With a market cap valued at over a staggering $1 trillion, cryptocurrency’s (or “crypto(s)”) exponential market growth has led to a hotly debated, new-found regulatory force by the U.S. Securities and Exchange Commission (“SEC”). (Forbes). The SEC’s eager regulatory control over crypto has fueled legal battles, with the most recent development involving investors advocating for bitcoin exchange-traded funds (“ETF(s)”). (Aislinn Keely, Law360). The Commission has historically resisted investor’s efforts. (Hannah Lang, et al., Reuters). However, a recent District of Columbia Court of Appeals decision, dubbed a victory for plaintiff and digital asset management company Grayscale Investments (“Grayscale”), has proven hopeful to investors. Id. This post explores the Grayscale decision, the SEC’s and Grayscale’s respective arguments, and both the narrow and broad implications of the decision against the backdrop of the SEC’s position on cryptocurrency.  

The path to the recent Grayscale decision stems, in part, from the SEC’s regulatory scrutiny over cryptocurrency. (Roger Barton, et al., Reuters). Although crypto’s operation was largely independent from 2009 until roughly 2018, the SEC led a charge for regulatory oversight over all digital currency products. Id. This move was particularly prompted by the general recognition of crypto’s volatility, susceptibility to fraud, and lack of sufficient investor protections. Id. In 2021, current SEC Chair Gary Gensler asserted that the SEC considers crypto as a security under the “Howey Test,” derived from the Supreme Court case, SEC v. W.J. Howey Co. Id. Under the Howey Test, a digital currency is a security if it requires: (1) the investment of money, (2) in a common enterprise, (3) with a reasonable expectation of profits from the efforts of others. Id. Gensler, utilizing the Howey Test, claimed: (1) investors raise money to sell a token of sorts, (2) investors pool their assets to invest, and (3) the buyer expects a profit based on the efforts of promoters, or other third parties. Id. Moreover, in 2017, Gensler’s predecessor cautioned that crypto would likely fall under the category of securities and recommended registering it in accordance with securities laws. Id. Accordingly, as voiced by the two most recent SEC chairs, the SEC seeks recognition of crypto assets as securities to consequently adhere to applicable regulations. Id.

To this end, the SEC commenced legal battles against crypto creators under the Howey Test to argue that digital currency should be regulated. In 2019, the SEC commenced successful litigation against the instant messaging app, Kik, resulting in a $5 million penalty after Kik raised millions for its “Kin tokens” and failed to register the tokens as securities. Id. Meanwhile, in 2022, BlockFi agreed to a $100 million settlement after the SEC issued a cease-and-desist order for the platform’s failure to register its crypto interest accounts as securities. Id. Recently, in June 2023, the SEC charged Coinbase for failing to register the offer and sale of a crypto asset. (SEC). The SEC’s quickness to dish out fines and commence lawsuits shows its stance on crypto and subsequent crackdown on securities regulation. The SEC’s position may stem from its admonition to investors—warning them of crypto’s volatility and potential exploitation by fraudsters. (SEC). Despite the SEC’s warnings and successful litigation streak, recent lawsuits appear to tip the scales.

The Grayscale victory, along with another investor win in an SEC suit against blockchain developer Ripple Labs in a similar crypto-classification suit, hints at a potential shift in the SEC’s rigorous crypto oversight. (Brady Dale, Axios; Crystal Kim, Axios). Grayscale Investments sought to convert its Grayscale Bitcoin Trust into a spot ETF, listed on the New York Stock Exchange’s (“NYSE”) Arca market. (Hannah Lang, Reuters). Despite the SEC denying Grayscale’s application for failing to meet market manipulation prevention standards, Grayscale sued. (Hannah Lang, et al., Reuters; Hannah Lang, Reuters). The D.C. Court of Appeals ruled against the SEC, stating that the SEC was “wrong to reject Grayscale’s proposed bitcoin ETF,” citing the SEC’s prior approval of bitcoin futures ETFs founded on a market surveillance arrangement with the Chicago Mercantile Exchange (“CME”), the primary futures venue that monitors market conditions to prevent price manipulation (Hannah Lang, et al., Reuters; Hannah Lang, Reuters). Grayscale initially sought to list its bitcoin ETF on the NYSE Arca, but its counsel later proposed CME market oversight, arguing for its application acceptance based on the SEC’s prior approval of bitcoin futures ETFs through a CME oversight agreement (Hannah Lang, Reuters). Nonetheless, the court’s rationale, resulting in a seeming victory for bitcoin ETFs, offers a different kind of investment protection than the SEC emphasized when denying Grayscale’s application.

Grayscale sought to push its spot bitcoin ETF, as opposed to another vehicle, for heightened investor protection. Id. Bitcoin ETFs would provide investors the benefit of CME oversight, which can prevent market manipulation. Id. This added layer of protection is vital because most Americans invest in bitcoin through relatively less established and unregulated means. Id. Despite Grayscale’s rationale, the SEC asserted the firm, “lacks data to determine whether the CME futures surveillance agreement could also detect potential manipulation in the spot markets.” Id. The SEC’s argument comes from its historical denial of bitcoin ETFs. Id.

The SEC and Chair Gensler’s position on blocking the bitcoin ETF is rooted in crypto’s potential exposure to fraudulent activities. (Colin Wilhelm, The Block). That is, general crypto fraud and scams the SEC warns against, such as bogus coin offerings, pyramid schemes, and social media Ponzi schemes. (SEC). While Gensler has declined to comment directly on bitcoin ETF applications, in a July 2023 interview, Gensler vocalized concerns about fraud and manipulation in the crypto industry when asked about such applications, citing noncompliance with “time-tested” protections against such vices. (Colin Wilhelm, The Block). Based on Gensler’s comments, regulatory concerns and fraud point to the SEC’s historical blockage of bitcoin ETFs. Id. Nonetheless, the Grayscale ruling presents various potential implications.

The court’s ruling could lead the SEC to approve Grayscale’s ETF, dependent on different legal factors. First, both parties have 45 days to appeal the court’s ruling, and if successful, the case would go to the U.S. Supreme Court or an en banc panel review. (Hannah Lang, Reuters). If the SEC does not appeal, the court could require the SEC to approve the application or revisit the application. Id. If ordered to revisit the application, the SEC could reject it on other grounds. Id. Given the varying legal outcomes, one cannot assert with certainty that the product will be approved. At best, the Grayscale outcome may pave the way for other pending spot bitcoin ETF applications, from entities such as multinational asset management firm BlackRock, to financial services giant, Fidelity. (Hannah Lang, et al., Reuters). The court’s decision seemingly recognizes that Grayscale’s proposed spot bitcoin ETF is similar to the SEC’s approved bitcoin futures ETFs. As the SEC has a history of blocking ETF applications (Colin Wilhelm, The Block), I would argue the SEC will attempt to find inroads to continue to reject applications. Gensler and the SEC continue to seek overarching regulatory control over cryptocurrencies since the surge in digital currency and could simply wish to further assert control to safeguard against general fraud and market manipulation.

The SEC’s keenness to classify cryptocurrencies as securities has erupted into instances of doling out fines and lawsuits in the last four years—due to concerns about fraud and subsequent investor protection. (Roger Barton, et al., Reuters; SEC). The Grayscale bitcoin ETF decision is a seeming triumph for crypto investors who seek greater protection. However, the success of Grayscale’s product is uncertain amidst other bitcoin ETF applications as the SEC will likely seek the upper hand in its dance with the “digital dollar.”