Grayscale Wins Court Battle Against SEC: Can Spot Bitcoin ETFs Be Far Behind?

Abstract

Initially, GBTC was designed with a redemption feature. However, on October 28, 2014, the U.S. Securities and Exchange Commission (SEC) suspended GBTC's redemption mechanism. Currently, investors who subscribe to GBTC face a 6-month lock-up period, after which they can only trade on the secondary market.

On August 30, 2023, a federal appeals court ruled that the SEC was wrong to reject Grayscale Investments' application to create a spot Bitcoin exchange-traded fund (ETF). On the same morning when the ruling was announced, Digital Currency Group (DCG) and Genesis reached an in-principle deal with creditors.

Based on available data, at least 16 Bitcoin-related ETF applications are awaiting regulatory approval. The SEC has a maximum of 240 days to decide on these applications. If the SEC grants three extensions, it will be mandated to issue a final verdict, either approving or rejecting the applications.

According to a senior ETF analyst at Bloomberg, there's a 75% likelihood of a Bitcoin spot ETF being introduced this year, and a strong 95% probability of it launching no later than the end of 2024.

Grayscale Investments: An Overview

Grayscale Investments, a US-based digital asset management company, was founded in 2013. It is renowned as one of the global pioneers in introducing cryptocurrency investment trust funds. Grayscale provides investors with an alternative avenue for investing in digital assets, without the necessity to directly purchase and store cryptocurrencies. From 2013 to 2017, Grayscale's flagship offering was the Bitcoin Investment Trust (BIT), crafted to offer investors a streamlined method of investing in Bitcoin. BIT enabled investors to indirectly participate in the Bitcoin market by purchasing shares in the trust.

With the ongoing development of the cryptocurrency market, Grayscale has consistently expanded its product offerings, introducing a diverse range of trust funds for various digital assets, such as ETHE, LTCN, ETCG, BCHG, and more. Among these offerings, the Grayscale Bitcoin Trust (GBTC) has stood out as one of their most prominent and successful products. Grayscale caters to a wide and diverse customer base, including individual investors, institutional investors, hedge funds, family offices, retirement plans, and various other investment institutions.

How Does Grayscale's Trust Products Operate?

Grayscale's products, designed as trusts, provide a convenient avenue for both institutional and individual investors to enter the cryptocurrency market, while mitigating the risks and complexities of directly holding and managing digital assets. Let's use GBTC as an example to delve into how Grayscale's trust products operate.

Initially, GBTC was designed with a redemption feature. However, on October 28, 2014, the SEC suspended GBTC's redemption mechanism due to concerns about potential manipulation of GBTC redemption prices. Grayscale accepted this decision in 2016 and relinquished the profits generated from redemption fees. (Note: Prior to this suspension, Genesis, a subsidiary of DCG and a sibling company of Grayscale, played a central role in managing GBTC's buyback and cancellation operations.)

At present, investors subscribing to GBTC encounter a 6-month lock-up period. After this period, they are unable to redeem BTC directly from Grayscale but can only trade the shares in the secondary market. While this arrangement reduces GBTC's liquidity in the secondary market, it also prevents concentrated redemptions during bearish market periods. Since the removal of the redemption feature, GBTC has somewhat decoupled from the price of BTC. The price of GBTC is now influenced by trading activity in the secondary market. During bullish BTC market conditions, GBTC may trade at a premium, whereas in bearish BTC markets, it may trade at a discount.

When investors purchase GBTC shares, they acctually acquire shares representing a specific quantity of Bitcoin. The exchange rate typically stands at 1 GBTC share for 0.00095 BTC. Grayscale is responsible for securely safeguarding the Bitcoin assets corresponding to GBTC, and they charge an annual management fee of 2%. In terms of investor eligibility, GBTC is subject to regulatory restrictions in the United States. It can only be purchased by qualified individual and institutional investors who meet specific criteria outlined by U.S. securities regulations, including accreditation as investors. These criteria are designed to ensure that investors meet certain financial thresholds and possess the necessary experience and knowledge to engage in such investments.

Grayscale's Ties with Its Parent Company DCG

The year 2022 witnessed a significant downturn in the cryptocurrency market, leading to substantial losses for various cryptocurrency institutions. Notably, even the renowned crypto empire DCG was not exempt and faced a liquidity crisis. In December 2022, Bitvavo, a Dutch cryptocurrency exchange, announced that it was unable to access €280 million (approximately $297 million) worth of assets held within DCG. On January 2, 2023, Cameron Winklevoss, co-founder of Gemini, took to social media to allege that DCG owed Genesis approximately $1.675 billion. He claimed that Barry Silbert, the founder of DCG, misappropriated these funds, stating, "You used this money to fuel greedy share buybacks, illiquid venture investments, and kamikaze Grayscale NAV trades..."

To tackle the crisis, DCG had to resort to sell its cryptocurrency holdings, including FIL, ZEN, ETC, and NEAR, as well as shutting down its subsidiary companies, such as the institutional trading platform TradeBlock, in order to raise funds. Despite DCG's best efforts to cut costs, the situation remained dire. Grayscale alone may hold the key to DCG's salvation.

According to official documentation from Grayscale, as of September 30, 2022, DCG, Genesis, Coindesk, and several affiliated companies jointly held a significant amount of GBTC assets, totaling 66,972,899 GBTC shares, which represents approximately 10% of the circulating shares. However, due to the restrictions imposed by Rule 144 under the Securities Act of 1933, these entities were limited to selling only 1% of the total circulating shares to the public market every three months. Grayscale, while heavily influenced by its parent company DCG, functions as a distinct legal entity with independent fund management. To address DCG's liquidity crisis, Grayscale has also initiated a "rescue mission".

Grayscale's "Rescue Mission" and Its Lawsuit Against the SEC

Grayscale's "rescue mission" revolves around two primary strategies. The first strategy involves striving to convert GBTC into a Bitcoin ETF. If successful, this conversion would reestablish the correlation between GBTC and the price of Bitcoin, effectively addressing the current discount issue in trading GBTC shares on the secondary market. This move would substantially strengthen DCG's financial position, alleviating its liabilities. Hence, Grayscale has taken legal action, initiating litigation with the SEC. In the event that the first approach proves unsuccessful, Grayscale will explore the possibility of conducting a tender offer to repurchase the circulating shares already issued. In this scenario, Grayscale would utilize its funds to buy back GBTC shares from the open market, assisting DCG in managing the GBTC holdings that cannot be immediately sold. This injection of liquidity serves to support DCG in sustaining its operations and addressing its immediate needs.

In December 2022, as reported by The Wall Street Journal (WSJ), Grayscale's CEO, Michael Sonnenshein, clarified the following points in a letter to investors: If the conversion of GBTC into a Bitcoin ETF falls through, they will explore the possibility of conducting a tender offer to repurchase already-issued circulating shares. During a specified timeframe, investors would have the opportunity to sell their GBTC shares at a specific price. While there is no set timeline for this repurchase, they have made preparations for all scenarios. Initially, they estimate repurchasing approximately 20% of circulating shares. However, the final terms of the repurchase would be subject to approval from both the SEC and shareholders. If the initial attempt proves successful, they may consider additional tender offers.

On August 30, 2023, according to court documents, a three-judge panel of the District of Columbia Court of Appeals in Washington overturned the SEC decision to block Grayscale's ETF. The court deemed the SEC's rejection of Grayscale's proposal arbitrary and inconsistent, as the SEC failed to fully explain its reasoning and the differential treatment of similar products. As a result of this development, the negative premium on GBTC substantially narrowed. On the same morning when the ruling was announced, DCG and Genesis reached an in-principle deal with creditors. The agreement outlined that unsecured creditors would receive recoveries ranging from 70% to 90% of the dollar value, while physical recoveries would range from 65% to 90% based on the face value of the digital assets. Overall, DCG's "rescue mission" has proven remarkably effective.

How Far Away Are We From A Bitcoin ETF?

After Grayscale won its lawsuit against the SEC, the U.S. regulator announced on September 1st that the approval timeline for spot Bitcoin ETFs would be postponed. The approval for at least three spot ETFs proposed by WisdomTree, Valkyrie, and Invesco has been deferred until at least mid-October. As of September 5th, data shows that there are at least 16 ETF applications related to Bitcoin awaiting regulatory approval, and these companies have not withdrawn their applications.

After initiating the review process, the SEC has a total of 240 days to reach a decision on the application. During this review period, critical decisions must be made at several key time milestones: at 45 days, 60 days, and 90 days. If the SEC grants three extensions, it will be mandated to issue a final verdict, either approving or rejecting the applications. Once the 240-day period expires, the SEC will no longer have the authority to further postpone the decision as per the established procedure.

Bloomberg analyst James Seyffart stated on August 15th that the review deadline in early September might not lead to a decision. He emphasized that the greater focus should be on the final deadline of January 10th. Eric Balchunas, Bloomberg's senior ETF analyst, suggests that potential delays in ETF applications by the SEC shouldn't come as a surprise. He points out that there's still room for the SEC to make concessions, ultimately resulting in the approval of these applications. He predicts that there's a 75% likelihood of a Bitcoin spot ETF being introduced this year and a strong 95% probability of it launching no later than the end of 2024.