(Bloomberg) - The risks of creating a new way for retail investors to pour money into cryptocurrency markets are at the heart of a court fight Tuesday between Grayscale Investments LLC and a top US financial regulator.
Grayscale wants to convert its $14 billion Bitcoin Trust, the largest investment vehicle tied to the No. 1 cryptocurrency, into an exchange-traded fund. But the Securities and Exchange Commission rejected the plan in June, saying cryptocurrency markets are too ripe for fraud and manipulation. Grayscale sued, asking a federal appeals court to overturn a decision the company called arbitrary.
The legal battle before a three-judge panel in Washington has big implications for the crypto industry because it could clear the way for similar ETFs, fueling a major expansion of the market by making it easier for everyday investors to bet on the success or failure of digital assets.
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“Allowing an ETF means anybody with a brokerage account — which is basically available to anybody who can fog a mirror in the US — can now speculate on Bitcoin,” said James Angel, an associate finance professor at Georgetown University. Angel signed on to one of the amicus briefs in support of Grayscale.
Arguments at the DC Court of Appeals will hinge on whether ETFs backed directly by Bitcoin are any riskier than ETFs already approved by the SEC that are linked to cryptocurrency futures contracts. Grayscale claims there’s little difference, while the government says futures, unlike spot Bitcoin, are traded on a public exchange with federal oversight.
The court case is a major test for the SEC, which has taken an aggressive stance toward the crypto industry, including through increased enforcement following the collapse of several companies, including FTX, last year. The SEC has claimed that most digital assets are securities that have to be registered with the agency.
US regulators are concerned the next crypto disaster might have greater repercussions if digital-asset businesses grow large enough to affect the broader financial system, which was mostly insulated from the current crisis.
For Grayscale, the stakes are high. The trust has effectively operated as a closed-end fund that didn’t redeem shares when prices fell, which left the trust trading at discounts of more than 40% to its underlying Bitcoin. The structure of an ETF allows shares to be created and redeemed to keep pace with shifting demand. A conversion could unlock $6 billion in value, according to Elliott Stein, senior litigation analyst with Bloomberg Intelligence.
The steep discount on the Bitcoin trust, which trades under the symbol GBTC, has been at the center of recent lawsuits. Rival Osprey Funds claims Grayscale misled investors by saying the conversion to an ETF was a “forgone conclusion.” Investment firm Fir Tree Capital Management claims there’s no legal reason that stops the trust from allowing investors to exit.
Grayscale called the Osprey suit “frivolous” and said in response to Fire Tree that it remains “100% committed to converting GBTC to an ETF, as we strongly believe this is the best long-term product structure for GBTC and its shareholders.”
‘Preventing Redemptions’
Alameda Research, the bankrupt trading arm of FTX, also sued this week, alleging “exorbitant management fees” and accusing Grayscale of “improperly preventing redemptions” from the Bitcoin and Ether trusts it manages. Grayscale said the claim was “misguided” and that it “has been transparent in our efforts to obtain regulatory approval” for the conversion to an ETF.
The case against the SEC is also important for Grayscale’s parent company, Digital Currency Group, which has a separate business unit that’s going through bankruptcy proceedings. Grayscale is a lucrative part of the DCG empire, raking in millions of dollars in fees each year. Its Bitcoin trust holds about 3.3% of all Bitcoin in circulation as of Dec. 31, according to a company filing.
In court filings, Grayscale accused the SEC of being “arbitrary and capricious,” as well as discriminatory, for rejecting the Bitcoin ETF when the regulator already allows ETFs based on futures contracts. Both Bitcoin and the futures derive their pricing from the same underlying markets, the company said.
“It’s just a classic case of taking like cases and treating them differently,” Don Verrilli, Grayscale’s lawyer, told reporters last week in a preview of his argument.
The SEC argued that an ETF based on Bitcoin, which trades on unregulated markets, doesn’t meet the same standards for oversight as funds based on futures, which trade on the Chicago Mercantile Exchange. The CME is regulated by the government and “performs extensive surveillance of the trading activity on its market,” SEC lawyers said in court filings.
Close Case
Stein, the Bloomberg Intelligence analyst, predicted Grayscale had just a 40% chance of prevailing in the case.
“The court will be somewhat loath to substitute its own view for that of the SEC’s,” Stein said. “Though a surveillance-sharing agreement with a regulated futures market like the CME is sufficient to help detect fraud and manipulation affecting a related futures-based ETF, it’s not clear to us that it would do the same for a spot-based ETF, even though Bitcoin spot prices underlie both types of ETFs.”
Grayscale’s team remains confident they can persuade the judges to overturn the SEC ruling.
“The more you get into the specifics, the stronger our case gets,” said Verrilli, who was US solicitor general during the Obama administration and successfully argued the government’s position in landmark Supreme Court cases on same-sex marriage and the Affordable Care Act.
The DC Circuit judges are likely to reach their decision in the coming months, meaning a resolution could come as early as this summer. Even then, however, the case could be far from over as Grayscale has indicated it’s willing to appeal all the way to the US Supreme Court if needed.
The case is Grayscale v. SEC, 22-1142, US Court of Appeals for the District of Columbia Circuit.
By Allyson Versprille and Sabrina Willmer
