It’s been a busy year for cryptocurrencies and the regulators who oversee them. There were several concerning signs for proponents—for instance the price of Bitcoin has dropped more than $18,000 since its high in December 2017, highlighting the volatility of trading in crypto assets. In February 2018, Securities and Exchange Commission (SEC) Chairman Jay Clayton testified in a Senate hearing that every Initial Coin Offering he’d seen came within the scope of securities law, despite a lack of SEC enforcement action.
However, there were also bright spots for cryptocurrency promoters. Director of the SEC’s Division of Corporate Finance William Hinman indicated in a speech that cryptocurrencies like Bitcoin—and possibly Ethereum—do not qualify as securities, exempting them from a number of filing and disclosure requirements. Just last week, JPMorgan Chase announced it would become the first major U.S. bank with its own cryptocurrency.
Perhaps more importantly, SEC Commissioner Robert Jackson suggested that approval of an Exchange Traded Fund (ETF) for cryptocurrencies could be on the horizon. Commissioner Hester Peirce echoed that stance in remarks a few days later. As more actors enter the crypto field and the SEC reviews more applications for ETFs, it should seek to provide a greater level of clarity and consistency to crypto innovators and potential investors.
The SEC’s Wait-and-See Approach Causes Significant Uncertainty
The SEC has moved cautiously in determining the appropriate regulatory framework for cryptocurrencies. Simultaneously, however, it has demonstrated its interest in exercising regulatory authority over cryptocurrencies and the various financial products that base their value on those assets. To date, the SEC has been reluctant to issue official guidance, instead relying on unofficial statements from commissioners and high-level employees to provide the most reliable indicators of its positions on key issues.
In July 2017, the SEC released its report on The DAO, which concluded that tokens sold through The DAO were securities. That report, coupled with unofficial statements like those referenced above, have left the crypto industry with significant uncertainty regarding how the SEC will regard the status of particular cryptocurrencies, initial coin offerings (ICOs), and ETFs. Already, this regulatory uncertainty has caused at least one crypto developer to shutter its project, resulting in more than $133 million returned to investors. While the SEC has been equally cautious with crypto-based ETFs, a number of proposals remain under consideration.
The Appeal of a Cryptocurrency Exchange Traded Fund (ETF)
ETFs combine features of mutual funds and exchange-traded stocks. Essentially, ETFs seek to replicate the performance of a particular index or set of assets. Similar to a mutual fund, an ETF allows investors to pool money in a professionally managed fund. However, shares of any given ETF trade on stock exchanges and can be bought and sold over the course of a trading day. Unlike certain cryptocurrencies and tokens, ETFs are securities and are subject to certain regulatory requirements. These include registration and disclosure obligations, as well as certain statutory limits on leverage.
Some market observers have noted the “pent-up” demand for a Bitcoin ETF. That demand exists in part because crypto ETFs could present attractive options for multiple reasons. First, they would enable investors to diversify portfolios consisting of stocks and bonds, since cryptocurrency value has a low correlation with the value of more conventional products. Second, ETFs could provide some assurance to hesitant investors in that qualified managers would manage the funds, as opposed to potentially unknown developers who oversee particular cryptocurrencies. Third, an ETF may help decrease the risk of holding any one cryptocurrency since an ETF would reflect the overall market value for multiple currencies.
Initial SEC Reactions to Cryptocurrency ETFs
So far, however, proposals seeking SEC approval of cryptocurrency-based ETFs have not been met with success. Last August, the SEC rejected nine applications for Bitcoin ETFs because they were inconsistent with Exchange Act § 6(b)(5). In contrast, some European regulators have approved Exchange Traded Products comprised of various cryptocurrencies.
In a 2018 response to one application for a Bitcoin ETF, the SEC identified five concerns for that application, as well as any future application for a similar ETF. Those concerns include: (1) valuation, (2) liquidity, (3) custody and safekeeping, (4) arbitrage, and (5) manipulation and other risks. Many of these concerns are motivated by the significant volatility in crypto assets.
Specifically, for valuation and liquidity, the letter noted particular concern with the significant price fluctuation in cryptocurrencies like Bitcoin. These concerns may be especially pronounced given that the value of many cryptocurrencies tends to track the value of Bitcoin. Additionally, as regards safekeeping concerns, the SEC noted concern with protecting against cyber-attacks. Such an attack wreaked havoc on The DAO as well as the Ethereum network, prompting the SEC to issue its well-known report. Moreover, since ETFs inherently involve some level of arbitrage, the SEC noted the importance of ensuring that the fragmentation, volatility, and volume of cryptocurrency trading would not prevent a given crypto ETF from complying with SEC rules and orders.
Perhaps most significantly, the SEC expressed weariness that an ETF would provide adequate investor protections. Chairman Clayton has commented on the fact that cryptocurrency markets appear to offer fewer investor protections than more traditional exchanges. Additionally, given varying levels of investor sophistication, the SEC highlighted the need for an ETF to provide assurances that individual investors receive adequate safeguards.
A New Level of Openness to Crypto ETFs?
It would seem that, at least in some circumstances, SEC commissioners are willing to approve a crypto ETF. Commissioner Peirce has been the most vocal supporter of applications for a crypto ETF. In July, she provided the lone dissent to an SEC order disapproving a rule change sought by backers of cryptocurrency exchanges. As noted above, earlier this month she reiterated her position that the SEC should refrain from “impulsive[ly] running away from anything labeled crypto.”
In an interview earlier this month, Commissioner Jackson stated he expected an ETF would “satisfy the standards” the SEC has identified. While Commissioner Jackson felt some earlier proposals were not hard cases, he suggested future proposals could be more promising. Importantly, his comments indicate his approach is distinct from the views Commissioner Peirce criticized. These remarks lend further credence to the idea that the existence of a Bitcoin ETF is a question of when, not if. Indeed, his remarks elicited significant notice to that effect from cryptocurrency bloggers and commentators.
Even so, the official position SEC positions with regard to crypto ETFs remain murky, especially given continued questions of which cryptocurrencies do or do not constitute securities. The recent indications from Commissioners Jackson and Peirce are no doubt a welcome sign for Bitcoin advocates, but the SEC should do more to provide clarity and certainty to the industry. Whether this comes in the form of formal guidelines for crypto ETFs or ad hoc consideration of ETF proposals remains to be seen.