Beyond Bullish: What SEC’s ETF Approval Really Means for Bitcoin By Richard Reinhardt, Merkle Science Lead Investigator

This article will explain what SEC-approved spot bitcoin ETPs are and how they will impact the corporate governance policies of issuers, the trading behavior of retail investors, and investment activity and adoption of the cryptocurrency as a whole. 

The Path to ETP Approvals  

In the rush to celebrate the SEC’s approval of 11 spot bitcoin exchange-traded product (ETP) shares on January 10, 2024, most outlets overlooked the build-up that led to the landmark decision. The Securities and Exchange Commission had previously denied 20 filings for spot bitcoin ETPs between 2018 and 2023. 

One of the applicants, Grayscale, took the matter to the U.S. Court of Appeals for the District of Columbia in Grayscale Investments LLC v. Securities and Exchange Commission. In the court documents, Grayscale argued that “the Commission acted arbitrarily and capriciously by denying the listing of Grayscale's proposed bitcoin ETP and approving the listing of materially similar bitcoin futures ETPs.” This argument was about the bitcoin futures, which had been approved in 2022 under the 1933 Act. 

The U.S. Court of Appeals for the District of Columbia remanded the matter back to the SEC, citing that the agency had failed to provide adequate rationale for disproving the listing. With the matter back on the table, SEC Chair Gary Gensler conceded that approval of Grayscale’s filing and those for other spot bitcoin ETP shares is “the most sustainable path forward.”

It’s important to clarify what the SEC exactly approved. Several outlets have used the terms ETP and exchange-traded fund (ETF) interchangeably, but there bears some distinction. An ETP is the broader category term, and an ETF is a particular sub-type. ETPs refer to financial instruments that “track underlying security, index, or financial products.” In the case of bitcoin, when a retail investor buys shares of an ETP, it is “backed by its net assets, in this case bitcoin, held by a custodian on behalf of the trust.” In contrast, ETFs are a “pooled investment security” that tracks a “particular index, sector, commodity, or other assets.” 

The confusion between the two terms is because most ETPs are structured as ETFs, which are registered with and regulated by the SEC as investment companies under the Investment Company Act of 1940. They differ, however, in their investment focus, with most ETFs generally focusing on investments in stocks or bonds and have diversification requirements. In contrast, ETPs, including the SEC-approved spot bitcoin ETPs, invest in commodities, currencies, or commodity- or currency-based instruments such as futures and do not fall within the mandate of the Investment Company Act of 1940. SEC-approved spot bitcoin ETPs are instead registered in accordance with section 8(a) of the Securities Act of 1933.

The SEC-approved spot bitcoin ETPs give retail investors exposure to Bitcoin without the necessary hassle of direct ownership and all the concomitant risks that it brings, which will be discussed later in this article. This newfound access may be particularly appealing to certain investor segments, such as Millenials and Zoomers. 

“Bitcoin is beginning to become a benchmark asset for the younger generation. We know most investors can’t beat benchmarks, so adding the new benchmark to your asset allocation is the only way to try to keep up,” said Anthony Pompliano, the founder of Pomp Investments, which may create a US$50 to US$100 billion inflow into the US$30 trillion wealth management industry. 

What the SEC approval means 

For the legitimization of Bitcoin and cryptocurrency 

Many journalists, analysts, and experts held up the SEC approval as evidence that the agency is becoming increasingly pro-crypto. This view is misguided. The SEC is neither pro-crypto, nor anti-crypto. Its mandate is to protect investors, maintain fair markets, and facilitate capital formation, which will necessarily require an evolving stance toward different financial products, cryptocurrency included.

To the extent that the SEC has an ideological stance toward cryptocurrency, it is that most digital currencies are indeed securities, a position that the agency even reiterated in its recent announcement. 

“As I’ve said in the past, and without prejudging any one crypto asset, the vast majority of crypto assets are investment contracts and thus subject to the federal securities laws,” wrote SEC Chair Gary Gensler.

This view is evident in the SEC enforcement actions over the previous year, which should serve as a weighty counterbalance to the idea that the agency has gone pro-crypto and that the spot bitcoin ETF will instantly legitimize bitcoin. Most notable were its actions against unregistered offerings, such as those by Nexo, who had to pay a US$22.5 million civil penalty, and unregistered exchanges, including prominent names such as Binance and Coinbase. In February 2023, the SEC filed charges against Terraform and CEO Do Kwon for defrauding investors, a lawsuit that eventually led the firm to file bankruptcy less than a year later. 

In this view, the advent of the SEC-approved spot Bitcoin ETPs should not necessarily be viewed as a legitimization of Bitcoin. This turning point was caused purely by institutional pressure, which brought down the rather spurious reasoning the SEC previously gave and was publicly criticized by Commissioner Hester Pierce.

“The Commission, rather than admitting error, offers a weak explanation for its change of heart. In the past, the Commission, allowing our prejudice against the underlying asset to get in the way, has rejected applications on the basis that the bitcoin market was still immature and that there were outstanding manipulation concerns,” she wrote. 

As a result, the approval should be viewed as merely an opportunity for broader acceptance of cryptocurrency-based financial products, albeit within a stringent regulatory framework: How the market responds will be the sole arbiter in whether the spot bitcoin ETFs truly bring the currency into the mainstream. 

For ETF issuers 

The initial group of 11 ETF issuers have an enormous business opportunity: They can capture the enormous demand for bitcoin from investors who previously put off the investment due to concerns with holding the digital currency. In fact, one survey from Bitwise and VettaFI in fact found that 88% of financial advisors were waiting to trade bitcoin until only after a SEC-approved spot bitcoin ETPs was passed.

There is a caveat: The ETF issuers must also now take on greater responsibility. The first is in the area of corporate governance. The issuers must “provide full, fair, and truthful disclosure” about the ETFs, including information pertaining to the underlying assets, associated risks, and related fees. In addition, the issuers must list the products on securities exchanges registered in the United States that operate under rules designed to prevent fraud and manipulation, which the SEC will continually monitor. Furthermore, there will be standard rules and standards of conduct that apply to the purchase and sale of SEC-approved spot bitcoin ETPs, including regulating best interests for broker-deals and upholding fiduciary duty under the Investment Advisers act for investment advisers. 

The issuers must also prioritize cybersecurity. All of the issuers will use a third-party custodian to store and hold the bitcoin. Because this role is paramount, issuers should give preference to custodians that have a strong track record of digital cybersecurity. Such accounts for why most of the issuers chose Coinbase as its custodian, which has yet to have a public hack. The concentration of so much bitcoin to a single custodian, however, presents its own risks, which 

Halbourn Chief Operating Officer David Schwed warned about in an op-ed for CoinDesk.

“What worries me is the extreme asset concentration in a single custodian. And given the cash-like nature of crypto assets, that makes the situation inherently concerning,” he wrote. 

Given the supreme importance of both corporate governance and cybersecurity, regtech will take an even more important role. ETF issuers must use regtech to ensure compliance with SEC’s new policies and standards of conduct. ETF issuers must use market surveillance to monitor custodial wallets and accounts to ensure that the funds represented by the ETFs are safe and secure. At Merkle Science, we welcome collaboration with ETF issuers in addressing this challenge head-on, just as we have helped regulators and law enforcement agencies with their regtech needs. 

Because there are so many demands of ETF issuers, there may be some market consolidation to maximize the business opportunity around ETFs. Such has already transpired: Valkyrie Funds, which was one of the ETF issuers approved by the SEC, was purchased by CoinShares just three days later. There may be additional market shake-ups as brokerages target ETF issuers as their inroads into cryptocurrency, or as cryptocurrency marketplaces nab ETF issuers to expand their portfolio in the space.

For consumers

These new SEC-approved spot bitcoin ETPs give retail investors unprecedented access to Bitcoin. Instead of having to go through a separate, rigorous know-your-customer process for a cryptocurrency exchange, they could trade Bitcoin through any US-based brokerage that offers the SEC-approved spot bitcoin ETPs. Users must meet the requirements to open an account with a US-based brokerage, which includes an assessment of their investment knowledge, tax status, and more. 

This ability also dramatically lowers the technical expertise necessary to hold Bitcoin. Previously, retail investors had to not only sign up for a cryptocurrency marketplace but also go through the trouble of storing the cryptocurrency in a hot or cold wallet. 

This kind of personal custodianship was notoriously susceptible to different types of failure, including unintentional loss (i.e. a person could lose their private keys) and malicious theft (i.e. there are many scams and hacks targeting wallets). 

Because these failures were common, bitcoin has gotten a reputation - deservedly or not - as a risky investment to hold. The 11 new SEC-approved spot Bitcoin ETPs eliminate these risks, giving exposure to Bitcoin without any of the technical hurdles or security concerns. The fact that 11 SEC-approved spot bitcoin ETPs were approved also gives retail investors a selection of choice on which issuer they would like to use as their entry point into spot bitcoin.

When access is improved to any financial instrument, trading activity will likely increase. This is what people naturally anticipated with the emergence of the SEC-approved spot bitcoin ETPs, including that it would likely surpass the previously released bitcoin futures. Reuters analyst Hannah Lang pointed out that some experts predict the trading volume could reach US$55 billion within five years. 

What the experts did not anticipate was that some SEC-approved spot Bitcoin ETPs, such as the one issued by Blockrock, are outperforming Bitcoin itself. This fact suggests that there may indeed be more trading activity around Bitcoin, but only through the SEC-approved spot Bitcoin ETPs themselves and not via direct ownership. This also serves as a stark counterpoint to the idea that the SEC-approved spot bitcoin ETPs will drive greater adoption and usage of bitcoin as a form of currency. If retail investors are primarily drawn to SEC-approved spot bitcoin ETPs rather than the underlying asset, it is clear that investors still view bitcoin as a financial instrument for buying and selling, not as a currency for spending and transacting. 

The SEC-approved spot bitcoin ETPs will dramatically change the landscape for ETF issuers, who must abide by strict new regulations; consumers, who may invest more into SEC-approved spot bitcoin ETPs than bitcoin itself due to greater accessibility; and for crypto legitimization as a whole, which may continue to see a further boost but within a tighter regulatory landscape.