On the Spot: Remarks at “Regulatory Transparency Project Conference on Regulating the New Crypto Ecosystem: Necessary Regulation or Crippling Future Innovation?”

The topic of today’s event is “regulating the new crypto ecosystem.” It is a hot topic of conversation in Washington, DC. The conversation reminds me of a book for toddlers, Are You My Mother?[1] In that book, a newly hatched bird searches for his mother. He asks a cat, dog, hen, cow, and front-end loader, each of which disappoints the baby bird with the news that it is not the baby bird’s Mom. Rest assured, baby bird and his actual mother are finally reunited. The crypto industry seems to be on a similar journey; only it is not looking for a mother, but is out looking for its regulator. In a bureaucratic twist on the story in the children’s book, in our story, every agency claims to be the regulator. So crypto is looking to Congress to decide who ought to regulate it. A bipartisan bill announced last week attempts to answer that question.[2] Some people in the crypto industry are celebrating the allocation of certain authorities to the Commodity Futures Trading Commission (“CFTC”) instead of the Securities and Exchange Commission (“SEC”). This view is likely rooted in a disappointment that the SEC has not used more proactively the authorities it already has to sensibly regulate crypto. I understand and share that disappointment, but I am hopeful that we can change course and use our existing and any prospective authorities wisely.

Watching the SEC refuse over the past four years to engage productively with crypto users and developers has prompted feelings of disbelief at the SEC’s puzzling, out-of-character approach to regulation. The Commission, of course, occasionally has explained its actions—or inaction—but those explanations often have been confusing, unhelpful, and inconsistent. I have communicated my discomfort with the Commission’s behavior to my colleagues and the public, though the results to date seem to be underwhelming: the agency continues to brush off crypto products and services seemingly without consideration for the consequences. A concrete example, and the one on which I will dwell for a few minutes today, is the Commission’s persistent refusal to approve a spot bitcoin exchange-traded product.

Before going any further, let me give you a few important disclaimers. First, the views that I am expressing are my own views and not necessarily those of the SEC or my fellow Commissioners. Second, this speech is not an endorsement of bitcoin, bitcoin exchange-traded products, or any other crypto-related asset. People—exercising skepticism great enough to quell the dangerously seductive fear of missing out—should choose what to put in their portfolios when and in what quantities. Whether assisted by a financial professional or flying solo, investors should invest based on factors such as their own present and anticipated future circumstances, informed risk assessments of the asset they are considering buying and the portfolio of assets in which it will sit, and a candid gut-check of their stomach for market volatility and financial loss. They should be aware, as recent events illustrate, that past performance of an asset is no guarantee of future performance. People should not look to regulators to make investment decisions for them, and regulators should not seek to play that role. Third, although many of the early bitcoin exchange-traded product denials were issued by the staff under authority delegated from the Commission, my criticisms about these denials and other policy choices are leveled at the Commission, not the staff. The staff appropriately is following the Commission’s lead, and the Commission has not been leading well.

1. It is time for the Commission to stop denying categorically spot crypto exchange-traded products.

The Commission’s resistance to a spot bitcoin ETP is becoming almost legendary. “When is the Commission going to approve a bitcoin exchange-traded product?” is one of the most frequent questions I get. For the last four years, my answer has been approximately the same, “I have no idea,” tinged with a note of disbelief. Although bitcoin is a new asset, the concept of affording access to commodities through an exchange-traded product is not new. The Commission long has allowed investors to gain exposure to a number of non-securities instruments through these pooled investment vehicles, which have been a boon to investors, as their shares trade continually on national stock exchanges at market prices, much as a regular stock would. Through a process of creating and redeeming shares of the fund, institutional traders called authorized participants help to keep the price of these shares in line with the price of the assets in the investment pool.

The Commission has added crypto-specific hurdles to what used to be fairly straightforward processes for approving these pooled investment vehicles—whether exchange-traded funds (ETFs) under the Investment Company Act of 1940 (1940 Act) or commodity-based exchange-traded products (ETPs) under the Securities Act of 1933 (Securities Act). Indeed, although in the past eight months both ETFs and ETPs based on bitcoin futures have begun trading, the Commission has continued to disapprove ETPs based on the spot bitcoin market.

The reasons for this resistance to a spot product are difficult to understand apart from a recognition that the Commission has determined to subject anything related to bitcoin—and presumably other digital assets—to a more exacting standard than it applies to other products. In a 2018 letter, for example, the Division of Investment Management expressed a willingness to engage with 1940 Act fund sponsors interested in incorporating crypto assets into their funds, but outlined “significant outstanding questions concerning how funds holding substantial amounts of cryptocurrencies and related products would satisfy the requirements of the 1940 Act and its rules.”[3] Those questions related to custody, valuation, liquidity, the arbitrage mechanism for ETFs, and manipulation and other risks. Asking these questions is not inherently problematic and might even be characterized as positive because it sparked important thought on these issues. The Commission, however, gave few external indications of progress on grappling with, let alone resolving, these issues.

Retail funds that tried to incorporate exposure to bitcoin into their portfolios encountered a series of challenges. The disclosure review process plays an important investor protection role, but the Commission has many subtle ways of exercising merit regulation, often without a clear legal basis for doing so. Certain funds looked for ways to get exposure to bitcoin, such as holding over-the-counter products, investing in companies with crypto exposure, or putting small sleeves of bitcoin futures in their portfolios. Closed-end funds, which do not provide daily redemption, were the first to incorporate bitcoin futures. But even as late as May 2021, the staff reminded closed-end funds “seek[ing] to invest in the Bitcoin futures market to consult with the staff, prior to filing a registration statement, about the fund’s proposed investment, anticipated compliance with the Investment Company Act and its rules, and how the fund would provide for appropriate investor protection.”[4] The statement acknowledged that some open-end funds “are investing or seek to invest in Bitcoin futures and these funds believe they can do so consistent with” the securities laws, but warned that the staff would be watching their regulatory compliance and the effect of these funds’ “investments in Bitcoin futures on investor protection, capital formation, and the fairness and efficiency of markets.”[5] Review to ensure that funds clearly disclose risks is an important Commission function, as is watching what is happening in the markets, but when we attempt to step into the shoes of the marketplace to assess whether a fund’s holdings are unacceptably risky, we have gone too far. The Commission appropriately works with fund sponsors to ensure that they disclose what kinds of assets funds are holding and the associated risks, but we have no authority to tell funds that they cannot hold particular assets.

Although a number of funds managed to hold bitcoin futures, many sponsors wanted to provide exposure to bitcoin in an exchange-traded form. The Commission continued to signal to would-be sponsors of such products that it would not look favorably if they sought to register such products. In October 2021, however, the SEC finally allowed futures-based bitcoin ETFs to begin trading. Enabling the change was a clear signal from Chair Gary Gensler, who pointed to the 1940 Act protections, along with the CFTC’s oversight of the futures markets, as a key basis for his comfort with such products.^[6] These funds proved popular, but demand for a spot-based product remains because futures products are more expensive to manage and may not as closely track the spot price.

Until this year, all of the futures-based exchange-traded products that were approved fell under the 1940 Act. In April of this year, however, the Commission approved the first non-1940 Act ETP holding bitcoin futures for listing and trading on an exchange. This approval implicitly acknowledged that the protections afforded by the 1940 Act are not relevant to the question of whether approval under the Securities Exchange Act of 1934 (Exchange Act) is appropriate. The protections the 1940 Act affords are, as industry commenters have highlighted, “designed and intended to protect investors against self-interested managers.”^[7] In other words, as another commenter described, “the 1940 Act’s protections do not address and thus are not relevant to the concern the Commission has repeatedly invoked to deny [Exchange Act] Rule 19b-4 applications for spot Bitcoin ETPs . . . : market manipulation and fraud in the underlying Bitcoin market.”^[8] Some observers found this development notable because spot-based bitcoin products would likewise be Securities Act products that would need to be approved by the Commission for listing and trading on an exchange under the Rule 19b-4 process. The Commission still has not approved any ETP based on the spot bitcoin market.

Despite the success of futures-based ETP applicants over the past eight months, using the same tired reasoning, the Commission keeps denying spot bitcoin ETPs. The Commission requires an applicant, which is the exchange on which the ETP will be listed, to demonstrate that its proposal is consistent with the requirements of Exchange Act Section 6(b)(5), and in particular, the requirement that the rules of a national securities exchange be “designed to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.”[9] In demonstrating consistency with Section 6(b)(5), the exchange applying to list the ETP has a choice—show a surveillance agreement or a unique resistance to manipulation.[10]

The first option is for the exchange to show that it has a comprehensive surveillance-sharing agreement with a regulated market or group of markets of significant size. An acceptable surveillance-sharing agreement would provide for the unimpeded sharing of information about market trading activity, clearing activity, and customer identity. Significant market size is determined, for example, by showing a reasonable likelihood that a person attempting to manipulate the ETP would have to trade on that market to successfully manipulate the ETP. Only then would a surveillance-sharing agreement assist in detecting and deterring misconduct. One way that a market could count as being significant in size is if it is reasonably likely that a person seeking to manipulate the ETP would also have to trade on that market to succeed in doing so and if trading in the ETP would be unlikely to be the predominant influence on prices in that market.[11]

Alternatively, the exchange seeking to list the ETP can show that the underlying bitcoin markets are uniquely resistant to fraud and manipulation. The standard requires a level of resistance higher than what exists in traditional commodity markets or equity markets.

According to a majority of the Commission, no exchange successfully has made the case using either approach. An ETP disapproval order issued last month embodies the now standard denial rationale. The exchange here opted for alternative two—showing that the bitcoin markets are uniquely resistant to fraud and manipulation:

As with the previous proposals, the Commission here concludes that the Exchange’s assertions about the general liquidity, growth, and acceptance of the bitcoin market do not constitute other means to prevent fraud and manipulation sufficient to justify dispensing with the requisite surveillance-sharing agreement. While the Exchange states that the significant liquidity in the spot market and resultant minimal impact of market orders on the overall price of bitcoin mitigates the risk associated with potential manipulation, such assertion is general and conclusory.[12]

The reasoning underlying the Commission’s denials of spot bitcoin ETPs is itself general and conclusory, which makes it difficult to know how approval could be achieved. The Commission does not grapple seriously with important characteristics of these products and the underlying spot markets, including the widely distributed nature of trading in bitcoin and the methods used by these ETPs to calculate their net asset value. It does not take into account the evidence from other jurisdictions where regulators have approved similar products. Absent a wholesale rejection of its now standard analysis, how does the Commission put itself in a position where it could approve these products? With each new disapproval, the SEC doubles down on its reasoning.

The continuing refusal of the SEC to approve a spot bitcoin ETP is puzzling to many agency observers. The bitcoin market has grown, matured, become more liquid, and attracted more, and more sophisticated (in the traditional financial market sense of the word), participants. At thirteen years old and as of about an hour ago, bitcoin has a market cap of approximately $430 billion and is trading at around $22,500.[13] Bitcoin investors comprise natural persons and institutions, including regulated market participants. Many insurance companies, asset managers, university endowments, pension funds, large banks, and public companies have invested in bitcoin or are considering doing so. Increasingly sophisticated infrastructure has built up around bitcoin and crypto markets more generally. Like the traditional finance landscape, the crypto terrain is dotted with trading platforms, trading firms, venture capital firms, hedge funds, law firms, and accounting firms. In contrast to 2018 when the Division of Investment Management wrote that “we are not aware of a custodian currently providing fund custodial services for cryptocurrencies,”[14] custodians now compete to offer their services.[15] A cornerstone of institutional participation, bitcoin futures have been trading in the United States since late 2017. The daily notional value of open interest in the Chicago Mercantile Exchange (“CME”) bitcoin futures market hovers around $1.7 billion.[16]

Spot ETPs have launched in other countries without incident and with great investor interest. In Canada, for example, the first spot bitcoin ETP reached $1 billion Canadian dollars in assets under management a month after launch in 2020.[17] Spot crypto ETPs are also popular in Europe, where there are more than 70 crypto ETPs with an estimated total of $7 billion in assets.[18] ETPs in these other jurisdictions have functioned, even in volatile markets.[19]

Why is the SEC a holdout? At what point, if any, does the increasing maturity of the bitcoin spot markets and the success of similar products elsewhere tip the scale in favor of approval? Of course, the facts and circumstances of each application matter, but will I ever stop hearing that well-worn question: “When a spot bitcoin ETP?”

The approval of futures-based products first under the 1940 Act and more recently of a similar Securities Act product for listing and trading under the Exchange Act might appear to open a door to changing course on spot-based products, but the language of these orders provides precious little basis for optimism that the Commission will approve a spot bitcoin product. The futures-based approvals turn on the regulated nature of the futures market, the CME, which is where the assets held by the ETP themselves trade. The Commission explains, somewhat tautologically, that the CME “can reasonably be relied upon to capture the effects on the CME bitcoin futures market caused by a person attempting to manipulate the proposed futures ETP by manipulating the price of CME bitcoin futures contracts.”[20] This reasoning obviously does not apply to spot-based products, and it is difficult to see how it is even relevant for an instrument that trades on hundreds of exchanges worldwide.

It is true that, in these approvals, the Commission reiterated its position that its concerns about the lack of a surveillance-sharing agreement in filings seeking to list and trade spot-based ETPs could be addressed “by demonstrating that there is a reasonable likelihood that a person attempting to manipulate the spot bitcoin ETP would have to trade on the CME,”[21] but the Commission also went out of its way to state that the evidence does not demonstrate this type of connection between the two markets—an observation that was not necessary to the Commission’s approval of the futures-based ETPs.[22] Perhaps the Commission could be persuaded that the similarity of pricing mechanisms for the futures-based product and the spot-based product undermines its rationale for treating them differently. The Commission’s willingness to be persuaded, though, turns on whether the Commission’s primary concern is legal and logical coherence with our approvals of bitcoin futures products and other commodity-based products and not, say, using the prospect of a spot bitcoin ETP approval as an inducement to get exchanges to come in and register.

Why does this matter? Investors might prefer a spot bitcoin ETP to other options, and we ought to care about what investors want. This kind of product, depending on how it is designed, could enable retail investors to gain exposure to bitcoin through a securities product that, because of the effective ETF arbitrage mechanisms, likely would track the price of spot bitcoin closely. It likely would be inexpensive to manage such a fund, so fees likely could be low. It could sit conveniently in investors’ brokerage accounts alongside other securities. It would allow investors to buy and sell their bitcoin exposure the same way they buy and sell other exchange-listed products. Investment advisers too would find it easier to assist clients seeking exposure to bitcoin if a straightforward spot-based ETP were available.

Some people might object to retail exposure to bitcoin, and thus might oppose a product that makes it easier for retail investors to get exposure to bitcoin. Making it harder to access bitcoin, however, does not mean investors will not find other ways of doing so. Some do and will continue to hold bitcoin directly. For the reasons I mentioned above, however, many investors want to get exposure to bitcoin through US securities markets. They have several options for doing so, but these methods can be a less direct and more expensive way to get exposure to bitcoin. They include holding shares of a fund that has bitcoin futures exposure, buying an over-the-counter product that lacks the arbitrage mechanism to keep prices in line with underlying bitcoin prices; buying a foreign spot-based ETPs, which are generally unavailable to U.S. retail investors;[23] or buying a bitcoin futures-based ETP, which is unlikely to track spot bitcoin exactly and may be more costly given the complexities in managing such a fund. Are we really serving investors by keeping them in products that only approximate the exposure they are trying to get and might cost more? The Commission has deemed this question as irrelevant in its consideration of ETP applications.[24]

Other people might object to a spot ETP on the grounds that its advocates stand to gain a tremendous amount when a spot ETP launches. Many advocates of a spot ETP are bitcoin investors who want to see the price go up. An ETP certainly could influence the price of bitcoin, but bitcoin markets do not always perform as people anticipate. A spot-based ETP, because of the ease with which it can be bought and sold, would be a way for more voices to weigh in on the value of bitcoin. Other types of ETPs have helped markets more efficiently incorporate information. Detractors of underlying ETP assets, therefore, can take comfort in the contribution that liquid, efficient markets play in working out the real value of those assets, whether they are shares of company, gold, or bitcoin.

Some bitcoin “hodlers” might themselves object to the introduction of a bitcoin ETP. One feature of a non-sovereign, censorship resistant mechanism for storing and transferring value is its ability to function outside of the traditional financial system. Why drag it inside tradfi and thus expose it to the meddling of incumbent financial firms and incumbent governmental regulators? To these people I say, the concern for liberty and personal autonomy that drives you to prefer “we-at” to fiat ought also cause you to reject a government that arbitrarily limits people’s investment options.

2. It is time for the Commission to embark on a more productive path to crypto regulation.

The Commission’s reluctance to approve a spot bitcoin ETP is of a piece with its more general reluctance to build a regulatory framework for crypto using standard regulatory processes. Instead the Commission has tried to cobble together a regulatory framework through enforcement actions. Enforcement is the appropriate tool to address the rampant fraud in the crypto space. One-off enforcement actions that represent the first time the Commission has addressed a particular issue publicly, however, are not the right way to build a regulatory framework. For that, Congress gave us other tools, including the authority to craft tailored exemptions and notice-and-comment rulemaking.

Enforcement actions short-cut the regulatory process. Consider the recent $100 million BlockFi settlement with the SEC and 32 states.[25] BlockFi is one of a number of companies that offers crypto lending products, which were determined to be securities products. The Commission, in its settlement, set out a path pursuant to which BlockFi could register under the Securities Act and register or take steps to qualify under an Investment Company Act exemption from registration. The specific path laid out in settlement agreement crafted between BlockFi and the SEC, if successful, is likely to become the standard for regulation of crypto lending. Other crypto lenders, users of those services, consumer advocates, and other interested parties were not part of those negotiations, but the results affect them.[26] A preferable approach would have been, once we identified crypto lending as implicating the securities laws, to commence a rulemaking or invite crypto lenders and other members of the public to come in and discuss the appropriate path forward through careful use of our exemptive authority. We might similarly consider, rather than a reactive enforcement approach, a proactive regulatory approach with respect to non-fungible tokens, stablecoins, decentralized exchanges, decentralized autonomous organizations, and other crypto innovations.

People doing things in crypto need to consider whether the laws, including the securities laws, govern their behavior. For this to happen in a more efficient and comprehensive way, the Commission needs to provide a level of clarity that heretofore has been absent. The SEC could think through issues with people in the crypto community with an eye toward achieving our regulatory objectives pragmatically. By doing so, we could both facilitate good actors’ compliance and inhibit bad actors much more effectively than we do through resource-intensive and delayed enforcement actions.

We have a number of suggestions and examples of how to proceed. My colleague Commissioner Caroline Crenshaw set up a special mailbox through which she solicited commentary about regulatory issues related to DeFi.[27] Why not make that a Commission-wide request for input? Similarly, J.W. Verret, in a recent petition to the Commission, recommended opening a comment file so that people could discuss open questions about how to reconcile our securities laws with today’s technology.[28] The Financial Accounting Standards Board, having heard a lot of concern about the current accounting standards for digital assets, recently opened a project to improve financial reporting for digital assets, including recognition, measurement, presentation, and disclosure.[29] A group of crypto lawyers has put together a number of concrete proposals—an iteration on my safe harbor proposal[30] and an exempt offering framework for digital assets[31]—that could be starting points for Commission regulatory action in this space. CFTC Commissioner Caroline Pham and I recently called for the two agencies to conduct joint roundtables.[32] Our two agencies have worked effectively in the past in areas where our jurisdictions are closely linked, and we can do so here also. Finally, a recent rule proposal that seems to implicate crypto platforms generated a number of comments from people and organizations willing to work with us on crafting an appropriate regulatory approach.[33] People stand ready to work through the myriad questions and regulatory concerns around crypto. Now all we have to do is extend them a hand.

3. Conclusion

Although, in today’s remarks, I have been quite critical of the SEC’s approach, I remain optimistic that we can change course. The agency just celebrated its 88^th birthday last week, and there is no better age than 88 to start grappling with difficult, interesting regulatory questions around crypto to keep the agency’s mind sharp.

Regardless of what one thinks of crypto, it is in both investors’ and the SEC’s interest to take a more productive approach. Using the tools Congress has given us and drawing on public input, we can provide regulatory clarity, facilitate iterative experimentation, and pursue bad actors in the crypto space. I am looking forward to the upcoming panel, which I hope will include discussion of ways in which we can make substantive progress on regulating crypto responsibly.