Serendipity and Self-Regulation: The Case of Cryptocurrency-Based ETPs

Cryptocurrency enthusiasts rejoiced when the Securities and Exchange Commission (SEC) approved the listing of bitcoin – and ether-based exchange-traded products (ETPs) – on U.S. stock exchanges earlier this year. There is yet a certain irony in this outcome: Why did the cryptoasset community advocate for the regulation of cryptocurrency products as a security when it generally resists regulation of cryptocurrencies themselves (and by extension, other cryptoassets) as a security? Part of the answer is that classification as a “security” not only imposes obligations (offering and disclosure rules, antifraud and anti-manipulation rules, trading regulation) but also affords substantial privileges (broad accessibility to retail and institutional accounts).

In a recent essay, I argue that we often overlook the role of securities and futures exchanges and other self-regulatory organizations (SROs) in managing these trade-offs. SROs, as the cartilage of financial markets, add value by adapting regulatory structures to new products, transactions, and circumstances. These processes may serendipitously lead to new ways of thinking about balancing innovation, competition, and investor protection. In particular, cryptocurrency-based ETPs trace their provenance to two distinct strands of SRO innovation: first, the development of exchange-traded commodity-based trusts; and second, the financialization and retailization of bitcoin-based products through self-regulatory exchanges and execution facilities.

The development of the exchange-traded commodity-based trust reflects over 40 years of negotiations among the SEC, the stock exchanges, and the investment fund industry. Since the first passively managed exchange-traded index fund was launched in 1992, securities exchanges have proposed incremental but ambitious listing standards for products involving specialized indexes, active management strategies, nontransparent portfolios, and non-securities holdings. In assessing these standards, the SEC has calibrated its conditions for listing, including the availability and adequacy of arbitrage opportunities, information regarding portfolio composition or valuation, and joint surveillance agreements. For some ETPs, the SEC has used its authority to grant exemptions from federal securities laws to impose terms; for others, the SEC has negotiated with SROs through its authority to approve SRO rules.

The transformation of bitcoin from an alternative currency to a retail financial instrument, meanwhile, transpired through a graduated series of self-regulatory markets under federal securities and commodities law. SRO suitability rules, for example, held back the infiltration of cryptoasset products into traditional markets while the SEC and the Commodity Futures Trading Commission (CFTC) vied for jurisdiction over them. Meanwhile, CFTC-regulated execution facilities sought to demonstrate that bitcoin derivatives had a legitimate economic purpose and that traditional market structures were up to the task of allocating associated market risk.

More to the point, Congress’ determination to streamline SRO rule-approval processes over the past two decades may have effectively tipped the burden of persuasion toward greenlighting new products. One may question the wisdom of these decisions – ostensibly to improve the competitiveness of for-profit exchanges post-demutualization – and whether they have exposed the public to flawed or systemically risky products. It is nevertheless unsurprising that the CFTC chose not to publicly challenge the self-certification of bitcoin futures by the CME Group and Cboe in 2017 (after heightened review behind the scenes).

Once bitcoin futures were launched, the SEC could no longer maintain that bitcoin-linked instruments were not traded in “regulated markets of sufficient size” – a pivotal condition for listing commodity-based ETPs. In 2022, the SEC approved bitcoin futures ETPs for stock exchange listing, which redoubled pressure to approve the listing of spot bitcoin ETPs. Over the SEC’s protestations, in Grayscale Investments v. SEC, the D.C. Circuit found that petitioner’s spot Bitcoin ETP was “materially similar, across relevant regulatory factors, to the approved bitcoin futures ETPs” such that the SEC’s “unlike regulatory treatment of like products [was] unlawful.”[1] Rather than risk another roll of the dice, the SEC approved bitcoin spot ETPs (and ether-based ETPs) shortly thereafter.

The mere fact that SRO incentives, processes, and facilities paved a path to the approval of bitcoin- and ether-based ETPs, of course, does not prove that the resulting regulatory framework is optimal, or even applicable to all cryptoassets. Conversely, the fact that a regulatory framework is “serendipitous does not make it any less desirable.”[2] Viewed in light of legislation pending in Congress and alternative regulatory models, self-regulatory processes may well have fashioned a more pragmatic framework for regulating and allocating jurisdiction over cryptoassets than anything Congress can concoct.

Consider the SEC’s mandate to compel issuer disclosures and to police securities markets for fraud and insider trading. The SEC maintains that issuer-based disclosures are necessary as long as promoters, developers, or other “active participants” control or dominate the operation of a cryptoasset’s associated digital ledger or entity. Meanwhile, the Financial Innovation and Technology for the 21st Century Act – which has passed the House but is stalled in the Senate – would strip the SEC of jurisdiction over cryptoassets once they are fully “decentralized.” Perhaps the SEC might be game to implement an “issuerless” disclosure regime for decentralized assets on its own initiative – comparable to current bitcoin- and ether-based ETP disclosures – if it can oversee decentralization through the SRO approval process.

One might similarly weigh the trade-offs with respect to investor protection. Listing standards tied to the integrity of associated futures markets and evidence of near-perfect correlation between futures and spot trading may well serve as a proxy for an assessment of institutional and retail suitability. The SEC might also consider whether the ETP custodial structure provides better-tailored protection against the blockchain’s vulnerabilities than parallel efforts to upgrade customer safeguards to hold cryptoassets in retail brokerage accounts. While the SEC itself cannot check the manipulation of spot markets by concentrated blockholders, the CFTC and other federal regulators arguably have an equally compelling interest in protecting digital ledgers from falling into the control of malevolent actors.

The D.C. Circuit’s reasoning in Grayscale, moreover, may open the door to indirect SEC oversight of cryptoasset market mechanisms. Under its listing approvals, the SEC has required ETP sponsors to disseminate an intraday trust value in order to track and enforce the relationship with the ETP’s market price. For bitcoin, these data feeds have evolved from rates based on one or more cryptoexchanges to more elaborate third-party indexes that synthesize prices from multiple trading venues. Arguably, the SEC may pursue further refinement in the quality of cryptocurrency market data through its continuing role in the approval of ETP listing rules. Moreover, were professional ETP trading to outstrip futures trading, or eventually to lead price discovery in spot market trading, the SEC might be able to leverage the threat of delisting to demand additional price discovery guardrails.

Reasonable minds may differ as to whether SRO processes have struck a viable framework for regulating retail cryptoasset trading. Even so, Congress might well reflect on whether it is preferable to regulate cryptoasset markets through the SRO rule-approval process, rather than undertake a wholesale revision of federal securities and commodities law to accommodate them. The SEC in turn might consider whether it can more effectively carry out its investor protection mandate through oversight of stock exchange listing rules and continued collaboration with the CFTC and futures exchanges, rather than aggressively testing the scope of its authority through enforcement.

More generally, the evolution of cryptocurrency-based ETPs demonstrates how SROs and SRO processes contribute to financial innovation. SROs have their detractors, and the constitutionality of self-regulation has of late come under renewed judicial scrutiny. But self-regulatory bodies uniquely have both a commercial incentive to develop and accommodate innovative products and the regulatory tools and obligations to ensure that such products and the markets in which they trade serve the public interest. Developing new products and markets within an SRO framework may thus reveal opportunities for collaboration and coordination that we might otherwise never imagine on our own.

ENDNOTES

[1] Grayscale Invs., LLC v. SEC, 82 F.4th 1239, 1252 (D.C. Cir. 2023).

[2] John C. Coffee, Jr., Market Failure and the Economic Case for a Mandatory Disclosure System, 70 Va. L. Rev. 717, 733 (1984).

This post comes to us from Onnig H. Dombalagian, the John B. Breaux Chair in Law and Business and George Denègre Professor of Law at Tulane University School of Law. at Tulane University School of Law. It is based on his recent article, “Serendipity and Self-Regulation: The Case of Cryptocurrency-Based ETPs,” available here.

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