August 13, 2018
On July 26, 2018, the Securities and Exchange Commission (SEC) denied an application for a rule change that would have allowed the Bats BZX Exchange, Inc. to list and trade shares of the Winklevoss Bitcoin Trust, primarily because it viewed Bitcoin, the underlying asset, to be vulnerable to fraud and market manipulation. The Securities Exchange Act of 1934 directs the Commission to disapprove a proposed rule change of a self-regulatory organization (SRO), such as BZX, if the Commission finds that the proposed rule change is inconsistent with the requirements of the Exchange Act and the rules and regulations applicable to the SRO.
Commissioner Hester M. Peirce, in a stinging and thought-provoking dissent, said that the Commission incorrectly applied a statutory standard, and that its action “sends a strong signal that innovation is unwelcome in our markets.”
In June 2016, BZX filed a proposed rule change with the SEC, seeking to list and trade shares of the Trust. The Commission, acting through delegated authority, disapproved the proposed rule change in March 2017, citing concerns about liquidity and the potential for market manipulation of the underlying asset, Bitcoin. BZX filed a petition seeking Commission review of the denial. In March 2018, the Commission sought public comment on its denial.
The Commission’s Denial
After conducting a de novo review of the BZX proposal, the SEC concluded that the proposal is not consistent with Section 6(b)(5) of the Exchange Act, which, among other things, requires that a national securities exchange be designed “to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.”
The Commission rejected BZX’s argument that its proposal is consistent with Section 6(b)(5). BZX argued that the “geographically diverse and continuous nature of bitcoin trading makes it difficult and prohibitively costly to manipulate the price of bitcoin” and, therefore, the bitcoin market is generally less susceptible to manipulation than the equity, fixed income and commodity futures markets.
The Commission also said it believed that exchanges should enter into surveillance-sharing agreements with markets that underlie a proposed exchange-traded company. Here, the Commission said, BZX failed to enter into a surveillance-sharing agreement with the bitcoin exchanges, thus depriving it of a valuable tool to discourage and prevent market manipulation.
The Commission went to great lengths to emphasize that its denial of the application is not a reflection on whether bitcoin or blockchain technology has utility or value as an innovation or an investment. Rather, the Commission said, the denial simply reflects its belief that BZX has not demonstrated to its satisfaction that the proposal is consistent with the requirements of Section 6(b)(5), particularly that its rules “must be designed to prevent fraudulent and manipulative acts and practices.” Moreover, the Commission noted that a “substantial majority” of bitcoin trading occurs on unrelated, overseas venues and that the bitcoin derivatives markets are not sufficiently developed.
In her dissent, Commissioner Peirce said that she believed that the proposed rule change satisfied the Section 6(b)(5) statutory standard. She said that the SEC “erroneously reads” the statutory requirement, which requires the rules of a national securities exchange to be “designed to prevent fraudulent and manipulative acts and practices [and] to protect investors and the public interest.” The Commission, she said, evaluated the underlying bitcoin market, rather than the ability of the exchange to prevent market manipulation.
Commissioner Peirce took issue with the Commission’s overall approach to evaluating the BZX proposed rule change:
“I am concerned that the Commission’s approach undermines investor protection by precluding greater institutionalization of the bitcoin market. More institutional participation would ameliorate many of the Commission’s concerns with the bitcoin market that underlie its disapproval order. More generally, the Commission’s interpretation and application of the statutory standard sends a strong signal that innovation is unwelcome in our markets, a signal that may have effects far beyond the fate of bitcoin ETPs.”
The SEC’s denial of the BZX, and Commissioner Peirce’s dissent, underscore the disagreement among market participants on how the regulators should apply the federal securities laws to cryptocurrencies and funds that seek to invest in them. This debate is not likely to be resolved any time soon.