Investments, LLC v. SEC, both parties are seeking to differentiate between the spot market and futures market for Bitcoin.

The SEC has now rejected multiple spot ETF applications for Bitcoin funds on the grounds that the applicants have failed to demonstrate that the investing public will be protected from “fraudulent and manipulative acts and practices.”

However, the SEC began permitting Bitcoin futures ETFs in October 2021. In Tuesday's hearing, a lawyer for the regulator said it was “undisputed” that the spot markets for Bitcoin are “fragmented and unregulated." 

Futures-backed ETFs, on the other hand, are traded on the regulated CME futures exchange and have "surveillance sharing" agreements. Lawyers for Grayscale questioned the benefits of that surveillance, arguing that manipulation of the spot markets would ultimately show up in futures contract prices.

As of March 6, the Grayscale Bitcoin Trust (GBTC) had approximately $14 billion of assets under management (AUM). The GBTC discount to its net asset value had fallen to 42%, the lowest level in a month, ahead of the arguments. This is often referred to in crypto markets as the "Grayscale discount" and the asset manager argues that an ETF would close the arbitrage gap.

FTX Trading Firm Sues Grayscale

In a separate development yesterday, the bankrupt FTX exchange said its affiliate Alameda Research is suing Grayscale for imposing a "redemption ban" that "could realize over a quarter billion dollars" in assets for its customers.

FTX argues if Grayscale had reduced its fees and not applied “improper” redemption measures, its shares would be worth nearly 90% more than the current value of those locked up with the asset manager.

"Our goal is to unlock value that we believe is currently being suppressed by Grayscale's self-dealing and improper redemption," said FTX's interim CEO John J. Ray III.

FTX claims that relief on redemptions would, "unlock a combined $9 billion or more for shareholders and a quarter of a billion dollars" for the bankrupt company.

"FTX customers and creditors will benefit from additional recoveries, along with other Grayscale Trust investors that are being harmed by Grayscale's actions," Ray added.

The Bottom Line

The Grayscale V. SEC case could either see vindication for the SEC's stance or open the door to a flood of applications for spot bitcoin exchange-traded funds.

Other companies rejected by the regulator include Fidelity, SkyBridge Capital, and Valkyrie Investments Inc. More recently, in January 2023, the SEC denied a spot ETF application by Ark Invest and 21Shares.

Grayscale's focus on the ETF decision will now be tested by the FTX lawsuit as it fights on two different fronts.

Correction—March 8, 2023: A previous version of this article incorrectly labeled risks in the spot market as a part of the Key Takeaways.